Stay Ahead of the Curve When Choosing Desired Tax Treatment

Daily Journal

A foreigner starting business in the U.S. usually hires attorneys for visas, leases and licenses. The tax advisor comes later, when returns loom. This tendency is unfortunate because entering the U.S. starts the clock for many tax filing and compliance deadlines, one of which is filing an IRS Form 8832 (Entity Classification Election).

Tax advisors call Form 8832 a "check-the-box" election because the client actually does check a box whether the business entity should be a "corporation," "partnership" or "disregarded entity" for tax purposes. This mundane election assumed a semi-starring role in a drama which started with what appears to have been some aggressive early- 2000s tax planning (evoking Tom Cruise's sit-down with Sonny Capps in the movie "The Firm") and has morphed into a tug-of-war between the IRS and U.S. Virgin Islands and a split between the federal circuits.

The Internal Revenue Code has its own way of treating business entities, such as corporations or partnerships, for tax purposes. The code adds the concept of an "association taxable as a corporation," because Congress did not want taxpayers forming unincorporated entities (like business trusts) that looked like corporations but weren't taxed like corporations. As states developed new business entities like limited partnerships and limited liability companies, tax lawyers and the IRS engaged in increasingly Laputa-like analysis (a.k.a the "four factors") as to whether an unincorporated entity was an "association" or "partnership."

In the mid-1990s, the IRS junked the "four factors" and issued the check-the-box regulations. These regulations start by providing that a "corporation" under U.S. law is always a "corporation" for tax purposes. Further, certain business entities under foreign laws - "per se corporations" - are always corporations for U.S. tax purposes. The regulations and Form 8832 instructions list per se corporations by country. If the entity is neither a U.S. corporation nor a foreign per se corporation, then the entity can make a check-the-box election.

If the eligible entity is formed in the U.S., and unless it elects to be treated as an association, its default treatment is as a partnership if it has two or more owners and a disregarded entity if it has one owner. A disregarded entity is treated as if it does not exist separate from its owner for tax purposes, even though it is a viable independent entity for state law purposes.

If the eligible entity is formed outside the U.S., then if (1) it has two or more owners and at least one owner has unlimited liability for the entity's debts, its default treatment is as a partnership unless it elects to be an association; (2) it has two or more owners and all owners have limited liability, its default treatment is as an association unless it elects to be a partnership; or (3) it has one owner with unlimited liability, its default treatment is as a disregarded entity unless it elects to be an association.

The genesis of the IRS-Virgin Island tug-of-war is that Virgin Islands residents satisfy their tax obligations by filing solely with the Virgin Islands Bureau of Internal Revenue and paying taxes on their worldwide income to the Virgin Islands and by doing so do not have to file with the IRS or pay any taxes to the U.S. federal government. Several individuals filed with the Virgin Islands, but the IRS asserted that they were not bona fide Virgin Islands residents and sent notices of tax deficiencies to all of them. One of these individuals (in George Huff v. Commissioner) argued that he was a member of a Virgin Islands entity that was a partnership for U.S. tax purposes and, therefore, the IRS's deficiency notice was invalid because it should have proceeded through an audit of the partnership return and not against the individual directly.

The Tax Court rejected this argument, noting that under check-the-box the Virgin Islands entity's default treatment was as an association and therefore the rules requiring the IRS to first proceed via an audit of the partnership did not apply. The Tax Court since then has denied the Virgin Islands' attempt to intervene in these cases (after all, the Virgin Islands wants to keep the money, not give it to the IRS). The 3rd, 8th and 11th U.S. Circuit Courts of Appeals have sided with the Virgin Islands against the IRS and the Tax Court (the 11th Circuit most recently in the consolidated cases of Huff v. Commissioner, McGrogan v. Commissioner and Cooper v. Commissioner in February), but the 4th Circuit has sided with the Tax Court and IRS against the Virgin Islands. Look for this imbroglio to work its way up to the U.S. Supreme Court. What, then, should a practitioner do? First, a non-tax practitioner's engagement should exclude tax advice, and advise the client to retain a tax specialist immediately (not later when returns come due).

Second, the tax advisor must be alert to the "trigger" that starts the clock ticking to make any desired Form 8832 election. A safe rule of thumb is that the trigger for a domestic entity is the formation date, and for a foreign entity when it first enters into a business transaction in the U.S. or when a U.S. taxpayer first acquires an ownership interest in that entity. The deadline for filing an election is 75 days after the trigger date. The IRS, however, allows a taxpayer to make an "automatic" election past that deadline on a Form 8832 so long as the retroactive effective date is not more than three years and 75 days before the date of filing and the taxpayer made an honest attempt to comply with the tax laws. Beyond that "automatic" relief window a taxpayer needs to file a formal request to the IRS's legal department in Washington, D.C. for a ruling allowing the taxpayer to make a late election, and such a ruling request entails attorney fees to prepare and a $6,900 filing fee with the IRS. So, it is best to try to file within the 75 days, and in no event past the 3-year-and-75-day window allowed for a late election in the Form 8832.

Third, the tax advisor should inform the client of the advantages and disadvantages of the different tax treatments as a corporation, partnership or disregarded entity. There is no "right" answer for a client, but the client needs to understand the advantages and disadvantages of the different treatments.

Fourth, if there are two or more advisors, they should agree on who files a desired election. Otherwise the fly ball may drop between the befuddled outfielders.
Fifth, when the client has settled on the desired tax treatment {preferably, within the 75 day deadline) the practitioner should determine whether the form must be filed based on the entity's "default" treatment under check-the-box. A practical approach for a foreign entity is simply to file the election for the desired tax treatment: If the election turns out to be unnecessary (because the foreign entity's default treatment matched the elected treatment anyway), the advisor has wasted a bit of time and a postage stamp.

The Form 8832 is filed by mailing to the IRS center listed in the instructions (Ogden, Utah for California taxpayers) and like all filings of this kind the election should be sent certified mail, return receipt requested. The Form 8832 election is simple, but as in the case of many simple things the consequences can be severe for not doing it right. Non-tax practitioners need to liaise with tax specialists immediately to ensure that this important task does not get fumbled.

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