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     Effective 01/01/97 the IRS adopted regulations which permit most domestic unincorporated business entities to elect whether to be taxed as corporations or partnerships. California followed this doctrine with passage of Senate Bill 1234. The election is made by checking a box on a tax form and has come to be known as "check the box" taxation ("CTB" in this overview). The CTB election, together with the recent emergence of limited liability companies ("LLC(s)") as available vehicles, creates entirely new perspectives on entity selection for both start ups and ongoing businesses.

Background

     For many years, business transactions sought to combine the liability protection afforded by a corporation with the pass through tax benefits of a partnership or sole proprietorship. The IRS position was that a partnership risked being taxed as a corporation if it possessed more than two of the following corporate characteristics: (i) limited liability; (ii) centralized management; (iii) free transferability of interests; and (iv) perpetual existence. The consequences of inadvertent corporate tax status were disastrous and for many years this was a guiding consideration in transaction structure, leading to exotic results (such as limited partnerships with corporate general partner(s)) many of which continue to exist.

     Most of the legislation creating LLCs is relatively recent (California LLCs have existed only since 1995) and is designed to comply with the traditional IRS position by ensuring the absence of at least two corporate characteristics: the transferability of LLC interests is typically restricted and the LLC itself has a limited life. With CTB these two characteristics are now irrelevant for tax classification purposes and LLCs are apparently free to adopt corporate look and feel without tax risk. Note that restricted transferability and limited life are in most cases imposed by the enabling statutes and will continue in effect until addressed by further legislation at the state level.

Check the Box Summary

     Entities which are organized as corporations under state law, certain listed foreign entities and various specified types of businesses (such as insurance companies and state chartered banks, no matter how organized) are ineligible for CTB and will automatically be taxed as corporations (26 CFR 301.7701-2). Those entities not specifically excluded are defined as "eligible entities" which are entitled to make the CTB election. (26 CFR 301.7701-3). In the business context, "eligible entities" will typically include sole proprietorships, general partnerships, limited partnerships and LLCs.

     An eligible entity with only one member can elect to be taxed as a corporation or to have the separate entity disregarded for tax purposes. If the separate entity is disregarded, the entity will be taxed as a sole proprietorship (if the single member or owner is an individual) or as a branch or division (if the single member or owner is a corporation). Eligible entities with at least two members can elect to be taxed as either a partnership or a corporation.

     Eligible entities that do not make an election will fall under the default rules. Absent an election, domestic eligible entities will be disregarded as separate entities if there is only one member and classified as partnerships if there are two or more members. The default status continues until an election is made. Thus, a newly formed California LLC will be taxed as a partnership unless and until it affirmatively elects to be taxed as a corporation. The default rules for foreign eligible entities depend on the existence of limited liability.

     The election is made on Form 8832. Once an election is made, it cannot generally be changed for sixty months, although the IRS is authorized to waive this limitation by private letter ruling if more than 50% of the entity’s ownership has changed hands. Form 8832 must be signed by all owners or by an officer, manager or member who is authorized to act on behalf of the entity and so represents under penalty of perjury. The filing entity can choose the effective date of the election which cannot be more than 75 days prior to or more 12 months after Form 8832 is filed.

Effect of Change in Classification

     The Regulations do not directly address the effect of a change in classification, but Form 8832 contains the following statement:

     The resulting tax consequences of a change in classification remain the same no matter how a change in entity classification is achieved. For example, if an organization classified as an association elects to be classified as a partnership, the organization and its owners must recognize gain, if any, under the rules applicable to liquidations of corporations.

     Presumably this would also apply to a partnership or LLC which elects to be taxed as a corporation and subsequently elects to revert to partnership tax status. Since corporations will usually be ineligible for the CTB election, most of the questions will arise in the context of a partnership or LLC which elects to be taxed as a corporation. By analogy to the above quoted statement, the election may be treated as the liquidation of the partnership or LLC (which can be taxable), followed by the contribution of the assets to a corporation (which is usually tax free).

Resources

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IRS Form 8832                  Entity Classification Election

IRS Regs. 301.7701-3      Classification of Certain Business Entities

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