Check-the-Box Regs. Upheld

By Alistair M. Nevius, J.D.

The check-the-box (CTB) regulations have not generated much litigation since their promulgation in 1996. Now, in a case of first impression, Littriello, 4/13/07, the Sixth Circuit has upheld the regulations, holding that they do not exceed Treasury’s authority, do not conflict with principles set forth by the Supreme Court in Morrisey, 296 US 344 (1935), do not disregard the separate existence of a limited liability company (LLC) under state law and do apply to employment taxes. The Second Circuit has also upheld the regulations (McNamee, 5/23/07).

The CTB regulations clarify the rules for determining the classification of certain business entities for Federal tax purposes; see Regs. Secs. 301.7701-1 through -3. Under the regulations, a taxpayer may elect to treat an unincorporated business association as a corporation or as a partnership (or to be disregarded, in the case of a sole proprietorship). Taxpayers that do not make an election will be treated under the regulations as partnerships or sole proprietorships, by default.

Littriello: In Littriello, the taxpayer’s businesses were organized as LLCs under state law, with the taxpayer as the sole member. The taxpayer did not elect under the CTB regulations to have the businesses treated as corporations; thus, by default, they were disregarded for Federal tax purposes. The LLCs were not subject to corporate tax, and the taxpayer reported his income from them on Form 1040, Schedule C.

When the taxpayer failed to pay Federal employment taxes due, the Service notified him of its intention to enforce previously filed tax liens that had been levied on his property as security for the unpaid employment taxes. An IRS Appeals Office determined that the taxpayer was individually liable as a sole proprietor because he had failed to elect to be treated as a corporation.

The taxpayer contested the finding of liability in district court, arguing that the CTB regulations were invalid because they exceeded Treasury’s authority, that the regulations were invalid under Morrisey and that they impermissibly altered the legal status of his state-law-created LLC. Before the Sixth Circuit, he also contended that the regulations do not apply to employment taxes.

The district court upheld the assessment against the taxpayer and held that the regulations were a reasonable interpretation by the Service of an otherwise ambiguous statute (Sec. 7701). The Sixth Circuit agreed that Sec. 7701 is ambiguous when applied to newer business entities (such as LLCs) and that it is reasonable for Treasury to develop regulations to fill statutory gaps. The Sixth Circuit held that the CTB regulations were a valid exercise of Treasury’s authority and that, because the taxpayer failed to elect to have his LLCs taxed as corporations under the regulations, he is individually liable for the employment taxes due and owing from those LLCs, because they constitute sole proprietorships under Sec. 7701 and he is the proprietor. The Sixth Circuit also agreed with numerous courts that state laws of incorporation may affect, but do not control, Federal tax provisions and held that state LLC laws did not abrogate the taxpayer’s Federal tax liability.

McNamee: In McNamee, the plaintiff owned a single-member LLC (SMLLC) that was disregarded as a separate entity under the CTB regulations. The Service assessed unpaid payroll taxes of the SMLLC against the owner and placed a lien on his property.

The plaintiff argued that the regulations contradict the Code (because they attempt to regulate entities that are not defined therein) and ignore state limited liability laws. Using an analysis similar to the Sixth Circuit’s, the Second Circuit rejected the plaintiff’s arguments, upheld the CTB regulations as not arbitrary, capricious or unreasonable, and affirmed the lower court’s judgment against him.

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