Understanding the U.S. Tax Classification of Your Foreign Business Entity
A common misconception we find in our practice is the belief that the classification of a foreign (non-US) entity is necessarily the same under both the foreign country’s laws and under U.S. tax law. In fact, the U.S. tax Code and regulations, and the IRS which enforces them have their own specific rules for determining tax classification, which essentially ignore the foreign legal or tax classification. In many cases, this leads to a company having one classification for foreign tax purposes and another classification for U.S. tax purposes.
Why is tax classification important?
Determining tax classification is much more than just an academic exercise. Tax classification can have a number of important practical effects, including:
1. how you and your company are taxed (for example, tax rates may be higher or lower depending on the company’s classification); and
2. the extent to which you and your company have compliance or reporting obligations (for example, additional forms may need to be filed with the IRS depending upon the company’s classification)
How U.S. Tax Classification is Determined
While the rules of tax classification can be complex and should be applied on a case-by-case basis, understanding the basics can be a helpful starting point. Broadly speaking, tax classification is a three-step process:
First, as a most basic matter, if your situation involves a counterparty, it should be determined whether or not the arrangement between you and the counterparty rises to the level of a foreign “entity” (as opposed to a mere a contract or co-ownership arrangement).
Second, assuming you are holding an entity, it must be determined whether your foreign entity is considered a trust (the purpose of which generally is to vest in trustees responsibility for the protection and conservation of property for beneficiaries) or a business entity (the purpose of which generally is to generate a business profit).
Third, assuming you are holding a foreign business entity, it must then be determined whether the entity has corporation, partnership, or disregarded status. While a corporation is generally taxed at the entity level, a partnership’s income “flows through” to its partners for tax purposes, and a disregarded entity is generally treated as if it has no tax existence.
Classification of a Foreign Business Entity
In the case of a foreign business entity, the U.S. Treasury regulations contain a set of default classification rules. A foreign business entity is classified as an association and thus a corporation if all of its members have limited liability. A foreign business entity is classified as a partnership if it has two or more members and at least one member does not have limited liability. Finally, an entity is disregarded for tax purposes if it has a single owner and that owner does not have limited liability with respect to the entity.
An important aspect of U.S. tax law that is unique to entities with corporation status is the potential application of the anti-tax-deferral regimes. The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. They are the:
- Controlled Foreign Corporation (“CFC”) regime; and
- Passive Foreign Investment Company (“PFIC”) regime
A foreign corporation is a CFC when more than 50 percent of the voting power or value of its shares is owned by “U.S. shareholders.” A “United States shareholder” is generally a U.S. person owning 10% or more of the voting power of the corporation. U.S. shareholders of a CFC are taxed on a current basis on certain types of income (generally referred to as “Subpart F” income) earned by the CFC even though the CFC has not made an actual distribution to the shareholder.
Furthermore, this income is taxed at ordinary income rates even if it would have been treated as capital gain (possibly taxed at lower tax rates) had it been earned directly by the shareholder.
Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets. A number of foreign investment products are classified as PFICs for U.S. federal tax purposes.
PFIC investment income is generally subject to highly punitive U.S. federal tax rates. A non-deductible penalty interest charge can also compound regularly while holding an interest in a PFIC. Several elections are available to mitigate the more onerous aspects of PFIC taxation (e.g., a so-called “QEF election” or “mark-to-market” election).
The Entity Classification (“Check the Box”) Election
An eligible entity (i.e., an entity that is not on the list of entities prohibited from electing their status) may affirmatively elect its classification by filing Form 8832 with the IRS. This election effectively overrides the entity’s default classification. The election is commonly referred to as a “check the box” election, because you put a check in the box on the form next to the entity classification you have chosen for your company.
It’s important to note that the election, if not made to correspond with the company’s incorporation or creation date, can trigger U.S. tax implications. A tax advisor should be consulted if you are considering tax planning that involves a check the box election.
A foreign entity that is required to file a federal tax or information return for the taxable year for which an election is made (e.g., the company has taxable activities within the U.S.) must attach a copy of the Form 8832 to its return. If the entity is not required to file, a copy of the Form 8832 generally must be attached to the return of an owner of the entity. The failure to comply with these filing rules does not invalidate the election, but may trigger penalties.
The Takeaway for U.S. Expats
For U.S. expats living abroad, owning a foreign business entity can have both tax and reporting implications. The classification of your entity will greatly affect such implications, so it is important to consult with an international tax expert who can advise you on these matters.
If you are a U.S. citizen living abroad, it is essential that you remain compliant with your continuing U.S. tax obligations, particularly those associated with your business activities abroad. Our experts at Expat Tax Professionals are available to help you understand your U.S. tax filing requirements and to assist you with all of your U.S. tax compliance needs.
By Ephraim Moss, Esq. & Joshua Ashman, CPA