The IRS recently issued general legal guidance illustrating the application of the often misunderstood relevance rules for foreign entities in various settings.1 This article provides a brief summary of the relevance rules and discusses the recent IRS guidance, highlighting some of the planning implications in the pre-immigration setting.
The entity classification regulations (commonly known as the "check-the-box" regulations) allow certain entities known as "eligible entities" to elect how they would like to be treated for U.S. federal tax purposes (i.e., as a corporation, partnership, or disregarded entity).2 This flexibility can afford numerous benefits, both in the domestic and cross-border setting, examples of which include:
For foreign entities, an additional hurdle known as "relevance" has to be considered when considering a check-the-box election. In short, a foreign eligible entity's classification is "relevant" when that classification affects the liability of any person for U.S. federal tax or information purposes. As an example provided in the regulations, if the amount of withholding on an item of U.S. source income paid to a foreign entity would vary depending on whether that entity was classified as a partnership or a corporation, that entity's classification is relevant.
When dealing with the check-the-box regulations and related planning techniques, it is important to understand the difference between an election that produces a "change in classification" and an election that produces an "initial classification." A change in classification is just what it sounds like, meaning that an entity has made an election to change the way it was previously classified under the entity classification rules. As a general matter, a change in classification occurs when an entity makes a check-the-box election with an effective date after the date that the entity was formed.
Importantly, when a change in classification occurs, certain transactions are deemed to occur for U.S. federal tax purposes. Most notably, 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 (even though the entity has not liquidated and is still in existence for local law purposes). It should also be noted that once an entity changes its classification for U.S. federal tax purposes, it cannot change its classification again for 5 years (commonly known as the "60 month rule").
On the other hand, a check-the-box election that produces an initial classification does not carry with it any of the deemed transactions that attach to a change in classification, and the entity is free to change its classification at any time thereafter, subject to the above limitation on changes in classification after the first change in classification occurs. This may seem harmless enough, but in the cross-border setting, the outcome could be disastrous.
Ordinarily, corporate liquidations are not necessarily desired in a purely domestic setting because of the double tax that results (i.e., tax on the corporation as a result of a deemed sale of its assets to its shareholders in complete liquidation, and tax on the shareholders as a result of the exchange of their shares for the assets received in the liquidation). One benefit, however, is that the shareholders receive a stepped up basis in the assets received to their fair market value at the time of the liquidation.3
In the cross-border setting, however, this stepped up basis can often be obtained without triggering U.S. federal tax liability, which can be an invaluable planning opportunity.4 In order to produce this outcome, however, the check-the-box election for the foreign entity must produce a change in classification. The running concern (whether warranted or not) has been – if the foreign entity's classification was never relevant, does a check-the-box election result in the desired benefits (i.e., a change in classification, producing a step up in basis in the underlying appreciated assets), or is the check-the-box election more properly viewed as an initial classification?5
The recent IRS guidance answers the question favorably for taxpayers, clarifying that an election by an entity whose classification was previously never relevant nevertheless results in a change in the entity's classification. In the scenarios provided in the guidance, the IRS confirms that the foreign entity's check-the-box election will be treated as a change in classification, carrying with it the deemed tax consequences that attach to changes in classification.6 The IRS further clarified that notwithstanding the foregoing change in classification, solely for purposes of applying the 60 month rule, the entity's check-the-box election would be treated as though it produced an initial classification and, therefore, the entity is not precluding by the 60 month rule from changing its classification.
The practical takeaway from the IRS guidance is that it would appear only a single election is required to produce a change in classification for a foreign entity whose classification has never been relevant.7 While this may put minds at ease, it should be remembered that this particular form of guidance issued by the IRS (a legal memorandum prepared by the IRS Office of Chief Counsel) cannot be relied upon by taxpayers as precedent. Additionally, like most IRS guidance, it invites follow-up questions. For example, how should the Form 8832 be prepared in this setting? Should the entity indicate it is making an initial classification, or should it indicate that it is making a change in classification? And if the latter, will a subsequent election to change classification within 60 months (if desired) be rejected at the outset by the IRS if there is no accompanying explanation? It is also worth noting that because the filing of the check-the-box election will constitute a change in classification, extra care should be taken to confirm that a change in classification is the desired legal effect for U.S. tax purposes.
The foregoing discussion is a gross oversimplification of the relevant rules in this area (no pun intended). Clients would be wise to consult with counsel well in advance of implementing any of the strategies discussed herein, particularly in the pre-immigration setting, where the stakes are high.
1 See IRS Chief Counsel Memorandum, AM 2021-002 (April 2, 2021).
2 An entity classification election is made by making a so-called check-the-box election on IRS Form 8832.
3 Note, however, that in cases where the assets have declined in value, the liquidation would result in a "step down" in basis.
4 It is worth remembering that foreign persons who move to the U.S. do not receive an automatic step up in basis solely because they are becoming U.S. tax resident.
5 With the global reach of FATCA, query whether those compliance obligations create relevancy, a question to which there may never be a definitive answer.
6 In the case of the IRS guidance, the change in classification is from a disregarded entity to a corporation.
7 If a foreign entity is classified as a partnership or a disregarded entity by default, however, additional planning will be necessary to produce the desired step up in basis.