Unincorporated businesses have always had, and still have, the option of becoming a corporation for tax purposes by contributing the business to a newly formed corporation. The “check-the-box” CTB regulations create some planning opportunities and an opportunity to simplify the incorporation of a partnership.
Businesses can operate as one of several entity types and file one of four types of tax returns:
1) Sole Proprietorship (one owner) – files a Schedule C with the owner’s 1040
- Unincorporated entity (owner is personally liable for business debts)
- Limited liability company (owner is not personally liable unless he/she guarantees business debts)
2) Partnership (more than one owner) – files a partnership return (Form 1065):
- General partnership (GP)
- Limited partnership (LP)
- Limited liability company (LLC)
- Limited liability partnership (LLP)
3) Statutory corporations (SC) one or more owners:
- C corporation – files Form 1120
- S corporation – files Form 1120S
Entities taxed as corporations include SCs and LLCs that have elected to be taxed as a corporation.
Prior to 1996, entities that were classified by IRS regulations as a sole proprietorship or a partnership were not permitted to file corporate tax returns. In 1996, the IRS changed its regulations to permit LLCs to elect to file corporate tax returns. These regulations are referred to as “check-the-box” (CTB) regulations as they permit an LLC to elect to be taxed as a corporation by checking a box on Form 8832 and filing that form with the IRS.
The “check-the-box” (CTB) regulations also allow an LLC that has elected to be taxed as a corporation to make an election to be taxed as an unincorporated business, either as a partnership, if the LLC has more than one owner, or a sole practitioner, if the LLC has only one owner. Statutory corporations are not allowed to elect out of corporate tax treatment. The IRS also publishes a list of entities in foreign corporations that cannot elect out of corporate tax treatment. Once a CTB election is made, the entity is prohibited from making another CTB election for 60 months.
Here are some situations in which an unincorporated business might want to incorporate:
- To raise capital – many if not most private equity and venture capital investors only invest in SCs.
- To shift income from one year to the next year – a calendar year partnership can elect to close its partnership year on 10/31/16 and be taxed as a corporate entity with a year beginning 11/1/16 and ending in 2017. This will shift income earned in November and December of 2016 to 2017.
- To change an accounting method without having to request IRS permission.
- To take advantage of the fact that small C corporations are not subject to alternative minimum tax (AMT).
Situation 1 will require the LLC incorporate using a statutory corporation. Nevertheless it probably makes sense for the LLC to make a check the box election and then merge the LLC into a statutory corporation. This avoids having to obtain a new employer identification number (EIN) for the corporation. If the LLC doesn’t make a “check-the-box” (CTB) election the statutory corporation has to obtain a new EIN and that is painful, particularly when it comes to filing payroll tax returns.
Situations 2, 3 and 4 can be done by forming a SC or making a CTB election. One big advantage of a CTB election is timing. A SC cannot be formed retroactively but a CTB election can be made up to 75 days retroactively.
“Check-the-box” (CTB) elections are important in international tax planning. It is not uncommon for a US corporation to set up a foreign subsidiary that is taxed as a corporation in the foreign country but makes a CTB election to be taxed as a branch of the US corporation for US tax purposes.
This is a brief overview of a complicated topic. Don’t do anything without talking to your tax advisors.
Written by Joe Shulman, Partner