Part 4. Examining Process
Chapter 61. International Program Audit Guidelines
Section 5. Entity Classification
This text contains background and guidelines for classifying a form of foreign business organization for U.S. tax purposes. Entity classification affects the extent of the U.S. taxing jurisdiction, including, in some cases, whether the entity is subject to U.S. tax in any event. A U.S. corporation pays U.S. tax on its worldwide income while a foreign corporation generally pays U.S. tax only on its income effectively connected with a U.S. trade or business (or, in the case of a corporation entitled to applicable treaty benefits, on income attributable to a permanent establishment in the United States or otherwise subject to U.S. tax under the treaty).
The entity classification regulations under IRC section 7701 are generally effective January 1, 1997, (hereafter referred to as the check-the-box regulations). The check-the-box regulations allow certain business entities to choose their classification for Federal tax purposes under an elective regime. "Per Se" corporations are statutory corporations and are not allowed to choose their classification. " Per Se" corporations are defined in Reg. 301.7701-2(b) and a list is provided in Reg. 301.7701-2(b)(8).
The classification of a foreign entity as a corporation, a partnership, or disregarded entity, potentially affects many aspects of U.S. taxation.
Applying the U.S. entity classification criteria under the prior regulations to foreign forms of business organization was difficult due to the differences among the various national legal systems. The most difficult cases ultimately turn on the facts and circumstances. For cases which fall under the old regulations, lEs must carefully evaluate their taxpayers based on the factors outlined under the "Prior Classification Rules" below.
U.S. tax law governs the classification of a form of foreign business organization for U.S. tax purposes.
The check-the-box regulations under IRC section 7701, are generally effective January 1, 1997, provide that any "business entity" that is not required to be treated as a corporation is an "eligible entity" that may choose its classification. The regulations provide default classification rules. Eligible entities may elect out of the default rules. Entities that wish to change their previous classification must also do so by filing an election that qualifies for purposes of IRC 7701.
The first step under the check-the-box regulations is to decide whether there is an entity for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
The next step is to determine whether an entity is a business entity.
A business entity is any entity recognized for federal tax purposes that is not properly classified as a trust or otherwise subject to special treatment under the IRC.
The rules for determining whether an entity is classified as a trust for federal tax purposes are in Reg. 301.7701–4. Usually, the beneficiaries of an entity properly classified as a trust for this purpose do no more than accept the benefits of trust property and do not create the trust.
Certain business entities are by definition classified as corporation under Reg. 301.7701–2(b). Reg. 301.7701–2(b)(8) contains a list of foreign entities that are corporations by definition ("per se" entities).
A business entity that is not necessarily classified as a corporation under Reg. 301.7701–2(b) (an "eligible entity" ) can elect its classification for federal tax purposes under the rules of Reg. 301.7701–3. Those rules provide that
An eligible entity with: Can be classified as: At least two members Either partnership or an association taxable as a corporation A single member An association or "disregarded as an entity separate from its owner (a"disregarded entity)" )"
The activities of a disregarded entity are treated in the same manner as a sole proprietorship, branch or division of the owner.
The check-the-box classification regulations provide a default rule for an eligible entity that does not elect its classification. An election is necessary only when an eligible entity chooses to be classified initially other than under the default rule, or when the entity chooses to change its classification.
A foreign eligible entity is generally an eligible entity that is not created or organized in the U.S. or under the law of the U.S. or any State. The key for the default classification for foreign entities is whether the members have limited liability. A foreign eligible entity is an association and thus a corporation if all of its members have limited liability. A foreign eligible entity is a partnership if it has two or more members and at least one member does not have limited liability. The entity is a branch or proprietorship if it has a single owner and that owner does not have limited liability. The entity is a disregarded entity if it has a single owner and that owner does not have limited liability with respect to that foreign eligible entity.
The default classification of an entity in existence prior to January 1, 1997, is generally the classification that the entity had claimed prior to that date. A foreign eligible entity is treated as being in existence prior to January 1, 1997, only if the entity’s classification was relevant at any time during the sixty months prior to that date. If a foreign eligible entity’s classification was relevant prior to January 1, 1997, but the entity did not claim a classification, the entity’s classification default classification is determined under the prior classification regulations.
An entity that was formed after December 31, 1996, and before October 21, 2003, has a classification even it is it not relevant. An entity that was formed on or after October 22, 2003, has a classification only when it becomes relevant.
A foreign eligible entity is relevant when its classification affects the liability of any person for federal tax purposes.
A special rule applies to foreign eligible entities in existence and relevant on May 8, 1996, and on the per se corporation list of Reg. 301.7701–2(b)(8). Under this rule, such entities may retain their claimed classification after January 1, 1997, if
they had a reasonable basis for claiming the classification under prior law;
no person (including the entity) for whom the classification was relevant on May 8, 1996, treats the entity as a corporation for the taxable year including May 8, 1996;
any change in the entity's classification within 60 months prior to May 8, 1996, occurred solely as a result of a change in the entity's organizational documents, and the entity and all members of the entity recognized the federal tax consequences of the change; and
neither the entity nor any member was notified in writing on or before May 8, 1996, that the classification of the entity was under examination (in which case the entity's classification will be determined in the examination).
An entity whose initial classification is determined by default retains that classification (without regard to changes in the members’ liability) until the entity makes an election to change its classification.
An eligible entity may affirmatively elect its classification by filing Form 8832, Entity Classification Election . The election is effective on the date specified on Form 8832, or if no date is specified, on the filing date. However, if an election specifies an effective date more than 75 days prior to the date on which the election is filed, it will be effective only 75 days prior to the date it was filed. In addition, if an election specifies an effective date more than 12 months from the date on which the election is filed, it will be effective 12 months after the date it was filed. If an election specifies an effective date before January 1, 1997, it will be effective as of January 1, 1997.
The election must be signed by each member of the entity or by an authorized representative who represents to having such authorization under penalties of perjury. A retroactive election must also be signed by every person who was an owner during the period of retroactivity, but is not an owner at the time the election is filed.
A change of classification may constitute a recognition event for U.S. tax purposes.
A taxpayer that makes an entity classification election (other than an election effective on January 1, 1997, or an election by a newly formed entity effective on the date of formation) generally cannot change its classification by election during the sixty months following the effective date of the election. However, the Commissioner may permit a change within that time if more than fifty percent of the ownership has changed since the filing date or effective date of the election.
An eligible entity required to file a federal tax or information return for the taxable year for which an election is made must attach a copy of the Form 8832. If the entity is not required to file a return, a copy of the Form 8832 generally must be attached to the federal income tax return or information return of any direct or indirect owner of the entity. Failure to comply with these filing requirements does not invalidate the election, but the non-filing party may be subject to penalties.
The classification rules in effect prior to January 1, 1997, were found in former Reg. 301.7701–1 through –4.
Under the prior regulations, an entity with associates and an objective to carry on business was classified as a corporation if it had a preponderance of the following factors:
continuity of life;
centralization of management;
free transferability of interests;
The prior regulations remain applicable prior to January 1, 1997. If an entity incorrectly claimed a classification prior to January 1, 1997, the default classification rule for existing eligible entities in the new regulations could cause a change in entity classification as of January 1, 1997. However, the check-the-box regulations provide that an entity’s claimed classification will be respected for prior periods if:
the entity had a reasonable basis (within the meaning of section 6662) for its claimed classification,
the entity and all owners recognized the federal tax consequences of any change in classification within 60 months prior to January 1, 1997; and,
neither the entity nor its owners had been advised that the entity was under examination on or before May 8, 1996.
The prior regulations are relevant under the new regulations in determining the default classification of foreign eligible entities in existence prior to January 1, 1997 with no claimed classification. See section 7.3.1(8).
When it is necessary to classify a foreign form of business organization for tax years before January 1, 1997, if there is any doubt as to the proper classification, an IE should consider requesting technical advice.
Technical assistance on the application of the check-the-box classification regime is available from the Office of Chief Counsel and from the responsible International Technical Advisor.