Check the Box: Entity Classification Made Simple

On April 3, 1995, the Internal Revenue Service (IRS) and the Treasury Department issued Notice 95-14 in response to the increasing complexity of entity characteristics that have traditionally been used to distinguish between corporations and partnerships. As the reason for simplification, the notice cited increased costs both to the taxpayer and the government of determining proper classification. Then, on May 9, 1996, the IRS issued Proposed Section 7701 "check-the-box" regulations. The proposed regulations would replace the existing "four-factor" entity classification rules found in regulation Sections 301.7701-1, 7701-2, and 1.7701-3.

Under the proposed regulations, taxpayers may elect corporate or noncorporate status for any domestic or foreign entity, with the exception of specified entities that are automatically treated as corporations. In addition, the proposed regulations establish a default classification that depends upon the nature of an entity, the number of members, and the presence or absence of member liability for the entity's debts.

The IRS will not challenge an entity's classification for periods to which the current regulations apply, provided that the following classification requirements are met:

  • There was a reasonable basis for its claimed classification.
  • The entity claimed the same classification in all prior years.
  • Neither the entity nor any member of the entity has received written notification on or before May 9, 1996, that the classification of the entity is under examination.

Members of business entities who want to choose their classification must meet the definition of an "eligible entity." The proposed regulations for being an eligible entity differentiate between domestic and foreign corporations.

Domestic Entities
A domestic entity is one created or organized in the United States or under U.S. or state law. A "domestic eligible entity" is any business entity not required to be a corporation under Proposed Regulation 301.7701-2(b). Entities required to be corporations include those referred to by a state statute as incorporated, joint-stock companies, banks, and insurance companies.

Unless the taxpayer elects treatment as a corporation, the following default classifications are made to domestic eligible entities:

  • Newly formed entities with two or more members are deemed to be partnerships.
  • Newly formed entities with only one member are disregarded as an entity separate from its owner.

Domestic eligible entities can file an election changing the default classification upon formation or at a later date, with certain exceptions. Generally, a new entity must file an election within 75 days of formation to make the election effective as of the date of formation. Once an election has been filed, new elections are prohibited for the next 60 months.

The IRS will respect the classification of domestic entities in existence before the effective date of the final regulations if they meet the requirements for prior classifications.

Foreign Entities
A "foreign eligible entity" is a business entity that is not required to be classified as a corporation under Proposed Regulation 301.7701-2(b)(8). If no election is made upon the formation of a foreign eligible entity, the following defaults apply:

  • If one or more of the entity's members has unlimited liability, and the entity has two or more members, it will be classified as a partnership.
  • If an entity only has one member, the entity will be disregarded as a separate entity.
  • If an entity has two or more members and they have limited liability, it will be classified as an association (corporation).

If an existing foreign entity is included on the "mandatory corporation" list, the IRS will respect its classification as a partnership provided four requirements are met. The first three are the same as listed above for retaining prior classification. The final provision states that the classification had to have been "relevant to any person for federal tax purposes" at any time during the taxable year that includes May 8, 1996.

If an existing foreign entity is not included on the "mandatory corporation" list, the IRS will respect its classification under those same three provisions. Also, the foreign entity will be treated as existing before the effective date of the final regulations, and thus not subject to the default classification, only if the entity's classification is relevant to any person for federal tax purposes at any time during the period immediately prior to the date the final regulations are published in the Federal Register.

Making the Election
The proposed regulations require a taxpayer to make an election only when a new business entity opts to be classified as other than the default classification, or when an eligible entity chooses to change its classification. The election must be filed with the appropriate service center and must include the following information: name; address; taxpayer identification number of the entity; the chosen classification; whether the election is a change of classification; and whether the entity is domestic or foreign.

The election must be signed either by each member of the electing entity or by any officer, manager, or member of the entity authorized to do so. A copy must be attached to the tax return for the taxable year in which the election will be effective. The effective date cannot exceed 75 days before the election was filed. If no effective date is specified, the effective date will be the date the election was filed.

The proposed "check-the-box" regulations will apply to periods beginning on or after the date that the final regulations are published in the Federal Register.

Bruce Bulloch, CPA, Julie M. Hardnock, CPA, and Glen E. Goold

Bruce Bulloch, CPA, a tax partner with Ernst & Young/Kenneth Leventhal Real Estate Group, serves many of the firm\'s real estate development, home-building, and REIT clients in the Baltimore and Washington, D.C., area. Julie M. Hardnock, CPA, is a tax senior with Ernst & Young/Kenneth Leventhal Real Estate Group based in Baltimore. Glen E. Goold is a tax associate with the Ernst & Young/Kenneth Leventhal Real Estate Group based in Baltimore.