Research in Taxation

Check-the-Box Regulations on Entity Classification

Gary Cao
February 8, 1997

Outline
1.  Facts on three cases
2.  Definition of the issues
3.  Conclusion
4.  List of authorities
5.  Discussion 
(1)  Current final regulations
(2)  Previous regulations 
(3)  History of regulations on tax entity selection
(4)  S corporation
(5)  International implications of "check the box" regulations
(6)  Discussion on Case 1
(7)  Discussion on Case 2
(8)  Discussion on Case 3
6.  Summary


1.  Facts on three cases

Case 1

	Mr. X wants to form a single-owner business enterprise subject to one tier of 
taxation with the protection of limited liability.  Within the next five years, his three 
children will become owners with him.  One child is not a U.S. citizen.  He seeks advice 
on an appropriate entity classification.

Case 2

	Entities formed under the laws of foreign countries may have hybrid attributes 
which make their classification under domestic state law impossible.  A foreign client 
seeks advice on an appropriate entity classification.

Case 3

	X Corporation will be formed as a domestic subchapter C corporation, and will 
form wholly owned Y under the laws of Country A.  Y will then form wholly owned Z 
under the laws of Country B.  The tax rates of the U.S., A, and B are respectively 40%, 
30%, and 45%.  Prior to the "check the box" regulations, the foreign tax credit available 
to X for U.S. tax purposes was limited by the lower tax rate to which the second tier 
subsidiary Y was subject.  X wants to know the effect of the "check the box" regulation 
on this foreign tax credit limitation.


2.  Definition of issues

Case 1

	Mr. X plans for two phases for his enterprise: (1) Phase One (first five years of 
operation, from 1997 to 2001), and (2) Phase Two (2002 and beyond).   He wants to 
choose an entity classification which is subject to one-tier taxation and which has the 
protection of limited liability for both phases.

Case 2

	The foreign client wants to know that, as a hybrid entity formed under foreign tax 
laws, whether it has the room for flexibility to choose an entity classification to fit its 
business needs.

Case 3

	X Corporation wants to know if it is possible to increase the foreign tax credit to 
the higher rate of 45% which is the rate for the currently third-tier subsidiary Z (in 
Country B).


3.  Conclusion

Case 1

	As a single-owner entity, Mr. X's business enterprise cannot achieve the desired 
two goals (one-tier taxation and limited liability).   His only choice is proprietorship.  
However, if he changes his mind and invites one of his friends to join him as co-owners, 
the entity may elect to be a limited liability company (LLC) or an S corporation for Phase 
One (1997 to 2001).  The entity should elect to be a LLC for Phase Two (2002 and 
beyond).  For simplicity, Mr. X may choose LLC at the beginning, if he gives up the 
single-ownership criterion.

Case 2

	A foreign hybrid entity may elect to be classified as a partnership if it has more 
than two members and at least one member does not have limited liability.

Case 3

	Y can elect to be classified as a branch of X, making Z the second-tier subsidiary 
and X can use the foreign tax credit at 45% tax rate in Country B.


4.  List of authorities

(1)    IRS Decision T.D. 8697;
(2)    IRS PS-43-95;
(3)    IRS Notice 95-14;
(4)    IRS Regulation 301.7701-1;
(5)    IRS Regulation 301.7701-2;
(6)    IRS Regulation 301.7701-3;
(7)    Morrissey v. Commissioner, 296 U.S. 344 (1935);
(8)    U.S. v. Kintner, 216 F.2d 418 (9th Circuit Court 1954);
(9)    Larson v. Commissioner, 66 T.C. 159 (1976);
(10)   IRS Ruling 88-76.


5.   Discussion

(1)  Current final regulations

	The IRS has published final "check-the-box" entity classification regulations 
(T.D. 8697) under section 7701 that are effective January 1, 1997.  The regulations 
replace the existing rules for classifying business organizations with a simpler elective 
classification system that will generally allow eligible entities to choose to be taxed as 
partnerships or corporations.

	On the per se corporation list, the final regulations clarify the treatment of entities 
formed in 80 countries such as Aruba, Canada, People's Republic of China, India, 
Indonesia, Netherlands Antilles, and Sweden. 

	The default rules provide that a newly formed foreign eligible entity will be (1) 
treated as a partnership if it has at least two members and at least one member doesn't 
have limited liability; (2) treated as an association if all members of the entity have 
limited liability; and (3) disregarded as a separate entity if it has a single owner that does 
not have limited liability.  The rules provide that a member does not have limited liability 
if the member, by virtue of being a member, has personal liability for any portion of the 
debts of the entity.

	Because many state statutes authorizing limited liability company (LLC) permit 
the election of some or all four of the corporate characteristics -- limited liability, free 
transferability of interests, centralized management, and continuity of existence -- the 
combination of the  check-the-box  regulations and section 7704 effectively would permit 
passthrough tax treatment for any non-corporate business whose equity interests are non-
publicly traded.  Except for non-publicly traded corporations already locked into 
corporate form, one would expect that in the foreseeable future all, or nearly all, not 
publicly traded businesses will receive passthrough tax treatment.  Publicly traded 
businesses, however, generally will be treated as corporations subject to the double tax 
regime.

(2)  The Previous Classification Regulations

	Under the previous regulations, the Service divides business organizations into 
associations, partnerships, and trusts.  IRC section 7701(a)(2) defines a partnership to 
include a syndicate, group, pool, joint venture, or other unincorporated organization, 
through or by means of which any business, financial operation, or venture is carried on, 
and that is not a trust or estate or a corporation.  Section 7701(a)(3) defines a corporation 
to include associations, joint-stock companies, and insurance companies.

	Associations are subject to the corporate tax, while partnerships and trusts are not.  
To apply the regulations one must first determine whether the entity in question "more 
nearly resembles a corporation than a partnership or trust."  An entity resembles a 
corporation if it possesses more than half of the major corporate characteristics.  The 
major corporate characteristics are: (1) associates, (2) objective to carry on business, (3) 
continuity of life, (4) centralization of management, (5) free transferability of interest, 
and (6) limited liability. This is commonly known as the "resemblance test" or the 
"Kintner test."

	To distinguish an association from a partnership or trust, one should not consider 
characteristics that the entities naturally have in common.  Thus, since both partnerships 
and corporations normally have associates and an objective to carry on business, an entity 
will be considered a partnership only if it avoids two of the remaining four 
characteristics.  "Corporate characteristics" refer to continuity of life, centralized 
management, free transferability of interest, and limited liability.

	Continuity of life is avoided if, absent consent of at least a majority of the 
members, the entity will dissolve upon the death, insanity, bankruptcy, retirement, or 
expulsion of any member.  Centralized management is present if any person or group that 
does not include all the members has continuing exclusive authority to make the 
management decisions for the business.  Free transferability of interest exists if members 
owning a substantial majority of interest may transfer all of the attributes of that interest 
to third parties without the consent of the other members.  Limited liability means that 
under local law there is no member of the organization who is personally liable for the 
business debts. 

	The previous regulations indicate that, in addition to the six enumerated 
characteristics, "other factors" may be taken into account to determine an entity's status.  
However, in Larson v. Commissioner (1976),  the court held that a number of corporate-
like characteristics were either elements of the major enumerated characteristics or were 
not of "critical importance" in making the association distinction.  The Service has 
subsequently accepted the Larson rule.  Thus, in modern application, the resemblance 
test serves as a definitive litmus test of an entity's tax status.  In short, an unincorporated 
entity can either secure or avoid association status simply by controlling the number of 
corporate characteristics manifested by its operating agreement.


(3)  History of regulations on tax entity selection

	Morrissey v. Commissioner (1935) is widely recognized as the leading case on 
entity classifications.  In Morrissey, the taxpayers transferred 155 acres of real estate to a 
trust and subsequently declared themselves trustees.  The purpose of the trust was to use 
the land to generate a profit.  To this end, 42 acres of the trust property were platted and 
sold.  The remaining property was turned into a golf course and operated by the trustees 
through a separate corporation.  The beneficial interests of the trust were originally 
divided into 2,000 preferred shares with a par value of $ 100 each, and 2,000 common 
shares with no par value.  During the operation of the trust, the number of interests 
ranged from 2,172 to 3,016, with between 275 and 920 interest owners.  The trustees 
owned between 16 and 29 percent of the interests.  The trustees managed the trust 
property as if it were their own, and shareholder votes were to be advisory only.  The 
trust was to continue for 25 years unless the trustees terminated it sooner.

	The issue in Morrissey was whether the trust income should be subject to the 
corporate tax prior to its distribution to the beneficiaries.  The government argued that 
the "business trust" possesses specialized functions that make it more appropriately 
classified as an association than a trust.  The court agreed, holding that the trust was an 
association because it more closely resembled a corporation than a trust.

	Morrissey represents an important statement of corporate tax policy: the corporate 
tax is not arbitrarily imposed upon statutory forms.  Under Morrissey,  the corporate tax 
is meant to apply to any entity that possesses a majority of the attributes of a corporation.  
In essence, the corporate tax is not meant to tax the corporate form, but rather the 
corporate substance.  State laws cannot control the method of entity classification for 
federal tax purposes.

	The cases and legislation subsequent to Morrissey have repeated this policy.  In 
United States v. Kintner (1954), a group of doctors organized their practice with the 
intention of forming an unincorporated entity that would be classified as an association. 
The entity was essentially a partnership implanted with enough corporate characteristics 
to be considered an association for tax purposes.  Each member of the entity agreed to 
exchange his interest in the business assets for pension benefits to be paid upon the 
member's death or withdrawal.  The taxpayers benefited from classification as an 
association because, while they were subject to and did pay the corporate income tax, 
taxes on the pension fund were avoided.  If the entity had been classified as a partnership, 
the portion of the fund attributable to each member would have been taxed to that 
member.

	The government argued that it would be inappropriate to treat medical 
associations as corporations under federal tax law, because they are not allowed to 
incorporate under state law.  The court disagreed, however, noting that the government's 
contention was inconsistent with its long-standing policy not to be bound by state law 
classifications.  The court's holding, which largely relied on Morrissey, exemplifies the 
policy that the corporate tax is not dependent on business classifications under local law.  
It is not a tax on a form of business entity, but rather a tax on the substance of an 
organizational scheme.

	Kintner is an important case for the following two reasons.  

	(A)  The case presents the classification issue in a counterintuitive way.  Much of 
modern business planning, particularly that dealing with the limited liability company, is 
an effort to maximize the existence of corporate characteristics while avoiding the 
corporate tax.  However, professional associations, such as the one in Kintner, often 
benefit more by being classified as an association.  In fact, this is frequently the only way 
to secure the pension benefits at issue in Kintner, because many states do not allow 
medical associations to actually incorporate.  

	(B) The Kintner case was the catalyst for the modern classification regulations.  
Following Kintner, the government re-designed the 1953 regulations to make it more 
difficult for an entity to be classified as an association.  The resulting 1960 classification 
regulations are substantially similar to those in place today.  It is interesting that, while 
the 1960 regulations were designed to minimize the use of the professional association 
for tax benefits, they have opened the door for the creation of another type of entity, the 
limited liability company (LLC), which is used for similar purposes.  Furthermore, LLC 
is cited in Notice 95-14 as a major reason for abandoning the classification idea 
altogether.  Thus, Kintner was not only the catalyst of the modern classification 
regulations, but may have also been the precursor to their ultimate demise.

	In Larson v. Commissioner (1976), Judge Tannenwald stated that "the partnership 
possessed the corporate characteristics of centralized management and free transferability 
of interests and lacked the corporate characteristics of continuity of life and limited 
liability, and had no other significant corporate or non-corporate characteristics.  They 
are taxable as partnerships defined in sec. 7701(a)(2), I.R.C. 1954, and not as 
corporations within the meaning of section 7701(a)(3) and Regulation section 
301.7701-2."

	After the Larson court's interpretation of the resemblance test, partnerships could 
easily adopt two of the four corporate characteristics without fear of losing their status as 
a partnership.  However, a partnership cannot simply declare itself to have the 
characteristic of limited liability, because a partner's liability status is controlled by state 
law.  Thus, for an entity to achieve limited liability, it must assume a form that the state 
recognizes as having limited liability, such as a limited partnership with a corporate 
general partner.  Conversely, for an entity to receive partnership tax treatment, it must 
assume a form that the IRS recognizes as a partnership and not an association.

	In 1977, Wyoming became the first state to strike this balance.  The Wyoming 
Limited Liability Company Act created an unincorporated entity, none of whose 
members or managers were personally liable for company debts.  In addition to limited 
liability, the act provided the option of centralized management.  The initial IRS reaction 
to the statute was to propose regulations that would automatically classify any LLC as an 
association.  This reaction appeared to be a policy decision that limited liability should 
be the controlling factor in the corporate characteristics test.  However, under strong 
protest to the proposed regulations, the Service abandoned this view and agreed to study 
the new entity.  In 1988, the Service completed its study and issued a revenue ruling that 
granted partnership status to the Wyoming LLC.  Ann Veninga, the principal author of 
this revenue ruling (Ruling 88-76), stated that "M (the Wyoming LLC) has associates and 
an objective to carry on business and divide the gains therefrom, but lacks a 
preponderance of the four remaining corporate characteristics. Accordingly, M is 
classified as a partnership for federal tax purposes."

	In Ruling 88-76, the Service first reaffirmed the decision in Larson by stating that 
the resemblance test must be applied by giving each of the four corporate characteristics 
equal weight.  Looking separately at each characteristic, the Service found that the LLC 
possessed limited liability because none of the members or managers were personally 
liable for company debts.  It possessed centralized management because fewer than all of 
the members had exclusive decision making authority.  Continuity of life was not present 
because, in the absence of unanimous consent by all members, the LLC would dissolve 
upon the termination of any member.  Finally, the company did not possess free 
transferability because nonmembers could not acquire all the attributes of a member's 
interest without unanimous consent of the other members.

	Revenue Ruling 88-76 was a significant step in corporate tax history.  It firmly 
established that the resemblance test measures discrete and quantifiable corporate 
characteristics, all of which are of equal weight.  Furthermore, classifying the LLC as a 
partnership brought full circle the theory of corporate taxation that emerged in Morrissey:  
State law classifications do not control the tax classifications of business entities.  
Businesses that are in like circumstances should be taxed alike, regardless of the 
particular form under which they happen to be organized.

(4)  S Corporation

	Subchapter S made possible the combination of passthrough tax treatment and 
limited liability when the latter was available only through corporate form.  However, S 
corporation as a tax entity classification has some restrictions.  S corporation cannot have 
more than one class of stock; none of its owners can be non-U.S. citizen; none of its 
owners can be non-individual institutions; the maximum number of its owners is 75.

	Now, LLC and related entities make limited liability available without corporate 
form.  The LLC rulings and the proposed "check-the-box" regulations allow businesses to 
bypass subchapter S and still achieve both passthrough treatment and limited liability. As 
a result, LLC and related entities make corporate form obsolete for all but publicly traded 
businesses.  In the future, the dominance of LLC and related entity forms will make 
subchapter K the dominant tax regime for non-publicly traded businesses, other than 
those locked into C corporation and S corporation status.  Subchapter S corporation 
would be marginalized by LLC and related limited liability partnerships or limited 
liability limited partnerships.

(5)   International implications of "check-the-box" regulations

	Under the "check-the-box" regulations, a foreign entity can be one of two things: 
(i) a per se corporation, i.e., an entity treated automatically as a corporation, or (ii) an 
"eligible entity", i.e., an entity that can elect to be treated as either a corporation or as a 
passthrough entity (a branch or a partnership).  Foreign per se corporations are simply 
listed in the proposed regulations; in each of the listed 80 countries, one or two forms of 
legal entities are considered per se corporations.  All other foreign entities are eligible 
entities and can elect to be treated as a partnership (if they have at least two partners), as 
a branch (if wholly owned), or as a corporation.  In the absence of an explicit election, 
foreign entities will be classified under the default rule as partnerships or branches if any 
member has personal liability for the debts of the entity, and as corporations if no 
member has such liability. 

	These regulations have very significant implications for the international tax rules 
of the United States.  The most important of these implications is that, as Michael Schler 
pointed out, the "check-the-box" regulations mean the end of deferral -- but on an 
elective basis, i.e., only for those foreign entities for which the taxpayer chooses to end it.  
A taxpayer cannot choose passthrough status for the enumerated per se corporations, but 
it can avoid using that type of vehicle.

	The following is a partial list of those situations in which taxpayers would likely 
opt for ending deferral by using a foreign eligible entity and electing passthrough status:

--  when the foreign entity is expected to generate losses, which can be deducted on a 
current basis; 
 
--  to obtain direct foreign tax credits under section 901 and avoid the requirements for 
the indirect credit under section 902 (corporate status of the shareholder and 10 
percent ownership);
 
--  to avoid the separate basket for "non-controlled section 902 corporations", i.e., 
corporations that are more than 10 percent U.S.-owned, but are not controlled foreign 
corporations (CFCs), such as a 50/50 joint venture;
 
--  to avoid the three-tier limitation of the indirect credit (by electing passthrough status 
for fourth- and lower-tier entities);
 
--  to avoid subpart F inclusions for dividend income from unrelated foreign entities that 
conduct an active business;
 
--  to ensure look-through treatment for purposes of the PFIC rules for less-than-25-
percent-owned foreign entities, and to achieve look-through treatment for any related 
entities for purposes of the foreign personal holding company (FPHC) rules;
 
--  to achieve a more favorable allocation of interest expense by directly including the 
assets and liabilities of the foreign entity in the consolidated computation required 
under section 864(e);
 
--  to avoid U.S. withholding tax for foreign entities that receive U.S.-source payments;
 
--  to avoid the application of section 367 to outbound transfers to the foreign entity 
(section 1491 would apply to transfers to a partnership, but not to a branch);
 
--  to ensure look-through treatment for purposes of determining whether a U.S. 
corporation is engaged in an active trade or business for purposes of section 355.
 
	On the other hand, the taxpayer will likely elect corporate status (or use a per se 
corporation) in the following situations:
 
--  to achieve deferral of foreign-source active income that cannot be sheltered by 
credits;
 
--  to avoid deemed termination of a partnership under section 708 and deemed re-
contribution of assets to a new partnership subject to section 1491;
 
--  when foreign members of the entity wish to avoid being engaged in a U.S. trade or 
business;
 
--  to avoid U.S. withholding tax on interest payments made by the entity;
 
--  to enable the entity to be a party to a tax-free reorganization under section 368;  In 
addition, there may be further advantages under foreign tax laws from using hybrid 
entities, i.e., entities treated as, for example, branches under "check-the-box" but as 
corporations by the foreign jurisdiction. 

	Despite these significant advantages for taxpayers,  "check-the- box" is definitely 
a step in the right direction, because, as the New York State Bar Association Tax Section 
pointed out, when the system was first proposed but its application to foreign entities was 
in doubt, the same result can almost always be achieved under current law, but with more 
complexity and transaction costs.  Thus, "check-the-box" makes it possible for taxpayers 
to avoid transaction costs, without putting the IRS in a significantly worse position than it 
was under prior law, and also reduces the likelihood that classification issues will be the 
subject of litigation, which is costly for both taxpayers and the IRS.

(6)  Discussion on Case 1

	The "check the box" regulations adopt a passthrough default for domestic 
entities, under which a newly formed eligible entity will be classified as a partnership if it 
has at least two members, or will be disregarded as an entity separate from its owner if it 
has a single owner.

	Mr. X will be the only owner of the business enterprise for the first five years of 
its operations.  For Phase One, since Mr. X wants one-tier taxation, the form of C 
corporation is excluded.  The available choices are: S corporation, limited liability 
company, and partnership.  In addition, Mr. X also wants the protection of limited 
liability, this leaves him with two choices: S corporation and LLC.  However, since Mr. X 
will be the only owner of the enterprise, while S corporation and LLC require at least two 
owners (shareholders), Mr. X cannot achieve his plan with both one-tier taxation and 
limited liability.  The answer may be:

(i)  If Mr. X insists to be the only shareholder of the enterprise, his only choice is 
proprietorship (with one-tier taxation but without limited liability);

(ii)  If Mr. X is flexible enough to invite a third party to join him as owners of the 
enterprise, he may choose either S corporation or LLC, with both one-tier taxation and 
limited liability.

	Mr. X may choose to change the classification five years later.  The "check the 
box" regulations limit the ability of an entity to make multiple classification elections by 
prohibiting more than one election to change an entity's classification during any sixty 
month period.

	For Phase Two, since Mr. X wants to avoid double taxation and/or adverse tax 
effect, and one of Mr. X's children is not a U.S. citizen, the forms of C corporation and S 
corporation are excluded.  The available choices are limited liability company and 
partnership.  In addition, since he may also want the protection of limited liability, 
partnership is excluded, and the only choice is LLC.

	I would advise Mr. X to invite a friend to form the enterprise and choose LLC; 
five years later, when his three children join him and his friend as owners, his friend may 
choose to withdraw from the ownership or stay as a passive owner.

	For simplicity purpose, Mr. X may choose LLC at the beginning, if he gives up 
the single-ownership criterion.

(7)  Discussion on Case 2

	In the "check the box" regulations, the default for foreign entities is based on 
whether the members have limited liability.  Thus a foreign eligible entity will be 
classified as an association if all members have limited liability.  A foreign eligible entity 
will be classified as a partnership if it has two or more members and at least one member 
does not have limited liability; the entity will be disregarded as an entity separate from its 
owner if it has a single owner and that owner does not have limited liability.

	The client's entity is formed under the laws of a  foreign country and has hybrid 
attributes.  The "check the box" regulations have a per se C corporation list for 80 
foreign countries.  If the client's entity is not on the per se C corporation list, it has the 
opportunity to select a classification that is optimal to its business needs.  After careful 
tax planning, if it believes that the benefits of C corporation classification is the most 
important factor, it may choose to be a C corporation; if, as in a common case, the client 
wants one-tier taxation, it may adjust the factor of limited liability and choose to be a 
partnership for U.S. tax purposes.


(8)  Discussion on Case 3

	The default rules of the regulations provide that a newly formed foreign eligible 
entity will (1) be treated as a partnership if it has at least two members and at least one 
member does not have limited liability; (2) be treated as an association if all members of 
the entity have limited liability; and (3) be disregarded as an entity separate from its 
owner if it has a single owner that does not have limited liability.

	X Corporation plans to maximize the foreign tax credit in order to minimize its 
U.S. taxable income.  Prior to the "check the box" regulations, the foreign tax credit is 
limited to the lower tax rate for the second-tier subsidiary Y (in Country A), which is 
30% in this case.  By making Y as a branch of X, Z becomes the second tier subsidiary of 
X for U.S. tax purposes.  Therefore, X may use the 45% tax rate (for Z in Country B) in 
calculating its foreign tax credit, instead of 30% rate (for Y in Country A).


6.   Summary

	In summary, although some commentators have suggested that certain issues 
remain unsolved, the "check the box" regulations on tax entity classification are a giant 
positive step toward simplification.  In Notice 95-14 and T.D. 8697, the IRS concludes 
that the state law differences between corporations and partnerships have narrowed to 
such a degree that the venerable corporate resemblance test for classifying 
unincorporated entities should be abandoned in favor of a simple classification regime 
that is generally elective.  To that end, the final regulations discard the four factor 
classification system, which is de facto elective for individuals with skilled tax advisors, 
and replace it with the "check the box" system in which most new unincorporated 
entities (except the ones included in the per se corporation list) will automatically be 
classified as partnership for federal tax purposes unless the entity elects to be an 
association taxable as a Subchapter C corporation.