Under the check the box rules, entities owned by one person can often be disregarded for federal tax purposes. Such entities are referred to as "disregarded entities."
As time has progressed since the passage of the check the box rules, the IRS has created more and more exceptions to the disregarded treatment. For example, disregarded entity status is ignored or modified in regard to employment and withholding taxes of a disregarded entity.
The IRS has now issued final treasury regulations that provide that an entity whose disregarded status is ignored for employment tax purposes will be treated as a corporation. Treas. Regs. §301.7701-2(c)(2)((iv)(B).
It would be helpful to put in one place the several exceptions that now exist to disregarded entity status. The following is a summary of the principal exceptions, but is not intended to be exhaustive. If any readers think I have missed anything major, please feel free to comment to this posting and let us know what the item is.
A. Status is modified if the single owner of the entity is a bank. Treas. Regs. §301.7701-2(c)(2)(iii).
B. Status is modified for certain tax liabilities. Treas. Regs. §301.7701-2(c)(2)(iii). These include: (1) federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded; (2) federal tax liabilities of any other entity for which the entity is liable; and (3) refunds or credits of federal tax.
C. Disregarded status ignored or modified for taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code) and taxes imposed under Subtitle A, including Chapter 2—Tax on Self-Employment Income. Treas. Regs. §301.7701-2(c)(2)(iv)(A).
D. Status is modified for certain excise taxes, as described in Treas.Regs. §301.7701-2(c)(2)(v). Although liability for excise taxes isn't dependent on an entity's classification, an entity's classification is relevant for certain tax administration purposes, such as determining the proper location for filing a notice of federal tax lien and the place for hand-carrying a return under Code §6091 .
E. Conduit financing proposed regulations will treat a disregarded entity as separate from its single member. Code §7701(l).
F. Special rules will apply in hybrid situations. Hybrid situations are circumstances where an entity is not disregarded in one jurisdiction but is disregarded in another.
(1) Hybrid payments made between a CFC and its hybrid branch, or between two hybrid branches of a CFC, would be recharacterized as subpart F income in the same amounts, if the conditions of the regulations are met. Those conditions are as follows: (1) the hybrid branch payment reduces the foreign tax liability of the payer; (2) the payment would have been FPHC income if paid between two CFCs; and (3) a disparity exists between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the payment had been taxed to the payer. If no tax rate disparity exists, no recharacterization would occur. Proposed Regulations under TD 8827, 1999-30 IRB 120.
(2) In certain cases, payments made by domestic reverse hybrid entities to related foreign interest holders are recharacterized as a dividend. Such payments are recharacterized as dividends to the extent of the interest holder's proportionate share of payments by the domestic entity to the domestic reverse hybrid entity that are treated as dividends by either jurisdiction. The recharacterization as a dividend means that the payments cannot be deducted by the domestic reverse hybrid entity. This prevents the use of a domestic reverse hybrid entity to make deductible payments to the foreign interest holder that are taxed at lower withholding tax rates. Treas.Reg. §1.894-1(d)(2)(ii)(B).
(3) Special rules relating to allocation of foreign tax credits. Prop.Regs. §1.901-2(f)(3).