In short, a “check-the-box” election is an entity classification election that is made on I.R.S. Form 8832, Entity Classification Election. The procedure to make a check-the-box election is quite easy. You simply check the appropriate box, specify the date that the election is to be effective, sign and file the form.
Be aware, however, that the tax implications of making such an election can be extremely significant. It is therefore very important that taxpayers speak with a tax adviser to discuss the implications of making such an election before the election is made.
Per Se Corporations
Only “eligible entities” can make check-the-box elections. The regulations contain a list of the types of entities that are not eligible entities. Treas. Reg. § 301.7701-2(b). These non-eligible entities must be treated as corporations and are often referred to as “per se” corporations.
In the domestic context, an entity organized as a “corporation” or as “incorporated” under a federal or state statute would be a per se corporation. For foreign entities, a country-by-country list is provided in the regulations that specifies the per se corporations for each country. Typically, S.A.s, N.V.s, P.L.C.s, and A.G.s are per se corporations.
Default Entity Classifications
There are three possible U.S. tax classifications for “business entities” --- corporation, partnership, or disregarded entity. The regulations provide default classification rules for eligible entities (i.e., non-per se corporations) that do not make check-the-box elections. Treas. Reg. § 301.7701-3(b).
A U.S. domestic “eligible entity” defaults to be treated as a partnership if the entity has more than one owner and as a disregarded entity (similar to a sole proprietorship for individuals or to a branch or a division for corporations) if the entity has only one owner.
For instance, if a U.S. L.L.C. is created with two owners and no check-the-box election is filed, the entity will default to be treated as a partnership. If the U.S. L.L.C. only has one owner and no check-the-box election is filed, it will default to be treated as a disregarded entity.
The default classification rule for non-U.S. entities is different. It is often assumed by taxpayers and their domestic tax advisers that a foreign entity that is similar to a U.S. L.L.C. will default to be treated as a partnership or disregarded entity (as would be the case for a U.S. L.L.C.). However, foreign L.L.C.s almost always default to be treated as corporations.
The rule for a foreign eligible entity is that it will default to be treated as:
- a corporation if all of its owners have limited liability,
- a partnership if it has two or more owners and at least one owner does not have limited liability, and
- a disregarded entity if it has a single owner that does not have limited liability.
When an entity is initially formed, it will obtain an “initial classification.” This initial classification can be determined under the default rules or it can be determined as a result of a check-the-box election. Check-the-box elections can generally only be retroactive 75 days from the date of filing (certain late elections may also be allowed). Thus, if no election is made within 75 days of establishing an entity, the default classification will apply.
In the foreign context, this can be problematic where the entity defaults to be treated as a corporation (the typical situation) and the owners would prefer that the entity be treated as a partnership or a disregarded entity, but the owners did not in advance seek the advice of a tax advisor knowledgeable in this area.
Change in Classification
It is important for the taxpayer to understand the tax implications of changes in an entity’s classification. If an entity changes its classification from a corporation to either a partnership or a disregarded entity, the transaction will often be a taxable liquidation. A taxable liquidation triggers gain or loss to both the corporation and to the shareholder(s). For a foreign entity, gain at the corporate level can trigger Subpart F Income and gain at the shareholder level is often taxed as ordinary income.
Although it may be very simple to file Form 8832 and change the classification of an entity, the tax costs can be immense. Taxpayers are well advised to speak with a knowledgeable tax advisor prior to the filing of any check-the-box election.