If a business owner chooses to incorporate there business under state law, it is important for them to also declare their corporation with the IRS for taxing purposes. A corporation is nothing more than a legal entity owing its existence to the laws of the state in which it is incorporated. Basically, state law defines all the legal relationships that a corporation can have. The state statutes however do not provide guidance on the taxation for federal purposes; this is the job of the IRS.
Prior to 1977, the taxation of corporations was a confusing matter. A legal corporation was not guaranteed corporate status for federal tax purposes unless it had a majority of corporate characteristics including centralized management, continuity of life, limited liability, and many more. Since this was causing a good amount of problems for corporations, the IRS has put into place Code Sec. 7701 which greatly simplifies the process of entity classification.
Check the Box System
The IRS has put in place what is called the “Check the Box” system. This system basically automatically treats certain business entities as corporations for federal tax purposes. These entities include firms incorporated under federal or state law, associations, joint stock companies, or joint stock associations, insurance companies, banks, business entities wholly owned by a state or political subdivision of the state, business entities that are taxes as corporations under IRS Code section, and certain foreign entities.
Under the check the box system, entities that are not automatically treated as a corporation may elect to be treated as a corporation for federal tax purposes. This is very beneficial for a lot of entities that do not wish to change their specific entity choice but want to be taxed as a corporation.
In the event an entity has one owner, it may elect to be taxed as a corporation or by default it will be taxed as a sole proprietorship. If the entity has two or more owners it may also elect to be taxed as a corporation or by default it will be taxed as a partnership.
Changing Entity Classification
If an entity wishes to change its default classification for federal taxation purposes, it may do so by filing Form 8832 (Entity Classification Election). It is important to keep in mind that once this form is filed and the change is enacted, another change cannot take place for five years.