The U.S. tax system has a unique feature called “check-the-box”, which distinguishes it from the Canadian tax system. Implemented in 1997, the “check-the-box” regulations under section 7701 of the Internal Revenue Code (“IRC”) provide taxpayers with flexibility in choosing their own entity classification for US federal tax purposes. This flexibility is available to US domestic business entities that are not required to be treated as corporations, trusts, or in other special ways under the IRC pursuant to regulations 301.7701-3 and 301.7701-2(b). Some of the benefits for these check-the-box regulations for our clients are discussed below.
Benefits of Check-the-Box Regulations for Entities with Two or More Members
A domestic entity with two or more members can be taxed either as a partnership or as a corporation. Domestic entities with two or more members have a default classification of partnership if they do not file an election.
However, checking the box to elect to be taxed as a corporation can afford certain benefits to the taxpayer. A corporation has perpetual duration and is considered a separate legal entity. As a separate entity that is a resident of the US, a corporation can benefit from Canada-US Tax Treaty provisions that are not available to flow-through entities. The shareholders of a corporation also benefit from added liability protection, subject to the piercing of the corporate veil.
Benefits of Check-the-Box Regulations for Entities with One Member
A domestic entity with one member that does not elect to be taxed as a corporation will be a disregarded entity, which means that it will be treated as a sole proprietorship. A one-member entity that checks the box to be treated as a corporation benefits from the same advantages mentioned above.
Choosing to be treated as a sole proprietorship, on the other hand, allows the proprietorship’s gains and losses to “flow through” to the owner, as discussed below.
Benefits of the IRC Section 761 Election for Unincorporated Entities
Entities that are not incorporated can elect through IRC section 761 to have only some rules from Subchapter K apply, which are the provisions in the IRC that apply to partnerships. As such, an unincorporated entity in the US may elect to either completely or partially exclude itself from the partnership rules, which provides a substantial amount of flexibility to the taxpayer.
For example, a US Limited Liability Company (“LLC”) can elect to be taxed as a partnership to avoid taxation at the entity level, while its members can still enjoy the same limited liability as the shareholders of a corporation. However, note that a single-member LLC cannot elect to be treated as a partnership, as by definition, at least two partners are necessary to make this election.
Not checking the box generally results in the taxpayer creating a flow-through entity such as a partnership or sole proprietorship whereby the entity’s gains or losses can be “flowed-through” to the owners.
The US “check-the-box” regulations afford taxpayers with a substantial amount of flexibility that provide beneficial tax and estate planning opportunities. Please contact us to discuss these opportunities.