Submitted by: John DeBruyn
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Stuart Levine, designated hitter on the Tax Section's comments to Treasury on the proposed Check-the-Box regulations, posted this in the LNET-LLC discussion group as a series of four messages.
A group of chairs and vice chairs in the LLC/Partnership Task Force representing both the Real Property and Probate Trust Divisions of the Real Property/Probate Section have also reviewed the proposed regulations. This group was concerned about the proposed regulations failure to clarify the initial test that is applied in the case of an entity classified as a trust under state law to determine whether it is a trust for income tax purposes rather than not-a-trust (business entity) that would be classified under the proposed regulations as a partnership in the absence of a contrary election. The group decided that the trust classification issues were problematic and which, if considered seriously by the Treasury, could easily delay the issuance of the regulations.
The group committed to lending its support to a project with the Treasury and the Service to deal with the trust classification issues after a consensus is reached within the Probate and Trust Division of the issues to be clarrified. Like other LLC/Partnership Task Force projects, the committees on the Real Property side, including the Land Trust Committee, will be involved.
In the meantime the group, along with the task force group working on the LLP and LLLP uniform act amendments, will begin work on model or prototype amendments for consideration by state drafting committees to take advantage of the opportunities for simplification that the Check-the-Box regulations will permit in the LLC, partnership and limited partnership acts of the various states. The joint group will be especially mindful of the need for continuity of life in most real estate and estate planning uses of these entities.
Any comments posted here will be passed on to Stuart and used for the revision of the forgoing comments which will become part of this item when it is posted on the virtual committees home page. The virtual committee is planning an electronic and hard copy newsletter--Business Valuation and Planning Update--to circulate items like this which have a bearing on business valuation and planning. The committee's home page of the is being beta tested at:
http://www.exit109.com/~ademaio/vcbvhome.shtml
Your comments will be appreciated,
John DeBruyn, chair, virtual committee on business valuation
-- John DeBruyn, Denver, Colorado, The Mile High City, USA (jdebruyn@usa.net)
Stuart's messages with his cover sheet first:
Date: Tue, 2 Jul 1996 11:52:05 -0400
From: Stuart Levine
Subject: Check the Box
Below, is the memo which covered my first draft of comments on check the box. The comments themselves follow in separate letters. [Ed: These four email letters of the same date are appended below with there headers deleted so that this is one document.]
Enclosed is a first draft of the comments on check the box. I fully expect a blizzard of (hopefully constructive) criticism. I suspect that the main targets for that criticism will be the brevity of the comments and matters that were omitted. In anticipation, let me briefly outline for you my reasons for drafting the comments in the form set forth.
The overriding goal was to draft comments which said: "Get these regulations in force as soon as possible." Alongside of that goal was my intent to use the comments to Notice 95-14 as a springboard. After all, it would have seem churlish, at best, if we criticized the proposed regulations for taking positions that we espoused only a year ago. With that as a background, let me outline my reasoning behind the points more specifically. The transition rules seemed to have engendered the most concern among practioners. In a technical sense, this concern is valid. However, I believe that, albeit only with a wink and a nod, the Service has actually conceded that from May 10, 1996, the current regulations have been withdrawn and the proposed regulations substituted in their stead. I think that the comments set forth with tend to solidify that position even though they may not fix it in concrete to the extent that some would like. I received some comments that we should request that the regulations address topics outside of the narrow confines of entity classification. I have rejected this approach for several reasons which I set forth in reverse order of importance.
First, comments of this sort were not reflected in our submission to Notice 95-14. I hardly think that we should criticize the proposed regulations for not addressing issues that we failed to address.
Second, the regulations are revolutionary enough without breaking further new ground.
Third, some of the areas which were suggested are already the subject of intense discussion by other groups. By way of example, the FICA/SECA problems and the Banoff-Frost-Keatinge proposal being actively debated and hammered into final form by the LLC Task Force. I felt that it was premature to raise those issues here.
One of the comments relates to use of nominees to form "one member" LLCs in states that have not yet modified their statutes to allow one member LLCs. I inserted this comment because it seemed to me that there will be a number of states where this problem is presented. However, I must express some ambivalence on the subject. Are we really asking for the IRS to do an end-run around state legislatures? Is the problem even a problem? After all, my guess is that the vast majority of states will have modified their statutes within, at most, two years after the regulations are finalized. Finally, the weakest section of my draft is clearly the section relating to foreign business entities. This section of the regulations varies from our 95-14 suggestions more than do the proposals relating to domestic entities. Yet, I feel that the proposed regulations even here represent such an incredible advance that I am reluctant to tamper with the Service's and Treasury's handiwork.
My greatest fear is that I missed something critical. I am certain, however, that my correspondents will set me straight.
This is the first part of the comments:
On May 10, 1996, the Treasury Department (the "Treasury") and the Internal Revenue Service ("IRS") proposed regulations that would replace the existing entity classification rules. The supplementary information released by the Treasury and IRS with the proposed regulations stated that the proposed regulations represent a "simplified regime that is elective for certain business organizations."
The proposed regulations, taken as a whole, represent a welcome change in the manner in which entity classification is determined. This point cannot be overemphasized. There are comments which follow directed to specific portions of the proposed regulations that may present particular problems.
However, the proposed regulations, taken as a whole, are so significant and important, that they should be adopted as quickly as is reasonably possible.
This paper makes the following principal comments and recommendations:
1. The proposed regulations should be adopted as quickly as possible with a view to adoption on or before January 1, 1997.
2. The transition rules governing the classification of entities prior to the adoption of the final regulations should provide that the IRS will respect the tax classification of an entity chosen prior to the adoption of the final regulations provided that (1) the entity claimed the classification for all prior years and (2) neither the entity or any member has been notified in writing on or before May 9, 1996, that the classification of the entity in under examination.
3. The limitation set forth in proposed Reg. §301.7701-2(c)(1)(ii) that allows a business entity only one election every sixty (60) to change its classification should be limited to foreign business entities.
4. With respect to foreign business entities, in addition to the methods set forth in the proposed regulations, an election should be effective if all of the U.S. owners of the business entity join in making the election.
In Notice 95-14, 1995-1 C.B. 297, the Treasury and the IRS announced that they were considering simplifying the classification regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as associations on an elective basis. The Treasury and the IRS also stated that they were considering adopting similar rules for foreign business organizations.
Comments were invited on the simplification of the current regulations, including alternative methods for simplification. In addition, comments were invited with respect to specific approach set forth in Notice 95-14. In response, the Section of Taxation of the American Bar Association submitted a paper. Among the comments and recommendations that were made were the following:
1. With respect to domestic unincorporated organizations:
a. The general approach suggested by Notice 95-14 should be adopted.
b. The default rule with respect to domestic organizations formed after the change in the regulations should be that unincorporated entities will be classified as partnerships.
c. The default rule should also operate with respect to organizations which are formed prior to the date of adoption of the regulations so long as their tax compliance actions have been consistent with partnership treatment. Thus, if any of these entities reported their income as partnerships rather than as corporations, they could continue to do so.
d. Any election allowed by the final regulations should be allowed to be made at the time the first return for the entity is due after the effective date of the final regulations.
e. An election should be sufficient if it is made in a manner which is authorized by the instruments governing the affairs of the organization. There should be no requirement that all of the owners affirmatively consent to the making of any election.
f. Once made, an election to be classified as either a partnership or a corporation should be honored (and operative) for all purposes.
g. There is no reason to classify limited liability entities which have only one member as corporations unless the entities either make an affirmative election to be so classified or the entities are organized as corporations under state law.
2. With respect to foreign organizations:
a. Foreign organizations should be classified as partnerships unless they make an affirmative election to be taxed as corporations. b. Because the use of hybrids does not have any impact upon U.S. tax revenue, it is inappropriate to address these issues by an arbitrary position that all unincorporated business organizations must be classified consistently for both foreign local and U.S. tax purposes. c. The default rule for a foreign organization that does not file an election would be to treat it as a corporation, except in two cases, namely:
(i) Where the parties initially believed that the arrangement was a contractual arrangement that did not give rise to any separate reporting requirement; and
(ii) Where the foreign organization initially elected to be classified as a partnership, but, pursuant to I.R.C. Section 708, dissolved and re-formed due to a sale of more than 50% of the interests in the entity in a twelve month period.
In either of the two cases just cited, the default rule should be classification as a partnership.
d. There should be no requirement that all of the owners affirmatively consent to the making of any election. An election should be effective either if:
(i) The organization makes an election pursuant to the terms of its governing instrument(s); or
(ii) All of the U.S. owners of the organization join in making an election.
With respect to domestic business entities, the proposed regulations are closely aligned to the suggestions we submitted in response to Notice 95-14.
With respect to foreign business entities, there are some differences, but the proposed regulations nevertheless generally achieve the overarching goals of simplicity and certainty.
In its opinion in Morrissey v. Commissioner, 296 U.S. 344, 354-355 (1935), the Supreme Court noted that:
As the [tax code] merely provided that the term "corporation" should include "associations," without further definition, the Treasury Department was authorized to supply rules for the enforcement of the [tax code] within the permissible bounds of administrative construction. Nor can this authority be deemed to be so restricted that the regulations, once issued could not later be clarified or enlarged so as to meet administrative exigencies or conform to judicial decision.
The central problem posed with respect to any classification regime is rooted in the difficulty of analytically differentiating between corporations, on the one hand, and unincorporated associations, on the other. As business laws have evolved, the distinctions upon which federal income tax classifications have traditionally been based have increasingly become blurred. Thus, to a great extent, limited liability partnerships, limited partnerships, limited liability limited partnerships, and limited liability companies are or can be as "incorporated" as corporations, while, depending on the manner in which they are structured, corporations organized under the statutory close corporation statutes of many states may more closely resemble traditional partnerships than corporations. Similar results can be obtained under the laws of various foreign jurisdictions. As a consequence, taxpayers may now, in effect, elect whether to have their business enterprises classified as corporations or partnerships for federal tax purposes without regard to the manner in which the relationships among the owners are arranged.
Notwithstanding the fact that taxpayers can effectively elect whether to be treated as corporations or partnerships, for many taxpayers there remains a significant toll charge involved. Specifically, they must successfully navigate the tricky and somewhat difficult straits of the current classification regulations. This passage inevitably exacts costs in terms of professional fees incurred in planning and some degree of uncertainty, since the precise boundaries of the law are still in the process of being fleshed out by private letter rulings, published letter rulings, and revenue procedures. The costs imposed upon taxpayers are mirrored by the costs imposed upon the IRS and the Treasury in issuing pronouncements attempting to define the elusive specific qualities that give rise to the distinctions between corporations and partnerships.
As indicated by the Supreme Court in Morrissey (". . . the regulations, once issued could [. . .] later be clarified or enlarged so as to meet administrative exigencies . . ."), the Service and the Treasury have broad latitude to promulgate regulations in this area. Given the large and growing number of businesses currently organized as pass-through entities that possess limited liability, there is a compelling need to simplify the regulatory thicket. The proposed regulations go a long way in filling that need.
We are in favor of the general approach to dealing with domestic unincorporated entities outlined in the proposed regulations for the following reasons:
1. As noted above, the current regulations, de facto, allow knowledgeable taxpayers to elect whether their business entities will be taxed as corporations or as partnerships for federal income tax purposes. Thus, to the extent the current regulations seek to draw a distinction between corporations and partnerships, that distinction is without consequence to informed taxpayers.
2. While knowledgeable taxpayers can effectively elect whether their business enterprises will be classified as corporations or partnerships, less sophisticated taxpayers may not be aware of the available options. The result is that similar types of taxpayers are treated differently based solely on the relative amount of knowledge and sophistication they possess.
3. Even those taxpayers who are knowledgeable must incur significant costs for professional advice. In essence, these costs become a toll charge incurred solely to utilize the flexibility currently available in this area.
4. In addition to the costs incurred by taxpayers, the Service and the Treasury must devote substantial resources in this area responding to questions raised by taxpayers and their advisors and providing additional guidance through published letter rulings and revenue procedures.
5. Finally, it is our perception that as entities such as limited liability companies become more popular, many taxpayers are unwittingly treating themselves as partnerships even though a careful review applying current standards enunciated by the Service would result in them being classified as corporations. The taxpayers who presently fall into this category do so, in the main, because their advisors do not fully understand the operative rules in this area. However, because of the large number of limited liability companies being organized, there is no cost effective audit mechanism with respect to the classification issue. As a consequence, we anticipate that the inability of large numbers of taxpayers to adequately comply with the classification rules will, of itself, lead to the establishment in practice of ever more liberal rules. Thus, there will likely be a continuing process leading to the formation of ever increasing numbers of limited liability companies which fall further and further outside of the safe harbors set forth in Rev. Proc. 95-10, blurring even more the artificial lines between corporations and partnerships.
At about the same time as the proposed regulations were issued, limited liability company statutes were passed in the last three states to enact legislation. Numerous states have enacted limited liability partnership legislation and there is now a movement to enact limited liability limited partnership act legislation. The pace of legislation to allow these new forms of business enterprise is a reflection of the perceived need in the business community for pass-through entities that have limited liability. Limited liability company acts, however, generally adopt as default rules provisions relating to continuity of life, free transferability, and centralization of management in order to insure that entities formed under their provisions are classified as partnerships under the current tax classification regime. It is likely that, after the proposed regulations become final, state legislatures will desire to amend these default rules. Since state legislatures generally meet in the first half of the calendar year, the regulations must be finalized no later than January 1, 1997, to allow the state legislatures sufficient time to amend the various statutes so that any amendments will be effective in 1997.
Notice 95-14 stated that the anticipated regulations would "apply to all such organizations that have two or more associates. . . ." Nevertheless, Notice 95-14 also requested comments on the proper treatment of organizations which have only one member. In our comments in response to Notice 95-14, we stated that:
We believe that there is no reason to classify limited liability entities which have only one member as corporations unless the entities either make an affirmative election to be so classified or the entities are organized as corporations under state law.
Obviously, we are pleased that the proposed regulations have adopted the approach we suggested. Two additional comments are in order, however.
First, just as the default rules of the various limited liability company statutes will likely be amended to allow full use of the flexibility inherent in the regulations, many statutes will also have be amended to allow the formation of one-person limited liability companies. This again points up the necessity of early finalization of the regulations.
Second, however, for a variety of reasons, it may take a while after the regulations are issued for appropriate state legislation to be drafted, enacted, and then become effective. In order to allow businesses to utilize the planning possibilities inherent in the final regulations to form one member business entities treated as sole proprietorships, divisions, or branches, the final regulations should provide that business entities that have two members will be treated as though they had only one member if (1) one of the members is wholly-owned by the other member, and (2) one of the members has only a nominal stake in the business entity.
Proposed Reg. §301.7701-2(e) provides that, except for those business entities that will always be taxable as corporations, business entities in existence prior to the effective date of the final regulations will have their claimed classification respected for all periods prior to the effective date if:
(i) The entity had a reasonable basis (within the meaning of Section 6662 of the Internal Revenue Code) for its claimed classification; (ii) The entity claimed the same classification for all prior periods; and (iii) Neither the entity or any member had been notified in writing on or before the date of promulgation of the proposed regulations that the classification of entity was under examination, in which case the entity's classification will be determined in the examination.
The proposed "reasonable basis" requirement has engendered perhaps the most concern among practitioners. For one thing, the requirement utilizes a concept that is itself so susceptible of different definitions that no final regulations attempting to map its exact boundaries have ever been issued. More significantly, however, the requirement seems to be at war with the basic intent of the proposed regulations. Under the proposed regulations, the highly subjective tests for entity classification utilized by the present regime are rejected in favor of bright-line, objective tests. The plinth upon which this change rests is the premise that it is desirable to have certainty with respect to entity classification. There would seem to be no reason not to apply this fundamental premise for all periods after the issuance of the proposed regulations on May 10, 1996.
As the proposed regulations are currently drafted, even after finalization, there would continue to be uncertainty concerning the possibility of a challenge that, during the transition period, a particular business entity did not have a "reasonable basis" for its chosen tax classification. In other words, there would still be a possibility for a significant challenge that a subjective standard had not been met. We believe that the same policy considerations that support a bright-line test after the final regulations are issued also support a bright-line test during the transition period between the time the regulation were proposed and when they are finalized. Accordingly, we would suggest that the "reasonable basis" requirement set forth in Prop. Reg. §301.7701-2(e)(1) be deleted and that business entities in existence prior to the effective date of the final regulations have their claimed classification respected for all periods prior to the effective date contingent only upon the requirements that (i) the entity claimed the same classification for all prior periods; and (ii) neither the entity or any member had been notified in writing on or before the date of promulgation of the proposed regulations that the classification of entity was under examination, in which case the entity's classification will be determined in the examination.
The proposed regulations allow a business entity only one election every sixty months to change its classification. It is our understanding that this provision was primarily intended to address potential abuses in the foreign area. We are not aware of any potential abuses that would arise if the sixty month limitation did not apply to domestic business entities. The only potential problem might arise with respect to administration of an entity that is constantly changing its classification.
However, we believe that the fact that "a change in classification, no matter how achieved, will have certain tax consequences that must be reported" is sufficient to discourage wholesale "flip-flopping" from partnerships to corporations and back again. Unless there is some potential for abuse, elections to move from one classification to another should not limited.
Even though the proposed regulations concerning foreign business entities do not follow our suggestions as closely as those pertaining to domestic business entities do, we are still generally pleased with the result. One change that we would suggest relates to the manner in which an election is made.
Under the proposed regulations, an election by a foreign business entity to opt out of its default classification must be signed by either (i) each member of the electing entity, or (ii) any officer, manager, or member of an electing entity who is authorized to make the election and who represents, under penalties of perjury, having such authorization. We believe that, in addition to the vehicles set forth in the proposed regulations, all members of an electing entity who are U.S. persons should be allowed to unanimously make an appropriate election.
In our comments to Notice 95-14, we stated:
U.S. outbound investors in foreign joint ventures are often at an extreme business disadvantage when they must negotiate with foreign partners in order to obtain concessions necessary to assure the U.S. tax treatment. If, in order to obtain pass-through classification by filing an election, it is necessary for the U.S. joint venturer to obtain the assent (or worse, actual execution of an election) of its foreign joint venture partners, then the situation regarding bargaining for entity classification will not have been improved. Accordingly, it is strongly recommended that the election system be implemented in the foreign area by virtue of filing of an election by either the tax matters partner for the partnership or a filing by all of the partners that are U.S. persons. This is consistent with the reporting requirements for foreign partnerships with U.S. partners under both the existing and the proposed regulations under I.R.C. § 6031. While the opportunity for inconsistent elections among the partners must be avoided, a requirement that all owners, including the foreign owners, execute the election will make it impractical.
We believe that a default rule allowing the U.S. owners of a business the right to make U.S. tax elections is entirely justified.
The proposed regulations set forth a list of various foreign entities that will always be classified as associations taxable as corporations. Neither the proposed regulations nor the preliminary explanation detail the factors which lead to the inclusion of any particular entity on this list. We understand that some commentators take issue with the inclusion of specific entities.
We have chosen to keep these comments general in
nature. That
choice should not be viewed as constituting an agreement that
all of the entities set forth on the list are properly
included there.