Entity classification election

For United States income tax purposes, a business entity may elect to be treated either as a corporation or as other than a corporation.[1] This entity classification election is made by filing Internal Revenue Service Form 8832. Absent filing the form, a default classification applies. U.S. corporations of the type that can be publicly traded must be treated as corporations. There is a list of specific foreign entities that must be treated as corporations.[2] The election is effective for Federal income tax purposes.

If an entity is not classified as a corporation, it is treated as a partnership for U.S. tax purposes if it has more than one owner, or is treated as a "disregarded entity" if it has a single owner (i.e. is treated as part of the single owner).

The classification of either a U.S. or non-U.S. entity for U.S. tax purposes has no effect for purposes other than U.S. income tax.

Eligibility to make an election

An entity, which is eligible to make an election, is referred to as an eligible entity. Generally, a corporation organized under U.S. federal or state statute (and referred to as a corporation, body corporate or body politic by that statute) is not an eligible entity. However, the following types of business entity are treated as eligible entities:

The list of foreign entities classified as corporations for federal tax purposes (so called per se corporations, not eligible to make an entity classification election) includes, as of September 2009:[3]

In 2013, the IRS added a Croatian dioničko društvo to the list of per se corporations.[4]

• 1) An eligible entity that previously elected to be an association taxable as a corporation by filing Form 8832. An entity that elects to be classified as a corporation by filing Form 8832 can make another election to change its classification, subject to the 60-month limitation rule.
• 2) A foreign eligible entity that became an association taxable as a corporation under the foreign default rule described below.
• 3) A foreign corporation that is not identified as a corporation under

Default classification

An eligible entity is classified for federal tax purposes under the default rules described below unless it files Form 8832 or Form 2553, Election by a Small Business Corporation, to elect a classification or change its current classification. The IRS uses the information entered on the form to establish the entity's filing and reporting requirements for federal tax purposes.[5] Certain domestic and foreign entities that were in existence before January 1, 1997, and have an established federal tax classification generally do not need to make an election to continue that classification. If an existing entity decides to change its classification, it may do so subject to the 60-month limitation rule.[6]

Unless an election is made on Form 8832, a domestic eligible entity will be classified by default as:[5]

Unless an election is made on Form 8832, a foreign eligible entity will be classified by default as:[5]

The effect of these rules is that a U.S. limited liability company (LLC) or

Use in international tax planning

The "check-the-box" regulations paved the way for various new tax avoidance and tax deferral strategies.[8] Specifically, they expanded the opportunity for "hybrid branch" or "hybrid entity" strategies, which take advantage of differences in the classification of an entity as a corporation or not in multiple jurisdictions, in order to engage in cross-border tax arbitrage. The possibility that the check-the-box rules would greatly expand the potential for such strategies had been pointed out prior to implementation, and at one point some commentators suggested disallowing foreign entities from electing their classification at all; however, in the end, the IRS, while acknowledging such concerns, issued regulations which gave foreign and domestic entities largely similar powers to elect their own classification.

US owners of foreign subsidiaries benefit from the ability to have those foreign subsidiaries treated as disregarded entities. Under the United States' Internal Revenue Code Subpart F, payments between related Controlled Foreign Corporations (CFCs), or from American companies to related CFCs, may be "treated as Subpart F income" (subject to current taxation as if they were profits in the hands of the ultimate American owner of the corporate structure), in an effort to limit the ability of American citizens and corporations to defer US tax on the income of foreign corporations they control. However, payments between an American-owned foreign entity which is taxed as a corporation, and a foreign subsidiary of that entity which itself has elected to be treated as a disregarded entity, are not treated as Subpart F income.[8]

History

Prior to 1996, whether domestic and foreign entities were classified as corporations was based on a six-factor test which looked at:[12]

An entity which had a preponderance of the first four factors (the last two, in practice, were shared by all business entities) was treated as a corporation, otherwise as a partnership or an association.[13] In practice, however, this test was easily manipulated.[12]

The "check-the-box" regulations (Treasury Decision 8697) were adopted in 1996 in order to simplify the issue of entity classification. A grandfather clause allowed entities in existence on May 8, 1996 to continue using their previous classification, even if they would no longer be eligible to elect that classification under the new rules.[14] There were three conditions for this grandfathering:[13]