Vol. 9, No. 2, Pg. 20. Finally, Real Tax Simplification: Check-the-Box Regulations Published by the IRS.

• Author: By Thomas C. Stanley, Fred L. Kingsmore Jr. and William G. Newsome III

South Carolina Lawyer

1997.

Vol. 9, No. 2, Pg. 20.

Finally, Real Tax Simplification: Check-the-Box Regulations Published by the IRS

20FINALLY, REAL TAX SIMPLIFICATION: Check-the-Box Regulations Published by the IRSBy Thomas C. Stanley, Fred L. Kingsmore Jr. and William G. Newsome IIIOn December 18, 1996, the Internal Revenue Service (IRS) accomplished what can be considered a rarity, at best: simplification of the federal income tax rules.

On that date, the IRS published final regulations, effective January 1, 1997, that change and streamline the way unincorporated business entities (such as limited liability companies (LLCs), partnerships and sole proprietorships) are classified for federal income tax purposes.

The entity classification regulations, more commonly referred to as the "check-the-box" regulations, allow most unincorporated businesses to elect whether they will be taxed as a corporation or as a pass-through entity (for example, a partnership or sole proprietorship) for federal income tax purposes.

The promulgation of the check-the-box regulations promises to eliminate much of the need for these contorted, tax-driven operating agreements.

THE PRIOR RULES

The check-the-box regulations replace the former entity classification regulations, also known as the Kintner regulations. Those regulations utilized a bulky, cumbersome four-factor test to determine if an unincorporated business entity was more appropriately taxed as a corporation or as a pass-through organization. The Kintner regulations dictated that any business entity possessing a majority of four corporate factors (limited liability, continuity of life, centralized management and free transferability of interests) would be taxed as a corporation.

Conversely, if the entity had two or fewer of these characteristics, it would receive pass-through treatment. Under the Kintner regulations, lawyers were forced to spend countless hours drafting operating agreements with the correct number of corporate factors to secure the optimal tax treatment for clients forming a limited partnership, LLC or other unincorporated business entity.

These provisions often had little relation to the true business needs of the affected organizations. Instead, the provisions were drafted with the sole purpose of cloaking an unincorporated entity with the appropriate number of corporate characteristics to attain the most beneficial tax treatment. The promulgation of the check-the-box regulations promises to eliminate much of the need for these contorted, tax-driven operating agreements.

THE CHECK-THE-BOX TEST REGULATIONS

As stated above, the check-the-box regulations replaced the four-factor Kintner test with an elective scheme designed to allow most unincorporated business entities to choose how they will be taxed. To be eligible for the elective regime, however, entities must satisfy three preliminary requirements.

First, the entity must be a separate entity for federal tax purposes. 26 C.F.R. § 301.7701-1(a). This is a question of federal tax law; the mere fact...