A recent case addressing the validity of the "check the box" entity classification regulations illustrates why simplification isn't a simple task. In Littriello v. United States, No. 3:04CV-143-H (W.D. Ky. May 17, 2005), the District Court held that those regulations were valid. The significance of the case, the first in which the issue was decided, is tempered by several factors. It is a district court decision. The case may be appealed. Criticism of the decision abounds. Nonetheless, there may be a lesson in the story for advocates of simplification. It isn't and won't be easy.
The basic question is an easy one. So long as corporations and partnerships are taxed differently for income tax purposes, it matters whether an entity is a corporation or a partnership. Although many people unfamiliar with legal issues might react justifiably with the comment, "It is what it is," the simple (ha ha) fact is that sometimes it isn't clear what it is. Certainly something formed as a corporation under state law is a corporation. Yes, that's easy. And simple. But what about the hybrid creatures of state law and the law of foreign jurisdictions?
Some history is not only helpful, but necessary. An abbreviated outline must suffice, considering that extensive descriptions are easily found in the tax literature. Once upon a time, as all good stories begin, the tax law made being a corporation more advantageous than being a partnership. It had to do mostly with the treatment of deferred compensation, but those details don't matter. What matters is when the IRS interpreted the statutory definitions of corporation and partnership, which don't answer the tough question, it issued regulations that, in effect, made it difficult to be a corporation. Years passed, as sometimes happens in a good story. The first era of tax shelters dawned. Partnerships provided excellent vehicles for tax shelters because of, among other things, the pass-through rules, the inclusion of partnership debt in partner basis, and the then-wide-open ability to make all sorts of special allocations. When the IRS began challenging tax shelters, its principal attack rested on reclassifying the entity as a corporation. Because tax shelter operators preferred the limited partnership, and because limited partnerships do have some corporate-like features, such as limited liability, it wasn't all that outlandish to argue that they were corporations. In those days, the state of subchapter K meant that if the entity was a partnership, there were very few, if any, effective tools for the IRS to use to shut down the shelter. Thus, the conflict centered on entity classification.
Unfortunately, because the IRS' own regulations made it difficult for an entity to be a corporation, it also made it difficult for the IRS to prevail in court. Practitioners in the know had the expertise to structure a limited partnership so that it lacked sufficient corporate characteristics to be a corporation. As I told my classes, "If you want to be a partnership and know what you are doing, you can be a partnership." The folks who did NOT know what they were doing were the ones getting trapped, and their numbers were diminishing. Ironically, by this point many of the deferred compensation advantages accruing to corporations had dissipated because of legislation narrowing, and at that time, almost eliminating, the major differences between corporations and partnerships in terms of deferred compensation. So the IRS was left with regulations issued to prevent a perceived abuse that no longer existed to any substantial degree, but that made the task of shutting down tax shelters through judicial action almost impossible. So as limited partnership tax shelter "vehicles" proliferated, the IRS was drowning in ruling requests, audits, litigation, and other time-consuming efforts that went nowhere.
As time passed, state legislatures began to add other entity forms to the mix. The headline arrival was the limited liability company. What was it? Corporation? Partnership? In the meantime, the Congress, busily enacting not only a series of reforms to subchapter K that dampened the utility of partnerships as tax shelter vehicles (contributed property allocation rules, disguised sale rules, varying interest allocation rules, restrictions on special allocations, etc) but also the wider-focused at-risk and passive loss limitations, paid no attention whatsoever to the entity classification of LLCs or the other hybrids.
At this point, the IRS, knowing that expertised practitioners could cause the entity to be what it wanted to be, announced it was considering a regulation that permitted entities to file a form on which they simply "checked a box" to indicate that they wanted to be a corporation or a partnership, or, in the case of a single-member LLC, a sole proprietorship or division of a corporation. By the time the regulations were issued, the IRS shifted to a set of default rules, from which taxpayers could elect out. After all, why get deluged with hundreds of thousands of forms when most entities presumably would want to be partnerships? After all, by now the IRS had a stable of tools to use against improper tax shelters and no longer saw the issue decided simply on the basis of entity classification. Ironically, nowhere in the regulations is the phase "check the box" used. Someone searching a digital database of the tax regulations who uses that phrase as a search term will get nothing. Yet in the tax world, the regulations have that name. I use this as an example when teaching tax to explain how tax is more than a set of rules but a culture with its own terminology best known by its insiders.
In general, the check the box regulations are simpler than those they replaced. The ones they replaced required analysis of six characteristics. Determining whether an entity had a particular characteristic required an extensive analysis of its organic documents, its contracts, its side deals, its activities, and all other sorts of facts and circumstances. A flow chart of those regulations would fill dozens of pages. In contrast, most flow charts of the check the box regulations fill one or two pages, depending on how they are designed.
Most, if not all, taxpayers, took the check the box regulations as good news. They were simpler. They provided flexibility. They eliminated thousands of ruling requests, all sorts of classification audit attention, and litigation over classification. Essentially, entities formed as corporations are corporations. So, too, are a long list of specific foreign entities. Special entities, such as regulated investment companies and real estate investment trusts, are so classified and don't get treated as corporations or partnerships as such. Trusts are carved out and subject to the special tax rules applicable to trusts. All other domestic entities, including LLCs, are divided into two major groups: single-member and multiple-member. Single-member entities can elect to be corporations. Otherwise, they are disregarded, which means that if they are owned by an individual they are sole proprietorships and if owned by a corporation, they are divisions of the corporate owner. For multiple-member entities, they are deemed to be partnerships unless they elect to be corporations. The presumption is reversed for foreign entities in which no one has any liability.
So what happened?
Well, some commentators took the position that the IRS lacked the authority to permit something not a corporation to be taxed as a corporation. Or to let an LLC be treated as a division of a corporation. They rested their argument on the Supreme Court's decision in Morrissey v. Comr., 296 U.S. 344 (1935). In that case, the Court held that the Treasury was not barred from revising the entity classification regualations to treat business trusts as a corporations nor that it exceeded its powers in providing that the extent or lack of control by the trust beneficiaries was not solely determinative of the classification. The Court also held that because the trust's characteristics were like those of a corporation, it was an association taxed as a corporation. The commentators consider that decision, absent Congressional revision of the statute, to preclude Treasury (and the IRS) from permitting an entity that is like a corporation from being treated other than as a corporation. For example, in "Can Treasury Overrule the Supreme Court?, 84 B.U. L. Rev. 185 (2004)," (available
here) Gregg Polsky argues, quoting from a message to me in response to my question about the issue, "that the regulations are invalid even assuming arguendo that they are consistent with the statute. In a nutshell, my argument is based on three Supreme Court decisions holding that the executive branch is bound by the Court's prior interpretations of a statute. *** Accordingly, I argue that, because the regulations are wholly inconsistent with Morrissey v. Comm'r, 296 U.S. 344 (1935), they would be determined to be invalid if challenged." Vic Fleischer, on the other hand, comes out on the other side, as he explains
here. For another analysis supporting pass-through treatment as the default, see John Lee, Entity Classification and Integration, 8 Va. Tax Rev. 57 (1988).
So with commentators somewhat split on the issue, the next question is a practical one. Who is going to challenge regulations that not only are favorable to taxpayers but that pretty much let taxpayers elect what they want? The few taxpayers that have no choice, such as corporations formed as corporations, wouldn't stand a chance if they challenged the regulations. To have standing, a person must demonstrate that application of the regulation causes a direct detriment to that person. That's why none of us can sue if we don't like the fact, assuming we knew it, that the IRS accepted, on audit, the explanation of our neighbor concerning her deductions.
So the Littriello case came as a surprise to many. Why could the taxpayer challenge the regulations?
The taxpayer was the sole member of an LLC, which did not elect to be treated as a corporation for federal income tax purposes. Hence, it was treated as a sole proprietorship. Remember that under state law it was a separate entity. The LLC failed to pay over to the Treasury income and FICA taxes withheld from employees. So the IRS proceeded against the taxpayer, who paid and sued for a refund. The taxpayer argued that the LLC was liable but that he was not. After all, under state law, the LLC member is not liable for the LLC's debts. On cross-motions for summary judgment, the court held that the check the box regulations were valid and that the taxpayer was liable for the taxes because the taxpayer was the employer.
In analyzing the validity of the regulations, the court applied the two-part test set down by the Supreme Court in Chevron v. Comr., 467 U.S. 837 (1989). First, has Congres directly addressed the precise question at issue? Otherwise, the question is whether the agency's position is based on a permissible construction of the statute.
As to the first question, the taxpayer argued that the regulations violate the manifest intent of Congress that a partnership and corporation are mutually exclusive, because two identical business entities can elect different classifications, and the IRS replied that the term "association" in the statute is ambiguous. The court noted that the term "association" used in the statutory definition of corporation and the phrase "group, pool or joint venture" used in the definition of partnership are not clearly distinct. Because an LLC is not clearly a corporation or a partnership under state law, there is an ambiguity that justifies giving LLCs an elective choice.
As to the second question, the taxpayer argued that the plain meaning of the statute precludes an elective regime because "taxation as intended by Congress is based on the realistic nature of the business entity." The taxpayer's chief evidence supporting this argument were the former regulations that were replaced by the check the box regulations. Interestingly, the court noted that "The check-the-box regulations are only a more formal version of the informally elective regime under the [former] regulations. A business entity could pick at will which two corporate characteristics to avoid in order to qualify as a partnership under the [former] regulations." Although recognizing that "some reasonable arguments support [the taxpayer's] position," the court held that the check the box regulations "seem to be a reasonable response to the changes in the state law industry of business formation" and "also seem to provide a flexible permissible construction of the statute."
The Court then rejected other arguments advanced by the taxpayer. It was not persuaded that the regulations violate "the basic principle of treating like entities alike" under the Code. Even though a single member LLC with all six corporate characteristics listed in the former regulations can elect not to be treated as a corporation and even though a single member LLC with no traditionally corporate characteristics can elect to be treated as a corporation, those choices reflect the fact that "In today's business environment, not all corporations are alike and not all partnerships share the same characteristics." Likewise, the court did not agree with the taxpayer that the regulations impermissibly changed the legal status of the LLC created under state law because it disregards the separate status of the LLC accorded by state law. The court noted that the regulations apply only for purposes of federal tax liability. To the taxpayer's argument that any tax liability rested on his status as agent of the LLC and not as his personal obligation, the court responded that for tax purposes the taxpayer was the employer and was liable for the taxes as an employer.
The taxpayer concluded by arguing that the IRS had only one avenue of collection, namely, section 6672, which requires that the IRS prove that the taxpayer was a responsible person for the LLC's failure to pay over the taxes. The Court concluded that the IRS was going after the taxpayer as a sole proprietor, but the fact that it has section 6672 available does not close the door to other approaches. The existence of those other approaches does not make the regulations an impermissible interpretation of the statute.
Whew! Yes, this is long, and far from simple. But it's important. If the taxpayer appeals, and that's a big "if," there is a chance that the Court of Appeals would reverse. Imagine the uncertainty, confusion, and chaos in the entitly classification corner of the tax world. Should the regulations be put at risk in a case involving failure to pay over taxes rather than in a case dealing directly with the classification issue?
That question has generated a lot of speculation. Surely, this can't be where the IRS wants to be? Or is it? Perhaps the IRS consciously decided that this would be a good way to open the judicial fray with respect to the validity of the regulations. After all, although the regulations are taxpayer-friendly, the IRS must be aware of the criticism offered by some commentators, and must have figured that someday the issue would arise. It may very well be that the issue would NOT arise in a case dealing directly with the classification issue because there is almost no likelihood that taxpayers who can choose to do what they want to do would challenge that opportunity.
After all, as has been asked, why didn't the IRS go the usual employment tax responsible person route under section 6672? The simple answer is that we don't know. Borrowing from comments made by Steve Johnson of the University of Nevada at Las Vegas Law School, the opinion doesn't clarify if the taxes in question were only the employer's portion or included "trust fund" taxes (those withheld from the employees). But my reading of the case suggests that withheld taxes were at least part of the taxes at issue, because the court states, "It [the LLC] failed to pay withholding and FICA taxes." Steve also asks if the statute of limitations for section 6672 purposes had expired. We simply don't know. Was the taxpayer a responsible person? How not? The taxpayer was the ONLY owner of the LLC.
This story isn't over. There's a reason that television writers leave the viewers hanging. It brings them back. Eventually there will be another chapter. But for now, anyone practicing in this area should resist the temptation to relax at the news that "the check the box regulations were held valid by a court" and remain vigilant for news of an appeal and the decision of a Court of Appeals.
Hey, you know, this could go to the Supremes. The issues, rather than involving complicated tax computational gymnastics, are administrative law issues far more appealing to the Supreme Court than the substantive stuff. But I'm getting ahead of the story, so it's time to sit back and wait. A simple thing to do, right?
