How is my interest classified for US tax purposes?
By Patrick J. McCormick, Drucker & Scaccetti
A threshold consideration sometimes inadequately explored by practitioners is how a foreign structure will be classified under United States tax rules. Frequently, advisors defer to foreign classification without fully examining details that could dictate alternative United States results. This article explores methods for determining classification, options for altering the default classification of an entity, implications of certain classification types, and considerations where the choice of entity classification is possible.
Existence of a Foreign Entity
It is vital to emphasise that the classification of an organisation in its home jurisdiction does not dictate its treatment in the United States. Internal Revenue Code provisions, rather than home country classifications, are dispositive as to how an organisation is treated for United States tax purposes. Circumstances can thus arise where, for example, a structure designated as a “trust” under rules of its home jurisdiction is treated as something entirely different under United States rules (i.e. a foreign corporation); cognisance of this fact is critical.
Is It a Trust?
New entities it is commonly classified under the US Regulations as either "trusts" or as business entities. For US tax purposes, a “trust” is an arrangement whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Importantly, the definition notes that trusts “vest in trustees’ responsibility for the protection and conservation of the property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” Whether a foreign structure will constitute a “trust” is inherently fact-specific; an organisation being nominally set up in trust form will not change the structure’s real character.
Foreign Business Entities
If an organisation exists, but it is not a trust, it is likely to be treated as a business entity; a business entity is any entity that is not classified as a trust or otherwise subject to special treatment. There are three types of business entities: disregarded entities, partnerships, and associations taxable as corporations.
Default rules for foreign entity classification are provided, hinging on the limited liability of the organisation’s members/owner. A foreign entity is classified as a partnership where it has two or more members, and at least one does not have limited liability. When the entity has a sole owner without limited liability, it is a disregarded entity (partnerships and disregarded entities are often termed “flowthroughs”). See 26 CFR § 301.7701-3(b)(2).
Conversely, where all owners maintain limited liability, the entity is classified as an association (with associations taxable as corporations). Whether limited liability exists, it is dictated by the local law of the entity’s place of formation.
Elections can ordinarily be made to override these default classifications. An entity with a single owner can commonly elect to be taxed either as a disregarded entity or as a corporation, and an entity with multiple members can ordinarily elect to be taxed either as a partnership or as a corporation. See 26 CFR § 301.7701-3(a).
Importantly, this ability to elect treatment applies only to business entities; it does not allow a foreign trust to elect treatment as a business entity.
Entity Classification Ramifications
Classification of a business entity significantly impacts its United States tax treatment, both at the entity and shareholder level (special United States tax rules apply to foreign trusts). For business entities, owners of foreign "flowthroughs" are usually directly responsible for income items of the entity. For entities classified as foreign corporations, separate entity status is respected, with the entity – rather than its owners – treated as income recipients.
Special rules, however, create current inclusion of specified income items for United States shareholders of foreign corporations. Historically, the primary method for current inclusion has been Subpart F, under which certain “movable” income items of controlled foreign corporations are included in the income of a United States shareholder in the year of receipt by the foreign corporation. The Tax Cuts and Jobs Act implemented Code Section 951A, under which each United States shareholder of a CFC must include in their current gross income their share of global intangible low-taxed income (“GILTI”) of the CFC. See 26 USC § 951A(a).
In addition to GILTI and Subpart F, passive foreign investment company holdings are subject to punitive tax ramifications under default rules: holders of PFICs are taxed on any excess distribution or disposition at the top marginal tax rates for individual taxpayers (with gains taxed as ordinary income), plus interest amounts calculated based on the taxpayer’s holding period. See 26 USC § 1291(a).
The previously mentioned rules apply only if an entity is classified as a foreign corporation; when an entity is treated for United States tax purposes as a "flowthrough", these rules are inapplicable. However, this is because the CFC/PFIC rules are intended to deter deferral of income recognition; where an entity is treated as a "flowthrough", no deferral option exists.
Optimal classification of a foreign business entity is not universal. Determinations often incorporate weighing the impact of reporting requirements and deferral availability of corporate status with the relative simplicity – but eschewal of deferral opportunities – associated with flowthrough treatment. Classification of the foreign entity in its home jurisdiction can be another vital factor to consider, based on how home country status will affect United States requirements.
This article is a reworked version of an article originally published by the author in the 12 November 2018 issue of Tax Notes.
Patrick J. McCormickDrucker & Scaccetti, P.C., Philadelphia, PA, USA
T: +1 215 665 3960
Patrick is a principal and attorney at Drucker & Scaccetti (D&S) who focuses on international taxation and related issues for domestic businesses and individuals. He has extensive experience in handling complex tax planning and tax controversy issues as well as the design, drafting and implementation of estate and gifting plans for American citizens and residents with foreign assets. He also helps clients with retroactive disclosures and assessments related to international assets.
Published: January 2019 l Photo: f11photo - stock.adobe.com