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Checking
the Box May Result in Unexpected Consequences
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Since
Jan. 1, 1997, businesses have been able to choose their federal
income tax treatment simply by checking a box. Sole proprietorship,
partnership, limited liability company (LLC) and S corporation
income passes through to the owners, so they pay income tax
only once. However, C corporation income faces double taxation
— at the corporation and shareholder levels.
In the past, companies had to meet tight requirements to retain
their pass-through status and avoid classification as a corporation
for federal income tax purposes. The Check-the-Box regulations
offer an opportunity to reevaluate and change existing entity
structures that were once created to accommodate these technical
requirements. Some businesses, including your own, may reap
tax savings and other benefits by choosing another business
structure.
But note: Checking the box may have tax consequences. For instance,
an existing corporation electing partnership treatment would
face tax liabilities because the IRS would view the transaction
as a liquidation of the corporation. Likewise, multistate businesses
must consider state tax consequences before changing business
structures.
Electing Your Tax Treatment
Although some entities are automatically treated as corporations,
many businesses with two or more owners may select partnership
or corporate tax treatment. Entities with a single owner generally
may choose sole-proprietorship or corporate tax treatment. The
IRS will auto-matically treat as partnerships most businesses
that don’t make an election if they have more than one
owner. The agency will disregard most that have a single owner,
treating individual owners as sole proprietorships and corporate
or partner owners as a division.
Some businesses lack a choice. For example, the IRS will treat
these entities as corporations: banks, insurance companies,
some publicly traded partnerships, real estate investment trusts
(REITs), taxable mortgage pools, certain entities that are corporations
by default and some foreign entities.
Multistate Businesses Beware
Multistate businesses must also consider state tax issues before
checking the box:
The regulations may influence nexus issues. When a business
has nexus within a state, the state may have the right to tax
that business and its owners. The entity structure and the state’s
rules will affect the tax result. The state level entity classification
of multi-state business influences the entity and its owners’
tax situation.
After making the election, the business may not be allowed to
file a consolidated state tax return because some states don’t
allow them. Disregarded entities in states following the Check-the-Box
regulations, however, may produce results similar to those of
a consolidated return, complicating the issue of whether the
business should file a consolidated or separate return.
A business with some physical presence in a state may be prone
to nexus. Because the definitions of nexus for tax purposes
vary from state to state, get to know the tax code of each state
you deal with. For example, some states won’t tax a company
with only one salesperson working there. Others may tax a company
whose salesperson visits the state a set number of times per
year.
The business may face double taxation. Some businesses
may choose partnership tax treatment by the IRS but be classified
as corporations at the state level.
The business may encounter allocation and apportionment complexities.
Certain entity classifications will affect a multistate company’s
allocation and apportionment percentages. For example, a company
classified as a corporation in one jurisdiction and a division
in another could have different apportionment percentages applied
to differ-ent tax bases. Several states won’t allow single-member
LLCs. Unless these states create new regulations, some states
will tax single-member LLCs as corporations — regardless
of how the IRS treats them.
The business may miss out on some tax credits. Partnerships
may have, at best, limited eligibility for the state and local
tax credits usually available to corporate or division businesses
or their shareholders.
More compliance burdens may exist. Businesses that fall into
the separate classifications at the state and federal level
generally face increased compliance issues. For instance, the
IRS may require some businesses to keep separate books for federal
and state tax returns — in addition to the set they may
already keep for shareholders.
Business Structure and Tax Deductibility of Losses
As you can see, your business structure can change how your
multistate business is taxed. Let’s look at how business
structure affects tax deductibility of losses.
• Sole proprietorships. If
the owner actively participates in the business, it can usually
fully deduct its losses against other income. The owner may
carry back or carry forward losses exceeding the current year’s
taxable income.
• Partnerships and LLCs taxed
as partnerships. Gener-ally, partners can deduct active partnership
losses against other income, up to their tax basis in the partnership
and based on the amount they have at risk in the business. Partners
receive basis for their shares of the partnership’s debt,
which can allow for greater losses.
• S corporations. Shareholders
can deduct losses to the extent of their basis. Unlike partnerships,
however, the shareholder’s proportionate share of the corporation’s
debt won’t increase his or her basis.
• C corporations. Corporations
can deduct the losses, carrying them back or forward to off-set
profitable years. But certain corporations are subject to the
passive loss rules.
Understanding the Pros and Cons
Check-the-Box regulations clearly present many tax planning
challenges for multistate companies. Because tax treatment is
less than favorable or still unclear in many states, call us
before checking the box.
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