To Elect or Not to Elect?
Treasury Regulations provide default rules for the proper tax characterization of both domestic and foreign entities.[i] Generally, a business entity that is not classified as a corporation under certain prescribed rules (referred to as “eligible entities”) can elect their tax characterization for federal tax purposes.[ii]
For example, an eligible entity (domestic or foreign) with two members can generally elect to be characterized as either a corporation or a partnership for federal tax purposes. Conversely, an eligible entity with only one owner can elect to be characterized as either a corporation or a disregarded entity.
Tax Consequences of not Making an Election
If an eligible entity fails to make a proper election, Treasury Regulations provide “a default classification.”[iii] Thus, if the eligible entity is a domestic eligible entity, the default classification is generally: (1) a partnership if it has two or more members; or (2) a disregarded entity if it has only a single owner.[iv]
But, the rules are different if the eligible entity is a foreign eligible entity. Specifically, under the Treasury Regulations, the characterization of the foreign eligible entity will depend largely on the number of members in addition to whether they have limited or unlimited personal liability.[v] The characterizations available for foreign eligible entities are:
- 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;
- a disregarded entity if it has a single owner that does not have limited liability.
A Closer Look at Foreign Eligible Entities Without Elections
As shown above, the determination of the proper characterization of a foreign eligible entity without a valid election depends largely on whether the member or owner has or does not have personal liability. For these purposes, a member of a foreign eligible entity has limited liability if the member has no personal liability for the debts or claims against the entity by reason of being a member.[vi] In making this determination, the governing foreign statute or foreign law should be applied unless the statute or law permits the entity to specify in its organizational documents whether the members will have limited liability.[vii] In these latter cases, the organizational document may also be relevant in this determination.
On the other hand, a member is considered to have personal liability if the creditors of the entity are permitted to seek satisfaction of all or any portion of the debts or claims against the entity from the member in his capacity as such.[viii] In addition, a member is deemed to have personal liability even if the member makes an agreement in which another person (whether or not a member of the entity) assumes the liability or obligation or agrees to indemnify that member for any such liability.
When the Classification is “Relevant”?
It may not surprise you to learn that a foreign entity’s classification for United States income tax purposes is largely irrelevant to the United States when no member or owner is a United States citizen or permanent resident. However, the classification certainly becomes relevant to the United States government when a member or owner becomes a United States citizen.
Accordingly, Treasury Regulations related to foreign entities discuss a “relevant” period.[ix] More specifically, a foreign eligible entity’s classification is relevant under the regulations when its classification affects the liability of any person for federal tax or information purposes. And the date the classification of a foreign eligible entity is relevant occurs on the date that an event creates an obligation to file a federal tax return, information return, or statement. By way of example, the classification of a foreign entity would become relevant on the date that an interest in a foreign eligible entity is acquired by a United States person, which may necessitate the filing of a Form 5471.
Chief Counsel Memo. 2021-22
On March 25, 2021, the IRS Office of Chief Counsel issued Associate Chief Counsel Memo. 2021-22 (the “Memo.”). The Memo. provides additional guidance related to the proper characterization of foreign eligible entities and the relevant date. One of the fact patterns is reproduced below.
On Date 1, S1 and S2, each a nonresident alien individual, form X, a foreign business entity that is eligible to make a classification election described in Treas. Reg. § 301.7701-3(c). On Date 2, S1 acquires all of S2’s interests in X and becomes the sole owner of X. On Date 3, S1 becomes a U.S. citizen. On Date 4, X makes a valid election, effective on Date 3, to be classified as a corporation. Before Date 3, the classification of X is not relevant. Neither S1 nor S2 has limited liability within the meaning of Treas. Reg. § 301.7701-3(b)(2)(ii) with respect to X at any time during their ownership.
Based on the Treasury Regulations, the Memo. concludes that the classification of X becomes relevant on Date 3 or the date in which the classification of entity X affects the federal tax or information reporting liability of a United States citizen, S1. Accordingly, under those regulations, the proper characterization of X must be made as of such date.
Interestingly, although the classification of X was not relevant until Date 3, the Memo. notes that the classification of X prior to such date now bears some relevance to the proper characterization of X as of Date 3. Thus, because neither S1 nor S2 has limited liability at any time, the default classification of X is a partnership on Date 1 and through the end of the day before Date 2. On Date 2 and through the end of the day before Date 3, X is a disregarded entity. Finally, on Date 3, X is characterized as a corporation.
Based on the above, the following are deemed to have occurred for federal tax purposes. First, on Date 2, when the partnership terminates, X is deemed to make a liquidating distribution of all of its assets to S1 and S2, and following this distribution, S1 is treated as acquiring the assets deemed to have been distributed to S2 in liquidation of S2’s X partnership interest.[x] Second, when X makes an election to be treated as a corporation for federal tax purposes, S1 is treated as contributing all of the assets and liabilities of X to X in exchange for X stock. Moreover, the deemed contribution occurs immediately before the close of the day before Date 3.[xi]
Foreign entity classification rules are important for federal income tax purposes. And the above Memo. demonstrates that foreign entity classification rules can be significant even prior to the introduction of a United States owner to the foreign entity. In instances in which a United States person has purchased or acquired ownership in a foreign entity, the United States person should familiarize themselves with the entity’s United States classification or classifications prior to the date of ownership. Moreover, the United States person should ensure upon acquisition that any foreign information returns are properly prepared and timely submitted to the IRS. The proper form will depend largely upon the foreign entity’s characterization for federal tax purposes.[xii]
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[i] Generally, a corporation or partnership is “domestic” if it was created or organized in the United States or under the law of the United States or of any State. Sec. 7701(a)(4). A corporation or partnership is “foreign” if it is not domestic.
[ii] Prior to January 1, 1997, an entity’s classification as either a corporation or a partnership was determined by a multi-factor test under the Treasury Regulations (referred to as the “Kintner regulations”).
[iii] Treas. Reg. § 301.7701-3(a).
[iv] Treas. Reg. § 301.7701-3(b)(1).
[v] Treas. Reg. § 301.7701-3(b)(2).
[vi] Treas. Reg. § 301.7701-3(b)(2)(ii).
[ix] Treas. Reg. § 301.7701-3(d).
[x] Rev. Rul. 99-6, Situation 1.
[xi] Treas. Reg. § 301.7701-3(g)(1)(iv), -3(g)(3).
[xii] For example, a United States person may have the following reporting requirements depending on the foreign entity’s characterization: (1) Form 5471 (certain ownership or other interests in foreign corporations); (2) Form 8865 (certain ownership or other interests in foreign partnerships); (3) Form 926 (certain contributions to foreign corporations); and (4) Form 3520 and Form 3520-A (certain beneficiary or other control over foreign trusts).