Examination of the Check-the-Box Regulation
Effective January 1, 1997, the IRS issued final regulations that implemented the entity classification system. These “Check-the-Box” rules allow unincorporated organizations to elect to be treated as either corporations or partnerships for federal income tax purposes. Certain business entities that are excluded from these rules are corporations organized under state statutes, foreign entities that resemble U.S. corporations, entities taxable as corporations under special Code provisions, and trusts. 1
An entity that does not elect a particular classification is classified under the default rules that state for federal tax purposes, non-corporate domestic organizations with more than one member are treated as partnerships, and single-member domestic entities are disregarded.
There are three steps that must be performed in order to determine if you qualify to choose your entity.
- Identifying Separate Entities
We must first determine if the organization is a separate entity. The “business entity” concept is the basis of the “Check-the-Box” rules. The federal tax law determines if the entity is separate from its owners for federal tax purposes and does not depend on the organization recognized as a separate entity under local law. 2 “Business entity” is defined by the regulations as any entity recognized for federal tax purposes that is not classified as a trust or subject to special treatment under the Code. 3
Single-Owner Organizations
Proprietorships
A disregarded entity is a business entity that is not a corporation, has a single owner, and is disregarded as an entity separate from its owner. 4 The check-the-box regulations allow a single owner to elect to be disregarded as an entity separate from its owner. The disregarded entity may retain its entity status for state law purposes, but is disregarded for federal tax purposes.
Community Property Entity
The IRS has stated it will respect the taxpayers’ choice of the entity as either a disregarded entity or a partnership in the case of a qualified entity owned exclusively by a husband and wife as community property. This qualified entity is a business entity entirely owned by a husband and wife as community property under the law of a state, is not treated as a corporation, and one in which no other person would be considered an owner for tax purposes. 5
Partnerships
The definition of a business entity other than a corporation is based on the number of members. A “partnership” means it is a business entity with at least two members and is not a corporation. 6
Corporations
An entity meeting the description in any of the following eight categories is classified as a corporation for federal tax purposes: 7
(1) a business entity organized under a federal or state statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic;
(2) an association;
(3) a business entity organized under a state statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association; 8
(4) an insurance company; 9
(5) a state-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute; 10
(6) a business entity wholly owned by a state or any political subdivision thereof;
(7) a business entity that is taxable as a corporation under a provision of the Code other than §7701(a)(3); or
(8) a business entity formed in one of numerous designated foreign jurisdictions.
- Eligible Entities
The second step is to determine whether the entity qualifies as an “eligible entity.” Only the “eligible entity” may elect the federal tax classification it wishes. The definition of an “eligible entity” is a business entity that is not classified as a corporation under Regs. §301.7701-2(b)(1), 301.7701-2(b)(3), 301.7701-2(b)(4), 301.7701-2(b)(5), 301.7701-2(b)(6), 301.7701-2(b)(7), or 301.7701-2(b)(8).
Entity with Two or More Members
An eligible entity having two or more members has the option of electing classification as either an association or a partnership. 11
Single-Member Entity
A single member eligible entity can elect to be classified as an corporation or as a disregarded entity separate from its owner. 12 An entity electing to be disregarded, will be treated as a sole proprietorship.
Default Classification Rules
An eligible entity will be classified under the default rules if it does not elect its desired entity classification. Unless the “eligible entity” elects otherwise, it will be classified as a disregarded entity if it has a single owner or a partnership if it has two or more members. 13
- Elections
There are only two situations that require an eligible entity to file a classification election. 14 The first situation is if the entity wishes to be classified differently than it would be under the default rules. The second situation is if the entity wishes to change its classification.
Election Procedure
In order to make a classification election, an eligible entity must file Form 8832, Entity Classification Election. 15 A copy of Form 8832 must be attached to the federal tax or information return of the entity for the taxable year for which an election is made. 16 Where an entity is not required to file a return for the year an election is made, a copy of the Form 8832 must be attached to the federal income tax or information return of all direct or indirect owners of the entity for the taxable year of the owner that includes the date on which the election was effective. 17 Failing to attach a copy of a Form 8832 to the return will not invalidate the election.
An election must be signed by either (i) each member of the electing entity who is an owner at the time the election is filed, or (ii) an officer, manager, or member of the electing entity who is authorized to make the election. 18
An entity that has an employer identification number (EIN) will keep their EIN even if their entity’s federal tax classification changes under Regs. §301.7701-3. 19 A single owner disregarded entity under must use the owner’s taxpayer’s identifying number (TIN) for federal tax purposes. 20 When a single owner entity’s classification changes and becomes recognized as a separate entity for federal tax purposes, that entity must use the EIN, not the TIN of the single owner.
An election is effective either on the date specified on Form 8832 or on the date the election is filed. A specified effective date will be allowed as long as it is not more than 75 days before the filing date or more than 12 months after the filing date. A specified date more than 75 days before the filing date will be effective only 75 days before the filing date. A date specified more than 12 months from the filing date will be effective 12 months after the filing date. 21
Restriction on Classification Changes
An eligible entity that elects to change its classification cannot change its classification by election again during the 60 months following the effective date. The IRS has the authority to waive the 60-month restriction if more than 50% of the ownership interests in the entity on the effective date of the election are owned by persons that did not own any interests on the filing date or on the effective date of the entity’s prior election. 22
Only an election to change classification will begin a 60-month waiting period. If a new eligible entity elects out of its default classification effective from the beginning, that election is not a change in the entity’s classification and does not prevent the entity from changing its classification by election within the next 60 months.
References
1Regs. §§ 301.7701-2(b)
2Regs. § 301.7701-1(a)(1)/Footnote/ ; Regs. §301.7701-1(a)(3).
3Regs. §301.7701-2(a).
4Regs. §301.7701-2(c)(2)
5 Rev. Proc. 2002-69, 2002-45 I.R.B. 831.
6 Regs. §301.7701-2(c)(1).
7Regs. §301.7701-2(b).
8Regs. §301.7701-2(b)(3).
9Regs. §301.7701-2(b)(4).
10Regs. §301.7701-2(b)(5).
11Regs. §301.7701-3(a).
12Regs. §301.7701-3(a).
13Regs. §301.7701-3(b)(1).
14Regs. §301.7701-3(c)(1)(i).
15Regs. §301.7701-3(c)(1)(i).
16Regs. §301.7701-3T(c)(1)(ii)
17Regs. §301.7701-3T(c)(1)(ii).
18Regs. §301.7701-3(c)(2)(i).
19Regs. §301.6109-1(h)(1),
20Regs. §301.6109-1(h)(2)(i).
21Regs. §301.7701-3(c)(1)(iii).
22gs. §301.7701-3(c)(1)(iv).
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.