An Article from our partner Aquarius Global Associates LLC (www.aquariusga.nyc)
by Marcel Wendland, MBA
Marcel is the Director of Administration and Operations at Aquarius Global Associates LLC and has been assisting high net individuals and international entities for the past 6 years focusing on tax compliance and planning.
Global entities and multinational individuals must deal with a number of subtleties from within the United States Internal Revenue Code (IRC) in order to minimize their exposure and tax obligations. One of the most powerful U.S. tax planning tools to better manage the intricacies relative to international entities is the “check‐the‐box” election under IRC §7701, which allows an eligible entity to change its “per se” entity classification to a corporation, partnership or “disregarded entity”. The check the box election was originally created to simplify US tax filings for companies by allowing them to affirmatively designate their US tax status as corporations, partnerships or disregarded entities.
A check‐the‐box election is an entity classification election that is made with the Internal Revenue Service (IRS) on Form 8832 and is used to affirmatively designate an entity’s US tax classification, which can have significant effects on the entity and its shareholders’ overall US tax liabilities. Only “eligible entities” can make check‐the‐box elections. Ineligible entities are treated as corporations and are often referred to as “per se” corporations. When an entity is initially formed, it has an “initial classification.” This initial classification is usually determined under the “default” rules, however, the default classification of a non‐US entities are different from those of domestic entities. There are three possible US tax classifications for business entities: corporations, partnerships or disregarded entities. Generally speaking a domestic entity that is incorporated or organized as a corporation under a federal or state statute is treated as a per se corporation for US tax purposes and is prohibited from participating in a check‐the‐box election. The IRS provides a list of foreign entities which specifies foreign per se corporations for each country and also specifies prohibited entities that cannot take advantage of the check‐the‐box election.
Domestic entities not set up as corporations, and with more than one owner, will, by default, be treated as partnerships. Non‐Corporate entities with a single owners will be treated as disregarded entities for tax purposes. However, the default classification rules for non‐US entities are different. For example, it is often assumed that a foreign entity that has a name similar to a US limited liability company (LLC) will be, by default, treated as a partnership or disregarded entity. However, foreign limited liability companies almost always default to a corporate status. For US tax purposes, foreign eligible entities will be treated corporations if all of their owners have limited liability. Conversely, the entity is treated as a partnership if the entity has more than one owner and at least one of the owners does not have limited liability. Finally, the foreign entity is treated as disregarded if the entity has a sole owner that does not have limited liability. This default treatment can be problematic in situations where the entity defaults to corporate status, but the sole owner would prefer that the entity be treated as a partnership or a disregarded entity.
Electing partnership or disregarded entity status has significant tax consequences. If the foreign entity files the check‐the‐box election to be treated as a partnership or disregarded entity, then the income and expenses of the foreign entity will pass through directly to the entity’s owner or owners. The owner or owners then report their items of income, expense and credits from the foreign entity on an individual US federal tax return and state returns, if applicable. The potential income from the foreign entity would only be taxed on the individual’s tax return, rather than being subject to double taxation similar to income from corporations which can be taxed once at the corporate level and again when the retained earnings are distributed as dividends to the shareholders (notwithstanding any foreign taxation but potentially reduced or offset by foreign tax credit or treaty provisions). At the current federal corporate income tax rate of 35% (for illustrations sake the standard 35% rate is used, though there are several different rates that apply depending on the amount of a corporations taxable income), the check‐the‐box election can result in significant tax savings if properly planned for and executed, especially with regards to long‐term capital gains subject to US individual taxation at maximum rates of 20%. The election can even result in further tax savings when corporate state tax rates are factored into the computation.
For example, a foreign entity or individual with $ 100,000 of US source long‐term capital gain income for the tax year ending December 31, 2015, could save as much as $15,000 in Federal income taxes by timely filing a check‐the‐box election. If the election is timely made, the income is reportable on the individual taxpayer’s prepared income tax return and will be taxed at his/her individual tax rate, effectively avoiding US corporate taxation entirely.
However, a change in the classification of an entity can also result in unwanted tax consequences to the entity and/or its shareholders, when there is a taxable liquidation. Generally, if an entity changes its classification from a corporation to either a partnership or a disregarded entity, the transaction will be considered a taxable event for US tax purposes, triggering gain to both the corporation and its shareholders. This change in classification, which constitutes a deemed liquidation for US tax purposes, may result in a deemed gain at the corporate level, resulting in corporate tax. However, it should be noted that an initial classification for an entity does not result in a recognizable event for US tax purposes, and therefore no gain is recognized. Consequently, it is important to consider an entity’s check‐the‐box election upon initial organization.
In certain instances, where both the owner and entity are outside of the US, this deemed liquidation treatment may be alleviated if the previously established foreign entity makes a check the‐box election to be effective the day before it has any US contact. For example, prior to becoming a US resident, a nonresident alien individual “NRA” may cause his/her wholly‐owned foreign corporation to elect to be treated as a disregarded entity for US 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 US tax on this deemed liquidation, as it occurred before the NRA became a US resident (except if US assets were owned within the corporation). In this case, a change of classification would produce the desired result. In short, utilizing tax planning tools like the check‐the‐box elections for foreign entities can result in significant US tax savings and a minimization of tax exposure for the individuals owning the entity.
Due to the use of the check‐the‐box election by multi‐national corporations, such as Apple, which is estimated to shift tax revenue of $10 billion away from the US annually, Congress may consider revising the check‐the‐box election rules further and prohibiting multi‐national corporations from shifting income to foreign jurisdictions with lower corporate tax rates. Several proposals are currently under consideration, and tax advisors need to be alert for future changes to the rules. Meanwhile, the effective and judicious utilization of the current rules depend on making timely and nimble decisions based upon research and sound information.