Final Check-the-Box Rules Terminate Certain Grandfathered Status

Treasury issued final regulations in October 2003 (TD 9093) to amend the check-the-box rules under Regs. Secs. 301.7701-2 and -3. The changes revoke the grandfathered partnership status of otherwise per se entities that undergo a 50% ownership change after Nov. 29, 1999.

The final regulations also clarify when an eligible entity is considered relevant for purposes of applying the 60-month rule, providing that a foreign eligible entity for which an entity classification election is made and which is not otherwise relevant for Federal tax purposes is deemed relevant only on the effective date specified on Form 8832, Entity Classification Election. In addition, the new regulations modify the classification rules for certain foreign eligible entities that have never been relevant or are no longer relevant for Federal tax purposes.

The regulations finalize 1999 proposed regulations and adopt them without substantive change, except that Treasury decided to withdraw Prop. Regs. Sec. 301.7701-3(h) (as announced in Notice 2003-46). These changes were effective Oct. 22, 2003.

Grandfathered Foreign Per Se Entities

The check-the-box regulations allow certain foreign business entities that (1) were in existence and treated as partnerships before the check-the-box regulations were proposed and (2) would otherwise be classified as per se corporations under Regs. Sec. 301.7701-2(b)(8)(i), to remain classified as partnerships if the conditions in Regs. Sec. 301.7701-2(d)(1) are met. These rules also provide that the occurrence of certain events results in a termination of grandfathered status; see Regs. Sec. 301.7701-2(d)(3)(i). According to Regs. Sec. 301.7701-2(d)(3)(i)(D), an entitys grandfathered status also terminates on the date in which one or more persons who were not owners of the entity on Nov. 29, 1999 own, in the aggregate, a 50% or greater interest in the entity. Because this rule was not applicable until Oct. 22, 2003, if persons that were not owners of a grandfathered entity on Nov. 29, 1999, obtained a greater-than-50% ownership interest in one between Nov. 29, 1999, and Oct. 22, 2003, the entitys grandfathered status did not cease until the later date.

Relevance of Classification

Regs. Sec. 301.7701-3(d)(3) provides that, if the classification of a foreign eligible entity that was previously relevant for Federal tax purposes ceases to be relevant for 60 consecutive months, then subsequently becomes relevant again, the entitys classification at the start of the subsequent period of relevance will be determined under the default classification rules (60-month rule). These final regulations adopt two of the proposed regulations on the application of the 60-month rule.

First, under Regs. Sec. 301.7701-3(d)(1)(ii)(A), the classification of a foreign eligible entity that files an entity classification election is deemed to be relevant for Federal tax purposes on the elections effective date for purposes of the 60-month rule. Second, under Regs. Sec. 301.7701-3(d)(2), the classification of a foreign eligible entity whose classification has never been relevant for Federal tax purposes will initially be determined under the Regs. Sec. 301.7701-3(b)(2) default classification provisions at the time entity classification first becomes relevant.

Extraordinary Transaction Rule Withdrawn

Notice 2003-46 announced the withdrawal of Prop. Regs. Sec. 301.7701-3(h). This proposed regulation would have disallowed an entitys election to be treated as a foreign disregarded entity if an extraordinary transaction occurred one day before or within one year after the election to treat the entity as disregarded. The withdrawal was formally and succinctly reiterated in regulations issued on Oct. 21, 2003.

Notice 2003-46 indicated that the IRS and Treasury remain concerned about cases in which a taxpayer, seeking to dispose of an entity, makes an election to disregard it merely to alter the tax consequences of the disposition and that the IRS will continue to pursue the application of other principles of existing law (such as the substance over form doctrine) to determine the proper tax consequences of such cases.

From Kelly Pedigo Maddux, J.D., and Michael Danilack, J.D., Washington DC