Eligible Entities and "Check the Box" Treasury Regulations

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Another Dive into Business Taxes: Eligible Entities and Choosing How You're Taxed

California state law classification of business entities is not always the same as the tax classification of an entity. Under the "check the box" treasury regulations, a business entity is classified either as a "per se" C-corporation or as an entity eligible allowing it to choose its tax classification. These enttities are referred to as eligible entities (see Treas. Regs. §§ 301.7701-2 and 301.7701-3). This blog post will continue our discussion of tax considerations that come up when forming a business entity.

Key Takeaways

  • Check the box treasury regulations allow eligible entities to choose to be taxed as a disregarded entity or partnership

  • Limited liability companies and partnerships are eligible entities

PER SE CORPORATIONS

Under the check the box treasury regulations, certain entities are automatically classified as per se C-corporations and therefore cannot make an election to be treated as a disregarded entity or partnership for tax purposes, which is to say that the entity is not an eligible entity (see Treas. Regs. §§ 301.7701-2 and 301.7701-3(a)). A corporation incorporated under California state law is a per se C-corporation for tax purposes.

However, a per se C-corporation that meets the requirements for the S-corporation election (limited number of stockholder, eligible type of stockholders, etc.) can elect S-corporation status at the outset and at the time of formation (see IRC §§ 1361 and 1362). If a C-corporation makes an S-corporation election after the time of formation, there are potential adverse tax consequences, which are discussed below.

ELIGIBLE ENTITIES

An eligible entity (meaning, a business entity not treated as a per se C-corporation) generally chooses its classification for tax purposes (see Treas. Reg. § 301.7701-3), and therefore can take advantage of entity level taxation by being recognized as a flow-through entity for tax purposes. Partnerships and LLCs organized under California state law are by default eligible entities under the same check the box treasury regulations.

Check the box treasury regulations include default rules for eligible entities (see Treas. Reg. § 301.7701-3(b)), which are noted below. Keep in mind that the rules for US businesses and foreign businesses are different. Under the default rules for US businesses, an eligible entity with a single owner is automatically classified as a disregarded entity; that is, unless the business elects C-corporation tax status, which would prohibit it from being treated as a disregarded entity for tax purposes, and bring about double taxation. The default rules also indicate that an eligible entity with multiple members is automatically classified as a partnership for tax purposes; that is, unless the business elects C-corporation tax status.

If an eligible entity desires to be treated as a C-Corporation, rather than being treated under the default tax status, then it only needs to make a formal check the box election on IRS Form 8832 (see also Treas. Reg. § 301.7701-3(a)).

As mentioned above, there are potential adverse tax consequences if the election is made after then time of formation. In order to avoid these adverse consequences, it is best to make the election at the time of formation; however, you can technically wait to file a check the box election until (but within) 75 days of entity formation (see and Treas. Regs. §§ 301.7701-3(c)(1)(iii) and 301.7701-3(g)).

Failing to meet this deadline causes the entity to be ineligible to make an election to change its tax classification to partnership or disregarded entity tax status for five years. The only exception to this rule is a when there is a significant ownership change (which is indicated by more than 50%) and the Internal Revenue Service (IRS) permits the change (Treas. Reg. § 301.7701-3(c)(1)(iv)). Keep in mind, this limitation on changing elective tax classification does not apply if the election to be taxed as a C-corporation is made by a newly formed eligible entity, and the election is effective on the date of formation.

An eligible entity electing C-corporation tax status can later elect S-corporation tax status, but there are potential adverse tax consequences.

Single-Member LLC: Disregarded Entity, C-Corporation or S-Corporation for Tax Purposes

Under the default tax classification rules, a single-member LLC is treated as a disregarded entity for tax purposes unless it elects C-corporation tax status. This arrangement is common for small businesses as they often organize as a limited liability company and only have one owner. However, a single-member LLC that otherwise meets the requirements laid out in the Code for S-corporation election can elect S-corporation tax status at the time of formation (or after formation if it elected C-corporation tax status) (see IRC §§ 1361 and 1362Treas. Regs. §§ 1.1361-1(c) and 301.7701-3(c)(1)(v)(C)).

As is often the case, a small business owner is presented with the opportunity to bring on another owner/member. If a single-member LLC adds another member, the LLC will automatically convert to a partnership for tax purposes. Keep in mind that this conversion may have tax consequences (either gain or loss recognition) for the original member, so if you're thinking of bringing on another member, be sure to seek counsel of an attorney and tax professional (see Treas. Reg. § 301.7701-3(f)(2)and Rev. Rul. 99-5).

Multiple-Member LLC: Partnership, C-Corporation or S-Corporation for Tax Purposes

As for multiple-member LLCs, the default tax classification rules indicate they are treated as partnerships for tax purposes unless the multiple-LLC elects to be treated as C-corporation for tax purposes. If an LLC is classified under the default rules as a partnership for tax purposes and its interests are publicly traded, the LLC is subject to the PTP rules, which you can discuss with us by getting in touch.

Like the single-member LLC, a multiple-member LLC that meets the requirements laid out in the Code for S-corporation election can elect S-corporation tax status at the time of formation (or after formation if it elected C-corporation tax status) (see IRC §§ 1361 and 1362Treas. Regs. §§ 1.1361-1(c) and 301.7701-3(c)(1)(v)(C)).

If a multiple-member LLC, which is treated as a partnership for tax purposes, reduces its membership to a single member, the LLC automatically converts to a disregarded entity for tax purposes, as you would expect based on the above and the default rules for tax classification. Again, keep in mind that this conversion may have tax consequences (either gain or loss recognition) for the original members, so if you're thinking of reducing the number of members, be sure to seek counsel of an attorney and tax professional (see Treas. Reg. § 301.7701-3(f)(2)and Rev. Rul. 99-6).

Partnership: Partnership, C-Corporation or S-Corporation for Tax Purposes

As indicated above, a partnership organized under California state law is classified as a partnership for tax purposes by default unless it elects C-corporation tax status, or is treated as a "publicly traded partnership" (PTP). While it is uncommon for a partnership to elect C-corporation tax status, a partnership treated as a PTP is taxed as a C-corporation unless it meets certain requirements. If you'd like more information about these requirements and PTPs, get in touch! 

As for partnerships being treated as S-corporations for tax purposes, the treasury regulations technically allow this. Specifically, a partnership meeting the requirements for the S-corporation election can elect to be treated as an S-corporation for tax purposes, but this is rarely done in practice (see IRC §§ 1361 and 1362Treas. Regs. §§ 1.1361-1(c) and 301.7701-3(c)(1)(v)(C) and the discussion below). Typically, an S-corporation election is made by a corporation or an LLC.

Converting from a C-Corporation to an S-Corporation after Formation

While it is possible to convert from a C-corporation to an S-corporation after formation, there are potential adverse tax consequences. This also assumes that the C-corporation is otherwise eligible to make the S-corporation election. If this is the case, and the C-corporation makes the election, the converted S-corporation pays an entity level tax at the highest corporate income tax rate (35%) on asset appreciation attributable to C-corporation years (which are called built-in gains) if it is recognized during a specified recognition period after the S-corporation election takes effect (this is referred to as the BIG tax, see IRC § 1374).

The specified recognition is now permanently five years. It was ten years, and then was temporarily reduced to seven years for taxable years beginning in 2009 and 2010. Any asset appreciation occurring after the S-corporation election is not subject to the BIG tax. As a general rule of thumb, a C-corporation may not want to covert to an S-corporation if there is a possibility of an acquisition in the recognition period because this would expose the S-corporation to the BIG tax if it is acquired by an asset purchase (or by a stock purchase that is treated as an asset purchase for tax purposes) during the recognition period.

As you can see, there is a lot think about from a tax perspective when you form a business entity. If you're ready to move forward, but are operating on a tight budget, ask about our Layaway Payment Plan! It's essentially a pay-as-you-go option for those on a tight budget. If you’d like guidance and assistance with creating an entity, schedule a strategy session today; we're happy to help.

Matthew Schlau is a co-founding principal of Schlau|Rogers and an estate and business planning lawyer practicing in Orange, San Diego, Los Angeles and Riverside counties. He is a husband, father, blogger, crossfitter, and really good at helping people achieve their goals.

At Schlau|Rogers, we do more than just estate and business planning, probate and trust administration. Our objective is to provide individually-tailored plans that allow you the opportunity to reach your goals, all while minimizing headaches and risk, and maximizing peace of mind.

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