Volume 9 Issue 3
Check the Box
© by Tax & Business Professionals
Effective January 1, 1997, the IRS put into effect new
Regulations dealing with entity classification, which is a complicated way of saying,
"Is it taxed as a partnership or a corporation?"
What is this all about, and, more importantly, do I have to do
anything affirmatively with regard to the new Regulations? For most taxpayers and
entities, the answer is, "no."
From 1960 through last year, the IRS Regulations determining
whether an association or entity was taxed as a corporation or partnership looked at six
characteristics of businesses. The first two carrying on a business and dividing
profits applied equally to partnerships and corporations, so the IRS reasoned that
if three of the remaining four characteristics were present, then the entity was a
These four "corporate" characteristics were:
continuity of life, centralized management, limited liability, and free transferability of
interests. If you have ever read a private placement memorandum for a limited partnership
interest, you will have read about the last four characteristics ad nauseam.
As states adopted Limited Liability Company "LLC"
laws, the old "three out of four characteristics" test became increasingly out
of touch with reality. Limited liability, in varying degrees, is now available to many
partnerships and LLCs, and in many states, like Virginia, one person can own all of the
interests in an LLC. Despite the IRSs usual, congenital myopia, the "check the
box" rules are a refreshing step in the right direction.
If one disregards foreign entities, which this newsletter does,
the "check the box" approach is fairly simple. It depends on Form 8832,
technically called "Entity Classification Election," not "Check the
Box" as nearly all articles and speeches refer to it.
In reality, Form 8832 is a series of boxes to be checked, and
(if foreign entities are ignored) there are basically only two boxes (choices) for most
entities which elect to use the form.
For most unincorporated entities, there is no need to file the
form. This is because of the manner in which the default mechanism operates. By doing
nothing, most unincorporated entities will be taxed as pass-through entities.
If, for example, your entity is created as an LLC or
partnership, doing nothing (not filing Form 8832) will, by default, cause you to be taxed
as a partnership.
The Regulations begin the choice-making by defining essentially
what constitutes a "corporation." If your entity is a corporation, then it will
be taxed as such (unless an "S" election is filed).
Any entity that is not a corporation (or
considered to be one) is an "eligible entity." The choices on the Form relate to
three types of "Domestic Eligible Entities." These choices allow a domestic
eligible entity (i.e., an unincorporated entity) to elect to be taxed as a corporation or
as a partnership, while a single-owner eligible entity (such as a one-person LLC) can
elect to be taxed as a corporation or be disregarded as a separate entity (i.e, sole
proprietorship). By default, one-owner entities are taxed as sole-proprietorships.
Are You Puzzled Yet?
Probably you are now scratching your head, and puzzling over
why any entity that defaulted to "flow-through status" would elect to be
(double) taxed as a "C" corporation. Or perhaps you are wondering why a
single-owner entity would want to elect to have the entity disregarded for tax purposes?
The answers usually involve specific or unusual situations that
require careful planning. For example, combinations of corporations, individuals, or other
entities may have different needs that require the help of professionals. A relatively
short newsletter is not an appropriate medium for considering unusual needs.
Nearly all corporations, LLCs, or partnerships formed before
1997, where there is no doubt about the status of the entity, will not need to make an
Some states, like California (which are not
"piggy-back" states), are still holding out and it is not clear if they will
accept the "check the box" approach. If you are living or practicing in such a
state, you need to inquire locally.
If your entity is a "C" corporation, you cannot avoid
the double tax on liquidation by dissolving the corporation and electing a different
status using Form 8832.
The governing agreements for many partnerships and LLCs
organized before 1997 may contain termination or management provisions that were included
solely to insure taxation as a partnership under the prior Regulations. With the advent of
"check the box," these provisions are no longer necessary for tax classification
purposes and therefore can, if desired, be eliminated or changed.
Finally, the "check the box" rules do
not lessen the need to take correct administrative actions at the local level about things
like filing annual reports and the like.
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