For U.S. expats with a business abroad, tax planning is essential to ensure that your company is operating tax efficiently.
Tax efficiency can be tricky for U.S. expats, because multiple taxing authorities will most likely play a part in how you and your business are taxed.
In some instances, modifying the U.S. tax classification of your company is a good way to reduce your overall U.S. tax burden without upsetting your local tax position.
Why is US Tax Classification Important?
Determining your company’s U.S. 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 your IRS Form 1040 depending upon the company’s classification)
To give an example, a U.S. expat who owns a non-US company is likely subject to the U.S. “controlled foreign corporation” rules, which trigger automatic owner-level taxation of foreign company earnings at potentially maximum rates in the United States. It also triggers the obligation to file additional CFC-related forms with the tax return.
In such a case, an entity classification election can reduce these negative effects, depending on the particular circumstances of the business owner, company operations, country of residence, and the provisions of the applicable tax treaty.
A Form 8832 Check-the-Box Election
Fortunately, the IRS gives U.S. taxpayers a lot of leeway in choosing a company’s tax classification.
Under a set of default rules (absent an election), a non-US business entity is classified as an association/corporation under U.S. tax law if all of its members have limited liability. It’s classified as a partnership if it has two or more members and at least one member does not have limited liability. Finally, it’s disregarded for tax purposes if it has a single owner and that owner does not have limited liability with respect to the entity.
With the exception of certain companies, the IRS allows you to file an entity classification election (often referred to as a “check-the-box” election) on Form 8832 to override the default tax classification of your company and change to a status of your choosing.
Changing the Election – the 60-Month Limitation
An entity classification election should be carefully considered, because once an entity elects to change its classification, it cannot make another classification change election during the 60 months after the effective date of the first election.
This restriction does not apply if the first election was made by a newly formed eligible entity effective on the date of its formation. Additionally, if there is a more-than-50% change in ownership within the 60-month period, the IRS may permit a new election.
Exceptions to the 60-Month Limitation
While the 60-month limitation can be restrictive in terms of long-term flexibility in choosing the classification of your company, there are some notable exceptions to the limitation.
Correcting Misstatements:
The IRS allows corrections for otherwise valid elections where the election misstates the actual number of owners of the entity. For instance, if an entity elects to be treated as a disregarded entity but is determined to have two members, the election can be corrected to be treated as a partnership, provided a corrected Form 8832 is filed (See IRS Revenue Procedure 2010-32).
Transactional Rescissions:
While the IRS Treasury regulations do not specifically address rescinding an election, there are instances where the IRS has allowed the rescission of a deemed transaction, such as converting a corporation back to an LLC classified as a partnership, without treating it as a liquidation for tax purposes (See IRS Private Letter Ruling 200613027).
Recission Option under the Internal Revenue Manual:
According to the Internal Revenue Manual, the IRS will accept a request to withdraw a classification election if the request is received by the due date of the "initial tax return.” It is not clear if extensions are taken into account.
If the rescission can be completed in the same taxable year as the initial conversion, it may be treated as a rescission of the initial reclassification, allowing the two reclassification transactions to be ignored entirely.
According to the Manual, the IRS will tell untimely taxpayers that they cannot change their classification for that tax year, but may request a timely return to their default classification for the following year (See IRS Internal Revenue Manual Section 3.13.2.27.10).
