Also known as the Regulations, the Check-The-Box regulations (CTB) is a classification process that allows an entity, if they so choose for U.S. tax purposes, to be recognized as a corporation or partnership. Entities that can be considered for CTB are those that have already been incorporated under federal or state law, associations, insurance companies, joint stock companies, state-owned entities, banks, publicly traded partnerships, and certain foreign entities.
When Did Check-The-Box Regulations Come Out?
The IRS declared in Notice 95-14 its intention to simplify the entity classification process. Final entity classification regulations under Internal Revenue Code 7701 and treasury regulations sections 301.7701-1 through 301.7701-3, also known as Check-the-Box or CTB regulations, went into effect on January 1, 1997, for all, whether they are domestic or foreign eligible entity. The regulations allow a qualified (or not automatically classified as a corporation) entity to be classified as a corporate (association) or a flow-through (partnership or an entity disregarded from its owner (DRE)) for U.S. income tax purposes if they wish so.
What Is A “Check-The-Box” Election (IRS Form 8832)?
A CTB election is an entity classification election for federal tax purposes made on Form 8832 – Entity Classification Election. The process can be relatively straightforward; you will need to select the appropriate box and the date that the election will become effective.
What Is The Effect Of A Check-The-Box Election?
Regulations under a Check-The-Box election allow an eligible (i.e., not automatically classified as a corporation) entity to be classified as a corporation (association) or as a flow-through (a partnership or entity that is disregarded from its owner (DRE)) for U.S. federal tax purposes.
The CTB regulations permit U.S. investors to create limited liability partnerships (LLP) or companies to incorporate business entities in foreign countries, particularly civil law countries. That way, all members would enjoy limited liability, which would be treated as a corporation under foreign limited liability and could be treated as a partnership or disregarded entity under U.S. tax law.
However, the entity cannot change its classification again for five years, with this limitation applying only to changes made by an election. Accordingly, a new eligible entity that elects from its default classification may change its classification by election at any time.
The Benefits Of The US Check-The-Box Regulations
Now that we have defined what the CTB is, let’s go into more detail about the benefits that come with it:
Benefits Of Check-The-Box Regulations For Entities With Two Or More Members
In a domestic entity with two or more members, the default classification (if no CTB election is made) is that of a partnership.
Some of the benefits of making a CTB election are:
- A corporation, such as C Corporations, is considered a separate legal entity and continues in perpetuity.
- As a U.S. corporation, it can benefit from various Double Tax Treaties the U.S. has in force.
Benefits Of Check-The-Box Regulations For Entities With One Member
The Default classification of a domestic entity with a single member is that it will be treated as a disregarded entity and, therefore, as a sole proprietorship. The same benefits will apply if an election is made to be taxed as a corporation.
Considerations On Whether To Check-The-Box For Foreign Subsidiaries
Following the benefits of CTB, the following are factors to take into mind before making a final decision:
Deferral And Timing Of Income
Due to U.S. taxpayers being taxed on a worldwide basis, U.S. owners of a transparent foreign entity are not able to defer or time the amount of U.S. tax on their foreign income. U.S. tax is payable when the income is earned, regardless of whether they repatriate the cash.
Making a CTB election for your foreign subsidiary to be classified as a corporation gives the U.S. shareholder more flexibility on whether and when they want to receive a dividend from the foreign subsidiary. U.S. tax is only payable once the cash is distributed to the U.S. owner.
Suppose you decide to treat a foreign eligible entity as transparent. In that case, the U.S. owner is considered to be earning the entity’s income directly and, therefore, taxable at the U.S. owner’s marginal rate, which could be as high as 37%.
If you make an election to treat the foreign subsidiary as a corporation and separate entity, the tax rate would be 21% in the U.S.
There are various tax planning opportunities available.
Use Of Foreign Losses
A US taxpayer may prefer a transparent entity initially to realize the current tax savings that foreign losses can provide.
Foreign Tax Credit Regime
This regime prevents U.S. taxpayers from paying U.S. tax on income that a foreign jurisdiction already has taxed.
U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to limitations). Generally, a U.S. person may only claim a credit for the foreign income tax if they paid.
However, Section. 902 allows domestic corporations to claim a credit for taxes paid by underlying foreign corporations as if the U.S. taxpayer paid these taxes directly. U.S. shareholders will then claim this deemed-paid credit in the same year the undistributed income is taxed.
Can An LLC Check-The-Box?
Yes, an LLC can apply CTB regulations. Limited Liability Companies have the advantage of the flexibility and limited liability for their owners. However, from a tax and accounting perspective, it will take on the complexity of the box it checks. An LLC can therefore make a CTB election.
New Check-The-Box Rules Simplify Entity Classification
The new regulations simplify entity classification. These new rules divide business entities into three groups:
- Those automatically classified as corporations – such as insurance companies, banking organizations, state-owned companies, and specific listed organizations formed outside of the U.S.
- Those that may elect to be classified as partnerships or corporations – include all other business entities with at least two members.
- Those that may elect to be classified as corporations or be disregarded for tax purposes – entities that may elect to be classified as corporations or be disregarded, include all business entities not in the group automatically classified as corporations with only a single owner.
Classifying Business Entities Under The Check-The-Box Regulations
If you already have a business, whether an LLC or Corporation, here are some ways to determine if it falls under CTB regulations.
Determining If a Separate Entity Exists
U.S. Federal tax laws are applied to determine whether a separate entity (S.E.). Local law will not be the determining factor.
If a business entity, for example, has more than a single member, and if participants were to carry on a trade, financial operation, business, or venture, followed by dividing the resulting profits, an S.E. is considered to exist (even if one is or isn’t considered to exist under an applicable state law). A mere expense-sharing collaboration or mere co-ownership of an asset, however, does not create an S.E.
Automatic Classification as Corporation
Below are the following entities that are automatically classified as corporations:
- A business entity is arranged under federal or state statute (or under the statute of a federally recognized Indian tribe) if that said statute should describe or refer to the entity as incorporated or a corporation, body corporate, or body politic.
- An association as determined under Regs. Sec. 301.7701-3, where an unincorporated entity that elects to be taxed as a corporation.
- A business entity is arranged under a state statute if that same statute describes or refers to the entity as a joint-stock association or company.
- A business entity is taxable as an insurance company.
- A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act. It is also amended or a similar federal statute.
- A business entity that is completely owned by a state or political subdivision. Also, a business entity is completely owned by a foreign government.
- Any business entity that can be taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3). For example, include a publicly traded partnership, real estate investment trust, tax-exempt entity, or regulated investment company.
- A foreign entity designated explicitly as a corporation (see Regs. Sec. 301.7701-2(b)(8) for a list).
- A business entity with multiple charters and is treated as a corporation in any one of the jurisdictions.
Classifying unincorporated domestic single-owner entities
A newly formed domestic single-owner entity that cannot be automatically classified as a corporation — including a single-member limited liability company or an LLP is, by default, classified as a disregarded.
Classifying unincorporated domestic multi-owner entities
A newly formed domestic entity that has two or more owners, which is an eligible entity, is classified by default rules as a partnership.
The IRS ruled in Rev. Rul. 2004-77 that if an eligible entity has two members under local law. Still, suppose one of the members is a disregarded entity owned by the other member. In that case, the eligible entity cannot be classified as a partnership and be taxed as a disregarded entity or also elect to be taxed as a corporation.
Beware Of Tax Consequences Of Classification Changes
Taxpayers need to understand the tax treatment when an entity’s classification changes. If that entity changes its classification from a corporation to a partnership or a disregarded entity, the resulting tax consequence of that transaction will often be treated as a taxable liquidation.
Although it may be straightforward to file Form 8832 to change the classification of an entity, the tax exposure can be significant and immense.
What Does It Mean When an LLC Checks The Box?
The IRS provides the following summary regarding the default rule:
- A Limited Liability Company is an entity created by state statute.
- Depending on elections made by Limited liability companies and the quantity of members, an LLC will be treated by the IRS as either a corporation, partnership, or a piece of the owner’s tax return (as a “disregarded entity”).
- A domestic LLC that has, at minimum, two members is classified as a partnership for federal income tax purposes. That would apply unless the members decide to file Form 8832 and elects to be treated as a corporation.
- For income tax purposes, limited liability companies that have a singular member will be treated as an entity that isn’t separate from its owner unless it files Form 8832 and affirmatively elects to be treated as a corporation. However, an LLC that only has a singular member is still considered a separate entity for employment tax and certain excise taxes.
For any more information on Check-The-Box regulations, contact Asena Advisors.