U.S. Entity Taxation and Check-The-Box Election
In the U.S. tax system, an entity can be thought of as either a flow-through or a blocker. A flow-through entity has no tax imposed at the entity level; instead, the entity’s owners pay tax on their share of income. Meanwhile, a blocker entity is subject to corporate income tax, and distributions made by the entity may also be taxed at the owner level, potentially creating two layers of tax on the income.
In most countries, whether an entity is treated as a flow-through or a blocker depends on its legal form. In the U.S., domestic corporations (Inc.) are blockers, whereas domestic limited companies (LLCs) and limited liability partnerships are flow-throughs by default. An LLC can, however, make an election to be treated as a corporation (blocker) by filing an entity classification election or check-the-box election on IRS Form 8832, Entity Classification Election. In addition, domestic corporations which meet certain ownership requirements may achieve a similar flow-through status by electing to be treated as an S corporation by filing Form 2553, Election by a Small Business Corporation.
An initial check-the-box election should generally be made within 75 days of its desired effective date by filing IRS Form 8832. However, a late filing exception is available in certain circumstances.
U.S. Tax Treatment of Foreign Entities
The rules are even more flexible regarding the U.S. taxation of foreign entities. The IRS has issued a per se corporation list that catalogs foreign countries’ entities that are considered blockers for U.S. tax purposes. Any foreign entity, not a per se corporation, may generally choose how to be treated for U.S. income tax purposes by making an initial election with Form 8832. However, eligible foreign entities that do not submit a check-the-box election should have a default treatment depending on the liability of the owners, with respect to the following:
- If any owner has unlimited liability, the foreign eligible entity defaults to a flow-through entity.
- If all owners have limited liability, the foreign eligible entity defaults to a blocker entity.
As mentioned above, an initial check-the-box election for an eligible foreign entity should be made within 75 days of its desired effective date, with a late filing exception available in certain circumstances. The desired effective date for an eligible foreign entity is usually the date of formation or the date the eligible foreign entity first becomes relevant for U.S. tax purposes. An eligible foreign entity becomes relevant when its classification affects the liability of any person for federal tax or information reporting purposes (i.e. when the entity first falls under the U.S. taxing or information reporting net). For example, if a U.S. person purchases an eligible foreign entity from foreign persons, the entity may become relevant for U.S. tax purposes on the date purchased by the U.S. person and an initial election may be made. Furthermore, it is also possible to change an entity’s classification with Form 8832; however, the change could have unintended tax consequences.
U.S. Tax Impact on Foreign Entities
The tax treatment for U.S. tax purposes can significantly impact the U.S. taxation and reporting requirements with respect to a foreign entity, such as:
- In a U.S. outbound context, the foreign entity’s U.S. tax status will dictate how the U.S. owners are taxed with respect to the income generated by the foreign entity.
- In a U.S. inbound context, the foreign entity’s U.S. tax status will dictate how the foreign entity or its owners are taxed with respect to its U.S. source income, if any.
When considering the outbound context, the preferable entity treatment will depend on many factors, including but not limited to the following:
- The ability to defer foreign income offshore
- The ability to utilize foreign income taxes
- The nature of the business
- The significance of fixed assets
- The foreign income tax rate and foreign taxable income
- The expectation of a future exit event
- The expectation and ability to repatriate earnings back to the U.S., including the impact of withholding taxes
In the inbound context, there are many important considerations including, but not limited to, the following:
- Is the foreign blocker needed for U.S. estate tax protection?
- Are there any potential treaty benefits?
- Is the U.S. income Effectively Connected or Fixed, Determinable, Annual, or Periodical (FDAP) Income?
- Is there a U.S. real property interest under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) rules?
The U.S. check-the-box election provides flexibility and the ability for significant tax planning. Taxpayers and their tax consultants can determine if a check-the-box election may be beneficial for the following:
- A foreign entity held by U.S. persons (directly or indirectly)
- A foreign entity held by foreign persons investing in the U.S.
- Foreign persons immigrating to the U.S. (who might benefit by making a check-the-box election before moving to the U.S.)
- A U.S. LLC
The check-the-box election provides flexibility and should always be considered when planning business structures. However, tax planning using the check-the-box technique is highly complex and should not be done without proper consideration. Significant and unintended negative tax consequences can arise. Please contact your WG tax advisor with any questions or to discuss planning opportunities for your outbound or inbound investments.