The Tax Classification in the US

Change in US Tax 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.

 

Unchecking the Box for tax reasons

 

President Obama looks anxious to revive a controversial pronouncement emanating from the Internal Revenue Service which was issued — and almost immediately discredited — during the Clinton years: The notorious Notice 98-11, 1998-1 C.B. 433. The aim of the notice was to prevent multinational corporations from "abusing" the so-called "check-the-box option." The option allowed flows of passive income between controlled foreign corporations (CFCs) disappear for purposes of the Subpart F rules. The best way to understand the President's plans is to review the facts and conclusions set forth in Notice 98-11, the principles of which the President has made clear he seeks to resuscitate.

 

Notice 98-11 sought to repair the hole in Subpart F created by the so-called "hybrid branch" strategy. The notice explains that a hybrid branch is one that is viewed, under U.S. tax principles, to be part of the CFC. Specifically, the branch is seen, therefore is "fiscally transparent." However, under the laws of the CFC's country of incorporation, a  hybrid branch is regarded as an entity separate from the CFC, so it is seen as "non-fiscally transparent."

Notice 98-11 notes that Subpart F was enacted — at the behest of President Kennedy in the Revenue Act of 1962 — to limit the deferral of U.S. taxation of certain income earned outside of the U.S. by CFCs. Limited deferral, however, was retained "to protect the competitiveness" of CFCs doing business overseas." Under the tax code, transactions of CFCs that involve related persons frequently give rise to "Subpart F income" unless an exception applies.

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