Larry's Tax Law

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 (6^th 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 81^st 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.

Earlier this year, the Idaho Supreme Court, in Noell Industries, Inc. v. Idaho State Tax Comm’n, --- P.3d ---- (2020), ruled that gain from the sale of membership interests in a limited liability company that had business operations in Idaho by a taxpayer domiciled outside of Idaho was not business income.  As a result, the gain was not taxable in Idaho.

The court, in a 3-2 decision, upheld the district court’s reversal of the Idaho Tax Commission’s determination to tax the income.  The sharks were circling the taxpayer, ready to attack, but the majority of the justices on the Idaho Supreme Court intervened, saving the taxpayer from a savage death (or at least a boatload of taxes).

BACKGROUND/PRIOR LAW

Under IRC § 708(a), a partnership is considered as a continuing entity for income tax purposes unless it is terminated. Given the proliferation of state law entities taxed as partnerships today (e.g., limited liability companies and limited liability partnerships), a good understanding of the rules surrounding termination is ever important.

Prior to the Tax Cuts and Jobs Act (“TCJA”), IRC § 708(b)(1) provided that a partnership [1] was considered terminated if:  

1.  No part of any business, financial operation, or venture of the partnership continues to be carried on by any of the partners of the partnership; or

2.  Within any 12-month period, there is a sale of exchange of 50% or more of the total interests of the partnership’s capital and profits.

As reported in my November 2013 blog post, for tax years beginning in 2015 or later, under ORS 316.043, applicable non-passive income attributable to certain partnerships and S corporations may be taxed using reduced tax rates.  The reduced tax rates are as follows:

• • 7 percent for taxable income of $250,000 or less;

• • 7.2 percent for taxable income greater than $250,000 but less than or equal to $500,000;

• • 7.6 percent for taxable income greater than $500,000 but less than or equal to $1,000,000;

• • 8 percent for taxable income greater than $1,000,000 but less than or equal to $2,500,000;

• • 9 percent for taxable income greater than $2,500,000 but less than or equal to $5,000,000; and

• • 9.9 percent for taxable income greater than $5,000,000.