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.