What are Check the Box Elections

When an entity is newly created, it is given a default classification for federal tax purposes. Our article on choice of entity gives an overview of the different types of entity classifications that business owners may select.

Unless the entity is organized as a corporation (in which case it may not change its entity classification status), a newly created entity can elect to change its default classification by filing Form 8832 (Entity Classification Election) with the IRS.[1]

The form is quite simple to complete; however, there is often significant tax analysis that has been performed to determine that changing an entity’s default classification is a desirable outcome.

Which entities can be chosen?

Other than a corporation which may not elect to change from its default classification, in many cases entities are allowed to check-the-box to change its default classification.  For example, partnerships and LLCs may elect to be treated as a corporation.

It is important to note that non-US jurisdictions may not respect an entity’s classification election.  For example, while a partnership may elect to be treated as corporation for US tax purposes, other countries will continue to view the entity as a partnership for tax purposes (and of course legal purposes). 

The hybrid nature of the entity can give rise to many interesting international tax planning opportunities.

M&A Considerations

As a buyer, it is important to confirm the entity classification of the target company because the entity type would carry with it different tax consequences and considerations.

For example, if the target company is an LLC, as part of the due diligence process, the buyer should confirm whether it is treated as a partnership for tax purposes (or a disregarded entity if the LLC only has one member).  In other words, the buyer should check to make sure a check-the-box election has not been filed.

On the other hand, if the partnership indicated that is has checked-the-box to be treated as a corporation, the buyer should examine the IRS Form 8832 that was filed to ensure that the election has been properly made.

For example, the buyer should check that all the required parties have signed the Form 8832, otherwise the election would not be valid.  If that were the case, adverse tax consequences may result and the buyer may find that it is succeeding to unwanted tax liability.

Conclusion

The Form 8832 is easy to complete: there are a number of boxes to check and a couple of questions to answer. The tricky part is determining which entity classification best fits your business model, while remaining as tax efficient as possible.

The best way to achieve this is through prior tax planning. Better yet, tax professionals proficient in M&A can help deal professionals structure the acquisition to achieve a favorable tax outcome in the immediate aftermath of the deal’s closing and many years into the future.

Moreover, it is paramount that buyers understand the differences between entity classifications. Without a basic understanding, it is difficult to understand what exactly is being bought, its tax ramifications, and the most cost-effective way to buy the target entity.

Given that an entity classification election can change the tax profile of a target company dramatically, during due diligence deal professionals should be confirm if any “check the box” elections have been filed and that they have been completed properly and timely filed.

Leo Berwick’s tax professionals can help guide buyers to a successful and tax-efficient deal in a merger or acquisition. Contact us today.

[1] 26 CFR §301.7701-3.