Check-the-Box Election: Is it Really that Simple?

A very important building block when establishing a business is selecting the best type of entity from both a legal and tax perspective. This “choice of entity classification” can make a huge difference in liability protection and tax outcome. When an international business is involved, it should come as no surprise that the complexities only grow when making this decision.

This post will explain it all. First, we need to understand some basic US tax rules governing entity classification.

US Tax Entity “Classifications”

Some entities are treated as flow-through entities (for example, partnerships or single-member US LLCs). This means that the income, losses, and credits of the entity “flow through” directly to the owners of the entity and are subject to tax only at the owner level, whether or not the entity actually makes a distribution to the owner.  Other entities, such as corporations (also called “associations”) are subject to income tax at the entity level and then tax is imposed again later, at the owner-shareholder level, when income is actually distributed to the owner (for example, a dividend).

Check-the-Box Regulations

Entity classification regulations were promulgated in 1997 by the Internal Revenue Service (IRS) under Internal Revenue Code Section 7701. These are commonly known as “Check-the-Box” or CTB regulations and are available for all domestic and foreign “eligible” entities. The regulations essentially allow the taxpayer to choose the type of entity desired for US tax purposes. If the entity is automatically classified as a corporation under the CTB regulations (a “per se” corporation), it cannot make the choice.  An eligible entity may elect to be classified as a corporate (association) or a flow-through (partnership or an entity disregarded from its owner (DRE)) for US income tax purposes.

Foreign (non-US) Entities

An ineligible entity is a deemed corporation if it is formed under US federal or US state corporate statutes, or, if it is a type of foreign entity found on a special list in Treasury Regulation Section 301.7701-2(b)(8)). The foreign entities on this list are automatically classified as “per se” foreign corporations and are taxed as such; they are not eligible to elect their classification. All other business entities are eligible to elect their classification. If no election is made, a default classification system will apply. The classification will depend on the number of owners, and for a foreign entity, whether the owners have limited or unlimited liability.

Depending on the precise facts, if a foreign entity is a “corporation” for US tax purposes, the entity may be able to defer US tax on its income. When distributions are made by the company to the company’s US owner(s), it will be taxed at that time. (Under various anti-deferral regimes, however, taxation can be imposed on a current basis to the US owners. For example, this can occur under the so-called Controlled Foreign Corporation (CFC) tax regime).

On the other hand, if a foreign entity is a pass-through for US tax purposes, US owners will pay tax on their share of the income every year as it is earned by the entity (even if actual distributions have not been made to the owners). If foreign tax has been paid by the entity, the owners should be able to use a foreign tax credit for the taxes paid by the entity to the foreign jurisdiction.  In addition, owners will be free to bring the profits from the foreign entity into the US without imposition of additional income tax.

Making the Election

The CTB election is made on IRS Form 8832 .  While the form itself is easy to fill out, the trick is to ensure the proper tax planning has been done beforehand and the best choice made for the business and its owners. The election must also be made in a timely fashion.  It is with respect to these considerations that a competent tax professional should be consulted.

The CTB election is effective on the date specified by the taxpayer on the Form 8832. If a date is not specified, then the election is effective on the date it is filed. The effective date cannot be more than 75 days prior to the date the election is filed (this is a retroactive date) and not more than 12 months after the date the election is filed (this is a prospective date). The Form 8832 must be signed by each member of the electing entity who is an owner at the time the election is filed or an authorized officer, manager, or member who will attest to such authorization under penalties of perjury.  The IRS will mail back an acceptance or non-acceptance letter.

Default Classification

If no election is made, and a foreign entity is not on the list of “per se” corporations, then a foreign entity’s default classification is determined as follows:

A partnership if it has two or more members (i.e., owners) and at least one member does not have limited liability;

A corporation (“association”) if all members have limited liability, or

A “Disregarded Entity” (DRE) if it has a single owner that does not have limited liability (think of the typical sole proprietorship).

“Limited liability” generally means a member/owner has no personal liability for the debts of the entity simply by reason of being a member. This determination is made under the law of the jurisdiction under which the entity is organized. A member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such (e.g., in the case of an individual, personal liability would mean the creditor could reach the individual’s personal assets such as his home, his car, personal investments and other assets).

Entity Classification in an International World

In the international context, entity classification issues arise all the time.  For example, many foreign nationals form single member US LLCs.  How might entity classification cause problems with a seemingly benign US LLC? In the US LLC context, let’s say that we have a nonresident alien husband, Henry, and that he is married to Wanda, a US citizen.  Assume the couple are domiciled in a community property jurisdiction such as Switzerland (or even China).  Henry uses funds from his solely titled bank account into which he deposits his salary in order to set up a US LLC.  He believes that he is the sole member and that as such, the LLC is a “single member disregarded entity”.  Since the couple is domiciled in a community property jurisdiction, Switzerland, the community property regime there applies (unless the couple elects otherwise by written documentation). Under the Swiss regime, Wanda is deemed to own one-half of the LLC (as well as one-half of Henry’s bank account). The LLC will be treated under US tax default rules as a “partnership” for US tax purposes; it cannot be a single member disregarded entity since under the law, it has two members. US tax consequences will result and must be sorted out for Henry, for Wanda, and even for the entity. For example, if treated as a partnership, the entity itself will have withholding obligations with respect to Henry.  Wanda will be required to report and pay tax on her share of the partnership income even if she did not think she was a partner in the LLC.

If instead, Henry had created an LLC under the laws of a foreign country and if all members have limited liability under those laws, the default characterization for US tax purposes would be that of a “corporation” rather than a “partnership”. See 26 CFR § 301.7701-3(b)(2)(i). This raises issues for Wanda as a US person – for example, she will be required to report dividend income on her US tax return and pay tax on the amount, she will have tax information reporting duties (e.g, Form 8938, Form 5471) and will have anti-deferral tax regime concerns as well.

We also see entity classification issues when an entity exists under foreign law, and we have no precise “equivalent” under US law.  For example, “stiftungs” organized in Liechtenstein and Switzerland can possibly be treated as trusts or “associations” taxable as corporations for US tax purposes.  Depending on the tax classification, the tax results will differ.

Similar issues arise when attempting to classify a “foundation”. This is an entity often used in succession planning and asset protection in European countries, and more recently in the United Arab Emirates. Perhaps (and in my view, most likely) in an attempt to woo foreign capital, two states in the US have very recently enacted “foundations” laws (New Hampshire was first in 2017 and Wyoming following suit in 2019).  To my knowledge, there is currently no precedent on how such US foundations may be treated for US tax purposes. While there is foreign law precedent, it is uncertain if the relevant US tax authorities would be willing to consider such foreign precedent.  However, the US tax classification of the entity must be examined. It cannot be ignored.  To my mind, since a foundation is not an entity traditionally encountered in the US, using a US foundation may be  fraught with difficulty.

The Takeaway

Entity classification is of critical importance and it gets complicated when foreign laws are involved. Don’t get caught out. Proper planning prior to creation of the entity is the best bet. We are here to assist you in making the right choice.

Posted May 28, 2020

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