Checkmate, the Treasury FinallySurrenders: The Check-the-Box TreasuryRegulations and Their Effect onEntity Classification

I. Introduction On March 29, 1995, the Department of the Treasury (Treasury) issued Notice 95-14(1) in which it announced its intent to simplify the tax entity classification rules.2 Within two years, on December 17, 1996, the Treasury finalized these rules that are popularly known as the "check-the-box" regulations.3 The new regulations permit an eligible entity to indicate its desired tax treatment simply by checking a box. This Note explains how the new regulations affect the classification of entities for tax purposes. Part II presents the fundamental distinction between corporate and partnership tax classification? Part III summarizes the history of entity classification for federal tax purposes.6 Part IV explains how an entity selects tax classification under the new check-the-box regulations.' Part V addresses the potential problems and opportunities that may accompany the new regulations during their transition into practice.8 Part VI concludes that the check-thebox regulations provide a simple and efficient means for determining entity tax classification. II. The Stakes: Partnership v. Corporate Classification In the game of entity classification, choosing the most beneficial tax status for an entity is at stake. In most cases, the choice will result either in corporate or partnership tax status. Corporate tax status exposes an entity's income to double taxation because the Internal Revenue Code (Code) taxes corporate income at the corporate entity level and at the shareholder level.9 On the other hand, partnerships, limited partnerships, limited liability partnerships (LLPs), and limited liability companies (LLCs) escape the entity-level tax.10 Instead, their income flows through to the partners or members, and the Code taxes this income only at the individual partner's or member's rate.11 Likewise, partners and members directly deduct partnership tax losses.12 To explain the effect of the difference between corporate and partnership tax treatment, consider the following example. A corporation producing $100 worth of taxable income can be taxed up to the 35% maximum corporate rate.13 After taxes, the corporation has only $65 to disburse to its shareholders in the form of a dividend.14 The Code taxes shareholder dividends up to a maximum 39.6 % rate for individuals.15 Thus, the shareholders receive only $39 out of every $100 of corporate earnings because of double taxation.16 In contrast, the Code does not impose an entity-level tax on partnerships.17 Instead, $100 earned by a partnership flows through to the partners and the Code only taxes this amount up to the 39.6 % maximum individual rate.18 Therefore, partners in most circumstances ultimately receive $60 for every $100 of partnership income. Tax treatment of partnerships was traditionally counterbalanced by the disadvantages of the partnership form, most notably individual liability for partnership debts.19 However, these disadvantages are largely a remnant of the past. At one time, limited liability distinguished partnerships from corporations.20 The corporate form allows shareholders to avoid personal liability for debts and obligations of the corporation.21 Corporate creditors may not proceed against the personal assets of the corporation's shareholders.22 Conversely, partnership creditors may proceed against a partner's personal assets to satisfy partnership liabilities.23 The limited liability distinction vanished over the years as partners devised new entity configurations to limit their liability. The first such entity was the limited partnership.24 A limited partnership is a two-tiered structure consisting of general partners and limited partners.25 The limited partnership form allows the limited partners to escape personal liability for partnership liabilities.26 General partners, however, remain personally liable for partnership debts.27 State created entities such as LLPs and LLCs took limited liability a step further and afforded complete limited liability for all members of the entity. …