What Foreign Nationals Relocating to the U.S. Needs to Know About the Check-the-Box Rules

 By Anthony Diosdi

Once a foreign national immigrates to the United States, he or she will likely become a U.S. person for income tax purposes. A U.S. person is subject to U.S. income tax on his or her worldwide income. He or she may also become subject to a comprehensive information reporting regime. This includes the filing of a Form 5471 for any foreign entities treated as a corporation for U.S. tax purposes. The Form 5471 is an incredibly complicated information return that can be costly to prepare. Sometimes an understanding of the U.S. check-the-box rules can result in significant reduction in U.S. tax on foreign holdings and tax compliance savings.

We will begin with a discussion regarding the taxation of U.S. business entities. Foreign nationals may operate domestic entities through a “C” corporation or a “pass-through” entity such as a partnership. Generally, the earnings and profits or “E&P” of a “C” corporation is included in the gross taxable income of a shareholder when a dividend is received. On the other hand, a “pass-through” entity such as a partnership is generally
not considered a taxable entity.  Income attributable to a partnership or other pass-through entity “flows through” to the owners and is taxable to them regardless of whether they receive the income or not.

These rules are also generally applicable to foreign business entities. One would think that a foreign business entity classified as a foreign corporation for U.S. tax purposes would generally only be subject to tax upon the receipt of a dividend or another payment from a foreign corporation, or upon the sale of his or her interest in the foreign corporation or the foreign corporation’s liquidation. The problem is the Internal Revenue Code has a number of anti-deferral tax regimes such as GILTI and subpart F. These taxing regimes are designed to accelerate the recognition of foreign source income. Under the GILTI and subpart F tax regimes, a U.S. person may be required to include his or her share of the foreign corporation’s earnings in his income, regardless of whether the foreign corporation makes any distributions to its shareholders. To make matters worse, in certain cases, U.S. shareholders of foreign corporations cannot utilize a foreign tax credit to reduce his or her exposure to U.S. income tax.

Thus, in certain circumstances, it may be better for a U.S. person to operate a foreign business entity as a pass-through entity rather than a foreign corporation. A foreign entity treated as a pass-through entity may avoid the GILTI and subpart F tax regimes. A U.S. person operating a foreign business as a pass-through entity may also qualify to claim foreign tax credits to offset U.S. income.

Whether or not a foreign business entity should be treated as a foreign corporation or a pass-through entity often depends on how the Treasury Regulations classify the entity for U.S. tax purposes. Pursuant to Treas Reg. Section 301.7701-2 and 301.7701-3 (the “Check-the-Box Regulations”), certain foreign business entities are “per se” (i.e., automatically) foreign corporations. A business entity that is not automatically classified as a corporation can elect its classification for U.S. tax purposes under certain circumstances.

In general, the Check-the-Box Regulations allow taxpayers to choose the U.S. classification of a foreign business entity that is not on the “per se” corporation list of Section 301.7701-2 (a “foreign Eligible Business Entity”). See 301.7701-2(b).
If a Foreign Eligible Business Entity does not make an election, certain default rules determine the U.S. tax classification of the entity. A Foreign Eligible Business Entity can be classified as: 1) a corporation when all members have “limited liability;” 2) a partnership when one or more members do not have “limited liability;” or 3) a disregarded entity when a single member owner does not have “limited liability.” See Treas. Reg. Section 301.7701-3(b)(2). A foreign business entity that is on the “per se” corporation list of the Check-the-Box Regulations must be so classified for U.S. tax purposes. See Treas. Reg. Section 301.7701-2(b)(8) and Treas. Reg. Section 301.7701-3(a).

In applying these rules, Treasury Regulation Section 301.7701-2(b)(8) provides a list of foreign entities that will be treated as corporations for U.S. tax purposes. If the foreign entity is on that list, it must be treated as a foreign corporation for U.S. tax purposes. If, on the other hand, if a foreign entity is not in that list, Treasury Regulation Section 301.7701-3(b)(2) should be consulted. This regulation provides a relatively comprehensive list of foreign entities that will be treated as per se corporations, and, unless an election to the contrary is timely filed, the foreign organization may be treated as a partnership or a disregarded entity that is separate from its owner.

A Foreign Eligible Business Entity may also elect to change its default classification by filing Form 8832, “Entity Classification Election,” generally limited to one such election in any 60-month period (with an exception existing for newly formed entities). In general, this election must be filed within 75 days of the date of the desired classification.

It is extremely important not to assume a foreign entity should be classified as a corporation for U.S. tax purposes. The Check-the-Box Regulations should always be reviewed to determine how a foreign entity should be classified for U.S. tax purposes. Doing so may result in significant tax and compliance savings.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.