Academic

In her paper, Heather Field analyzes the effectiveness of the check-the-box (CTB) regulations.  She suggests that the CTB regime represents an improvement over the prior four-factor Kintner test in the domestic context while concluding that the costs of the elective regime outweighs its benefits in the international setting.  Field also argues that the limitations on ?eligible entities? (i.e., those entities for which the election is available) ?undermine the provision of the election itself.? 

I enjoyed this interesting piece and found myself agreeing with much of what the paper argues.  I will therefore focus my comments on the few areas where I believe the paper might be improved.

Despite her criticisms of the current regime, Field does not make any specific recommendations for reform.  Perhaps this is because she concludes that the whole U.S. unintegrated business tax system is itself completely unjustifiable as a policy matter.  But it?s unclear to me whether Field is arguing that the Treasury and the IRS should therefore just keep the current CTB regime (warts and all) based on the rationale that any entity classification regime will be substantially flawed in our substantially flawed classical system.  I think it would be helpful for Field to clarify at some point in the paper whether and how she believes the CTB regulations (as they currently exist) ought to be reformed, if at all. 

Instead of focusing on specific reforms, Field?s focus is on whether, with the benefit of a decade of hindsight, the CTB regulations represent an improvement over the previous Kintner regime.  Field ably describes the benefits and the detriments of the CTB regime.  Many of the significant detriments stem from one particular feature of the CTB regime.  As Field points out, the CTB regulations created the concept of disregarded entities (DE), which in turn stimulated state legislatures to allow for single-member LLCs (SMLLCs).  So now we have entities that are respected for state law purposes as separate and distinct with independent rights and duties, yet these entities are to be ?disregarded? for federal tax purposes.  This was quite a new concept for the tax system to digest and it has resulted in complexities both in tax procedure (e.g., collection) and in the application of substantive tax law (which looks to state law consequences to determine the ?substance? of transactions).  As just one example of a procedural ambiguity, is a SMLLC that is a DE really disregarded for purposes of determining liability for excise and employment taxes?  The IRS has litigated these cases (and won, though it should have lost) and the CTB regulations have recently been amended.  With respect to substantive ambiguities, the IRS has had to clarify when a DE owned by a corporation can participate in a merger that will qualify for tax-free reorganization status.  More significantly, DEs have often been used abusively in the international context, as Field notes. 

Thus, many of the most significant detriments that Field identifies do not stem from the election feature of the CTB regime.  Nor do they stem from the CTB regime?s classification of entities as either corporations or partnership.  Rather, they stem from the regime?s creation of a brand new entity that now has to fit into a system that was never devised with it in mind.  The result has been administrative headaches and planning opportunities.   I would suggest that, given the fact that DEs have caused so many problems, Field devote a larger part of the paper to them.  A number of interesting issues come to mind.  Would the DE problem eventually have arisen under the Kintner regulations?  Would classifying all single-member entities with limited liability as corporations for tax purposes be a better approach?  Does Treasury have the statutory authority to treat only foreign DEs with limited liability as corporations, as recommended by the Joint Committee on Taxation? 

One issue that Field does not address is whether Treasury and the IRS had the authority to promulgate the CTB regulations.  Under administrative law principles, administrative agencies can fill statutory gaps and resolve statutory ambiguities, but they cannot contravene the clear intent of Congress as expressed in statutory text.  Some have argued (very persuasively, in my view) that sections 7701(a)(2) & (3) (which separately define ?partnership? and ?corporation? as mutually exclusive classifications) simply do not permit a result where two business entities that are wholly identical in every single substantive respect may nevertheless be classified differently.  These critics conclude that a statutory amendment would be necessary to implement an elective regime, which explicitly allows such a result.   While Treasury and the IRS apparently disagreed with this view (probably emboldened by the belief that the pro-taxpayer regulations would never be challenged because of strict taxpayer standing rules), they also appeared to recognize that they were not totally unconstrained by statutory text.  For example, the CTB regulations do not allow entities incorporated under state law (?state law corporations?) to elect their classification; instead they are always taxed as corporations.  Field criticizes this aspect of the CTB regulations (as discussed below), but the statute absolutely requires it.  Section 7701(a)(3) provides that ?[t]he term ?corporation? includes associations, joint-stock companies?? and section 7701(c) provides that the term ?include? should ?not be deemed to exclude other things otherwise within the meaning of the term defined.?  Even Treasury and the IRS, which were extremely aggressive in promulgating the CTB regulations, must have concluded that allowing state law corporations to elect partnership (or DE) status would contravene the plain meaning of the governing tax statutes. 

Field argues that, under the principles of the CTB regulations (i.e., virtually indistinguishable entities ought to be treated alike), state law corporations ought to be able to elect their classification because they can be identical in all substantive respects as LLCs.  While this is hard to dispute, this is not a criticism of the CTB regulations, instead it is a criticism of the statutory regime which requires that state law corporations be taxed as corporations.  (The same can be said of Field?s criticism that the CTB regulations unjustifiably prohibit publicly traded partnerships from making the election.  This too is a mandate from Congress found in section 7704 and it cannot be undone without legislative action.) 

Field?s argument regarding per se corporations suggests an interesting criticism of the CTB regulations that Field might consider entertaining.  The Kintner regime was substantially flawed, and because of the emergence of LLC statutes everyone now knew it.  Besides the question of how it should be fixed, there was the question of who should do the fixing:  Congress or the Treasury.  When Treasury decided to fix it, it was constrained by the relevant statutes?i.e., it did not have unfettered discretion to create a comprehensive and fully coherent fix.  Treasury could only operate within the amount of arguable ?space? given to it as a result of ambiguities and gaps in the statute.  If Treasury had decided that it simply lacked the statutory authority to implement the CTB regime (an extremely plausible view, to say the least) and instead invited Congress to fix the problem, perhaps a more positive policy outcome could have eventually resulted.  Maybe Congress would have taken the opportunity to address the fundamental problems in business taxation by fully integrating the system (stop laughing!).  More likely, Congress could have retained the corporate tax only for public firms (regardless of their state law entity classification), while providing for mandatory flow-through treatment for all other firms (regardless of their state law entity).  Perhaps Congress could have also at the same time gotten rid of the current dueling subchapter K and subchapter S flow-through regimes and created a single flow-through regime for nonpublicly traded businesses.  The point is that Treasury and the IRS let Congress off the hook by patching the roof.  Had they said to Congress ?we?d like to fix the Kintner problem but our hands are tied by the statutes,? perhaps Congress would have built a new house or at the very least put on a new roof.  As it stands now, we have a patchwork entity classification system (as Field correctly argues) on top of a patchwork business tax system (as many have argued).  It is not unreasonable to suggest that, in light of the proliferation of LLCs, Congress (at Treasury?s invitation) might have fixed the former while at least making marginal improvements in the latter.  Perhaps the greatest cost of the CTB regulations is the cost of this lost opportunity.