Overview: The Disregarded Entity & Check-the-Box

What Is a Disregarded Entity? How is it Used in US Tax Planning?

Certain business entities can be treated as “nonexistent” for federal income tax purposes.  That is, from a US tax perspective, they are simply “disregarded” and the entity is ignored by the Internal Revenue Service (IRS).   For other purposes, the entity is not disregarded, however.  A simple way to look at the effect of being a ‘disregarded entity’ is to view the business that is being carried on as separate from its owner for legal purposes (such as who has legal liability in the event of being sued), but not separate from its owner for tax purposes (such as who has to file tax returns and pay tax on the income earned in the business).  From a US tax point of view, the business’ assets, its liabilities and all of its activities are treated as those of its owner.  The beauty of a disregarded entity is that it is used most often by its owner to obtain limited liability, while at the same time, without causing any federal income tax consequences due to the structure.

Innovative Possibilities: “Check-the-Box”

In the US tax world, the most frequently encountered entities that are referred to as “disregarded entities” are single-member LLCs that are formed in the United States, grantor trusts and certain foreign (non-US) entities that make a so-called “check-the-box” (CTB) election on Form 8832.   Form 8832, “Entity Classification Election” permits an eligible entity to freely elect how it will be classified for federal income tax purposes as: a corporation, a partnership, or an entity disregarded as separate from its owner, called a “disregarded entity” or “DRE”.  In the case of a foreign (non-US) corporation making an election to be treated as “disregarded”, this is called a “foreign disregarded entity” or “FDE”.  If an entity does not make a CTB election, certain “default” characterization rules apply and will control how the entity will be treated from a tax perspective.

Ownership of US Real Property Through a Single-Member US LLC

Under the US tax rules, a single-member US LLC is by default treated as a disregarded entity.  This means that the IRS does not treat the LLC as an entity separate from its owner when it comes to income taxes.  This simplifies tax filings significantly, since all items of income and deduction “pass through” to the owner and only one tax return is filed.

Use of a single-member LLC is often seen in real estate investments. Investment in real property through a vehicle offering limited liability, as opposed to direct ownership, offers numerous protections.  Should any legal claims arise, such as in the case of tenant injury when renting out property owned through a corporation or LLC, the liability of a shareholder will be limited to their share of the corporate assets. If, for example, a shareholder owns 35% of a corporation and the corporation is sued but cannot pay the debt, the shareholder may lose his entire 35% investment since the corporation’s property will be used to satisfy the debt owing.  If debt is still owing to the injured party after the corporate property is fully liquidated, the shareholder’s personal assets remain safe.

When non-US individuals invest in US real property, many often consider owning the real estate through a single-member US LLC. While this structure provides for ease in US tax filing as well as limited liability protection, investors may forget that US Estate tax issues must also be considered.

If the non-citizen is treated as “non-resident” of the US at the time of death, his estate  will be subject to the US Estate tax on assets located, or deemed to be located, within the US. Real property located in the US is considered to have a US-situs.  Since the single-member LLC is a “disregarded entity”, the foreign individual will be treated as directly owning the real estate at death and thus has exposure to US estate tax.   While an estate tax exclusion amount is available, it is limited to a paltry US$60,000 of value of US assets owned at death for non-citizen/nonresidents.

US Estate tax is assessed on the fair market value of the property at a maximum 40% current rate.  You can learn more about how the US Estate tax rules apply to nonresident foreign individuals at my blog post here.  While the foreign individual can consider making a “check-the-box” election on Form 8832 to have the entity treated as a “corporation” for tax purposes, the problem will not be solved since the value of the US corporation’s shares are treated as US-situs assets. Thus, the estate tax result would be the same, since the value of the shares will reflect the value of the underlying real property owned by the corporation.  Various planning techniques can be implemented with professional tax advice to achieve a holding structure that is most optimal in light of the facts of the specific case.  These planning techniques go beyond the scope of this blog post, but we are happy to give personalized advice on this subject.

In addition, the laws of the home country must also be checked. For example, Canadian tax problems may arise for Canadian residents who use US LLCs to earn rental income or carry on business in the United States.  The Canada Revenue Agency considers such a LLC to be a corporation for Canadian tax purposes, even if the entity is considered “disregarded” under the US tax rules. The results can be disastrous.

A Cure for CFCs and PFICs?

Depending on the particular facts, a US shareholder of a closely-held foreign (non-US) corporation may be subject to US income tax on some or all of his share of corporate earnings even before the earnings are actually distributed out to the shareholder.  In other instances, a pay out from the foreign corporation or disposition of the shares can result in imposition of very harsh penalty taxes and compounded interest charges.  These results are attributable to US tax rules that are commonly referred to as “anti-deferral provisions” which are essentially designed to prevent US taxpayers from deferring paying tax by holding income in entities offshore the US.

The anti-deferral provisions are contained in two separate tax regimes: those for so-called “Controlled Foreign Corporations” (CFC) and those for so-called “Passive Foreign Investment Companies” (PFIC).  More detail about CFCs and PFICs at my blog post here.

A CTB Election can be used to avoid having a foreign corporation with a US owner classified as a CFC or a PFIC.  If the corporation has a sole shareholder, a CTB election can be made to disregard the entity resulting in a FDE. This can possibly save significant tax dollars as well as costly and very time-consuming tax preparation. If more than one shareholder exists, the entity will be treated as a “partnership” for US tax purposes if the CTB election is made, so a review of the possible tax consequences must always be made carefully.

Making a CTB election generally will avoid the attribution to the US shareholder of the corporation’s income under the CFC regime. It may also ensure that the US owner of the corporation is properly credited with the foreign taxes paid by the corporation and prevents the GILTI tax too.  With regard to PFICs, making a CTB election can prevent the loss of the beneficial long term capital gains tax rate upon the sale of PFIC shares.

Checking the box is easy… but don’t be fooled.  The decision to make a CTB election has to be carefully considered with advice from a knowledgeable tax professional.  My earlier blog post on CTB will also be of interest as it is full of details – you know the devil loves details.

Posted February 3, 2022

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