In an international practice unit (IPU), the IRS has provided its auditors with guidance about various aspects of the “check-the box” rules, including rules that differ for foreign and domestic entities.
Note: IPUs aren’t official IRS pronouncements of law or directives and can’t be used, cited, or relied upon as such. Nonetheless, they identify strategic areas of importance to the IRS and can provide valuable insight as to how IRS examiners may audit a particular issue or transaction.
When a business entity is created, its tax classification must be made. This indicates how it would be treated for U.S. income tax purposes.
Final classification regs, also known as check-the-box or CTB regs, are generally effective January 1, 1997, for all domestic and foreign eligible entities. For U.S. income tax purposes, the regs allow an eligible entity to elect to be classified as a corporation (also known as an association) or a flow-through (partnership or an entity disregarded from its owner). If no election is made, a default classification applies, depending on the number of owners and, for a foreign entity, whether the owners have limited or unlimited liability.
In the recent IPU, the IRS sets out instructions for its auditors when they audit taxpayers’ application of the CTB rules.
Domestic vs. foreign entity
Auditors must first determine whether an entity is a domestic or a foreign business entity. A business entity is domestic if it is created or organized as any type of entity:
- In the U.S.,
- Under the laws of the U.S. or of any state, or
- In both the U.S. and in a foreign jurisdiction.
A business entity is foreign if it isn’t domestic. The determination of whether an entity is domestic or foreign is made independently from the proper classification of the entity.
One of the results of the elective nature of the CTB regs is that a foreign entity may be treated differently for U.S. tax purposes than it is treated under foreign law. An entity may be classified as a flow-through for U.S. tax purposes but as a corporation for foreign tax purposes (commonly referred to as a “hybrid entity”) or as a corporation for U.S. taxes and a flow-through for foreign taxes (a “reverse hybrid entity”).
Only separate entities may make the election
To be eligible to make the election, the entity must be a separate entity. Whether an entity is separate from its owner is a matter of federal, not local, law. Joint undertakings or contractual arrangements may be separate if used to carry on a trade, business, venture or the like where participants divide the profits. However, mere expense sharing or passive co-ownership won’t create a separate entity. Cost sharing arrangements are specified as not being separate.
“Per se” corporations
For both foreign and domestic entities, “per se” corporations can’t make a CTB election; they must be treated as corporations for tax purposes.
A domestic entity is a “per se” corporation, and not eligible to elect, if it’s:
- Organized under a federal or state statute (or a statute of a federally recognized Indian tribe) if the statute describes or refers to the entity as incorporated, or as a corporation, body corporate, or body politic,
- A joint-stock company or association,
- An insurance company,
- A state-chartered bank,
- An entity owned by a state, political subdivision, or foreign government, and
- A business entity that’s generally, but not always, taxable as a corporation under a provision of the Internal Revenue Code.
For foreign entities, federal regulations list, on a country-by-country basis, which entities in those countries are per se corporations. There are limited exceptions to the list.
Failing to elect
Failure to timely make a CTB election on Form 8832 (“Entity Classification Election”) may be corrected under the following circumstances:
- Automatically under certain circumstances within three years and 75 days of the requested effective date of the eligible entity’s classification election,
- Automatically for certain foreign entities where a mistake in the number of owners exists, or
- When “9100 relief” is available to extend the time to make elections.
IRS auditors lack the authority to cure a late filed Form 8832.