Introduction
More than two decades ago, the Service announced its intention to consider simplifying the entity classification rules in Notice 95-14. It stated:
“The Internal Revenue Service and the Treasury Department are considering simplifying the classification regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as associations on an elective basis. The Service and Treasury also are considering adopting similar rules for foreign business organizations. Comments are requested regarding this and other possible approaches to simplifying the regulations.”
The Service asked for public comments on simplification of entity tax classification. It scheduled a public hearing on the matter for July 20, 1995.
In May 1996, proposed entity classification regulations were issued by Treasury. About seven months later, on December 17, 1996, Treasury finalized the regulations. The regulations are found in Treasury Regulation Section 301.7701.
The regulations were clearly designed to accomplish the IRS’s stated goal – simplifying entity tax classification. The regulations, commonly referred to as the “Check-the-Box” regulations, successfully brought an end to much of the long existing battle between taxpayers and the Service over entity tax classification. The regulations generally became effective on January 1, 1997. In a little over a month from now, they will be 25-years old.
The regulations, despite judicial challenge (e.g., Littriello v. United States, 2005-USTC ¶50,385 (WD Ky. 2005), aff’d, 484 F3d 372 (6th Cir. 2007), cert. denied, 128 S. Ct. 1290 2008)), have persevered, making the entity classification landscape free of many tax authority challenges and providing taxpayers with some objectivity and more importantly, much needed certainty. That said, despite the simplification brought into the world of entity tax classification by the Check-the-Box regulations, for which tax practitioners applauded the government, several new hazards were created. Whether these new hazards were intentional or unintentional is subject to debate. Unfortunately, not all of these hazards are obvious to taxpayers and their advisors. If taxpayers and their advisors are not extremely careful in this area, disastrous unintended tax consequences may exist. Accordingly, a good understanding of the regulations and the consequences of making, not making or changing an entity tax classification decision is paramount.
Last month, I presented a White Paper that I authored on the regulations at the NYU 81st Institute on Federal Taxation in New York City, and I will be presenting it again for NYU in San Diego on November 17, 2022. The paper provides exhaustive coverage of the regulations and covers numerous nuances and traps that exist for unwary taxpayers and their advisors. An issue which is often overlooked by practitioners is whether using the regulations to change entity status for income tax purposes is always a good idea. While I discuss the issue in some detail in the paper, the sub-issue of whether a taxpayer should use the regulations to change the tax status of a limited liability company (“LLC”) taxed as a partnership to a corporation taxed under Subchapter S needs discussion. I explore that sub-issue below.
On August 23, 2022, the Regular Division of the Oregon Tax Court issued its opinion in Santa Fe Natural Tobacco Co. v. Department of Revenue, State of Oregon. The court determined that the taxpayer in that case is subject to the corporate excise tax.
The taxpayer, Santa Fe Natural Tobacco Co., required that its wholesale customers located in Oregon accept and process returned goods. In addition, the taxpayer’s in-state sales representatives, who did not maintain inventory, routinely confirmed and processed purchase orders between Oregon retailers and wholesalers.
As previously reported, due to the COVID-19 pandemic, remote workforces currently dominate the landscape of most U.S. businesses. In fact, in many industries, remote workforces may be the new normal post-pandemic. Unfortunately, as workers become more mobile, the tax and human resources issues become more challenging for employers.
I was asked by Dan Feld, Principal Editor, Tax Journals, of Thomson Reuters, to author an article on this topic for the July 2022 Practical Tax Strategies Journal. With Dan’s approval, I have provided a link to the complete article, Remote Workforces: Tax Perils and Other Traps For Unwary Employers, for my blog readers.
More than 25 years ago, effective January 1, 1997, Treasury issued what have been called the “Check-the-Box” regulations (the “Regulations”).1 The Regulations ended decades of battles between taxpayers and the IRS over entity classification. Further, the Regulations simplified entity classification and brought much needed certainty to most entity classification decisions.
Under the Regulations, a business entity with more than one owner is either classified for federal tax purposes as a corporation or a partnership.2 Likewise, a business entity with only one owner is either classified as a corporation or is disregarded for federal income tax purposes as being separate and apart from its owner.3
If a business entity is disregarded, its activities are generally treated for federal tax purposes as the activities of its owner. There are five notable exceptions to that rule.
Background
Early in the pandemic, I reported on the widespread newly created remote workforces resulting from stay-at-home orders issued by the governors of most states. In many cases, neither the employer nor the workers were prepared to take this journey.
Fears were rampant among employers that workplace productivity would diminish, quality of work would be impacted, technology would not support remote workers, culture would be compromised, employee recruiting and retention would be harmed, and customer goodwill would be tarnished. On top of that, many employers worried that employee fatigue (mental and physical) would accompany the new workforce model.
Preliminary Results
Now that we are over two years into the pandemic, employers and employees alike are surprised to find that their fears, for the most part, were misplaced. In most cases, it is reported that the remote workforce model is working quite well.
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- Employees generally like the remote workforce model;
- In a large number of cases, employees desire to remain remote post-pandemic;
- The lack of commuting to and from work reduces employee disruption, stress and household expenses (commuting costs, daycare, meals and clothes), and allows more time for family and leisure activities;
- Workplace politics are diminished;
- It creates flexibility as to where employees may live, resulting in housing costs reductions in some cases; and
- Employee absenteeism is diminished.
As I previously reported, the Washington state capital gains tax has had a turbulent ride, commencing with a rough ride through the legislative process where it almost hit disastrous terrain on at least six (6) occasions. Then, it was hit with a lawsuit to strike it down as unconstitutional before Governor Inslee could even sign the legislation into law. Days later, it was sideswiped with a second lawsuit to end its short life.
As I reported on March 2, 2022, the new tax regime took a near lethal blow when Douglas County Superior Court Judge Brian C. Huber struck down the newly enacted Washington state capital gains tax as unconstitutional.
Judge Huber concluded:
ESSB 5096 violates the uniformity and limitation requirements of article VII, sections 1 and 2 of the Washington State Constitution. It violates the uniformity requirement by imposing a 7% tax on an individual's long-term capital gains exceeding $250,000 but imposing zero tax on capital gains below that $250,000 threshold. It violates the limitation requirement because the 7% tax exceeds the 1% maximum annual property tax rate of 1%.
As suspected by many local commentators, the state would not let the tax regime die without a fight. It is now seeking a higher court review of Judge Huber’s ruling, hoping to bring life back into the tax.
On March 25, 2022, Attorney General Robert W. Ferguson filed a notice of appeal. Instead of appealing to the Washington Court of Appeals (the normal course of review), Mr. Ferguson filed a petition requesting the Washington State Supreme Court hear the case.
As previously reported on May 7, June 17 and November 4 of last year, two lawsuits were filed in Douglas County Superior Court in Washington, seeking a declaration that the state’s new capital gains tax is unconstitutional. The court consolidated the cases. The parties filed cross motions for summary judgment, along with legal briefs in support of their positions. The lawyers for the State of Washington asked for a judgment that the tax regime meets constitutional muster. On the other hand, the lawyers for the taxpayers that initiated the case sought a judgment that the tax regime is unconstitutional.
The Oregon Legislature, in House Bill 3373, created the Office of the Taxpayer Advocate within the Oregon Department of Revenue. The new law became effective on September 25, 2021. According to the Oregon Department of Revenue website, the office is open and “here to help.”
The mission of the Office of the Taxpayer Advocate is threefold:
- To assist taxpayers in obtaining “easily understandable” information about tax matters, department policies and procedures, including audits, collections and appeals;
- To answer questions of taxpayers or their tax professionals about preparing and filing returns; and
- To assist taxpayers and their tax professionals in locating documents filed with the department or payments made to the department.
On November 19, 2021, HR 5376, the 2,476-page bill, commonly known as the Build Back Better Act, was passed by the U.S. House of Representatives by a vote of 220-213.
The House’s vote on HR 5376 was held after the Congressional Budget Office released its cost estimates for the proposed legislation. It estimates HR 5376 will cost almost $1.7 trillion and add $367 billion to the federal deficit over 10 years.
HR 5376 started out with robust changes to our tax laws, including large increases in the corporate, individual, trust and estate income tax rates, significant increases in the capital gains tax rates, taxation of unrealized gains of the ultra-wealthy, a huge reduction in the unified credit, a tax surcharge on high income individuals, trusts and estates, expansion of the application of the net investment income tax, elimination of gift and death transfer discounts, and additional limitations on the application of the qualified business income deduction.
To the cheer of most U.S. taxpayers, HR 5376, as passed by the House, is a dwarf, in terms of the tax provisions, compared to its original form. As tax legislation, at least in its current state, it is much ado about nothing.
However, U.S. taxpayers should not get too joyful about the legislation in its current form. It will likely be substantially altered by the Senate, regaining many of its original provisions (with or without modification). In fact, Skopos Labs reports that the bill, as passed by the House, has a 10 percent chance of being in enacted into law.
HR 5376, at its heart, provides funding, establishes new programs and otherwise modifies current provisions of the law aimed at enhancing a broad array of programs, including education, childcare, healthcare and the environmental protections.
While it may not be worth spending too much time focusing on HR 5376, as its tax provisions will be drastically altered by the Senate, it is worth briefly noting what is in the bill and what may be missing.
As previously reported on May 7 and June 17 of this year, Washington state lawmakers enacted a new capital gains tax, set to go into effect on January 1, 2022, but two lawsuits were initiated to declare the tax unconstitutional. To date, the court cases are continuing their way through the judicial process.
On November 2, 2021, as part of the statewide general elections process, Washington voters were not asked to vote on the new state capital gains tax; rather they were asked for their opinion on the tax.
The specific question posed, as written by the Office of the Attorney General, is as follows:
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Larry J. Brant
Editor
Larry J. Brant is a Shareholder and the Chair of the Tax & Benefits practice group at Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; Tulsa, Oklahoma; and Beijing, China. Mr. Brant is licensed to practice in Oregon and Washington. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
