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WHAT NEW HAMPSHIRE ACCOUNTANTS SHOULD KNOW ABOUT THE CHECK-THE-BOX REGULATIONS

Table of Contents PART 1 INTRODUCTION TO THE SEMINAR .................................................................................................................... 2

PART 2 INTRODUCTION TO THE CHECK-THE-BOX REGULATIONS ........................................................................... 3

PART 3 NEW HAMPSHIRE LLCS AND NON-LLC ENTITIES—BASIC STATUTORY COMPARISONS ........................ 5

PART 4 THE HISTORICAL BACKGROUND OF THE CHECK-THE-BOX REGULATIONS ............................................. 6

PART 5 THE CHECK-THE-BOX REGULATIONS; KEY DEFINITIONS AND RULES ...................................................... 8

[A] Key Definitions and Rules in the Check-the-Box Regulations Generally Governing Both Domestic and Foreign Business Entities ............................................................................................................... 8

[B] The Terms “Disregarded Entity,” “Eligible Entity” and “Association”—A General Comment ...... 11

[C] Key Definitions and Rules in the Check-the-Box Regulations Governing Foreign Business Entities………………… ........................................................................................................................... 11

PART 6 “STANDARD” CHECK-THE-BOX ANALYSES ................................................................................................. 12

PART 7 “REVERSE” CHECK-THE-BOX ANALYSES .................................................................................................... 14

PART 8 THE CHECK-THE-BOX REGULATIONS AND THE NEED FOR “TERMINOLOGICAL SCHIZOPHRENIA” ............................................................................................................................................. 15

PART 9 FORM 8832 AND THE FORM 8832 INSTRUCTIONS ........................................................................................ 17

[A] Introduction……………….. .................................................................................................................... 17

[B] The Contents of Form 8832 .................................................................................................................. 17

[C] The Form 8832 Instructions .................................................................................................................. 18

PART 10 THE PROPOSED FEDERAL TAX CLASSIFICATION OF LLC SERIES ........................................................... 19

PART 11 REV. RUL. 99-5—CONVERSIONS OF DISREGARDED ENTITIES TO PARTNERSHIPS ............................... 20

[A] Introduction to Rev. Ruls. 99-5 and 99-6 ............................................................................................. 20

[B] Rev. Rul. 99-5—Introduction ................................................................................................................ 20

[C] Rev. Rul. 99-5, Situation 1 ..................................................................................................................... 21

[D] Rev. Rul. 99-5, Situation 2 ..................................................................................................................... 23

[E] To Avoid the Potentially Serious Adverse Federal Tax Consequences of Rev. Rul. 99-5, Should Individuals Who Are Forming Single-member LLCs Consider Making S Elections for These LLCs?............................ .......................................................................................................................... 24

PART 12 REV. RUL. 99-6—CONVERSIONS OF PARTNERSHIPS TO DISREGARDED ENTITIES ............................... 24

[A] Introduction……………. ......................................................................................................................... 24

[B] Rev. Rul. 99-6, Situation 1 (Albert Sells His Interest in AB Partnership to Betty) ........................... 25

[C] Rev. Rul. 99-6, Situation 2 (Edward Buys Out Both Carl and Diane) ............................................... 27

[D] To Avoid the Potentially Serious Adverse Federal Tax Consequences of Rev. Rul. 99-6, Should Individuals Who Are Forming Two-member LLCs Consider Making S Elections for These LLCs?......................... ............................................................................................................................. 27

PART 13 FREQUENTLY OCCURRING CHECK-THE-BOX ISSUES AND HOW TO RESOLVE THEM .......................... 28

[A] XYZ Building, LLC ................................................................................................................................. 28

[B] ABC, Inc. and Its QSub .......................................................................................................................... 28

[C] Conversion of LMN General Partnership to a Multi-Member LLC ..................................................... 29

[D] Which is Better: an LLC or a Partnership? ........................................................................................ 29

[E] Which is Better: a Sole Proprietorship or a Single-Member LLC? .................................................. 29

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[F] What federal Tax Classifications and Federal Income Tax Regimens Are Available to a single-shareholder corporation Owned by an Individual? ............................................................................ 29

[G] What Federal Tax Classifications and federal income tax regimens Are Available to a Single-Shareholder Corporation Owned by an Entity? .................................................................................. 29

[H] Individuals A and B want partnership federal income taxation. What types of state-law business entities can qualify for federal partnership taxation? ........................................................................ 29

[I] Individual A Wants Sole Proprietorship Federal Income Taxation. What Types of Business Entities Can Qualify for Sole Proprietorship Federal Income Taxation? ......................................... 29

[J] Individual A Wants Subchapter S Federal Income Taxation. What Types of Business Entities Can Qualify for S Corporation Taxation? .................................................................................................... 29

[K] A and B form a Two-Member LLC called AB. A is the Member-Manager. B is the Non-Manager Member……………….. ........................................................................................................................... 29

PART 14 KEY CHECK-THE-BOX DEFINITIONS AND RULES—REVIEW ....................................................................... 29

PART 15 BIBLIOGRAPHY ................................................................................................................................................. 30

_________________________________________________________________________________________________ TABLE OF EXHIBITS

Exhibit A U.S. Treasury Department Form 8832 (the “Check-the-Box Regulations” form) and instructions

Exhibit B Key Check-the-Box terms and definitions

Exhibit C Key Check-the-Box rules ________________________________________________________________________

PART 1 INTRODUCTION TO THE SEMINAR 1) Greeting.

a) Good morning, ladies and gentlemen. I’m John Cunningham. I’m a lawyer with the New Hampshire law firm of McLane, Graf, Raulerson & Middleton, Professional Association. For the past 22 years, I’ve specialized in forming LLCs, converting non-LLC entities to LLCs, and writing and teaching about LLC law, tax and practice.

b) The subject of this morning’s seminar is the Check-the-Box Regulations. As you no doubt know, they are the key federal tax authorities in LLC tax.1

c) If you don’t already have a certificate of attendance at this seminar, my colleague Amanda Nelson will provide you with one. Please sign it, and state your e-mail address in it, and return it to Amanda. After the seminar, I will sign it, scan it and e-mail it to you as proof of your attendance.

2) The purpose of this seminar.

a) The purpose of this seminar is to provide an intensive introduction to the Check-the-Box Regulations.

1 As most or all of you will know, the reason the Entity Classification Regulations are popularly called the Check-the-Box Regulations is that elections under these regulations are implemented by checking a box in Treasury Department Form 8832.

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b) In doing so, I want to focus throughout the seminar not only on the definitions and rules in these regulations but also on the reasons for them. I think you’ll find it much easier to remember and apply the Check-the-Box definitions and rules if you understand these reasons.

c) The most basic reasons are these: i) The basic definitions in the Check-the-Box Regulations are the definitions of

the terms “corporation,” “partnership,” and “disregarded entity.”: (1) Definition of corporation—mandated by IRC. The IRS defined

“corporation” as it did because the Internal Revenue Code mandated this definition.

(2) Definition of partnership and disregarded entity—taxpayer freedom. The IRS defined partnership and disregarded entity so as to give taxpayers maximum freedom in choosing the federal income tax regimens of their partnerships and disregarded entities.

3) Foreign entities. The Check-the-Box Regulations contain several important rules about the federal tax classification of “foreign”—i.e., non-U.S.—business entities. However, since these issues rarely arise for most of us, I won’t discuss them in this seminar.

4) Ensuring three hours of CPE credits. This seminar is intended to provide attendees with three hours of CLE credits. Since this is the first time I’ve taught the seminar, I’m not certain how long it will take to cover the basic materials in the seminar. If I finish covering these materials in less than three hours, I will spend additional time, up to 150 minutes, reviewing the basic definitions and rules of the Check-the-Box Regulations, as set forth in Exhibits B and C and, if necessary, reviewing the text itself of the Check-the-Box Regulations.

PART 2 INTRODUCTION TO THE CHECK-THE-BOX REGULATIONS

1) The Check-the-Box Regulations—introduction. As all of you know, the Check-the-Box Regulations (technically known as the “Entity Classification Regulations”) are the U. S. Treasury Department regulations that determine the federal tax classification of state-law business entities—that is, how they are defined for federal tax purposes. This determination, in turn, determines the federal income tax regimens available to them. a) Thus, for example, as we’ll see, a state-law business corporation is defined for

federal tax purposes as a “corporation.” This means that, unless the corporation makes an S election, every provision of Subchapter C will apply to the corporation.

2) The four federal tax classifications; the four main federal income tax regimens. Under the Check-the-Box Regulations, there are four federal tax classifications—namely, classification as a corporation, a partnership, an association or a disregarded entity. There are, of course, four main federal income tax regimens—sole proprietorship taxation and taxation under Subchapters C, K and S.

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3) The issuance of the Check-the-Box Regulations; their validity. The Check-the-Box Regulations became effective on January 1, 1997—about 18 years ago—and they have not been substantially amended since. Their validity was upheld in 2007 in a federal court of appeals case called Littriello v. U.S., and, in 2008, the U.S. Supreme Court refused to review that decision. Thus, their validity is beyond question, and they are likely to be around, without significant amendment, for a long time.

4) The creativity and clarity of the Check-the-Box Regulations. a) The Check-the-Box Regulations determine the federal tax classification of tens of

millions of U.S. and foreign business entities. In most or all cases, the manner of their application is both clear and reasonable. They are arguably among the most creative and yet also among the clearest and most practical Treasury regulations ever issued.

b) However, they are so creative that, to some extent, they could be construed as rewriting the IRC on the issue of federal tax classification—e.g., by creating the concept of disregarded entity, greatly expanding the function of the term “association,” and creating the term “eligible entity.” But Littriello resolves this potential attack on the Check-the-Box Regulations.

5) The impact of Check-the-Box Regulations on LLCs. The issuance of the Check-the-Box Regulations was the major trigger for the growth in the popularity of both single-member and multi-member LLC.

a) LLCs first began to become popular in about 1990, but initially, their use was not widespread. However, with the issuance of the Check-the-Box Regulations in 1997, they became, almost overnight, by far the most popular U.S. business entity, and since then, their popularity has exponentially increased.

6) The importance of the Check-the-Box Regulations for accountants. What is the importance of the Check-the-Box Regulations for accountants?

a) Federal income tax returns. They are perhaps not normally important in doing returns.

b) Federal tax advice for business start-ups. However, they are indispensable in providing federal tax advice to clients who are forming new business entities.

i) For example, if your client says, I want a corporate management structure but partnership taxation, if you understand the Check-the-Box Regulations, you can advise the client how to get there—namely, form an multi-member LLC, accept the default federal tax classification of partnership, but provide for a corporate management structure in your operating agreement.

c) Advice to single-member LLCs admitting additional members.

i) They are also indispensable in advising clients who have single-member LLCs classified as disregarded entities if these clients want to admit new members. You need to understand Rev. Rul. 99-5 to advise them in this situation.

ii) But you can’t understand Rev. Rul. 99-5 unless you have a fairly deep understanding of the Check-the-Box Regulations. We will discuss Rev. Rul.

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99-5 in this seminar. d) Advice to multi-member LLCs becoming single-member LLCs.

i) They are indispensable in advising clients who have single-member LLCs classified as disregarded entities if these clients want to admit new members. You need to understand Rev. Rul. 99-5 to advise them in this situation.

ii) But you can’t understand Rev. Rul. 99-6 unless you have a fairly deep understanding of the Check-the-Box Regulations. We will discuss Rev. Rul. 99-6 in this seminar.

e) Using correct federal tax and legal terminology. In fact, as we’ll see, in the Check-the-Box era, you can’t accurately talk or even think about business entities unless you have a detailed understanding of the Check-the-Box Regulations. i) For example, without it, you won’t understand why the question “Which is

better, an S corporation or an LLC” makes no sense.

PART 3 NEW HAMPSHIRE LLCS AND NON-LLC ENTITIES—BASIC STATUTORY COMPARISONS

1) No Check-the-Box Regulations reference to LLCs. Although the Check-the-Box Regulations are about 45 pages long and contain about 15,500 words, they make not a single express reference to either single-member or multi-member LLCs. However, virtually every page of them makes at least an implicit reference to LLCs. Indeed, the main reason they were issued was to deal with LLCs. In essence, the subject matter of the Check-the-Box Regulations is, to a substantial degree, single-member and multi-member LLCs.

a) Thus, you can’t fully understand the Check-the-Box Regulations unless you have at least a basic understanding of LLC statutory law and how it compares to the statutory law governing non-LLC entities.

2) The four main statutory characteristics of LLCs. For present purposes, it’s useful to think of LLCs as having three main statutory characteristics. a) Liability shield. They provide their members and managers with a shield against

personal liability for third-party claims against them. b) Pick-your-partner protections. They provide their members with “pick-your-

partner” protections. These protections prevent creditors of LLC members from obtaining court orders transferring members’ LLC management rights to the creditors—e.g., their voting rights, contract-signing rights, fiduciary rights, their information rights, and dispute resolution rights.

c) Charging order protections. They provide their members with “charging order” protections. These protections prevent creditors of LLC members from obtaining court orders transferring to the creditors the rights of the members to allocations and distributions of LLC creditors.

d) Informality. State-law business corporation statutes impose significant formalities on state-law corporations and their shareholders. LLC statutes don’t

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impose statutory formalities. 3) The table. The following table compares New Hampshire LLCs and the main types

of New Hampshire non-LLC entities with respect to the above three chief LLC statutory characteristics. I won’t discuss the details of the table, but the table will make clear the superiority of New Hampshire LLCs over all other types of New Hampshire business entities.

TYPE OF ENTITY LIABILITY SHIELD PICK-YOUR-PARTNER

PROTECTIONS

CHARGING ORDER

PROTECTIONS

STATUTORY INFORMLAITY

1) SINGLE-MEMBER LLCs

Strong None Moderate None

2) MULTI-MEMBER LLCs

Strong Strong Strong None

3) STATE-LAW BUSINESS CORPORATIONS

Strong None None Substantial

4) GENERAL PARTNERSHIPS

None Strong Weak None

5) LIMITED LIABILITY PARTNERSHIPS

Strong Strong Weak None

6) LIMITED PARTNERSHIPS

Strong for limited partners, none for general partnerships

Strong Weak None

7) LIMITED LIABILITY LIMITED PARTNERSHIPS

Strong for both general and limited partners

Strong Weak None

PART 4 THE HISTORICAL BACKGROUND OF THE CHECK-THE-BOX REGULATIONS

1) The key role of federal tax classification; federal definitions govern. The federal income tax regimen to which a business entity is subject under the Internal Revenue Code depends on its business entity type. The IRC identifies two main types—“corporations” and “partnerships.” Federal tax cases and other federal tax authorities make clear that meaning of these terms for federal tax purposes is their federal tax meaning, not their state-law meaning. Thus, a particular entity can be a corporation or a partnership for state-law purposes but not for federal tax purposes.

2) The significance and importance of the federal tax classification of a state-law partnership. If a business entity is classified as a partnership, this means that every provision of the IRC that contains the word partnership applies to that entity, including all of the IRC 700’s. If a state-law partnership is classified for federal tax purposes as a corporation, this means that every provision of the IRC that contains the word corporation applies to that entity—thus, for example, the 300’s and 1300’s of the IRC.

3) The grave inadequacy of IRC Section 7701. Sections 7701,which purports to define the terms “partnership” and “corporation,” doesn’t do so effectively; it merely illustrates the terms with examples rather than defining them. However, in 1917, when Section 7701 was enacted, that was all that was necessary

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a) Partnership and partner. IRC §§ 7701(a)(2) and (3) define the term “partnership” and “partner” as follows:

Partnership and partner. The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization. (Italics mine.)

b) Corporation. IRC § 7701(a)(3) defines the term corporation as follows: Corporation. The term “corporation” includes associations, joint-stock companies, and insurance companies. (Italics mine.)

4) The Kintner Regs. From 1960 until 1997, the authorities governing the issue whether an entity that was a general or limited partnership for state-law purposes was a corporation for federal tax purposes were U.S. Treasury regulations called the “Kintner Regulations.” Under these regulations, a state-law partnership would be treated as a corporation for federal tax purposes only if, under applicable state law and its partnership agreement, it had a majority of these four state-law corporate characteristics:

a) Limited liability; b) Centralized management;

c) Free transferability of ownership interests; and d) Continuity of life.

5) The deficiencies of the Kintner Regs. However, as applicable to specific state-law partnerships, the meaning of the above four corporate characteristics was often unclear, but if the IRS found that a state-law partnership was subject to taxation under Subchapter C, not Subchapter K, the federal tax consequences could obviously be severe. Thus, partnerships often felt constrained to spend the substantial time and money necessary to obtain private letter rulings from the IRS to ensure Subchapter K taxation.

6) Emergence of LLCs and other non-traditional entities. Multi-member LLCs began to become popular in around 1990, and single-member LLCs began to appear and to become popular soon thereafter. And around the same time, other non-traditional business organizations emerged, including limited liability partnerships, limited liability limited partnerships, and statutory trusts; and it was not unreasonable to surmise that other non-traditional entities might appear before long. a) However, how the Kintner Regs applied to these new types of entities was often

unclear, and in the case of single-member LLCs, it was totally unclear. 7) The emergence of LLCs forced the emergence of the Check-the-Box Regulations.

Thus, the Treasury Department had no choice to but to replace the Kintner Regs with entity classification regulations. They did so with the Check-the-Box Regulations.

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PART 5 THE CHECK-THE-BOX REGULATIONS; KEY DEFINITIONS AND RULES

[A] KEY DEFINITIONS AND RULES IN THE CHECK-THE-BOX REGULATIONS GENERALLY GOVERNING BOTH DOMESTIC AND FOREIGN BUSINESS ENTITIES

The summaries of definitions and rules set forth below and in this part generally follow the order of the Check-the-Box Regulations. I will indicate, in the case of each provision of the Check-the-Box Regulations summarized below, whether the provision applies only to domestic business entities or to both domestic and foreign business entities. 1) Business entity—definition. Section 2(a) (first sentence) defines a business entity as,

in essence, “any entity [italics added] recognized for federal tax purposes [including disregarded entities]:

a) [That is] recognized as an entity separate from its owner; [and] b) That is not properly classified as a trust under [Section 4].”

2) What is an “entity”? The above definition applies to both domestic and foreign business entities. Implicit in the definition is that the term “entity” by itself indicates an organization: a) That is formed under state law; and

b) That is separate from its owner. 3) What is an organization? Black’s Law Dictionary defines an organization as “a body

of persons formed for a common purpose.” 4) Classification of a business entity with two or more owners as either corporation or

partnership. Section 2(a) (second sentence) provides that “a business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership.” This rule applies only to domestic business entities.

5) Corporation—definition. Sections 2(b)(1) through (7) provide that a domestic business entity is classified as a domestic “corporation” in the seven situations set forth below. The first two situations are by far the most common.

a) The entity has been formed under a statute that describes the entity as a corporation. The New Hampshire Business Corporation Act is such a statute.

b) The entity is an association within the meaning of the Check-the-Box Regulations.

c) The entity is a business entity organized under a state statute that describes or refers to the entity as a state-law joint-stock company and or as a state-law joint-stock association.

d) The entity is an insurance company.

e) The entity is a state-chartered business entity conducting bank activities (and meets certain other stated requirements).

f) The entity is a business entity wholly owned by a state or political subdivision

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thereof or wholly owned by a foreign government. g) The entity is taxable as a corporation under a provision of the IRC other than

Section 7701(a)(3). (An example of such a provision is IRC Section 7704, which taxes publicly traded partnerships as corporations.)

6) Rationale for definition of corporation. The IRS defined corporation as it did in the Check-the-Box Regulations because it had to in order to be consistent with IRC § 7701(a)(2) and other provisions of the IRC.

7) Association—definition.

a) The Check-the-Box Regulations do not expressly define the key Check-the-Box term “association.” However, associations have traditionally been defined for federal tax purposes in the relevant case law as “[bodies] of persons united without a [corporate] charter, but upon the methods and forms used by incorporated bodies for the prosecution of some common enterprise.”7

b) Under IRC Section 7701 and the Check-the-Box Regulations, eligible entities that, by filing a Form 8832, elect to be classified as associations are defined as corporations and thus taxable as corporations. (The above rules apply both to domestic and to foreign business entities.)

8) The rationale for the elective regimen for non-corporate entities in the Check-the-Box Regulations. a) Taxpayer freedom. The IRS philosophy underlying the rules in the Check-the-

Box Regulations permitting non-corporate entities is a philosophy of providing maximum freedom of choice to the owners of non-corporate entities to choose the federal income tax regimen that best suits them.

b) Influence of the Kintner Regs. However, I’m certain that in adopting this philosophy, the IRS was influenced by the practical impossibility of the main alternative approach—namely, the Kintner Regs approach of determining whether any particular non-corporate entity looked like a state-law corporation under the governing statute and its ownership agreement.

9) Classification of domestic eligible entities that have two or more owners as a partnership. Under Section 2(c)(1), a domestic eligible entity is classified as a partnership: a) If it is not a corporation (as defined in the Check-the-Box Regulations); and

b) If it has two or more members. The above rule applies both to domestic and to foreign business entities.

10) Types of entities classified as partnerships. There are six principal types of state-law business entities currently authorized under U.S. business organization law that have the default classification of partnerships under the Check-the-Box Regulations—namely,

7 Hecht v. Malley, 265 U.S. 144 (1924).

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i) General partnerships that have not registered as limited liability partnerships (i.e., that are not “LLPs”);

ii) LLPs; iii) Limited partnerships that have not registered as limited liability limited

partnerships (i.e., as “LLLPs”); iv) LLLPs;

v) Multi-member LLCs; and vi) Statutory trusts.

These six types of entities are generally referred to collectively in this outline as “multi-owner unincorporated business entities.”

11) Disregarded entity—definition. Under Section 2(c)(2)(i), a domestic business entity is a disregarded entity if, in general:

a) It has a single owner; and b) It is not classified as a corporation.

This rule applies only to domestic business entities. 12) “Trust.” Section 301.7701-4 of the Check-the-Box Regulations distinguishes among

“ordinary trusts,” “business trusts,” and “certain investment trusts.” a) “Ordinary trust,” as used in the IRC, refers to an arrangement created either by a

will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts

b) “Business trusts” generally are created by the beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships under the IRC.

c) An “investment” trust will not be classified as a trust under the IRC if there is a power under the trust agreement to vary the investment of the certificate holders of the trust.

13) Single-member LLCs are the only state-law business entities that qualify as disregarded entities. As noted above, the only kind of domestic business entity currently available under state law that qualifies under existing U.S. federal and state business organization law as a disregarded entity for purposes of the Check-the-Box Regulations is a single-member LLC.

14) Eligible entities.

a) Definition of eligible entity. As stated in Section 3(a) (first sentence): “A business entity that is not classified as a corporation . . . can elect its classification for federal tax purposes as provided in this section. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election.”

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b) Does the term “eligible entity” denote a federal tax classification? The term “eligible entity” is not a federal tax classification; it is the term used in the Check-the-Box Regulations for the two types of business entities that are allowed under the Regulations to elect out of their default classification and into the classification of “associations.” These two types of business entities are those classified either as disregarded entities or as partnerships.

c) Entities classified as partnerships are eligible entities. Section 3(b)(1)(i) provides that “[e]xcept as provided in paragraph (b)(3) of this section [concerning business entities already classified under pre-Check-the-Box Regulations], unless [a domestic eligible entity] elects otherwise, [it] is (i) [a] partnership if it has two or more members. . . .” i) Thus, multi-member LLCs, general partnerships, LLPs, limited partnerships,

LLLPs, and statutory trusts are eligible entities. d) Eligible entities classified as disregarded entities are eligible entities. Section

3(b)(1)(ii) provides that “[except] as provided in paragraph (b)(3) of this section [concerning business entities already classified under pre-Check-the-Box Regulations], unless [a domestic eligible entity] elects otherwise, [it] is (ii) [d]isregarded as an entity separate from its owner if it has a single owner.”

i) As noted above, there is only one type of state-law single-owner business entity that is an eligible entity—namely, a single-member LLC.

15) Right of domestic eligible entities to elect to be classified as associations. Under Section 3(a) (first sentence), domestic eligible entities (including both partnerships and disregarded entities) may elect to be classified as associations.

16) Forms to use in making above elections—general rule. Under Sections 3(c)(1) and (2), eligible entities generally must elect out of their default classification by filing IRS Form 8832. (This rule applies to both domestic and foreign business entities.)

17) Special rule for S elections. However, under Section 3(c)(1)(v)(C), entities that are eligible to make S elections may do so merely by filing IRS Form 2553 and need not (and, impliedly, should not) file Form 8832. (This rule applies only to domestic business entities, because only domestic business entities may make S elections.)

[B] THE TERMS “DISREGARDED ENTITY,” “ELIGIBLE ENTITY” AND “ASSOCIATION”—A GENERAL COMMENT

The creativity of the Check-the-Box Regulations is manifest above all: 1) In its drafters’ creation of the terms “disregarded entity” and “eligible entity” and in

their new use of the term “association”; and 2) In their providing taxpayers and their advisers with the freedom to elect the federal

tax classification of eligible entities..”

[C] KEY DEFINITIONS AND RULES IN THE CHECK-THE-BOX REGULATIONS GOVERNING FOREIGN BUSINESS ENTITIES

1) Classification of certain foreign business entities as per se corporations. Under

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Section 2(b)(8)(i), 86 specified types of foreign business entities are classified as per se corporations that are classified as corporations for federal tax classification purposes. These include, for example, German Aktiengesellschaeften (AGs) and British “public limited companies” (PLCs).

2) Classification of foreign business entities that are not per se corporations—in general. Section 3(b)(2) provides that, in general, the default classification of foreign business entities that are not per se corporations is that of associations. Under Section 3(a), these entities are eligible to elect out of their default classification.

3) Default classification of foreign eligible entities. However, under, respectively, subsections 3(b)(2)(i)(A) and (B):

a) If a foreign business entity has two or more members but at least one of its members lacks limited liability, the default federal tax classification of the entity is that of a partnership.

b) If a foreign business entity has only one member and this member lacks limited liability, the default federal tax classification of the entity is that of a disregarded entity.

4) Limited liability—definition. Under Section 3(b)(2)(ii), a member of a foreign business entity has “limited liability” if “the member has no personal liability for the debts of or claims against the entity by reason of being a member.”

PART 6 “STANDARD” CHECK-THE-BOX ANALYSES

1) As I’ve discussed earlier in this outline: a) The primary purpose of the Check-the-Box Regulations. The primary purpose of

the Check-the-Box Regulations is to provide rules for tax professionals in determining the federal tax classification of state-law business entities.

b) The Check-the-Box Regulations address federal tax classifications; they do not address federal income tax regimens. However, the Check-the-Box Regulations do not provide express guidance to tax professionals in determining the federal income tax regimens available to business entities. I find it useful to refer to the process of making this determination as a “Check-the-Box analysis.” And of course what LLC clients care about is not their federal tax classification but their federal tax regimen.

2) Standard Check-the-Box analyses—summary in the form of a table. The table below summarizes the above process as applicable to domestic state-law single-member LLCs, general and limited partnerships, and state-law single- and multi-shareholder corporations. Let’s briefly consider each of the eight rows in the table.

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TYPE OF BUSINESS

ENTITY

DEFAULT FEDERAL

TAX CLASSIFICA-

TION (AND DEFAULT FEDERAL

INCOME TAX REGIMEN)

FEDERAL TAX CLASSIFICATIONS

INTO WHICH ENTITY MAY

ELECT

AVAILABLE FEDERAL INCOME

TAX REGIMENS

AFTER ELECTION

UNAVAILABLE FEDERAL

INCOME TAX REGIMENS

AFTER ELECTION

EXAMPLE

1. Single-member LLC whose member is an individual

Disregarded entity (sole proprietorship taxation)

Association Subchapters C and S

Sole proprietorship

John Doe is the member of a single-member LLC.

2. Single-member LLC whose member is an entity

Disregarded entity (“divisional” taxation—i.e., tax items of single-member LLC are treated as those of the member)

Association Subchapter C (Subchapter S unavailable)

Divisional taxation and Subchapter S

XYZ, Inc. is the member of a single-member LLC.

3. Multi-member LLC (members may be individuals, entities, or a combination of individuals and entities)

Partnership (Subchapter K)

Association Subchapter C and (if they meet Subchapter S requirements) Subchapter S

Partnership taxation

John Doe and Mary Roe are members of multi-member LLC.

4. General and limited partnerships (including LLPs and LLLPs)

Partnership (Subchapter K)

Association Subchapter C and (if they meet Subchapter S requirements) Subchapter S

Subchapter K John Doe and Mary Roe are members of a general partnership.

5. Single-shareholder corporation whose shareholder is an individual.

Corporation (Subchapter C)

None Subchapter C and (if they meet Subchapter S requirements) Subchapter S

Sole proprietorship taxation

John Doe is the shareholder of a single-shareholder corporation.

6. Single-shareholder corporation whose shareholder is an entity.


None Subchapter C Divisional taxation XYZ, Inc. is the shareholder of a single-shareholder corporation.

7. Multi-shareholder corporations whose members are individuals


None Subchapter C and (if they meet Subchapter S requirements) Subchapter S

Subchapter K John Doe and Mary Roe are shareholders of a two-shareholder corporation.

8. Multi-shareholder corporations whose members include at least one entity


None Subchapter C Subchapter K XYZ, Inc. and John Doe are shareholders of a multi-shareholder corporation.

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PART 7 “REVERSE” CHECK-THE-BOX ANALYSES

1. What is a “reverse” Check-the-Box analysis? Although, as I’ve just noted, the primary purpose of the Check-the-Box Regulations is to provide rules for tax professionals in determining the federal tax classification of state-law business entities, these regulations can also be used to determine the types of state-law business entities available to each of the four main types of federal income tax regimens. I find it convenient to refer to this process as a “reverse” Check-the-Box analysis.

2. Reverse Check-the-Box analyses—tabular summary. The table below summarizes this process. Let’s briefly consider each of the rows in the table.

DESIRED FEDERAL INCOME TAX

REGIMEN

FEDERAL TAX CLASSIFICATION

TYPE OF STATE-LAW BUSINESS ENTITIES

THAT CAN BE CLASSIFIED IN THIS

CLASSIFICATION

EXAMPLE

1. Sole proprietorship taxation

Disregarded entity Single-member LLC whose member is an individual

John Doe is the member of JD, LLC, a single-member LLC.

2. Divisional taxation Disregarded entity Single-member LLC whose member is an entity

XYZ, LLC is a single-member LLC whose member is ABC, Inc.

3. Subchapter C Corporation or association State-law business corporations and any type of non-corporate entity that elects to be an association.

JD is the member of JD, LLC, a single-member LLC, which elects to be an association.

4. Subchapter S Corporation or association State-law business corporations and any type of non-corporate entity that meets Subchapter S eligibility and election requirements

JD is the member of JD, LLC, a single-member LLC, which elects to be an S corporation.

5. Subchapter K Partnership Any type of multi-owner unincorporated business entity, including multi-member LLC or a general or limited partnership or LLP or LLLP.

ABC, LLP, is a limited liability partnership.

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PART 8 THE CHECK-THE-BOX REGULATIONS AND THE NEED FOR “TERMINOLOGICAL SCHIZOPHRENIA”

1) Legal and tax terminology pre- and post-Check-the-Box Regulations. In the pre-Check-the-Box era:

a) The meanings of the terms “corporation” and “partnership” were much easier to deal with than in the Check-the-Box era. Indeed, there was basically an identity of meaning among tax partnership, the federal tax classification of partnerships, and law partnerships; and the same was true for corporations.

b) Indeed, until the 1990’s, legal and tax professionals had to deal only rarely, if at all, with single-member or multi-member LLCs, LLPs or LLLPs, or statutory trusts. But all this changed in the early 1990’s.

2) The “two-hats” rule. The key to dealing with all of these various types of state-law business entities in the Check-the-Box areas is simple in theory: You always have to comply with the “two-hat” rule. That is, you have to make sure to use:

a) Only federal tax terms when you’re addressing federal tax issues relating to a particular business entity and its owners; and

b) Only business organization law terms relating to the entity and its owners when you’re addressing legal issues.

c) To use a different metaphor: You have to think of law and tax as Mars and Venus.

3) “Terminological schizophrenia.” In other words, in the Check-the-Box era, you need to practice “terminological schizophrenia.” The table below provides guidelines for engaging in this practice.

LAW TERM FEDERAL TAX CLASSIFICATION

FEDERAL INCOME TAX TERMS

1. Single-member LLC whose member is an individual and which does not elect to be an association

Disregarded entity The member is a sole proprietor.

2. Single-member LLC whose member is an individual and which does elect to be an association

Association The member is the shareholder of a C or S corporation.

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3. Single-member LLC whose member is an entity and which does not elect to be an association

Disregarded entity The member is a “disregarded entity” for federal tax purposes (but a “division” for law purposes).

4. Single-member LLC whose member is an entity and which does elect to be an association

Association The member is a corporate subsidiary for federal tax purposes, and its member for law purposes is its shareholder for federal tax purposes.

5. Multi-member LLC whose members have not elected to be an association

Partnership The members are “partners.”

6. Multi-member LLC whose members have elected to be an association

Association The members are “shareholders.”

7. Operating agreement of multi-member LLC with federal tax classification of partnership

Partnership Partnership agreement

8. State-law business corporation

Corporation The owners are shareholders of C or S corporations.

9. Operating agreements of multi-member LLC with federal tax classification of association

Association Shareholder agreement

10. Membership in multi-member LLC whose federal tax classification is that of a partnership

Partnership Partnership interest

11. Membership in multi-member LLC whose federal tax classification is that of an association.

Association Share

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12. A person who manages a multi-member LLC that is classified as a partnership is a manager.

Partnership General or limited partner

13. A person who manages a multi-member LLC that is classified as an association is simply a manager.

Association Director or officer.

PART 9 FORM 8832 AND THE FORM 8832 INSTRUCTIONS

[A] INTRODUCTION 1) You need to master Form 8832 and the Instructions.

a) As noted above, Form 8832 is the IRS form that eligible entities must file with the IRS to change their default initial federal tax classifications and to make subsequent changes in their federal tax classifications. In order to be competent in forming LLCs and advising clients about federal tax classification matters, you need to have a detailed understanding of Form 8832 and the Form 8832 Instructions (the “Instructions”).

b) The starting point in gaining this understanding is to study Form 8832 and the Instructions line-by-line. It can also be useful to create hypothetical situations in which clients want to elect classifications or change them and to complete a Form 8832 for each of these situations.

2) My comments below. Fortunately, both Form 8832 and the Instructions are largely self-explanatory if you have a reasonably detailed understanding of the Check-the-Box Regulations. However, in the paragraphs that follow, I’ll make a few comments that I believe may be useful concerning the contents of Form 8832 and the Instructions where I believe these may be useful.

[B] THE CONTENTS OF FORM 8832

1) Top line of Form. The top line of Form 8832 is captioned “Name of eligible entity making election.”

a) As noted above, there are two kinds of eligible entities under the Check-the-Box Regulations—(i) single-owner unincorporated business entities; and (ii) multi-owner unincorporated business entities. No other type of state-law business entity can make an election under Form 8832 by any other means. For example, no single-shareholder or multi-shareholder state-law business corporation can do so.

b) As the top line of Form 8832 implies, only “eligible entities” as entities can use

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Form 8832 to elect their federal tax classification. The owners of these entities, as owners, cannot.

2) Uses of Form other than to elect initial federal tax classification. Immediately above Part I of Form 8832, Form 8832 effectively permits and requires entities to make use of it (i) to change their address, (ii) to seek late classification relief under Rev. Proc. 2009-1, and (iii) to seek late change of entity classification relief under Rev. Proc. 2010-32.

[C] THE FORM 8832 INSTRUCTIONS

1) S elections. The “Note” under the “General Instructions” states that “an entity must file Form 2553 if making an election under section 1362(a) to be an S corporation.” In my view, the Check-the-Box Regulations clearly implies, though they do not expressly state, that Form 2553 is the only form the entity should file and that it should not file a Form 8832 with its Form 2553. See also, to the same effect, the ninth bullet in the first column on page 5 of the Instructions. If this were not the case, the Check-the-Box Regulations arguably would not even mention the Form 2553.

2) The “TIP.” The “TIP” under the above “Note” states that “a new eligible entity should not file Form 8832 if it will be using its default classification (see Default Rules below).”

3) Automatic reclassifications of disregarded entities to partnerships and partnerships to disregarded entities upon changes in number of owners. Under the caption “Domestic default rule” in Page 4, Column 2, the IRS states that if the membership of an entity classified as a partnership is reduced to one member, this entity will automatically be reclassified as a disregarded entity, and a disregarded entity that comes to have more than one member will automatically be reclassified as a partnership.

4) Effect of change of classification on EINs. In the “Note” in Page 6, Column 1, the Instructions state that “any entity that has an EIN will retain that EIN even if its federal tax classification changes under Regs. § 301.7701-3.”

5) Eligible entities’ acceptance of default classification. Under the caption “Part I. Election Information”, Line 1, the Instructions state that eligible entities should not file Form 8832 if they want to be classified under the default rules. This statement echoes the above “Tip.”

6) Effective date of Form. The Instructions for Line 8 of Form 8832 provide that an election under Form 8832 will take effect: a) On the date entered in line 8; or

b) On the date filed (i.e., presumably on the date received by the IRS) if no date is entered on that line.

7) What is “reasonable cause” for late filings of elections under the Check-the-Box Regulations?

a) The Instructions for “Part II. Late Election Relief” provide that taxpayers may

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obtain relief for late filings of elections and changes of election of their federal tax classifications “for reasonable cause.” I know of no federal tax authorities defining “reasonable cause” for these purposes or giving examples of reasonable cause.

b) However, the commentators generally advise that reasonable cause will only exist if the lateness in question occurs because of the eligible entities’ lawyers’ or accountants’ negligence or because the envelope enclosing the election is destroyed through no fault of the eligible entity.

c) It seems safe to say that federal tax authorities concerning unintended revocations of S elections are far more liberal to taxpayers than federal tax authorities concerning late elections under the Check-the-Box Regulations.

PART 10 THE PROPOSED FEDERAL TAX CLASSIFICATION OF LLC SERIES

1) What is a series LLC? What is an LLC series?

a) Series LLCs are LLCs that, under the LLC act under which they are formed, are authorized to form LLC series. There are presently 13 U.S. jurisdictions whose LLC acts authorize the formation of series LLCs—namely, in alphabetical order, Delaware, the District of Columbia, Illinois, Iowa, Kansas, Missouri, Montana, Nevada, Oklahoma, Puerto Rico, Tennessee, Texas and Utah.

b) LLC series are, in effect, limited liability subsidiaries of series LLCs that generally resemble single-member LLC subsidiaries. However, to form a single-member LLC subsidiary, an LLC must file a certificate of formation or other document with the state Secretary of State or other appropriate figure.

c) By contrast, a series LLC may form any number of LLC series without any state filing. Furthermore, at least under the Delaware Limited Liability Company Act, LLC series and the member, assets and lines of business “associated” with them by the series LLC have a liability shield not only against claims against other LLC series but even against the series LLC.

2) Will New Hampshire ever authorize series LLCs? In my view, it is unlikely that the New Hampshire Revised Limited Liability Company Act will ever be amended to authorize series LLCs, since, among other considerations, this may significantly reduce New Hampshire revenues from the formation of single-member LLCs. However, from time to time, New Hampshire clients ask their lawyers and accountants about series LLCs, and we should be able to, among other things, advise them about the federal tax classification of these LLCs and of LLC series.

3) The Proposed Series Regulations. On September 14, 2010, the Internal Revenue Service published in the Federal Register proposed new regulations (the “proposed Series Regulations”) governing the federal tax classification of series LLCs and thus the federal taxation of series LLCs, their members, and series established by them. 75 Fed. Reg. 55699, 55699 (Sept. 14, 2010). The page numbering of that document is followed in the paragraphs below.

4) Content of the proposed Series Regulations. In brief summary, the proposed Series

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Regulations provide as follows:

• LLC series that have only one member will be treated under the U.S. Treasury Department Entity Classification Regulations as disregarded entities; and

• LLC series that have two or more members will be treated under the Entity Classification Regulations as partnerships.

5) When will we have final series regulations? The IRS has indicated informally, but not officially, that it will issue final series regulations on or about July 16, 2015.

PART 11 REV. RUL. 99-5—CONVERSIONS OF DISREGARDED ENTITIES TO PARTNERSHIPS

[A] INTRODUCTION TO REV. RULS. 99-5 AND 99-6 1) Rev. Ruls. 99-5 and 99-6—introduction. In 1999, the IRS applied the Check-the-Box

Regulations and various provisions of Subchapter K to a number of hypothetical situations which occur frequently in the real world of LLC practice.

a) Rev. Rul. 99-5 addresses the conversion of single-member LLCs classified as disregarded entities to two-member LLCs classified as partnerships.

b) Rev. Rul. 99-6 addresses the opposite situation—namely, the conversion of two-member LLCs classified as partnerships to single-member LLCs classified as disregarded entities.

2) This Part of the outline. In this Part of the present outline, I will summarize and briefly discuss Rev. Rul. 99-5. In Part 12, I will summarize and briefly discuss Rev. Rul. 99-6

3) Controversy. Rev. Ruls. 99-5 and 99-6 have been the subjects of substantial criticism by partnership tax experts.

a) In a letter to the IRS dated June 5, 2013, the AICPA has pointed out several key issues it finds troubling in Rev. Rul. 99-5 and has proposed solutions to these issues. The link to this letter is:

http://www.aicpa.org/Advocacy/Tax/Partnerships/DownloadableDocuments/Comments-on-Rev-Ruling-99-5-v-6-5-13submit.pdf

b) In a letter to the IRS dated October 1, 2013, the AICPA has pointed out several key issues it finds troubling in Rev. Rul. 99-6 and has proposed solutions to these issues. The link to this letter is:

http://www.aicpa.org/advocacy/tax/partnerships/downloadabledocuments/comments-on-rev-ruling-99-6-submit.pdf

[B] REV. RUL. 99-5—INTRODUCTION

1) Sale of membership rights by member of single-member LLC to third party vs. LLC’s grant of membership rights to third party. There are two main types of transactions in which a single-member LLC classified as a disregarded entity can convert to a two-

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member LLC classified as a partnership: a) The member of the single-member LLC can sell a part of the member’s own

membership rights to a third party. This transaction is addressed in Situation 1 of Rev. Rul. 99-5.

b) The third party can make a contribution to the LLC in exchange for the partnership’s granting a partnership interest to the third party. This transaction is addressed in Section 2. Effectively, in this transaction, the seller is, from a legal viewpoint, the LLC itself, not the member of the LLC.

2) A Rev. Rul. 99-5 examples in the “real world.” a) Third-party situation. Wife is the member of the single-member LLC. She needs

a cash investment in her LLC, or she needs a synergistic new co-member. b) Wife-Husband situation.

i) Wife, who has formed and operated a single-member LLC classified as a disregarded entity, wants Husband to become a co-member in order to obtain the stronger liability shield, pick-your-partner protections and charging order protections available to two-member LLCs.

ii) Should Wife spouse sell a 50% interest to Husband (Situation 1), or should she cause her LLC to issue a membership to Husband (Situation 2)?

3) The facts in Rev. Rul. 99-5. The facts in both Situation 1 and Situation 2 are frustratingly vague. Thus, in the discussion that following, while I will not change any facts, I will elaborate them.

4) Issues not addressed in Rev. Rul. 99-5. Both Situation 1 and Situation 2 fail to address several issues that very often arise in real-world conversions of single-member LLCs to multi-member LLCs—e.g., issues concerning depreciated and amortized property and assumed obligations. And in the real world, the potential fact patterns are virtually infinite.

5) Rev. Rul. 99-5 is the unavoidable starting point. a) However, regardless of how complex the facts may, the unavoidable starting point

for addressing these real-world situations are the two situations and the rulings applicable to them as stated by the IRS. In this discussion, I will merely try to state the Rev. Rul. as a starting point.

b) Under Rev. Rul. 99-5, you will often have to test both Situation 1 and Situation 2 to see which yield the best federal tax result for the affected taxpayers.

[C] REV. RUL. 99-5, SITUATION 1

1) Albert’s purchase of diamond, contribution to single-member LLC. On January 1, 2015, Albert purchases a diamond for $2,000. On that same date, Albert forms a single-member LLC and contributes the diamond to it.

2) LLC is disregarded entity. Since Albert does not elect for the LLC to be classified as an association, the LLC has the default federal tax classification of a disregarded entity, and thus, Albert, not the LLC, is deemed for federal tax purposes to be the

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owner of the diamond. 3) Appreciation of diamond. During the next five years, the fair market value of the

diamond appreciates substantially, and on January 1, 2020, the diamond is worth $10,000.

4) Betty’s purchase of LLC interest from Albert. On January 1, 2020, Betty purchases from Albert one half of his interest in the LLC (in legal terms, one half of Albert’s membership rights) for $5,000.

5) Results of purchase. As a result of the above purchase:

a) LLC becomes partnership. The LLC becomes a two-member LLC classified and taxable as a partnership. Albert and Betty are, for legal purposes, its members, but for federal tax purposes, they are its partners. i) Note that under Reg. § 301.7701-3(f)(2), an eligible entity that is disregarded

as an entity separate from its owner will automatically be classified as a partnership as of the date the entity has more than one owner. Under Reg. § 301.7701-3(f)(3), this automatic classification change will not be treated as a change in classification election and will not trigger a new 60-month waiting period for a change of classification to that of an association.

b) Betty’s purchase is deemed to be purchase of an interest in the diamond, not a purchase of a partnership interest. For federal tax purposes, Betty’s purchase is treated as a purchase by Betty from Albert of a 50% interest in the diamond.

c) Deemed contributions of interests in diamond to new partnership. Immediately after the above hypothetical purchase, Albert and Betty are treated for federal tax purposes as contributing their respective 50% interests in the diamond to a newly formed tax partnership in exchange for equal partnership interests in the partnership.

d) Albert’s gain. Under IRC § 1001, Albert must recognize gain from his deemed sale of a 50% interest in his diamond. Since his basis in this 50% basis is $1,000 and the deemed purchase price is $5,000, his gain is $4,000.

e) No gain or loss under Section 721(a). Under § 721(a), no gain or loss is recognized by Albert or Betty as a result of the conversion of the disregarded entity to a partnership.

f) Effect of Section 722. Under § 722:

i) Albert’s basis in his 50% interest in the partnership is $1,000. ii) Betty’s basis in her 50% interest in the partnership interest is $5,000.

iii) Partnership’s “split” basis in diamond. (1) Under § 723, the partnership’s basis in the one-half interests in the

diamond as deemed to have been contributed to the partnership by Albert and Betty is the adjusted basis of that property in Albert’s and Betty’s hands immediately after the deemed sale; that is, the diamond has a “split basis.” Thus, the partnership’s basis in the first half interest in the

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diamond is $1,000 and in the second half-interest it is $5,000. (2) Thus, if the diamond continues to appreciate after Betty’s purchase, and,

after a few years, the partnership sells it for a substantial gain, this gain must be prorated between the two half-interests in it with two different bases.

g) Effect of § 1223(1):

i) Albert’s holding period in his partnership interest. Albert’s holding period in his partnership interest includes his holding period as of the date when the LLC converted from a disregarded entity to a partnership. Thus, as of January 1, 2020, his holding period is five years.

ii) Betty’s holding period in her partnership interest. Betty’s holding period for her partnership interest begins on the day following the date of Betty’s purchase of the membership. Thus, her holding period on that date is zero.

h) Effect of § 1223(2). Under Section 1223(2), the LLC’s holding period for the diamond is a split holding period—namely, five years for Albert and zero years for Betty.

[D] REV. RUL. 99-5, SITUATION 2 1) Betty buys partnership interest not from Albert but from the LLC. In Situation 2, the

facts are the same as in Situation 1, except that, on January 1, 2020, Betty contributes $5,000 to the LLC in exchange for the partnership’s granting her a 50% interest in the partnership. In other words, in Situation 2, Betty effectively buys an interest in the LLC:

a) From the LLC itself ; and b) Not from Albert.

2) Single-member LLC becomes partnership. In Situation 2, as in Situation 1, Betty’s purchase results in the conversion of the LLC as a disregarded entity to an entity whose federal tax classification and federal income tax regimen are that of a partnership.

3) Albert’s deemed contribution of diamond to LLC. Under Rev. Rul. 99-5, Albert is deemed to contribute the diamond to the above partnership immediately before Betty’s purchase of a 50% interest in the partnership.

4) Effect of § 721(a). Under § 721(a), no gain or loss is recognized by Albert or Betty as a result of the conversion of the LLC from a disregarded entity to a partnership.

5) Effect of § 722. Under § 722:

a) Albert’s basis in his partnership interest. Albert’s basis in his partnership interest is $2,000—i.e., his basis in the diamond when he purchased it.

b) Betty’s basis in her partnership interest. Betty’s basis in her partnership interest is $5,000.

6) Effect of § 723. Under § 723, the partnership’s in the diamond is a split basis--$2,000

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for Albert’s contribution and $5,000 for Betty’s. 7) Effect of § 1223(1). Under § 1223(1):

a) Albert’s holding period in his partnership interest includes his holding period in his assets deemed contributed when his single-member LLC converted to a partnership.

b) Betty’s holding period for her partnership interest begins on the day after her contribution of the above $5,000.

8) Partnership’s holding period in diamond. Under § 1223(2), the partnership’s holding period for diamond is Albert’s holding period in it.

9) No gain to Albert in Situation 2. Note that in Situation 1, Albert received cash and realized gain from selling a 50% interest in the diamond to Betty; and he had to pay tax. In Situation 2, Albert receives no cash, he recognizes no gain, and he pays no tax.

[E] TO AVOID THE POTENTIALLY SERIOUS ADVERSE FEDERAL TAX CONSEQUENCES OF REV. RUL. 99-5, SHOULD INDIVIDUALS WHO ARE FORMING SINGLE-MEMBER LLCS CONSIDER MAKING S ELECTIONS FOR THESE LLCS?

1) Might Rev. Rul. 99-5 have serious adverse tax consequences? Whenever you are assisting individuals in forming single-member LLCs, you should determine whether there is a significant possibility that these individuals will eventually want to admit additional members and whether, if they do so, potentially serious adverse federal tax consequences may result from of Rev. Rul. 99-5.

2) Should your clients make an S election? If such a possibility exists, you should consider advising your clients to make S elections for these LLCs.

PART 12 REV. RUL. 99-6—CONVERSIONS OF PARTNERSHIPS TO DISREGARDED ENTITIES

[A] INTRODUCTION 1) As noted, the subject matter of Rev. Rul. 99-6 is the opposite of that of Rev. Rul. 99-

6. Rev. Rul. 99-5 deals with the conversion of single-member LLCs to multi-member LLCs. Rev. Rul. 99-6 deals with the conversion of multi-member LLCs to single-member LLCs.

2) The two “Situations” in Rev. Rul. 99-6. Like Rev. Rul. 99-5, Rev. Rul. 99-6 addresses two hypothetical situations, both of which occur with some frequency in the real world.

a) In Situation 1, one member of a two-member LLC taxable as a partnership buys out the other member.

b) In Situation 2, a third party buys out both members of a two-member LLC. 3) The citations of federal tax authorities in Rev. Rul. 99-6. In Rev. Rul. 99-6, the

enumeration of the relevant sections of the IRC and other federal tax authorities,

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including cases and administrative rulings, is far more extensive than in Rev. Rul. 99-5. However, in the present part of this outline, I will mention only a few of these authorities.

4) The hypothetical facts in my discussions of Rev. Rul. 99-6, Situations 1 and 2. In discussing the situations addressed in Rev. Rul. 99-6, as in discussing those in Rev. Rul. 99-5, I will use concrete hypothetical facts (as opposed to the very abstract facts in Rev. Rul. 99-6), and, as indicated, I will state the governing federal tax rules and effects only briefly. However, both in using these facts and in summarizing the relevant federal tax rules and effects, I will be faithful to the basic terms of Rev. Rul. 99-6.

[B] REV. RUL. 99-6, SITUATION 1 (ALBERT SELLS HIS INTEREST IN AB PARTNERSHIP TO BETTY)

In Situation 1: 1) Albert’s sale of his LLC interest to Betty.

a) Albert and Betty are equal partners in AB, LLC, a two-member LLC classified and taxable as a partnership.

b) Albert sells his entire interest in AB to Betty for $10,000. After the sale, AB continues its legal existence as an LLC, but now it is a single-member LLC classified as a disregarded entity, with Betty as its sole member.

2) Termination of partnership. As a result of Albert’s sale of his AB membership to Betty, AB’s federal tax status as a partnership is terminated under § 708((b)(1)(A).2 a) It is interesting that the IRS treats this as a partnership termination under §

708(b)(1)(A) (partnership no longer has two partners), not under § 708(b)(1)(B) (disposition of 50% or more of total interest in partnership capital and profits during 12-month period).

3) Gain or loss to Albert. Under Reg. § 1.741-1(b), Albert must treat the sale as the sale of a partnership interest to Betty. Thus, Albert must report gain or loss, if any,

2 Section 708 provides in relevant part as follows:

(a) General rule

For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated.

(b) Termination

(1) General rule

For purposes of subsection (a), a partnership shall be considered as terminated only if—

(A) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership. . . .

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resulting from this sale in accordance with § 741.3 4) Deemed liquidating distribution. Under a case called McCauslen and under Rev. Rul.

67-65, for purposes of determining the federal tax treatment of Betty in the above sale:

a) AB is deemed to make a liquidating distribution of all of its assets on an equal basis to Albert and Betty; and

b) Following this distribution, Betty is treated as acquiring from Albert the AB assets that Albert is deemed to have received in the above deemed distribution.

5) Betty’s basis in AB’s assets; her holding period. Betty’s basis in the assets attributable to Albert’s one-half interest in AB is $10,000, the price that Betty paid to purchase Albert’s interest in AB. Betty’s holding period for these assets begins on the day immediately following the date of the sale.

6) Deemed § 731(a) distribution to Betty after deemed termination of AB as partnership. Upon the termination of AB as a partnership, Betty is deemed to receive a distribution of the assets attributable to B’s former interest in AB as a partnership. Betty must recognize gain or loss, if any, on this deemed distribution of these assets to the extent required by § 731(a). Betty’s basis in these assets is determined under § 732(b). That section provides that:

The basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner’s interest shall be an amount equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction.

7) Possibility that Betty may have to recognize gain. If, in the above deemed distribution, Betty receives cash in excess of her basis in her interest in AB, then, under Section 731(a)(1), she will have to recognize gain and may be subject to tax on the transaction even though she is the buyer, not the seller.

a) It is also possible that Betty may have to recognize loss in the distribution under Section 731(a)(2).

8) Betty’s holding period. Under Section 735(b), Betty’s holding period in these assets includes the holding period of AB as a partnership in these assets except for purposes of § 735(a)(2) (relating to a distributee partner’s sales of inventory items).

9) Cross-purchase vs. redemption. Rev. Rul. 99-6, Situation 1 deals with a sale of a partnership interest structured as a cross-purchase—i.e., a purchase by one partner of the partnership interest of another. My guess is that if, for law purposes, the purchase in Situation 1 had been structured as a redemption—i.e., a purchase of Albert’s

3 Section 741 provides as follows:

In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).

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partnership interest by AB, not by Betty—the federal income tax results would have been the same; but I have found no authority on this issue. However, I think any tax professional handling the above Albert-Betty transaction would have to explore the tax results of a redemption before advising Albert and Betty on how to proceed in the transaction.

[C] REV. RUL. 99-6, SITUATION 2 (EDWARD BUYS OUT BOTH CARL AND DIANE)

1) Carl’s and Diane’s sales of LLC interests to “Edward.”

a) In Situation 2, Carl and Diane are equal partners in CD, a two-member LLC classified and taxable as a partnership.

b) Carl and Diane sell their entire interests in CD to Edward in exchange for $10,000 each. After the sale, Edward uses CD to continue CD’s previous business.

2) Partnership termination. Upon the above sale, CD as a tax partnership is deemed to be terminated under § 708(b)(1)(A).

3) Carl’s and Diane’s gain or loss. Carl and Diane must both report gain or loss, if any, from their sales of their LLC interests under IRC § 741.

4) Deemed distribution to Carl and Diane. a) Deemed distribution. For purposes of classifying the acquisition of CD by

Edward, the CD partnership is deemed to make a liquidating distribution of its assets to Carl and Diane, and immediately following this distribution, Edward is deemed to acquire the former partnership’s assets by purchase.

b) Relationship of Section 741 and 731. What if, in the above distribution, Carl or Diane receive cash in excess of their basis in CD as a partnership? I have found no authority on the issue whether, under Section 731, they will have to recognize gain or loss in respect of the distribution. If so, they may recognize gain or loss not only under Section 741 but also under Section 731.

5) CD as single-member LLC classified as disregarded entity immediately after sale. Although Rev. Rul. 99-6 does not expressly say so, it is clear that immediately after the sale, CD becomes a single-member LLC classified as a disregarded entity, with Edward as its only member and owner.

6) Edward’s basis in CD’s assets; his holding period in these assets. Edward’s basis in the assets is $20,000 under § 1012(a)—i.e., it is a cost basis. Edward’s holding period for the assets begins on the day immediately following the date of sale.

[D] TO AVOID THE POTENTIALLY SERIOUS ADVERSE FEDERAL TAX CONSEQUENCES OF REV. RUL. 99-6, SHOULD INDIVIDUALS WHO ARE FORMING TWO-MEMBER LLCS CONSIDER MAKING S ELECTIONS FOR THESE LLCS?

1) Might Rev. Rul. 99-6 have serious adverse tax consequences? Whenever you are assisting individuals in forming two-member LLCs, you should determine whether there is a significant possibility that these individuals will eventually become single-

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member LLCs because of, for example, the resignation or death of one of the members; and whether, if they do so, potentially serious adverse federal tax consequences may result from of Rev. Rul. 99-6.

2) Should your clients make an S election? If such a possibility exists, you should consider advising your clients to make S elections for these LLCs.

PART 13 FREQUENTLY OCCURRING CHECK-THE-BOX ISSUES AND HOW TO RESOLVE THEM

[A] XYZ BUILDING, LLC

1) Individual A is an accountant. Individuals B and C are financial advisers. Each of them has an office in XYZ Building, and they share equally the rent and related expenses relating to XYZ Building, including wages to a receptionist.

2) They have formalized their arrangements among themselves with respect to XYZ Building in a three-member LLC called XYZ Building, LLC. Every month, they contribute their respective shares of rent and expenses to XYZ, which pays them to their landlord and their receptionist. After the end of each calendar year, they distribute any excess contributions equally among the three of them. They report these distributions as their shares of XYZ income.

3) Should A, B and C make any changes in the above arrangements?

a) Should they dissolve their LLC? b) What is the federal tax classification of XYZ Building, LLC?

c) What federal tax compliances changes, if any, should they make?

[B] ABC, INC. AND ITS QSUB

1) ABC, Inc., a New Hampshire state-law business corporation taxable as an S corporation, has three Qualified Subchapter S subsidiaries.

2) IRC § 1361(b)(3)(B) defines a QSub as, in essence, “any domestic corporation which is not an ineligible corporation as defined in § 1361(b)(2).”

3) IRC § 1361(b)(2) defines “ineligible corporation” as including, among other things, certain financial institutes and insurance companies.

4) To avoid veil-piercing of its QSub, ABC complies with standard corporate formalities for each of them, including annual shareholder and director actions by consent.

5) ABC decides to make a statutory conversion to an LLC in order to protect its shareholders from the I&D Tax.

6) When it does so: a) Should it also convert its QSub to single-member LLCs?

b) Should it file with the IRS a termination of the QSub status of its QSub and treat them as disregarded entities?

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[C] CONVERSION OF LMN GENERAL PARTNERSHIP TO A MULTI-MEMBER LLC

1) LMN is a New Hampshire general partnership with two equal members. To provide its members with a liability shield and charging order and pick-your-partner protections, it decides to make a statutory conversion to an LLC.

2) On and after the date of this conversion:

a) What federal tax ID should LMN use? b) Should LMN file a short-year federal income tax return?

c) Should LMN file a Form 8832 election in which it elects a partnership federal tax classification?

[D] WHICH IS BETTER: AN LLC OR A PARTNERSHIP?

[E] WHICH IS BETTER: A SOLE PROPRIETORSHIP OR A SINGLE-MEMBER LLC?

[F] WHAT FEDERAL TAX CLASSIFICATIONS AND FEDERAL INCOME TAX REGIMENS ARE AVAILABLE TO A SINGLE-SHAREHOLDER CORPORATION OWNED BY AN INDIVIDUAL?

[G] WHAT FEDERAL TAX CLASSIFICATIONS AND FEDERAL INCOME TAX REGIMENS ARE AVAILABLE TO A SINGLE-SHAREHOLDER CORPORATION OWNED BY AN ENTITY?

[H] INDIVIDUALS A AND B WANT PARTNERSHIP FEDERAL INCOME TAXATION. WHAT TYPES OF STATE-LAW BUSINESS ENTITIES CAN QUALIFY FOR FEDERAL PARTNERSHIP TAXATION?

[I] INDIVIDUAL A WANTS SOLE PROPRIETORSHIP FEDERAL INCOME TAXATION. WHAT TYPES OF BUSINESS ENTITIES CAN QUALIFY FOR SOLE PROPRIETORSHIP FEDERAL INCOME TAXATION?

[J] INDIVIDUAL A WANTS SUBCHAPTER S FEDERAL INCOME TAXATION. WHAT TYPES OF BUSINESS ENTITIES CAN QUALIFY FOR S CORPORATION TAXATION?

[K] A AND B FORM A TWO-MEMBER LLC CALLED AB. A IS THE MEMBER-MANAGER. B IS THE NON-MANAGER MEMBER.

1) What is A for partnership tax purposes? 2) What is B for partnership tax purposes?

PART 14 KEY CHECK-THE-BOX DEFINITIONS AND RULES—REVIEW

1) For a list of Check-the-Box terms and definitions, see Exhibit C.

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2) For a list of Check-the-Box rules, see Exhibit D.

PART 15 BIBLIOGRAPHY

1) 290 articles. Since 1997, at least 290 law journal articles have been published on the subject of the Regs. Many of these articles deal with highly specialized topics, such as, for example, topics involving the application of the Check-the-Box Regulations in international taxation, in corporate reorganizations, and as affecting public charities under IRC § 501(c)(3), bankrupt entities, trusts, and hedge funds.

2) Articles of general interest. The following are a few articles of more general interest that have appeared in recent years:

i) Jeffrey M. Blair, “Regarding Single-Member LLCs: When Single-Member LLCs Treated as Disregarded Entities for Federal Income Tax Purposes May Not Be Disregarded,” 39 Texas Tax Lawyer (Winter 2012)

Link: http://www.texastaxsection.org/LinkClick.aspx?fileticket=QFwiTouZyd0%3D&tabid=80t)

ii) John, Trustkowsky, “Dealing with Disregarded Entities—Part 1,” 14 Business Entities 4 (July/August 2012)

iii) John, Trustkowsky, “Dealing with Disregarded Entities—Part 2,” 14 Business Entities 18 (September/October 2012)

iv) Martin J. McMahon, “Now You See It, Now You Don’t: The Comings and Goings of Disregarded Entities,” 65 Tax Lawyer 259

v) Heather M. Field, “Checking in on Check-the-Box,” 42 Loy. L.A. Rev. 251 (2009)

3) The “Steptoe” article. See also Steptoe & Johnson Practising Law Institute outline entitled “Use of Limited Liability Companies in Corporate Transactions,” Practising Law Institute Tax Planning For Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2013,” December 2012. The link to this outline is www.steptoe.com/assets/attachments/3599.DOC.

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