AICPA Suggests Changes To Check-The-Box Regs.

The American Institute of Certified Public Accountants has suggested several changes to the proposed check-the-box regs. The AICPA recommends that partnerships electing to change to the association classification be allowed to select the form that the incorporation is deemed to take. It also suggests that the regs prohibit entities from electing an effective date that is later than the first day of the tax year following the tax year in which the election was filed. The AICPA also says that the filing date should be the controlling date for determining which members of the entity must sign the election and that guidance should be provided on what constitutes authorization to make the election. In addition, the group states that the filing requirement in reg. section 301.7701- 3(c)(3) should be removed because it imposes an unnecessary compliance burden. Other changes proposed by the AICPA relate to the characterization of entities as single- or multiple-member, the list of per se corporations, and the transition rules.

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AMERICAN INSTTUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations Section 301.7701-1 to -3

Working Group Members

Submitted to the Internal Revenue Service

August 15, 1996

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations Section 301.7701-1 to -3

August 15, 1996

GENERAL COMMENTS

The AICPA commends the Treasury Department and the Internal Revenue Service on the issuance of proposed regulations to simplify the tax classification of unincorporated business entities. These regulations have been highly praised by the professional community and taxpayers, with comments being constructively focused on a narrow set of difficult issues. We support finalizing the proposed regulations, but recommend the following changes.

SPECIFIC COMMENTS

1. Form of Deemed Incorporation

The preamble to the proposed regulations reminds taxpayers that an election to change the federal tax classification of an existing eligible entity will have tax consequences. It notes, for example, that if an organization that is classified as an association taxable as a corporation elects partnership classification, the organization and its owners must recognize gain, if any, under the corporate liquidation rules.

Neither the preamble nor the regulations, however, address the tax consequences of electing to change classification from that of a partnership to that of an association taxable as a corporation. In Rev. Rul. 84-111, 1984-2 C.B. 88, the Internal Revenue Service ruled that the tax consequences of incorporating a partnership are determined according to the legal form of the incorporation. The ruling illustrated forms for incorporating and discussed the tax consequences associated with each form.

Because partnerships will have the option of either electing association classification under the regulations or formally incorporating, the regulations should provide a rule that promotes consistency in the tax consequences between elective classifications as associations and formal incorporations. We recommend the regulations provide that partnerships electing to change to association classification be permitted to select the form that the incorporation is deemed to take and, thus, the tax consequences of the deemed incorporation, based on the principles of Rev. Rul. 84- 111. The "check-the-box" election sheet could contain an election for selecting the form of the deemed incorporation, with the regulations providing a default form for the deemed incorporation if no selection is made.

2. Effective Date of Election

An eligible entity's election to have a classification other than its default classification, or to change its classification, is to be effective on the date specified in the election if that date is not more than 75 days prior to the date on which the election is filed, or on the date filed if no date is specified in the election. Prop. Reg. section 301.7701-3(c)(1). The proposed regulations do not place any limitations on the selection of an effective date that is subsequent to the election filing date. Thus, an entity could select an effective date that is several years after the taxable year in which the election is filed.

The failure to place limitations on the selection of an effective date that is subsequent to the election filing date could result in administrative complexities for taxpayers and the Internal Revenue Service. We recommend that the regulations prohibit electing an effective date that is later than the first day of the next taxable year immediately following the taxable year of the election. This would be consistent with the approach taken in I.R.C. section 1362(b) regarding an S corporation election.

3. Required Signatures on Election Statement

The proposed regulations require that an election be signed by: (1) each member of the electing entity, or (2) any officer, manager, or owner who is authorized to make the election and who, under penalties of perjury, represents to having such authorization. Prop. Reg. section 301.7701-3(c)(2).

A. Determination of Required Signatures

The proposed regulations do not indicate whether the effective date of the election or the date on which the election is filed is the relevant date for purposes of determining who is a member required to sign an election.

If the effective date is the relevant date, a signature may be required of someone who is not a member of the entity on the election filing date. This has the potential for creating compliance problems in that a former member, or a member admitted subsequent to the filing date, may not be agreeable to signing the election, particularly if the entity's reclassification results in adverse tax consequences to that member. Also, if the effective date for the election is subsequent to the filing date, an additional compliance burden would arise if the entity acquired new members after the election filing date; in such a case, an amended election would need to be filed. In contrast, if the filing date is the relevant date, the compliance burden is reduced, since signatures of former members or members admitted subsequent to the fifing date would no longer be required.

We recommend that the regulations provide that the filing date is the controlling date for determining which members must sign the election. This would be consistent with the approach taken in I.R.C. section 1362(a) regarding the relevant date for determining which shareholders must consent to an S corporation election.

B. Authorization to Sign Election Statement for Foreign Entity

Under some foreign legal systems, it may be unclear whether an officer, manager, or owner is authorized to make the election. We recommend that the regulations provide guidance concerning what constitutes authorization for this purpose and what form of documentation is necessary to evidence such authorization.

C. Signatures of Foreign Owners of Foreign Entity

To alleviate the potential compliance burden that would result from requiring an election to be signed by each member of a foreign entity, including members who are not subject to U.S. tax, consideration should be given to requiring the signatures of only those members for whom the entity's classification is relevant for federal tax purposes.

4. Attaching Election to Tax Return

The proposed regulations require that a copy of the election be filed with the electing entity's federal tax return for the taxable year for which the election is made, if the entity is required to file a federal return. Prop. Reg. section 301.7701-3(c)(3). This requirement may pose a problem for an electing entity if it inadvertently fails to attach the election. It also may pose an administrative problem for the Internal Revenue Service if an entity attempts to void an election by failing to file a copy of the election with the entity's return.

Since the election will already be on file with the Internal Revenue Service, it seems that this filing requirement constitutes an unnecessary compliance burden and, as noted above, may be a trap for the unwary or a vehicle for abuse of the system. We recommend that this filing requirement be removed from the regulations; this would be consistent with the S corporation rules which do not require the filing of a copy of Form 2553, Election by a Small Business Corporation, with a corporation's first S corporation return. In the alternative, we recommend that the regulations provide that this is solely a return filing requirement and that an entity's failure to file the election statement with its return will not affect the entity's election.

5. Characterization as Single-Member or Multiple-Member Entity

The Proposed regulations provide that a domestic single-member eligible entity will be disregarded as an entity unless it otherwise elects to be classified as an association taxable as a corporation. Prop. Reg. section 301.7701-3(b)(1). A similar rule is stated for a foreign single-member eligible entity, provided the member has unlimited liability. Prop. Reg. section 301.7701-3(b)(2). The proposed regulations do not, however, define a single-member entity.

A question arises, for example, as to whether both partners in a two-member partnership will be respected as such when both partners are commonly controlled and the only reason for having the second partner is so that the entity can be classified as a partnership under the entity classification rules. A similar question arises because some foreign and U.S. jurisdictions have legal requirements that certain entities have a minimum number of owners, even though all but one of the owners may hold only nominal interests in the entity. (For example, a Swiss GmbH must have at least two initial shareholders.) In many cases, but for these legal requirements, a single person would own 100 percent of such entities.

If the determination of single-member versus multiple-member entity status were to be made on a case-by-case basis, analyzing the relative size or activities of the members and the purpose for having multiple members, the administrative burden would be excessive relative to the matter at issue -- i.e., the difference between classification as a sole proprietorship/division on one hand and a partnership on the other. Further, a case-by-case factual analysis would be inconsistent with the proposed regulations' approach and intended goal with respect to entity classification, as stated in the preamble, of providing taxpayers with a "simpler approach that is generally elective."

Accordingly, we recommend that the regulations contain the following general rule and exception. Under the general rule, an entity that has more than one member will not be regarded as a single-member entity regardless of the size of the interests of the members and the purposes for the membership interests. An exception will apply if all but one of the members hold only nominal interests and the purpose for those nominal interests is solely to comply with applicable law; in such an instance, the entity will have the option to elect to be treated as either a single-member or a multiple-member entity.

(Precedent is found in I.R.C. section 1504(d) for providing taxpayers with the option of disregarding, for U.S. tax purposes, formal structure that was adopted merely to comply with local law. Section 1504(d) grants taxpayers the option of treating a Canadian or Mexican corporation as a U.S. corporation, and therefore as an includible corporation in a consolidated income tax return (assuming other requirements are met), if the Canadian or Mexican corporation is maintained solely to comply with the local law regarding title and operation of property.)

6. Listing of "Per Se" Entities

The proposed regulations provide a listing of foreign entities which will be classified "per se" as corporations for U.S. tax purposes. Prop. Reg. section 301.7701-2(b)(8). We are concerned that further research into the attributes of these foreign entities, coupled with future changes in foreign laws, will require periodic additions to and/or deletions from this listing. If taxpayers are required to be in compliance with this listing at all times, changes to the listing could result in detrimental tax consequences to a taxpayer.

We recommend that the final regulations explain the parameters for the determination of an entity's inclusion in this "per se" listing, and provide a procedure whereby an entity's inclusion can be challenged based on those parameters. We further recommend that the final regulations provide that additions to and/or deletions from this listing will be effective (a) only on a prospective basis, unless the change is the result of a challenge to the per se listing, and (b) only at the election of the taxpayer in cases where the taxpayer had previously relied upon the listing for the classification of an entity (or alternatively provide transitional relief in lieu of such an election).

7. Transitional Rules

A. "All Prior Periods" Requirements

The proposed regulations provide that an existing entity's claimed classification at the effective date of the regulations will be respected if, among other requirements, the entity has a reasonable basis (within the meaning of section 6662) for its claimed classification and the entity claimed that same classification for all prior periods. Prop. Reg. section 301.7701-3(e)(2). A similar rule is provided for partnership classification of an existing foreign entity that otherwise would be classified as a corporation under the "per se" list. Prop. Reg. section 301.7701-2(d).

The preamble contains no explanation for the "all prior periods" requirements. We can discern no need for these requirements and believe the imposition of such requirements is unjustified and would unduly deny entities transitional relief. We, therefore, recommend that the "all prior periods" requirements be deleted from Prop. Reg. sections 301.7701-3(e)(2) and -2(d).

B. Unintended Corporate Liquidations

The default classification provisions provide that an existing eligible entity will have the same classification the entity CLAIMED on the date prior to the effective date of the regulations, Prop. Reg. section 301.7701-3(b)(3). The Internal Revenue Service can challenge an existing entity's classification for periods prior to the effective date of the regulations. Prop. Reg. section 301.7701- 3(e)(2).

The automatic application of the default classification rule in the case of a successful challenge to an entity's prior classification may result in an unintended liquidation. For example, assume an existing entity is claiming status as a partnership and that the proposed regulations become final on January 1, 1997. If the Internal Revenue Service is successful in 1997 in challenging the entity's partnership status for 1996, the entity will be treated as an association taxable as a corporation for 1996; however, under the default rules, the entity will be treated as a partnership for 1997 because that is the status that the entity claimed on December 31, 1996. Thus, it appears the default rule could cause a deemed corporate liquidation, with all the resulting tax consequences, followed by the creation of a partnership.

The unintended liquidation could occur because an existing entity's default classification is determined by reference to its claimed classification, without reference to the reasonableness of the basis for that claimed classification, while the status of the entity prior to the effective date is determined by reference to reasonableness. As stated in the preamble, the purpose of the default rules is to provide entities with the classifications they would choose without filing an election. It seems unlikely that, in most situations, an entity would choose a classification that would result in a taxable liquidation.

We recommend that the regulations provide that, if an entity's claimed classification for periods prior to the effective date of the regulations is successfully challenged by the Internal Revenue Service, the entity will be allowed, at its option, to revoke the application of the default classification rule.

Representatives of the AICPA will be pleased to meet with the Internal Revenue Service to discuss these matters further. Please feel free to contact any of the following individuals: Michael K. (Mike) Carnevale, Chair of the Section 7701 Working Group of the Partnership Taxation Committee, at (202) 955-4131; Kenneth H. (Ken) Heller, Chair of the Partnership Taxation Committee, at (703) 993- 1765; or Jean E. Trompeter, AICPA Technical Manager, at (202) 434- 9279.