When immigrating to the United States, there are a number of tax planning opportunities to consider. For company owners, a particular opportunity may be available known as a “check-the-box election,” which is an election to change a company’s tax classification.
In this blog, we review the benefits of making a check-the-box entity classification election, analyze the issues involved with such an election prior to immigration to the U.S., and summarize recent IRS guidance providing several important clarifications.
Entity Classification Rules
Under the U.S. entity classification regulations, a business entity is assigned a default classification, which depends on certain factors. A non-U.S. entity, for instance, has a default classification of a partnership if it has two or more members and at least one member does not have limited liability; a corporation if all members have limited liability; or a disregarded entity if it has a single owner that does not have limited liability.
The entity classification regulations are, however, quite flexible in that they allow taxpayers to choose a different classification using a check-the-box election.
An election can either be an “initial” classification, which is when the effective date of the election is the date the entity was formed, or a “change” in classification, which is when the effective date of the election is after the date that the entity was formed.
When a change in classification occurs, certain events are deemed to occur for tax purposes. For instance, when an entity that was initially classified as a corporation elects to change its classification (either to a partnership or a disregarded entity), the entity is deemed to liquidate for tax purposes. In contrast, an initial classification does not trigger any deemed events, since the classification takes hold as of the date the entity was formed.
Tax Election Prior to Immigration to the US
In many cases, a deemed corporate liquidation can have adverse consequences because of the corporate-level and individual-level taxes that may result. One benefit of a liquidation, however, is that the shareholders of the company receive a stepped-up basis in the assets received to their fair market value at the time of the liquidation.
This can be especially beneficial for immigrating company owners, since both shareholder and foreign company are outside the U.S. tax net prior to immigration, so the deemed liquidation from the election should result in no U.S. federal tax liability. However, as the IRS has recently clarified, the election should in any event achieve a stepped-up basis for the company owner. This could significantly reduce the gain realized if and when the company is later sold while the owner is tax resident in the United States.
Relevance Prior to Immigration to the US
In a recent IRS Chief Counsel Memorandum, the IRS addressed several issues surrounding the effects of a check-the-box election, and provided favorable answers.
One issue relates to a concept found in the entity classification regulations known as “relevance.” Briefly, a foreign eligible entity's classification is considered to be “relevant” when that classification affects the liability of any person for U.S. federal tax or information purposes. Under the regulations, if the classification of a foreign entity has never been relevant, then the entity's classification will initially be determined when the classification of the entity first becomes relevant.
As such prior to the IRS guidance, the concern practitioners had was the following - if a foreign entity's classification was never relevant, for instance prior to the owner’s immigration to the U.S., does a check-the-box election result in merely an initial classification (rather than a change in classification), which would not trigger a step-up in the owner’s basis in the company’s shares?
Clarification in Recent IRS Guidance
In IRS Chief Counsel Memorandum, AM 2021-002 (April 2, 2021), the IRS clarified that an election by an entity whose classification was previously never relevant nevertheless results in a change in the entity's classification, triggering the deemed events that attach to a change in classification.
The guidance further clarifies that the so-called “60-month rule” that normally applies to a change in classifications (i.e., that once an entity changes its classification, it cannot change its classification again for 5 years), does not apply to such a check-the-box election by an entity whose classification was previously never relevant. This gives a taxpayer immigrating to the U.S. more flexibility to change his or her mind, if circumstances change such that non-corporate status is no longer tax advantageous.
While a Chief Counsel Memorandum cannot be relied upon by taxpayers as official precedent (in contrast to authorities such as a statute, regulation or revenue ruling), it does show how the IRS views these issues favorably for taxpayers, particularly those who are using the check-the-box election in a cross-border context.