Abstract: The introduction of the Trump reforms is reshaping the way businesses and private clients analyse entity choice within the US and abroad. The way US corporations and flow-through entities are classified and taxed, and the choices available to taxpayers, have always created planning opportunities for Australian businesses expanding into the US and families investing in the US. Under the US “check-the-box” (CTB) regime, eligible entities such as limited liability companies, Australian general and limited partnerships, Australian unit trusts and Australian proprietary limited companies can elect for their tax classification as either a corporation or transparent entity, subject to certain requirements. This article provides an overview of the CTB regime and the US income tax issues that drive entity choice. This is important for Australian businesses who are expanding into the US and families that are investing in the US, with particular focus on the new tax reform rules introduced by President Trump.
The United States (US) taxes business entities based on how they are classified for income tax purposes. This is determined by the “check-the-box” (CTB) regime.
Under the regime, eligible entities1 such as limited liability companies (LLCs), Australian general and limited partnerships, Australian unit trusts2 and Australian proprietary limited companies can elect for their tax classification as either a corporation or transparent entity, subject to certain requirements.
This article will provide an overview of the CTB regime and the US income tax issues that drive entity choice. This is important for Australian businesses who are expanding into the US and families that are investing in the US, with particular focus on the new tax reform rules introduced by President Trump through H.R.1 – An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 (Bill and Trump reforms).
Prior to the CTB regulations, the US had a set of rules called the Kintner regulations,3 which set the criteria for classifying an unincorporated entity as either an association, partnership or trust. The Kintner regulations provided the “six factor test” detailing characteristics that resemble a corporation. An entity had to merely resemble, but not be identical to, a corporation to be classified as a corporation. As this required an examination of the facts and circumstances concerning each entity, classifying the tax status of an entity could be a complex task.
In 1996, the Internal Revenue Service (IRS) replaced the Kintner regulations with the CTB regulations in an attempt to simplify and improve the way in which unincorporated companies were classified for tax purposes.
Under the CTB regulations, entities classified as “per se” entities (generally public listed companies) are always regarded as corporations and thus are unable to elect their tax status. All other entities that are “eligible entities” (discussed further below) can choose their own tax classification. This includes an entity that is a foreign eligible entity.2
Despite the advantages that the CTB regime provides, where a taxpayer has not considered the application of the CTB regime and its tax consequences for any foreign-owned entities, there can be unintended tax consequences, lost opportunities and even hefty penalties for non-compliance of reporting requirements.
To be able to make an election under the CTB regime, the entity must first be considered an eligible entity. The CTB regulations provide that all “business entities” other than those classified as corporations for federal tax purposes (ie per se entities) are eligible entities and may elect their tax status.4 A “business entity” is an entity not classified as a trust or otherwise subject to special treatment under the Internal Revenue Code (code).
The CTB regime provides a default classification for eligible entities, which differs depending on whether an eligible entity is domestic or foreign. The default classification for foreign eligible entities comes down to whether the member or members have limited liability. A foreign eligible entity will be taxed as a corporation for US purposes if all of its members have limited liability; a partnership if it has two or more members and at least one member does not have limited liability; and a disregarded entity (ie flow-through) if it has a single owner that does not have limited liability.2
An eligible entity can make a CTB election to elect out of the default classifications to be taxed as either a flow-through tax entity or as a corporation.5 Whether the election is an “initial election” or “change of entity” election can have a major impact on the tax consequences for the entities members.
Where an LLC (which by default is a flow-through entity) “checks the box”, it means that the LLC has elected to be taxed as a corporation.
An initial entity classification election is for a newly formed entity and must generally be made within 75 days of formation.6 In the context of foreign eligible entities, the initial classification is determined as of the date the entity becomes “relevant” for US tax purposes and will only have a classification once it becomes relevant. Essentially, an entity does not exist in the US system until it becomes relevant and therefore an initial election can be made to choose its tax classification as if it was a newly established entity.
Whether a foreign entity is relevant is defined in the code as being when its classification affects the liability of any person for US federal tax or information purposes. For example, a foreign entity’s classification would be relevant if US income was paid to the entity, and the amount to be withheld would vary depending on whether the entity is classified as a partnership or a corporation.7 The date classification becomes relevant is the date on which an obligation arises to file a US tax return or information return. For example, the date an interest in an entity is acquired will require a US person to file information return form 5471 (information return with respect to certain foreign corporations).8
An entity whose initial classification is determined under the default rules will generally retain that classification until the entity makes an election to change its classification. If an eligible entity makes an election to change its classification, the entity cannot change its classification again for 60 months.9 However, an exception may apply where there has been a change in ownership of greater than 50% in the entity.
A change of entity classification election differs from an initial election in that it applies to an entity that is already relevant to the US tax system and will be classified as either a corporation or a flow-through entity under the code. It is very important to note that a change of entity classification from a corporation to a flow-through entity will trigger a liquidation event and a potential liability for tax. It will also result in a step-up in basis equal to the market value of the corporation on that date. As such, where used correctly, this can be an effective tool for migrating foreign held assets into the US tax system. The timing of “relevance” in determining whether a foreign entity classification election is an initial election or change of entity election is an important process in analysing the tax implications for a “foreign eligible entity”.
The introduction of the Trump reforms is reshaping the way businesses and private clients analyse entity choice within the US and abroad. The federal corporate tax rate reduction of 14% (ie from 35% to 21%) and the movement of the US to a modified territorial corporate tax regime (rather than a regime that taxes corporations on a worldwide basis) through the introduction of a participation exemption10 is resulting in the US being considered as a competitive holding company jurisdiction for the first time in history.
Taxpayers are once again asking the question whether being taxed as a corporation is more tax effective than being taxed on a flow-through basis.
When considering what US business entity is best for a given circumstance, the two most common entities that impact Australian businesses and Australian families investing in the US are C corporations and LLCs.
The choice of entity is always driven by the commercial objectives of a client. Does a client wish to build a business or develop an asset class for sale or build a long-term passive income stream?
Prior to the Trump reforms, and subject to a broad range of issues that could alter our advice, we would often recommend that an Australian-owned US operational business be run via a C corporation because the ability to retain profits within a C corporation was often preferred to the benefits of flow-through, where profit distributions11 were not required. Practically, this approach also simplifies tax administration because Australian stockholders of C corporations are not required to lodge US returns. However, for Australian shareholders, choosing corporate (rather than flow-through) taxation in the US would come at the cost of very high combined US and Australian tax rates applying to US profits distributed to Australian shareholders.12 Consequently for private clients, considerable analysis was required to inform the choice between flow-through or corporate taxation.
By contrast, we often preferred that US passive investments or passive assets (ie real estate) be owned via an LLC because of the ability of the LLC to flow-through investment yields to the underlying Australian individual members facilitating the claiming of foreign income tax offsets and mitigating the impact of double taxation.
While both LLCs and corporations will continue to have their advantages, the Trump reforms now require taxpayers and their advisers to reconsider past strategies and to decide whether for entity selection they should “check the box”. The significant reduction in US corporate tax means that the benefit of accumulation may now be so compelling that many LLCs that had previously elected for flow-through taxation choose to be taxed
as a corporation.
The two tax reforms that will impact entity structure for businesses and high net worth families are: (1) the reduced corporate tax rate of 21%; and (2) the 20% deduction for qualified business income derived by flow-through entities.13
The changes have introduced a permanent reduction in the federal corporate tax imposed on a C corporation’s taxable income to a flat tax rate of 21%. This reform means that the corporate tax rate is lower than the highest federal marginal tax rate for an individual. It should be noted that the company profits may also be subject to state income tax and, if dividends are declared to shareholders, taxed again on the distribution of dividends to shareholders.
The reduction in corporate tax provides significant additional advantages for companies.14 This is particularly important for small businesses and high-growth companies that will often re-invest profits of the company back into the business.
This change shifts the US corporate tax system from being a high tax holding company jurisdiction to a globally competitive corporate tax jurisdiction.
Despite the obvious benefits of a corporate tax rate reduction, the new 20% deduction for “qualified business income” derived by “qualified businesses” should also be considered for flow-through entities in determining the appropriate structure.
For tax years beginning after 31 December 2017, a deduction of 20% is allowed for taxpayers who have domestic “qualified business income” from a pass-through or sole-proprietorship engaged in a “qualified trade or business”.15 The purpose of the new 20% deduction is to ensure that flow-through entities that derive qualified business income are more tax efficient on an after-tax basis than corporations. It is noted that the 20% deduction available for qualified businesses is subject to the W-2 wage and qualified property limitations, which are discussed further below.
To be classified as qualified business income, the income must be effectively connected to a “qualified trade or business” (discussed below) and is not (inter alia):
In essence, qualified business income encompasses all business income other than investment income and compensation payments.
Furthermore, to utilise the deduction, the entity must be a “qualified trade or business”. A qualified trade or business specifically excludes any trade or business other than a specified trade or business,16 a trade or business of performing services as an employee, a trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners, or which involves the performance of services that consist of investing and investment management, trading or dealing in securities.
For the purposes of these rules, a specified trade or business under this Bill includes any trade or business income involving the performance of services in the fields of:
The deductible amount for those who qualify for the 20% deduction will be limited to 50% of the taxpayer’s pro-rata share of W-2 wages paid by the flow-through entity, or 25% of W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (which is all tangible depreciable property). As such, the benefit of the 20% deduction for certain business income will generally only be material where the business has a substantial number of employees or plant and equipment such as to maximise the benefit of the 20% deduction.
The way US corporations and flow-through entities are classified and taxed and the choices available to taxpayers has always created planning opportunities for Australian businesses expanding into the US and families investing in the US.
More recently, the Trump reforms are now reshaping how we analyse and compare US structural choices. While careful consideration of the issues will continue to be necessary, the significantly lower tax rate has established a clear case for corporate taxation where a company is high growth and is looking for capital growth over passive income. That should lead to less complex affairs for Australians who might otherwise have had an undue bias towards the use of LLCs as flow-through entities.
Peter MA Harper
CST Tax Advisors
CST Tax Advisors
CST Tax Advisors
CST Tax Advisors
1 S 301.7701-2(b)(8)(iii) of the Internal Revenue Code (US) (excludes publically limited companies).
2 S 301.7701-3(b)(2) of the Internal Revenue Code.
3 Former s 301.7701-4 of the Internal Revenue Code from the leading case at the time of United States v Kintner, 216 F.2d 418 (9th Cir. 1954).
4 S 301.7701-2(a)&(b) of the Internal Revenue Code.
5 Elections are made on IRS form 8832: entity classification election.
6 In some circumstances, may make a late election which can be made retrospectively to an effective date within three years and 75 days.
7 S 301.7701-3(d)(1)(i) of the Internal Revenue Code.
8 S 301.7701-3(d)(1)(ii)(A) of the Internal Revenue Code.
9 S 301.7701-3(c) of the Internal Revenue Code.
10 S 245A of the Internal Revenue Code.
11 By “profit distribution”, it is meant profit distributed to the underlying owner. A dividend paid from a US C corporation that is an active business that is wholly owned by an Australian company will be subject to 5% withholding tax (reduced from 30% under the US–Australia income tax treaty) and be non-assessable non-exempt income under Subdiv 768-A of the Income Tax Assessment Act 1997 (Cth). The subsequent declaration of a dividend by the Australian company will be unfranked in the hands of the Australian shareholders.
12 For example, the profits of an Australian-owned Delaware corporation carrying on a business in California would bear tax at rates as high as 8.84% if the profits were fully paid out to Australian resident individual shareholders (assuming top marginal rates apply in Australia).
13 Flow-through entities that are deriving qualified business income.
14 It is noted that there is a possible “accumulated earnings tax” which is imposed on companies with retained earnings deemed to be unreasonable and in excess of what is considered ordinary.
15 The deduction against qualified business income is set to expire after 31 December 2025.
16 As defined in s 1202(e)(3)(A) of the Internal Revenue Code.