One of the most powerful tools in cross-border tax planning is the ability to make a “check-the-box” election. Pursuant to the entity classification regulations under Internal Revenue Code §7701 (the “check-the-box regulations”), certain business entities are permitted to choose their classification for U.S. federal income tax purposes by making a check-the-box election. The Federal tax classification of a foreign entity as a corporation, partnership, or a disregarded entity affects many aspects of U.S. taxation.
U.S. tax law governs the classification of a form of foreign business organization for U.S. tax purposes. The check-the-box regulations provide that certain types of organizations are required to be classified as corporations and that any “business entity” that is not required to be treated as a corporation is an “eligible entity” that may choose its classification.
The check-the-box regulations provide default classification rules for eligible entities. A foreign eligible entity is an association taxed as a corporation if all of its members have limited liability. A foreign eligible entity is a partnership if it has two or more members and at least one member does not have limited liability. The entity is a disregarded entity if it has a single owner and that owner does not have limited liability.
An eligible entity may make a check-the-box election and elect out of its default classification by filing Form 8832, Entity Classification Election. An initial entity classification for a newly formed entity must generally be made within 75 days of formation. In certain cases, late election relief is available that allows the election to be made retroactively to an effective date within 3 years and 75 days of formation. When the entity is a foreign eligible entity, however, the initial classification must be determined as of the date the entity becomes “relevant” for U.S. tax purposes. A foreign eligible entity that was formed on or after October 22, 2003, has a classification only when it becomes relevant. An entity that was formed prior to October 22, 2003, however, has a classification even if it is not relevant.
A foreign eligible entity is relevant when its classification affects the liability of any person for U.S. federal tax or information purposes. For example, a foreign entity’s classification would be relevant if U.S.-source income is paid to the entity, and the amount to be withheld by the withholding agent would vary depending upon whether the entity is classified as a partnership or a corporation. The classification of a foreign eligible entity also becomes relevant on the date that an obligation arises to file a tax return or information return for which the classification of the entity must be determined. For instance, the classification of a foreign entity becomes relevant on the date that a U.S. person acquires an interest in that entity that will require the U.S. owner to file a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. A foreign eligible entity is also deemed to be relevant on the effective date of its entity classification election.
An entity whose initial classification is determined by default generally retains that classification until the entity makes an election to change its classification. A change in the classification of an entity can result in tax consequences to the entity and/or its shareholders. For example, a change in the classification of an entity classified as a corporation constitutes a deemed liquidation for U.S. tax purposes and may result in a stepped-up tax basis. An initial check-the-box election for an entity that has never been previously relevant, however, does not result in a recognition event for U.S. tax purposes and therefore no basis step-up occurs. Consequently, the relevance of the foreign entity is important in determining whether the entity classification election is treated as an initial classification or a change in classification.
Check-the-box Elections in the Context of Pre-Immigration
Check-the-box elections are often used in pre-immigration tax planning. Prior to becoming a U.S. person, a nonresident alien individual (NRA) may cause his wholly-owned foreign corporation to elect to be treated as a disregarded entity for U.S. tax purposes. If this election constitutes a change in classification, it would result in a deemed liquidation and the NRA would be treated as owning the assets of the entity directly with a basis stepped-up to fair market value. The NRA would generally not be subject to U.S. tax, however, unless the entity owns certain U.S. assets . In this case, a change of classification would produce the desired result. If, however, the entity has never been relevant for U.S. tax purposes, the election would be treated as an initial classification without the deemed liquidation and tax basis step-up.
In other situations, an initial classification may be preferable. A former NRA who becomes a U.S. person, intentionally or unintentionally (e.g., by being physically present in the United States for a certain number of days), would be subject to tax on the deemed liquidation resulting from a check-the-box election for a relevant entity. If, however, the entity was not relevant prior to the NRA becoming a U.S. person, the election would be treated as an initial classification election and no recognition event would occur.
In short, tax planning involving check-the-box elections for foreign entities will often depend on the relevance of the entity. In order to avoid unintended tax consequences, relevance rules should be carefully considered when planning with check-the-box elections. In certain cases, it may even be possible to create the necessary relevance to ensure the desired result.