For United States income tax purposes, a business entity may elect to be treated either as a corporation or as other than a corporation.[1] This entity classification election is made by filing Internal Revenue Service Form 8832. Absent filing the form, a default classification applies. U.S. corporations of the type that can be publicly traded must be treated as corporations. There is a list of specific foreign entities that must be treated as corporations.[2] The election is effective for Federal income tax purposes.
If an entity is not classified as a corporation, it is treated as a partnership for U.S. tax purposes if it has more than one owner, or is treated as a "disregarded entity" if it has a single owner (i.e. is treated as part of the single owner).
The classification of either a U.S. or non-U.S. entity for U.S. tax purposes has no effect for purposes other than U.S. income tax.
An entity, which is eligible to make an election, is referred to as an eligible entity. Generally, a corporation organized under U.S. federal or state statute (and referred to as a corporation, body corporate or body politic by that statute) is not an eligible entity. However, the following types of business entity are treated as eligible entities:
The list of foreign entities classified as corporations for federal tax purposes (so called per se corporations, not eligible to make an entity classification election) includes, as of September 2009:[3]
In 2013, the IRS added a Croatian dionicko drustvo to the list of per se corporations.[4]
An eligible entity is classified for federal tax purposes under the default rules described below unless it files Form 8832 or Form 2553, Election by a Small Business Corporation, to elect a classification or change its current classification. The IRS uses the information entered on the form to establish the entity's filing and reporting requirements for federal tax purposes.[5] Certain domestic and foreign entities that were in existence before January 1, 1997, and have an established federal tax classification generally do not need to make an election to continue that classification. If an existing entity decides to change its classification, it may do so subject to the 60-month limitation rule.[6]
Unless an election is made on Form 8832, a domestic eligible entity will be classified by default as:[5]
Unless an election is made on Form 8832, a foreign eligible entity will be classified by default as:[5]
The effect of these rules is that a U.S. limited liability company (LLC) or limited liability partnership (LLP) is treated by default as a partnership (or disregarded entity if it has only one owner), whereas a foreign LLP is treated by default as a corporation (if, as is generally the case, all its members have limited liability).
If an entity has been operating under one classification for some time, but then elects to change its classification, there may be tax consequences. The initial regulations were unclear on this point, so the IRS issued Revenue Rulings 99-5 and 99–6 in 1999 to address questions surrounding the conversion of an LLC to a partnership and vice versa.[7]
The "check-the-box" regulations paved the way for various new tax avoidance and tax deferral strategies.[8] Specifically, they expanded the opportunity for "hybrid branch" or "hybrid entity" strategies, which take advantage of differences in the classification of an entity as a corporation or not in multiple jurisdictions, in order to engage in cross-border tax arbitrage. The possibility that the check-the-box rules would greatly expand the potential for such strategies had been pointed out prior to implementation, and at one point some commentators suggested disallowing foreign entities from electing their classification at all; however, in the end, the IRS, while acknowledging such concerns, issued regulations which gave foreign and domestic entities largely similar powers to elect their own classification.
US owners of foreign subsidiaries benefit from the ability to have those foreign subsidiaries treated as disregarded entities. Under the United States' Internal Revenue Code Subpart F, payments between related Controlled Foreign Corporations (CFCs), or from American companies to related CFCs, may be "treated as Subpart F income" (subject to current taxation as if they were profits in the hands of the ultimate American owner of the corporate structure), in an effort to limit the ability of American citizens and corporations to defer US tax on the income of foreign corporations they control. However, payments between an American-owned foreign entity which is taxed as a corporation, and a foreign subsidiary of that entity which itself has elected to be treated as a disregarded entity, are not treated as Subpart F income.[8] [9] This arrangement may be used to shift income between the two non-American jurisdictions and avoid local taxes in one or the other, e.g. through thin capitalization. Another category of US taxpayers who benefit from check-the-box regulations consists of US flow-through entities (S corporations and partnerships) with foreign subsidiaries. If the foreign subsidiary is treated as a corporation, the taxes it pays to the foreign government do not create a foreign tax credit for the US owner under Section 902. However, with a check-the-box election to be treated as a disregarded entity, the foreign taxes are treated as having been directly imposed on the US owner, thus giving rise to the tax credit.[10] [11]
For US owners with foreign subsidiaries, choosing to have a subsidiary treated as a disregarded entity is not always the most beneficial tax-planning choice, however. For example, if a US taxpayer owns a disregarded foreign entity, its income will be taxed at the owner's ordinary US income tax rates, less the foreign tax already paid. This may result in every marginal dollar being taxed at the highest rate. However, if the foreign entity had elected to be taxed as a corporation (or been classified as such by default), paid a low rate tax in the foreign country, then repatriated its income to the US by paying qualified dividends to its owner, the total proportion of tax paid on income might actually be less, as qualified dividends are only taxed at 15%. However, this treatment is only available for dividends from corporations in certain countries, and is set to sunset in 2010 under the Tax Increase Prevention and Reconciliation Act of 2005.[10]
Foreign owners of US corporations also benefit from the ability to have entities normally treated as flow-through instead be taxed as corporations by the IRS. In what is sometimes known as a "domestic reverse hybrid" strategy, a non-US corporation may set up a US holding company which elects to be treated as a corporation for US tax purposes, but which its home country tax law sees as a flow-through entity. The US holding company receives a loan from its home country parent which it invests in a US operating subsidiary; the US holding company receives dividends from the US operation subsidiary and pays interest to the non-US parent. US tax law thus sees a US company making a dividend payment to another US company (which is thus not subject to withholding tax, unlike a dividend paid to a foreign company) which then pays interest to a foreign company, while the home country tax law will see a US company paying dividends directly to its home country parent. Under typical treaties for the relief of double taxation, neither government has the right to tax the payment, because each sees it as a type of payment which only the other has the right to tax.
Prior to 1996, whether domestic and foreign entities were classified as corporations was based on a six-factor test which looked at:[12]
An entity which had a preponderance of the first four factors (the last two, in practice, were shared by all business entities) was treated as a corporation, otherwise as a partnership or an association.[13] In practice, however, this test was easily manipulated.[12]
The "check-the-box" regulations (Treasury Decision 8697) were adopted in 1996 in order to simplify the issue of entity classification. A grandfather clause allowed entities in existence on May 8, 1996 to continue using their previous classification, even if they would no longer be eligible to elect that classification under the new rules.[14] There were three conditions for this grandfathering:[13]
The initial regulations also included a list of foreign entities which would always be classified as corporations ("per-se corporations") and which could not elect to be disregarded.[12] The proposed regulations included naamloze vennootschap formed under the laws of Aruba or the Netherlands Antilles in that list, but they were removed from the final list; conversely, Canadian corporations were added to the list.[14]
In 1998, the IRS issued Notice 98–11, 1998-1 C.B. 433 in an attempt to combat the use of "check-the-box" in international tax planning (see below); however, the notice met opposition, and was withdrawn by Notice 98–35, 1998-2 C.B. 34.[8] Another proposal, around 1999, would have left the basic check-the-box regime in place, but allowed the IRS to disregard entity classification elections made in connection with "extraordinary transactions" (where the tax liability changes "significantly" as a result of the election).[8] An "extraordinary transaction" was defined as one in which there was a sale, exchange, transfer, or other disposition of a 10-percent or greater interest in a foreign entity; the proposed regulations provided that an election to be classified as a disregarded entity could be ignored, and thus the entity continue to be taxed as a corporation, if the election occurred within twelve months following the day before an extraordinary transaction.[15] However, various tax professionals opposed the changes, arguing that the threshold for defining an extraordinary transaction was far too low, and that existing internal revenue regulations, as well as common law doctrines such as the principle of substance over form and the step transaction doctrine, were already sufficient to combat any abuses of the check-the-box rules.[15] [16]
President Barack Obama attempted to revive the IRS' 1998 notice in his proposed 2010 budget.[9] Specifically, the proposal stated:[17]
The proposal was eventually dropped again due to criticism from businesses, and it was not included again in the 2011 budget proposal either.[18]