Check-the-Box: A Trap for the Unwary

Editor: Mindy Tyson Weber, CPA, M.Tax.

Corporations & Shareholders

The check-the-box (CTB) regulations (Regs. Secs. 301.7701-1 through 301.7701-3) have provided taxpayers with ease and flexibility with regard to choice of entity. It has never been easier to effect the choice of operating as a sole proprietorship, partnership, or corporation for federal income tax purposes. Overall, this is a good thing. However, sometimes when a choice becomes easy, unforeseen problems can result. Consider the following example.

Example: P is a C corporation that conducts two businesses, Business A and Business B. P conducts Business A directly and conducts Business B indirectly. Business B is operated by LLC, a disregarded entity wholly owned by P. Over the years, Business B has not been as profitable as anticipated, and P has loaned money to LLC to help provide needed working capital. As a result of these loans, LLC has a debt outstanding to P of $500.

Because LLC is a disregarded entity for federal income tax purposes, this $500 debt has no federal income tax impact, and Business B is treated as if it were merely a division of P. Thus, the debt owed by LLC to P is treated as owed by one division of P to another. Obviously, P cannot be both debtor and creditor with respect to the same debt, and the debt, like LLC itself, is disregarded for federal income tax purposes.

Suppose P decides it would make sense for Business B to be operated in a bona fide corporate subsidiary rather than through a disregarded entity. Thanks to the CTB regulations, P can implement this decision with little more than a snap of its fingers. With the simple filing of the proper election form, LLC will become a bona fide C corporation wholly owned by P.

What are the tax consequences of P’s implementing this simple decision? Because LLC was previously treated as a division of P, the election to have LLC taxed as a C corporation is treated as if P took all of the assets and liabilities of Business B and transferred them to New LLC, a corporation, in exchange for 100% of the stock of New LLC. This type of exchange falls under the rules of Sec. 351 and is typically both routine and tax free.

However, there may be a trap for the unwary. One of the liabilities P transferred to New LLC is the $500 that Business B had owed to P. While this debt was previously ignored for federal income tax purposes, the CTB election changes that treatment.

After LLC becomes a stand-alone corporation, one bona fide entity (New LLC) owes $500 to another bona fide entity (P). No longer ignored for federal income tax purposes, this debt is now quite real and has associated tax consequences.

Under the CTB regulations, P is treated as having transferred all the assets and liabilities of Business B to New LLC in a transaction addressed by Sec. 351. As stated, such a transaction is typically tax free. However, for the transaction to be tax free, the sole consideration received by P in exchange for the transfer of Business B must be stock of New LLC, but P did not receive only stock of New LLC in this transaction.

P received stock of New LLC and a brand-new note for $500. Since it is precluded from tax-free treatment by the rules of Sec. 351, the receipt of this note represents taxable boot to P (see generally Sec. 351(b)). Because the $500 note is not in fact new and has existed for some time, this result may not seem intuitively correct. The key to the transaction is that, previously, the note did not exist for federal income tax purposes, and now, by virtue of the CTB election to treat LLC as a C corporation, the note springs into life for federal income tax purposes.

Though case law indicates the note should not be treated as boot—see Wham Construction Co., 600 F.2d 1052 (4th Cir. 1979)—the IRS clearly does not agree with this case (see Rev. Rul. 80-228). Because this case and revenue ruling predate by more than a decade the publication of the CTB regulations, one may wish to debate the merits of applying the case or the revenue ruling. Yet, it certainly seems the revenue ruling better aligns with the current tax rules. Thus, taxpayers in situations akin to that faced by P need to be mindful of the potential for boot prior to making a CTB election in the same manner. While P and New LLC may file a consolidated tax return and thereby defer any immediate federal income tax consequences from the receipt of boot, state tax consequences flowing from this transaction might not be deferred.

Fortunately, a simple solution exists. Prior to making the CTB election to have LLC taxed as a corporation, P could forgive the $500 debt owed by LLC. If the debt is forgiven before the CTB election takes effect, there are no tax consequences. The debt was previously ignored for federal income tax purposes, and the forgiveness of an “ignored” debt would itself be ignored. Thus, no tax consequences result.

EditorNotes

Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.