Apr 28, 2008

Can Sole Owners Check the Corporate Tax Box?

After I read the new check-the-box tax regulations that provided default tax treatment for different types of businesses, I suffered the usual post-traumatic tax research distress: sinus pressure, slight dizziness, and irritability.

The language was arcane and circular - for example, a one-owner business is referred to as "an entity with a single owner that may be disregarded as an entity separate from its owner" and the organization of the material was all over the place. Nonetheless, I was impressed that the IRS seemed to have decided to treat business entities in a sensible way. The way I read it, the new regs said that a one-person unincorporated business, including a one-owner LLC, would be treated for tax purposes as a sole proprietorship; a two-person unincorporated business, such as a co-owned LLC, as a partnership; and a corporation as a corporation. The regs also seemed to say that any business could change its tax treatment by filing an election form.

Now, this "elect your own tax treatment" idea really was different. For example, if a partnership wanted to be treated and taxed by the IRS as a corporation, it could check the corporation box on an election form, and the IRS would treat it as a corporate tax entity, allowing it keep its books, deduct expenses, report and pay taxes on income, just like a corporation, even though the partnership had not changed its legal form. I wasn't sure it made a whole lot of sense for a partnership legal entity to be taxed like a corporation, but it seemed very gracious of the IRS to let businesses do it. In fact, I was a bit taken aback by the apparent flexibility afforded by the new rules. This wasn't the cranky, status-quo-preserving language I was used to seeing in IRS pronouncements.

When I could muster the courage, I reread the new regs, and I was at least a little reassured to find that it did indeed seem to contain a few if not unfriendly, at least familiarly opaque, provisions. One thing I noticed was that the rules harped on the term "eligible business entities." This phrase was peppered throughout the text, and I suspected that the IRS rule writers were using this term as code for some unpleasant type of tax result (they often hide traps for the unwary in their language, and I suspected they were having a bit of fun with this one).

Sure enough, the more I re-read the rules, the more convinced I became that sole proprietorships, which were "disregarded as entities separate from their owners" (there's that crazy phrase again), were not, in fact, "business entities," and therefore were not eligible to be included in the magical "eligible business entities" category. This in turn meant that they could not change their tax status, for example by electing to be taxed as a corporation.

Later, I read somewhere that a Congressional sponsor of the new regs had indeed not wanted sole proprietorships to be able to change their tax treatment, but no doubt the drafters got a kick out of keeping this tidbit to themselves.

Tax interpretation uncertainties like this can ensnare even the most experienced tax advisors. In one of my masters tax classes, a very smart tax prof who had an active private tax practice mentioned that any type of business, even a sole proprietorship, could avail itself or the new regs and elect corporate tax treatment. I just had to raise my hand.

I mentioned that I thought the regs might consider a sole proprietorship to be an ineligible business entity since they apparently weren't treated as business entities at all under the rules. He screwed up his face and told me he would look into it and get back to me. He didn't.

So, just keep in mind if you want to change your sole proprietorship tax status, there may be a little mud in the water. Check with your tax advisor to get some clarification before you jump in.

Copyright 2008 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax adviser for legal or tax advice.