The Ninth Circuit Court of Appeals affirmed the Tax Court’s 2017 decision in the case of Messina et ux. et al. v. Commissioner.[1] The appellate decision explains why the IRS is allowed to argue substance over form for a transaction, but that argument will not generally be helpful for the taxpayer—as it failed to be in this case.

LLCs were created by the state of Wyoming years ago to be an entity that the IRC had no way to classify.  That status has continued to today—an LLC is not an entity type for federal income tax purposes, even though it is an entity type for most other purposes under state law. Eventually the IRS decided to deal with the entity type issue by using what we refer to as a “check the box” election.

The check the box regulations, found at IRC §301.7703-3, allow the taxpayer to choose between certain entity types based on the number of equity holders of the LLC.  In essence, we pretend, for federal tax purposes, that the LLC is really some other entity.

If a S corporation has any accumulated earnings and profits, its S status is at risk due to “excess passive income” if it incurs such income for three straight years under IRC §1362(d)(3).  While rentals can generate such passive income, a rental does not provide such passive income if it is deemed to be derived in the active trade or business of renting property (Reg. §1.1362-2(c)(5)(ii)(B)(2)).  In PLR 201725022, the taxpayer asked the IRS to find that the rental income being received by a C corporation would not be treated as “passive income” if the corporation elected S status.

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A taxpayer that ended up buying back his S corporation stock from a corporation he had sold it to found the IRS was not willing to waive the requirement under IRC §1362(g) that the corporation would not be allowed to re-elect S status for five years (PLR 201636033).

In this case the individual, holder of 100% of the S corporation’s stock, sold the stock to another corporation.  The transfer of the shares to the corporation resulted in a termination of the corporation’s S status at that time.  Less than five years later the shareholder bought the stock back from the buyer—but now had a C corporation.

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PLR 201624003 reminds us that when it comes to S corporations, the “check the box” regulations can be more complicated than they first appear.

Under the check the box provisions found at Reg. §301.7701-3 an entity that is not automatically classified as a corporation is allowed to elect whether to be treated as a corporation or, if it has one owner, a disregarded entity or, with two or more owners, a partnership. Since, once an entity elects to be treated as a corporation under check the box it is treated as a corporation for the entire IRC (IRC §7701 applies “for purposes of this title” which means the entire Internal Revenue Code found at Title 26 of the United States Code), if the entity is otherwise eligible it may elect to be treated as an S corporation.

S corporation have always had issues with the risk of becoming a C corporation by accident. One of the key problems for an S corporations is the risk of having excess passive income (as defined by §1362(d)(3)(C)(i)) if the S corporation is determined to have accumulated earnings and profits as of the end of the tax year. If the corporation has such excess passive income for three straight years, the S election terminates at the end of the third year. [IRC §1362(d)(3)]

Generally, excess passive income is defined as the corporation having passive investment income in excess of 25% of its gross receipts for 3 consecutive years.  Despite the use of the word “passive” the income being discussed here is not generally income related to the passive activity rules of IRC §469.  Rather, passive income is generally defined as gross receipts from royalties, rents, dividends, interest, and annuities. [IRC §1362(d)(3)(C)(i)]  Various special exceptions apply to the inclusion of these types of income, most importantly related to rents derived in the active trade or business of renting property. [IRC Reg. §1.1362-2(c)(5)(ii)(B)(2)]

When a LLC “checks the box” by filing a Form 2553 to elect to be treated as a corporation and simultaneously elect S status, it must live by all the S corporation restrictions.  That includes the restriction on only having one class of “stock” issued by the entity during the time it wishes to remain an S corporation.

In reality, there is no such federal tax entity as an “LLC”—the structure was originally designed when the first statute was adopted by Wyoming decades ago to be an entity for which there was no federal tax treatment specifically mandated.  To this day the IRC does not have provisions outlining the tax treatment of “LLCs” but rather, under the check the box regulations found at Reg. §301.7701‑2 the entity is treated for federal tax purposes as one of the entities that the IRC knows about.