Entity Classification Election
Following our previous discussion about entity changes with check-the-box regulations, let’s go into another process that entrepreneurs and executives are likely to consider with the tax season fast approaching: the entity classification election.
What is the Purpose of Entity Classification Election?
The purpose of the entity classification election is to enable business entities to avoid the default tax classification applied by the IRS for federal income tax purposes. Business entities receive a default tax classification, which can result in paying for more federal taxes than necessary. If your entity is eligible to use the entity classification election form, you can change your tax election status and potentially lower your tax liability.
For example, a U.S. corporation can avoid double taxation by using the CTB regulations, and it also benefits foreign eligible entities by avoiding potential double taxation. For example, an entity in India could be classified and taxed differently in the U.S. than in India, such as a tax treaty or an income tax treaty. The CTB rules, therefore, provide the entity in India to elect its entity classification for U.S. tax purposes with that said tax treaty.
The entity set up in India can also use the tax treaty, along with any treaty benefits included, to qualify for lower dividend withholding taxes if it elects to be taxed as a corporation in the U.S.
A Parent company in the U.S. can also use the CTB rules to benefit from the tax treaty with India and avoid double taxation.
What Is A Business Entity Classification?
A business entity is any entity that is recognized for federal tax purposes that is not correctly classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Code regarding the entity’s classification. A business entity is classified as either a C-Corporation, partnership, or disregarded entity for federal tax purposes.
Here is how you can remember:
Association – For purposes of the CTB regulations, an association can be an eligible entity that’s taxable as a corporation by election or under the default rules for foreign eligible entities, as discussed below.
Business entity – A business entity is any entity recognized for federal tax purposes that is not accurately classified as a trust under Regulations section 301.7701-4. Or they are otherwise subject to special treatment under the Code regarding the entity’s classification.
Corporation – For federal tax purposes, a corporation is any of the following:
- A business entity is organized under a federal or state statute or a federally recognized Indian tribe statute if that same statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic.
- An association.
- A business entity is organized under a state statute if the statute describes or refers to the entity as a joint-stock company or joint stock association.
- 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 or a similar federal statute.
- A business entity that is wholly owned by a state or any political subdivision or is wholly owned by any entity described in Regulations section 1.892-2T, such as a foreign government.
- A business entity that can be taxable as a corporation under a provision of the Code other than section 7701(a)(3).
- A foreign business entity as listed on page 7 of Form 8832.
- An entity is created or organized under tax laws of more than one jurisdiction (an example can be a business entity that has multiple charters) if the entity will be treated as a corporation with respect to any of the jurisdictions. For examples, see Regulations section 301.7701-2(b)(9).
This federal tax form allows certain businesses to select whether they want to be taxed as a corporation, partnership, or disregarded entity for future tax purposes and protected under tax law.
What is IRS Form 8832?
You can use IRS form 8832 to choose to have:
- A corporation with more than one owner is treated as a partnership for tax purposes.
- A corporation with a single owner is treated as a ‘disregarded entity for tax purposes.
- A partnership is treated as a corporation for tax purposes.
- A ‘disregarded entity is treated as a corporation for tax purposes.
Which Businesses Can Use Form 8832?
Only businesses that are considered eligible entities can use Form 8832. The following are regarded as eligible entities:
- Single-member LLCs
- Multi-member LLCs; and
- Certain types of foreign entities
Not every type of business can use Form 8832 to change their business’s tax classification. The following can be considered businesses eligible for filing Form 8832:
- Single-member LLCs
- Multi-member LLCs
- Explicit types of foreign entities (Page 5, Form 8832)
The above entities can use Form 8832 to elect to be taxed as a C corporation, partnership, or sole proprietorship.
If you’re currently a limited liability company (LLC) taxed as a corporation, you can use Form 8832 to revert to a previous tax classification.
Eligible businesses that don’t fill out the form will be taxed based on their default tax status. If you are content with your current or default tax classification, do not fill out Form 8832.
Remember that your business can only change its tax classification once every five years.
Who is Not Eligible to File Form 8832?
Sole proprietors, domestic corporations, and foreign corporations are listed in IRS Regulations 301.7701-2(b)(8).
Form 8832 is a straightforward form to fill out and only requires the entity’s name, address, and tax identification number, followed by making an election by checking the relevant box and the signature of the entity’s eligible owner, member, partner, or officer.
Before you begin filling out your form, you need to gather some information. Take a look at what to have handy for Form 8832:
- Business name, address, and phone number
- Employer Identification Number (EIN)
- Owner’s name and Social Security number (if the business only has one owner)
There are two parts to the form: Election Information (Part I) and Late Election Relief (Part II). Part I asks a series of questions on your tax status election. Depending on your answers, you may be able to skip some lines.
Part II is for businesses seeking late election relief only. To be eligible for late election relief, all of the following must apply:
- The IRS denied a previous Form 8832 filing because you didn’t file on time.
- You haven’t filed your taxes because the deadline hasn’t yet passed, or you’ve filed your taxes on time.
- You have reasonable cause for not filing your form on time.
- It has been less than three years and 75 days from your requested effective date.
Is Form 8832 Complicated?
No. The required information you need to know is:
- The name of your business
- The phone number and address of your business
- The employer identification number (EIN)
Who Must File Form 8832?
Keep in mind that it is not a mandatory form at all. It provides eligible entities the option to change their default classification should they wish.
What Information is Required?
- The name of your business
- The phone number and address of your business
- The employer identification number (EIN)
- Owner’s name and Social Security number if the business only has a single owner
Where Should It Be Filed?
- The form can not be filed electronically.
- If you are living as either a resident or non-resident in the U.S., you will have to mail it to the appropriate IRS office in your state.
- If you are a resident or non-resident in a foreign country, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.
Where Do You Send the Form?
This will depend on the location your entity is residing in a domestic or foreign location:
- If you live in the U.S., you’ll mail it to the appropriate IRS office in your state.
- If you live in a foreign country as a resident or non-resident, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.
Once your specific office receives your form, they will notify you immediately whether it has or hasn’t been accepted. A final determination notice of the election change will be sent to you within 60 days of the acceptance decision.
What’s the Form 8832 deadline?
Because Form 8832 is not mandatory, it doesn’t have a deadline per se. It can be filed at any point by an eligible entity. There are, however, specific but basic rules to take note of. When you file the form, you can include the date the change will take effect.
Broadly, an election specifying an eligible entity’s classification will not take effect more than 75 days before the election is filed, nor can it take effect later than 12 months after the election is filed. However, an eligible entity may be able to apply for an exemption and receive a late election relief in certain circumstances.
How Long Does It Take to Prepare?
The IRS estimates that 17 minutes are required to prepare the form. However, this doesn’t take into account the time it will take to learn and understand the applicable tax law.
What Else Should I Know About Form 8832?
It is essential to know the difference between Form 8832 and Form 2553. Both forms allow certain businesses to request a new tax classification. However, the major difference is the type of tax classification you request.
Form 8832 authorizes businesses to request to be taxed as a corporation, partnership, or sole proprietorship, whereas Form 2553 is the form corporations and LLCs use to elect S-Corp tax status.
The check-the-box regulations authorize entities to elect to change their U.S. tax classification, though a change in tax classification, no matter how achieved, has tax consequences. This applies to U.S. and International business owners.
Essentially there are three ways to accomplish a classification change:
- An elective classification change by filing IRS Form 8832.
- An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners.
- An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.
Suppose a corporation elects to be classified as a partnership. In that case, it will be deemed to have distributed all its assets and liabilities to shareholders in liquidation. The shareholders are considered to contribute all the distributed assets and liabilities immediately after that to a newly formed partnership. An entity will be deemed to have liquidated under §331 or §332, and the deemed liquidation will be treated like it were an actual liquidation for tax purposes.
An entity not regarded as eligible will first need to convert into an eligible entity before making the check-the-box election.
Lastly, an actual conversion can be implemented.
Why to Use Form 8832
Businesses receive a default tax classification, which can result in paying more business taxes than necessary. If you’re eligible to utilize the entity classification election form, you can change your tax election status and potentially lower your liability on a tax return, saving you money and building more tax credit.
Even though this form is not mandatory, this will be an advantage for some taxpayers to decide whether their entity will be taxed as a partnership (one with multiple owners), as a corporation, or disregarded for tax purposes (single owner entity) and taxed like a proprietorship.
What is the Best Tax Classification for an LLC?
An ideal tax classification for a limited liability company (LLC) will depend on if you’d like your business profits should be taxed at your personal income tax or corporate tax rates. If you would rather use your personal tax rates instead, you can classify it as a disregarded entity or as a partnership. If not, you can classify it as a corporation instead.
An LLC can be taxed in several ways for the business and its owner to save on taxes. Below are ways how an LLC can be taxed, how your business can benefit from being taxed as an S corporation or as a corporation, and how you can elect this tax option:
An LLC can be considered as a disregarded entity, similar to the way sole proprietorships are treated, or can be taxed as a partnership if it has multiple members. Those are the most usual classification for LLCs, with each case having the profits ultimately taxed as a part of every member’s personal income.
It’s also possible for an LLC to be considered a corporation. If so, the entity will have to pay corporate taxes instead of passing profits through to each member’s personal income tax return.
To be taxed as a corporation, use the entity classification election or IRS Form 8832. The election for being taxed as a new entity will go into effect on the date entered on line 8 of Form 8832. However, the election cannot take effect over 75 days before the date the election is filed, nor will it take effect any later than 12 months after it is filed.
The form includes a consent statement that may be signed by all or one member on behalf of all other members. If one member does sign, there needs to be some record in a company membership meeting that all members have approved this specific election.
For single-member LLCs, you will need to provide the name(s) and owners’ Social Security number. The same will be applied for multi-member LLCs, but with an Employer ID Number instead of Social Security number.
You can fill out an IRS Form 2553 in order to be taxed as an S corporation, also known as an election by a Small Business Corporation. To start a new tax classification for a year, you will need to file by March 15, which will be effective for the entire year. You must also include all necessary information about each shareholder: name and address, Social Security number, the date the owner’s tax year ends, shares that they owned, and a consent statement.
For any change to a corporation, you must note the following: when your election to corporate status goes into effect, the IRS will determine that any and all liabilities and assets from the previous business (whether it was a partnership or a sole proprietorship) will be added to the corporation in exchange for shares of the corporate stock.
By default, the IRS can tax a multi-member LLC as a partnership since LLCs don’t have a separate IRS tax category.
If you want to convert your LLC’s tax status from a partnership to a corporation while not changing the LLC’s legal form, you will only need to file an IRS Form 8832 (taxed as a C corporation) or an IRS Form 2553 (to be taxed as an S corporation).
Note that once an LLC has elected to change its classification, it cannot elect again to change its classification for the 60 months after the election’s effective date.
Any election for changing a partnership classification to a corporation shall be treated like the partnership provided all of its liabilities and assets to the corporation in exchange for stock. The partnership is then immediately liquidated by distributing the stock to its partners.
IRS Form 8832: Q&As
If you have any further questions about Form 8832 and if this is the best decision for your business, please feel free to contact us at Asena Advisor for a private consultation or check out the IRS’ entity classification election page, which will have a digital copy of the form. Click here to check the latter.