IRS Issues Private Letter Ruling Allowing Late “Check-The-Box” Election For Foreign Entity

Through the early 1990s, there was significant dispute over the U.S. tax classification of a foreign legal entity. Foreign legal entities have characteristics that often differ from U.S. legal entities which U.S. taxpayers are accustom to, like corporations, partnerships, sole proprietorship, and more recently, Limited Liability entities of various types, under U.S. state laws which we are trained to understand.

Tax planners and taxpayers had to apply a maze of regulations and case law to determine if a particular foreign legal entity fit the mold of a corporation or a partnership for U.S. tax purposes. This is/was an extremely important determination as the taxation of income by a U.S. shareholder, partner or trust was dependent on whether a foreign legal entity was allowed the “flow-through” treatment of a partnership of taxable income and foreign tax credits, or the deferral of such items until a “distribution” of earnings and profits is received from a corporation. The complexities grew as tax planners would establish chains of legal entities (often under a tax-haven holding company) and the questions of what taxable income and credits flowed up to which legal entity in a particular year was the subject of full-time work for many tax planners and tax return preparers.

Thankfully, the law was changed to allow a foreign legal entity (with some restrictions) to be classified as whatever a U.S. shareholder wanted amongst the choices of a Corporation (“C” not “S”), a partnership, or a “disregarded entity” which is treated as a mere branch. This was accomplished by either doing nothing and having a “default” classification under the regulations apply, or by filing Form 8832 (AKA, the “check the box” election) to, if qualified, elect a different classification. The ability to tax plan with certainty of the I.R.S.’s agreement with the desired classification is a great tool for tax planners. Unlike the old days, where Private Letter Rulings were obtained in large, sensitive situations (in some cases the I.R.S. would not even provide rulings on this subject), now, a U.S. shareholder group or sole shareholder can file Form 8832 and get a clear, unambiguous, definitive letter back from the I.R.S. stating that the classification of the foreign legal entity by the taxpayer is accepted. No IRS “user fee” is required for the processing of Form 8832, unlike a Private Letter Ruling these days. Such an election is binding for 5 years, so the I.R.S. is not “whipsawed” by taxpayers switching classifications when it best suits their tax reduction desires.

The classification of a foreign legal entity impacts Subpart F calculations, PFIC calculations, Form 5471 reporting requirements, Form 8858 reporting requirements, Form 1118 Foreign Tax Credit calculations, the U.S. tax impact of overseas reorganizations, Cost-Sharing and Transfer Pricing calculations, Form 926 disclosures, FAS 109 and FIN 48 calculations (and their related financial statement impact on earnings per share), a company’s long-term dividend repatriation policy, and on and on.

Form 8832 must be filed with the U.S. taxpayer’s service center and can be effective up to seventy-five days prior to the date the form is filed or up to twelve months after the date the form is filed. Great care must be given to the filing of this form and the timing. It is best to file the form at the creation of the legal entity as the form triggers a deemed liquidation of fair market value to the U.S. shareholder or foreign parent company which can clearly trigger taxable income for FMV in excess of the shareholders tax basis in the foreign entity’s equity. The legal tax fiction under the law is that the foreign entity is immediately re-established after the deemed liquidation into the newly elected type of entity. So, again, take great care in making this election.

So, therein lies the problem. Often clients don’t tell their tax advisor about the existence of the new entity (e.g., “the sales guys set this up”) until sometime after 75 days has passed from the creation of the entity or from the beginning of the tax year.

An expensive, unintended tax result may occur simply from the lack of a timely filed Form 8832. Clients either have no idea of the tax issues involved, or assume that a timely election can be filed with the U.S. shareholder’s tax return for the tax year within which the foreign legal entity was established…generally due March 15th of the following year for a calendar year corporation…before the normal 6 month extension for large corporation. Hence, the discovery of this issue in September of, say, 2009 as the extended return is finalized for filing on September 15th, for an entity set-up in, say, March of 2008, is a big problem.

Private Letter Ruling 200916013 (issued January 8, 2009) gave a taxpayer an additional 60 days from the date of the PLR to make a late election. The PLR is the exercise the of the Commissioner’s authority under Internal Revenue Code Section 301.9100-1(c) to allow a “reasonable” extension. The extension in the letter ruling states the “taxpayer established to the satisfaction of the Commissioner that (1) the taxpayer acted reasonably and in good faith (which I read to mean it was just an honest mistake), and (2) granting relief will not prejudice the interest of the government.

It would be interesting to know more about how the Commissioner makes such a determination. If the U.S. tax due from the U.S. shareholder would have been $1 million without the extension, but is zero due with the extension, does that “prejudice the interest of the government? Or is the interest of the government served by allowing the taxpayer his choice of entity, as he is then stuck with that classification for 5 years. The PLR does not elaborate on this issue. Perhaps more guidance is in the Sec. 9100 regulations. Is the taxpayer required to provide a “with and without” calculation of U.S. taxable income to allow the Commissioner to make his determination?

That said, it is important to know that a PLR seeking Sec. 9100 relief is available as a last resort if the deadline for filing Form 8832 has been missed. I’d imagine that the PLR filing should be IMMEDIATELY after discovering the missed filing of Form 8832, since, as time passes, it would seem to establish the taxpayer knew what they were doing and intended to do so. Often in Sec. 9100 cases, the taxpayer pleads that they had no idea of the rules and were relying upon their tax advisor who was too busy to identify the issue until, in the tax return preparation process, the tax advisor realizes the consequences of the missed election and/or discovers that the new legal entity was established…long ago.

Often, the legal department of a corporation is required to inform the tax department or tax advisor of the creation of any new legal entity, in an effort to avoid the above and many other tax planning and tax compliance issues that can arise, when, too late, the tax advisor for a client becomes aware of a new legal entity. Various companies have SOX related requirement to avoid big mistakes that could be material to the financial statements (not to mention cash-flow) as a result of a missed tax election.

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