Editor: Mary Van Leuven, J.D., LL.M.
Procedure & Administration
For federal tax purposes, certain entities can elect passthrough tax treatment by simply checking the box. If the entity has one member, it would check to be treated as a disregarded entity; if the entity has more than one member, it would check to be treated as a partnership. As this item points out, checking the box for passthrough treatment is not so simple if the taxpayer is uncertain about whether the entity has more than one member.
If a taxpayer wants passthrough treatment for an entity but is uncertain whether one of the two members of the entity under local law would be considered a member of that entity for federal tax purposes, should the taxpayer file Form 8832, Entity Classification Election, by checking the box for partnership or for disregarded entity? The uncertainty may arise, for example, if a member receives only a fee for services with no other participation in profits and losses, or if a member has such a de minimis interest in the partnership that the IRS may determine that the member should not be treated as a partner. The significance of the issue is the fear that if the wrong box is checked, the election will be invalid (void), and therefore the entity will be classified under its default classification. In the foreign area, this default classification is often corporate status—the classification the taxpayer is trying to avoid.
Rev. Proc. 2010-32
In an effort to address this issue, the IRS issued Rev. Proc. 2010-32 on September 7, 2010. The stated purpose of the revenue procedure is to deal with taxpayer concerns about the validity of entity elections due to the uncertainty regarding the number of owners for federal tax purposes of a foreign entity on the effective date of the election.
If the requirements of the revenue procedure are satisfied, the IRS will treat an election under Regs. Sec. 301.7701-3(c) by a foreign eligible entity to be “a partnership or disregarded entity as an election to be treated as a partnership or disregarded entity (as appropriate) rather than as an association taxable as a corporation.”
To qualify to use the revenue procedure, the following requirements must be met:
- The business entity is an eligible entity under Regs. Sec. 301.7701-3(a);
- The business entity is a foreign entity under Regs. Sec. 301.7701-5(a);
- The classification of the business entity (either by default under Regs. Sec. 301.7701-3(b)(2) for a newly formed or newly relevant eligible entity or by election under Regs. Sec. 301.7701-3(c) for an existing relevant entity) would be or was an association taxable as a corporation;
- As permitted under Regs. Sec. 301.7701-3(c), the business entity filed an otherwise valid Form 8832 electing to be treated for federal tax purposes:
- As a partnership, based on the reasonable assumption that it had two or more owners as of the effective date of the election; or
- As a disregarded entity, based on the reasonable assumption that it had a single owner as of the effective date of the election;
- For federal tax purposes either:
- The business entity and its actual and purported owners (or owner) have treated the entity consistently with the election on the otherwise valid Form 8832 on all filed information and tax returns; or
- No information or tax returns have been required to be filed since the effective date for the election made on the otherwise valid Form 8832; and
- The period of limitations on assessments (as established under Sec. 6501(a)) has not ended for any tax year of the business entity or its actual and purported owners (or owner) affected by the election made on the otherwise valid Form 8832.
If these requirements are met, the revenue procedure treats an erroneous election to be a partnership as an election to be a disregarded entity (or treats an erroneous election to be a disregarded entity as an election to be a partnership) provided that:
- The owners (purported or actual) file original or amended returns consistent with the correct classification;
- All required amended returns are filed before the close of the statutory period of assessments for any relevant year; and
- A corrected Form 8832 is filed (with copies attached to amended returns) as described in the revenue procedure.
The revenue procedure also notes that a business entity that does not qualify for relief under the revenue procedure may request relief through the letter ruling process described in Rev. Proc. 2010-1 (or its successor).
Potential Issues
The publication of Rev. Proc. 2010-32 is clearly a well-intentioned attempt to provide an efficient mechanism to help ensure an entity’s appropriate classification. For taxpayers covered by the revenue procedure, an “automatic” remedy is indeed helpful. It also eliminates the administrative burden for the IRS employees who might have had to issue private letter rulings granting Sec. 9100 relief to taxpayers that feared their election was invalid. However, by its terms Rev. Proc. 2010-32 helps only those who become aware that their original election was incorrect before the period of assessment has expired on all affected filers.
What about taxpayers who made their best choice but still are uncertain about the number of members? By providing a mechanism for some taxpayers, the revenue procedure seems to suggest that a remedy is necessary if the wrong box was checked. Will those taxpayers who are uncertain about their selection have to worry that they may need future Sec. 9100 relief that they can only hope will be granted? Certainly, by providing fairly stringent requirements for automatic relief and by offering the private letter ruling process for those who cannot meet those requirements, there appears to be an implication that, absent taking such action, the selection of the wrong box renders an election invalid.
Granted, the revenue procedure does not specifically say that any election is invalid. Indeed, revenue procedures should not be read as announcing the IRS’s conclusions of law; that is typically reserved for revenue rulings. The revenue procedure’s stated purpose is “to alleviate concerns.” However, why provide only a limited remedy for checking the wrong passthrough box if a remedy is not necessary? In providing certainty to those taxpayers who early on become aware that they made a mistake, the revenue procedure may have created greater uncertainty for those still unable to determine whether they made a mistake.
Recommendations
There are certain steps taxpayers may take when faced with uncertainty in making an election for passthrough treatment. If a taxpayer determines that it checked the wrong box, it would be advisable for the taxpayer to follow the revenue procedure, if it applies. Although it is not certain that this is necessary, it would seem imprudent not to take advantage of the revenue procedure if the issue comes to light in time to meet the terms of the revenue procedure. If the issue does not come to light in time to meet those requirements, the taxpayer might consider contacting the IRS to inquire about the need for a private letter ruling to correct the election retroactively.
If a taxpayer is merely uncertain whether it checked the wrong box but still believes it made the best choice it could, it can await a determination to the contrary by the IRS, at which time the taxpayer may have to seek relief from the IRS to correct the error. It does not appear that by issuing Rev. Proc. 2010-32 the IRS intended to make it less likely that a taxpayer will get the intended passthrough treatment. But it would have been of greater benefit if the IRS had provided more comfort for the taxpayer that the entity would not inadvertently default to corporate status.
The authors of this item recently submitted a comment letter to Treasury and the IRS, proposing solutions to these potential issues. (See Comments on Rev. Proc. 2010-32, 2011 TNT 38-23 (February 24, 2011).)
EditorNotes
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.
Unless otherwise noted, contributors are members of or associated with KPMGLLP.
