As discussed in our previous blog – “Entity Classification Series: Corporate Taxation vs Passthrough – What is the Difference?” The United States (US) taxes business entities based on how they are classified.
This article will provide a brief overview of how to determine if your entity is an eligible entity in terms of the CTB regulations.
Entity classification regulations for US federal tax purposes can found under the Internal Revenue Code 7701 and is also known as Check-the-Box or CTB regulations. These regulations are applicable to all domestic and foreign eligible entities. The regulations allow an eligible (i.e., not automatically classified as a corporation) entity to elect 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.
In terms of the CTB regulations, it is of upmost importance to ascertain if your entity is eligible for election as this will determine if it will be taxed as a flow through entity or corporation. The choice is not always up to you. Further if no election is made, the default rules will apply.
WHEN IS YOUR ENTITY NOT ELIGIBLE FOR ELECTION?
An entity will not be eligible for election if it is deemed to be a corporation.
An entity is a deemed corporation if it is formed under federal or state corporate statutes or is a type of foreign entity as listed in Treasury Regulations 301.7701-2(b)(8) also known as per se foreign corporations. These entities are automatically classified as corporations and are not eligible to elect their classification.
However, as an exception to the rule the following types of corporations are treated as eligible entities -:
- An eligible entity that previously elected to be an association taxable as a corporation by filing Form 8832.
- An entity that elects to be classified as a corporation by filing Form 8832 can make another election to change its classification subject to the 60-month limitation rule.
- A foreign eligible entity that became an association taxable as a corporation under the foreign default rule described below.
WHEN IS YOUR ENTITY ELIGIBLE FOR ELECTION?
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.
Eligible entities include limited liability companies (LLCs) and partnerships. Generally, corporations are not eligible entities as explained above.
DEFAULT CLASSIFICATION RULES
If no election is made by the business entity in terms of the CTB regulations, the default classification rules as set out in Treasury Regulations 301.7701-3 will apply and classification is determined as follows –
The following Domestic entities will be classified as eligible under the default rules –
- a partnership if it has two or more members/owners [i.e., owners],
- or a DRE if it has a single owner.
The following Foreign entities will be classified as eligible under the default rules –
- a partnership that has two or more members and at least one of the members do not have limited liability.
- a corporation if all the members have limited liability, or
- a DRE if it has a single owner without limited liability.
WHICH CAME FIRST: THE CHICKEN OR THE EGG?
When it comes to structuring our financial affairs, it is human nature to always look at the most tax efficient way of how this can be done and exclude anything else. This is mainly because we want to save as much money as possible, but also that we like to push the limits in terms of what is legally possible. Everyone enjoys challenging revenue authorities.
So when someone is looking at the feasibility of investing in the US, the google searches will always contain a combination of the following words – “tax efficient structure”, “pass through or corporate tax” , “how to save the most tax” etc.
When it comes to entity classification in the US and CTB regulations the IRS will not entertain your argument of which came first: the chicken or the egg. You won’t win an argument with them about how your business should be taxed if you don’t understand your eligibility.
In short – Eligibility comes before taxation.
Unlike the age old debate about which came first: the chicken or the egg, the CTB regulations are very clear.
When considering what US business entity is best for a given circumstance, the two most common entities that impact Australian businesses and Australian families investing in the US are C corporations and LLCs.
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.