News Notes

Check-the-Box Regs. Upheld • New Law’s Small Business Tax Provisions

Alistair M. Nevius, J.D.

Court Decisions

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.

Legislation

New Law Contains Small Business Tax Provisions

On May 25, 2007, President Bush signed into law the Small Business and Work Opportunity Act of 2007 (SBWOA ’07) (P.L.110-28), which included several tax provisions.

Return preparer penalties: The SBWOA ’07 expands the scope of return preparer penalties and alters the standards of conduct that must be met to avoid penalties.

The new law replaces the prior-law Sec. 6694 requirement—applicable to income tax return preparers who knew or reasonably should have known of an undisclosed return position—that there be a realistic possibility that the position will be sustained on its merits, with a requirement that there be a reasonable belief that the tax treatment of the position was more likely than not the proper treatment. The SBWOA ’07 expands the scope of the return preparer penalties to include preparers of estate and gift, employment and excise tax returns, and returns of exempt organizations.

The new law increases the first-tier penalty under Sec. 6694 from $250 to the greater of $1,000 or 50% of the income derived (or to be derived) by the preparer from the preparation of a return or claim with respect to which the penalty is imposed. The second-tier penalty, for return preparers who engage in specified willful or reckless conduct when preparing a return, is increased from $1,000 to the greater of $5,000 or 50% of the income derived (or to be derived) by the preparer. (See “DC Currents” for more on this issue and the AICPA’s efforts in this area.)

Sec. 179 deduction: The SBWOA ’07 also increases the Sec. 179 deduction. For 2007, the inflation-adjusted amount of the deduction had been $112,000, reduced by the amount by which qualifying property put in service during the tax year exceeds $450,000 (as adjusted for inflation). Those amounts have been increased to $125,000 and $500,000, respectively, for tax years beginning in 2007–2010. In years beginning after 2007 and before 2011, the amounts will be adjusted for inflation.

Kiddie tax: Effective for years beginning after May 25, 2007, the new law expands the applicability of the Sec. 1(g) “kiddie tax” to apply to children who are 18 years old or who are full-time students over 18 but under 24. The expanded provision applies only to children whose earned income does not exceed one-half of the amount of their support.

Work opportunity credit: The SBWOA ’07 extends the Sec. 51 work opportunity tax credit for 44 months for qualified individuals who begin work for an employer after 2007 and before Sept. 1, 2011. The credit had been scheduled to expire as to individuals who began work for an employer after 2007.

The new law also expands the qualified veterans’ targeted group for purposes of the work opportunity tax credit and expands the definition of qualified first-year wages from $6,000 to $12,000 in the case of individuals who qualify under the expanded qualified veterans’ targeted group. It also expands the definition of targeted high-risk youths and of targeted vocational rehabilitation referrals.

Tip credit: The SBWOA ’07 provides that the Sec. 45B tip credit will continue to be determined on the basis of a minimum wage of $5.15 an hour (the Federal minimum wage on Jan. 1, 2007), insulating the tip credit from future increases in the minimum wage (which would have reduced the amount of credit available to employers).

GO Zone deduction: The new law extends to Dec. 31, 2008, the Sec. 1400N increased expensing amount for Gulf Opportunity (GO) Zone property used in certain portions of the GO Zone: the Louisiana parishes of Calcasieu, Cameron, Orleans, Plaquemines, St. Bernard, St. Tammany and Washington, and the Mississippi counties of Hancock, Harrison, Jackson, Pearl River and Stone.

S corporations: The new law makes several changes to the S corporation rules. It eliminates gains from sales or exchanges of stock or securities as an item of passive investment income. Also, restricted bank director stock is not taken into account as outstanding stock in applying the provisions of subchapter S. The SBWOA ’07 allows a bank that changes from the reserve method of accounting for bad debts for its first tax year for which it is an S corporation to elect to take into account all adjustments under Sec. 481 by reason of the change in the last tax year it was a C corporation. It also provides that when the sale of stock of a qualified subchapter S subsidiary (QSub) results in the termination of the QSub election, the sale is treated as a sale of an undivided interest in the QSub’s assets (based on the percentage of the stock sold), followed by a deemed transfer to the QSub in a transaction to which Sec. 351 applies.

The SBWOA ’07 provides, in the case of any corporation that was not an S corporation for its first tax year beginning after 1996, that the accumulated earnings and profits (AE&P) of the corporation as of the beginning of the first tax year beginning after May 25, 2007, are reduced by the AE&P (if any) accumulated in a tax year beginning before 1983, for which the corporation was an electing small business corporation under subchapter S. The new law provides that a deduction for interest paid or accrued on debt to acquire stock in an S corporation may be taken into account in computing the taxable income of the S portion of an electing small business trust.

Spouse joint ventures: For tax years beginning after 2006, the new law generally permits spouses filing a joint return who operate a qualified joint venture to elect under Sec. 761 not to have it treated as a partnership for Federal tax purposes. The joint venture must have only the husband and wife as members, and they both must materially participate in the business (and both must elect to have the provision apply).

Interest and penalties: Finally, effective for notices issued after Nov. 25, 2007, the SBWOA ’07 extends—to 36 months after the filing of the re-turn—the period during which accrual of interest and certain penalties are suspended under Sec. 6404(g), if the Service has not sent the taxpayer a notice specifically stating the taxpayer’s liability and the basis for it.