Our whitepaper, “United States Entity Considerations In The Trump Era” outlined how the check the box regime can impact Australian businesses. While that paper specifically addressed Australian corporate groups, the issues discussed have direct relevance to any global business. Let’s dive into the basics of a Check The Box Election:
What Is A “Check-The-Box” Election?
In short, a “check-the-box” election (sometimes referred to as check the box form as well) is an entity classification election that is made on Internal Revenue Services (IRS) Form 8832, Entity Classification Election. The procedure to make a check-the-box election is quite easy. You simply check the appropriate box, specify the date that the election is to be effective, sign and file form 8832.
Eligibility To Make An Election
The IRS stipulates that only “eligible entities” can make check-the-box elections. To be classified as an Eligible Entity for US Federal Tax Purposes the following requirements must be met:
- The entity cannot be an individual.
- The entity should not be automatically classified as a corporation And
- The entity must be a business entity.
History Of Entity Classification Election
Prior to 1996, whether domestic and foreign entities were classified as corporations were based on a six-factor test which the IRS looked at:
- limited liability;
- continuity of life;
- free transferability of interests;
- centralized management;
- objective to carry on business for joint profit
Check The Box Classifications
Per Se Corporations
Treasury Regulation §301.7701-2(b) contains a list of the types of entities that are not eligible entities. These non-eligible entities must be treated as corporations and are often referred to as “per se” corporations by the IRS. In the domestic context, an entity organized as a “corporation” or as “incorporated” under a federal or state statute would be a per se corporation. For foreign entities, a country-by-country list is provided in the regulations that specifies the per se corporations for each country.
Default Entity Classifications
The regulations provide default rules for eligible entities that do not make check-the-box elections.
A U.S. domestic eligible entity is by default treated as a partnership if the entity has more than one owner and as a disregarded entity if the entity has only one owner
For non-U.S. entities, the default classification is treated differently by the IRS.
The default classification for a foreign eligible entity is that it will default to be treated as:
- a corporation if all of its owners have limited liability,
- a partnership if it has two or more owners and at least one owner does not have limited liability, and
- a disregarded entity if it has a single owner that does not have limited liability.
When dealing with the CTB regulations, it is of utmost importance to understand the difference between an election that produces an initial classification and an election that produces a change in classification.
A CTB election that produces an initial classification does not carry with it any of the deemed transactions that attach to a change in classification, and the entity is free to change its classification at any time thereafter.
An election made on Form 8832 can specify an effective date not more than 75 days prior to the date of the filing of the form and not more than 12 months subsequent; if no effective date is specified, the election is effective as of the date the form is filed.
Change In Classification
A change in classification, basically means that an entity is electing to change the way it was previously classified under the entity classification rules. Most importantly, an election to change an entity’s classification will deem certain transactions to occur for US Federal Income Tax purposes. It should also be noted that once an entity changes its classification for U.S. federal tax purposes, it cannot change its classification again for 60 months.
In terms of the regulations, an elective change is treated as triggering one or more deemed transactions, which differ depending upon the reclassification that takes place. The tax implications and treatment of an elective change is determined under all relevant provisions of the Internal Revenue Code. This includes the step-transaction doctrine. The step-transaction doctrine ensures that the tax consequences of an elective change will be “identical” to the tax consequences if taxpayers had actually taken the steps described in the regulations.
It is therefore important for the taxpayer to understand the tax implications of changes in an entity’s classification. If an entity changes its classification from a corporation to either a partnership or a disregarded entity, the transaction will often be a taxable liquidation.
For a foreign entity, gain at the corporate level can trigger Subpart F Income and gain at the shareholder level is often taxed as ordinary income.
Classifying Business Entities Under the Check-the-Box Regulations
A business entity that is recognized for federal tax purposes as an entity separate from its owners can potentially be classified as:
- an association taxed as a corporation,
- a partnership,
- a disregarded entity, or
- a trust.
Determining if a Separate Entity Exists
Federal tax law determines whether a business entity will be treated as a separate entity apart from its owner(s) for federal tax purposes. Domestic law is not the deciding factor. A business entity that has more than one member, all the participants carry on a trade, business, or venture and the resulting profits are divided, a separate entity will exist.
However the mere co-ownership of an asset does not create a separate entity for tax law.
Automatic Classification as Corporation
The following entities are automatically classified as corporations:
- A business entity organized under a federal or state statute (or under the statute of a federally recognized Indian tribe), if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. Under this definition, any entity classified as a corporation under state law is automatically treated as a corporation for federal tax purposes.
- An association as determined under Regs. Sec. 301.7701-3.
- A business entity organized under a state statute, if the statute describes or refers to the entity as a joint-stock company or joint-stock association.
- A business entity taxable as an insurance company under Subchapter L, Chapter 1, of the Code.
- A state-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act, as amended, or a similar federal statute.
- A business entity wholly owned by a state or any political subdivision thereof. Also, a business entity wholly owned by a foreign government.
- A business entity taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3), such as a publicly traded partnership, real estate investment trust, regulated investment company, or tax-exempt entity.
- A foreign entity specifically designated as a corporation.
- A business entity with multiple charters that is treated as a corporation in any one of the jurisdiction
Classifying Unincorporated Domestic Single Owner Entities
A newly formed domestic single owner entity that is not automatically classified as a corporation will be classified by default as a disregarded entity.
Classifying Unincorporated Domestic Multi-Owner Entities
A newly formed domestic entity with two or more owners that is not automatically classified as a corporation is classified by default as a partnership. An election can also be made to classify it as a corporation.
When You Should Make A Check The Box Election
You should consider making the check-the-box election if you meet all of the following conditions:
- you own a foreign corporation;
- the US tax system is relevant for your corporation
- you need to apply foreign tax credits against your US corporate tax regime; and
- you wish to avoid applying the CFC or PFIC rules.
Timing-wise, check-the-box elections can generally only be retroactive 75 days from the date of filing (certain late elections may also be allowed). Thus, if no election is made within 75 days of establishing an entity, the default classification will apply.
In the foreign context, this can be problematic where the entity defaults to be treated as a corporation (the typical situation) and the owners would prefer that the entity be treated as a partnership or a disregarded entity, but the owners did not in advance seek the advice of a tax advisor knowledgeable in this area.
The election is effective on the date specified on Form 8832. If the date is not specified on the form, then the election is effective from the day that the form was filed. The effective date of the election cannot be:
- more than 75 days before the date the election is filed
- more than 12 months after the date the election is filed
What Is A Foreign Eligible Entity?
This is an entity that is defined by whether a member has limited liability (for example a Foreign LLP) or not. Under the check-the-box regulations this is a default tax classification.
If all the members of the corporation have limited liability the US taxes the foreign eligible entity as a corporation and when at least one member does not have limited liability the entity is not a foreign eligible entity.
An eligible entity may also make a check-the-box election to opt out of the default classifications.
When Will A Foreign Corporation Be A CFC?
When US shareholders own more than 50% of the shares in a foreign corporation, either directly or indirectly. To be considered a ‘US shareholder’ the person must own more than 10% of the voting rights or stock value of the foreign company.
When Is A Foreign Corporation A PFIC?
A passive foreign investment company (PFIC) exists when one of the following two conditions are satisfied:
- Passive investments generate at least 75% of a corporation’s gross income (Income Test); or
- At least 50% of the corporation’s assets create passive income (Asset test).
Use In International Tax Planning
The check-the-box regulations created various new tax avoidance and tax deferral strategies. Specifically, they expanded the opportunity for “hybrid branch” or “hybrid entity” strategies, which take advantage of differences in the classification of an entity as a corporation or not in multiple jurisdictions, in order to engage in cross-border tax arbitrage.
Electing Another Classification Change After An Earlier Election
Once an entity elects to change its classification, it cannot make another classification change election during the 60 months after the effective date of the first election. However, this restriction does not apply after a newly formed entity elects to change its default classification upon inception. If a more-than-50% change in ownership occurs within the 60-month period, the IRS has the discretion to approve an otherwise-prohibited classification change election.
Late Election Relief
Rev. Proc. 2009-41 provides relief from a late entity-classification election without having to obtain a letter ruling. To obtain relief, the entity must have timely filed all income tax returns consistent with the requested classification (unless those due dates have not yet passed); the entity must have reasonable cause for the failure to file; and the request for relief must be made before three years and 75 days from the requested effective date of the classification election. Reasonable cause might be that the taxpayers were relying on their tax preparer to file Form 8832, but the tax preparer missed the filing deadline. The request for relief can be made on Part II of Form 8832.
Taxpayers should consider carefully when making a check-the-box election, especially a change in classification that has significant income tax implications.
The choice of entity should always be driven by the commercial objectives of a client. The commercial objectives are therefore looked at first and this could be then structured in the most tax efficient manner. Which could be either by using a flow through entity or corporation for income tax
At Asena Advisors we make sure that your specific needs are catered for and that our recommendations on choosing a structure is family/business specific. Choosing between a flow through or corporations will therefore depend on the client’s needs and optimizing long term growth for the client.
The regulations offer businesses planning opportunities for income tax, but also raises questions.
The area where the greatest planning opportunities exist is with foreign entities. For example:
- minimizing subpart F income,
- avoiding the 10-50 foreign tax credit basket, and
- avoiding IRC sections 367 and 1491 by using a single owner Limited liability company (LLC), which is disregarded for U.S. tax purposes.
For more information on Check-in-the-box Elections, please contact one of our specialists at Asena Advisors. We make sure that your specific needs are catered for.