For U.S. owners of foreign businesses, the choice of legal entity is an essential part of operating efficiently overseas. Most jurisdictions have a variety of entity options (for example, corporation, partnership, trust, etc.) that can offer business owners the desired combination of legal and economic attributes.
\r\nA U.S. owner of a foreign business, whether he or she lives within or outside of the United States, faces the additional challenge of properly applying the U.S. tax rules, both in terms of substance and in terms of compliance, to a non-U.S. entity.
\r\nA chief misconception in this regard is that the classification of a foreign business entity for U.S. tax purposes should follow the classification given under the legal or tax rules of the local jurisdiction. While this seems intuitive, and, in fact, does have some relevance in certain areas of U.S. tax law, the general rule is that the U.S. Internal Revenue Code and Treasury Regulations essentially ignore local law and apply a very specific set of rules to determine the entity's classification for U.S. tax purposes.
\r\nThe fallout from this discrepancy can be that a foreign company has one classification for foreign legal and tax purposes and a completely different classification for U.S. tax purposes.
\r\nA foreign entity on its own generally should not be impacted by the U.S. tax rules, except mainly in the following two cases:
\r\nThe foreign entity has U.S. concerns, such as certain U.S. source income or activities within the U.S. that rise to the level of a U.S. trade or business under the U.S. tax rules; or
\r\nThe foreign entity has a U.S. owner (or member or partner, depending on the type of entity) and such ownership triggers the application of the U.S. tax rules.
\r\nIf either of these cases is true, then determining the U.S. tax classification of the foreign entity becomes essential in understanding how the U.S. tax rules should apply to the entity and/or its U.S. owners.
\r\nIn more practical terms, the tax classification of the foreign entity can have a number of important ramifications, including, for example:
\r\nThe rate of taxation (which may be higher or lower depending on the company's classification);
\r\nThe timing of taxation (a company, for example, treated as a partnership will see its income flow-through currently to its partners);
\r\nThe application of tax deferral regimes, such as controlled foreign corporation and a passive foreign investment company regimes (which can impose harsh rules in the case of foreign entities classified as corporation for U.S. tax purposes); and
\r\nThe extent and breadth of compliance or reporting obligations (additional forms may need to be filed with the IRS or the Treasury Department depending upon the foreign entity's classification for U.S. tax purposes).
\r\nThe tax ramifications of a foreign entity's classification can be particularly tricky when, as described above, the entity has one classification for U.S. tax purposes and another for local foreign tax purposes. In the case of such a so-called “hybrid” entity, the U.S. and foreign tax rules need to be carefully navigated to prevent double taxation or other potentially tax adverse outcomes.
\r\nWhile the U.S. tax classification rules are best applied on a case-by-case basis, there are some general concepts that permeate throughout the more specific regulatory provisions. In order to determine a foreign entity's foreign classification, one can follow this three-step process:
\r\nFirst, and most fundamentally, if your business venture involves a co-party, it should be determined whether or not the arrangement between you and the co-party rises to the level of a foreign \"entity\" (as opposed to just a contractual or co-ownership arrangement).
\r\nSecond, assuming \"entity\" status, you should consider whether the foreign entity should be treated as a trust for tax purposes as opposed to a business entity. In very general terms, Treasury Regulation Section 301.7701-4 describes a trust as an entity the purpose of which generally is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries.
\r\nThird, assuming \"business entity\" status, a final set of technical rules are employed to determine whether such entity has the status of a: (i) corporation, (ii) partnership, or (iii) a disregarded entity. While a corporation is generally subject to an additional layer of taxation (i.e., taxation at the entity and shareholder levels), the income of a partnership and disregarded entity generally \"passes\" or \"flows\" through currently to its partners or members for tax purposes (i.e., taxation only at the partner or member level).
\r\nThe U.S. Treasury regulations contain a set of default classification rules for foreign business entities under Treasury Regulation Section 301.7701-3. A foreign business entity is classified as an association/corporation if all of its members have limited liability, and it is classified as a partnership if it has two or more members and at least one member does not have limited liability. If the foreign business entity has a single owner and that owner does not have limited liability with respect to the entity, then the entity is classified as a disregarded entity for U.S. tax purposes.
\r\nUnder the classification regulations, a so-called \"eligible entity\" is allowed to elect its tax classification. This election, which is often referred to as \"check the box\" election (by virtue of checking the box next to the desired classification on the election Form 8832), cannot take effect more than 75 days before the date the election is filed with the IRS, nor can it take effect later than 12 months after the date of the filing. Non-eligible entities are those listed in the regulations that cannot elect out of corporation status.
\r\nThe ability to choose the tax classification of a foreign business entity offers owners quite a bit of flexibility in terms of structuring foreign business operations in a tax efficient manner. It's important to note, however, that if an election effective date is after the foreign entity's incorporation or creation date, adverse U.S. tax implications may arise. In such case, a tax advisor should be consulted to understand the full tax ramifications of the election both currently and moving forward.
\n","docType":"article","guid":"articles_f1b5a0060ea2a6f8489caa9859c027af","lastModified":"2017-12-12T08:00:00.000Z","published":"2017-12-12T08:00:00.000Z","structuredData":null,"subtitle":"Learn more about the U.S tax classification of foreign business entities.","template":"legacy","title":"A Guide to Foreign Business Entities and Their U.S. Tax Classification","type":"article","author":{"avatar":"https://staging.business.com/images/author/582/333ae3087b17f1bca78fd/100-100","bio":"After spending the majority of their respective careers at two of the largest accounting firms (PwC\r\nand Ernst & Young), Joshua Ashman (jashman@expattaxprofessionals.com) and Ephraim Moss\r\n(emoss@expattaxprofessionals.com) founded Expat Tax Professionals, a firm specializing in the\r\nneeds of U.S. citizens living abroad. You can visit the firm’s website at\r\nwww.expattaxprofessionals.com.","name":"Joshua Ashman Ephraim Moss","image":null,"slug":null,"social":{"facebook":"","linkedin":"","twitter":null,"website":"https://www.expattaxprofessionals.com/"},"status":"enabled","title":null,"type":"Old BDC Member","user":{"imagePath":"https://staging.business.com/images/uploads/user/profile/8a4dab23696c9114c98fde1a7a4579819bb4e.jpg","profile":{"company":"ExpatTax","jobTitle":"","website":"https://www.expattaxprofessionals.com/"}}},"breadcrumbs":null,"channels":{"primary":{"name":"Human Resources","slug":"human-resources"},"sub":{"name":"HR Solutions","slug":"hr-solutions"}},"meta":{"robots":"index, follow","description":"For owners of foreign businesses, U.S. tax rules can be complex. This guide explains the U.S. tax classification of foreign business entities.","title":"Foreign Business Entities and U.S. Tax Classification - business.com"},"parsedContent":{"toc":[{"id":"the-relevance-of-tax-classification","title":"The relevance of tax classification"},{"id":"practical-ramifications","title":"Practical ramifications"},{"id":"starting-point-for-tax-classification","title":"Starting point for tax classification"},{"id":"the-classification-rules-in-a-nutshell","title":"The classification rules in a nutshell"}],"json":[{"component":"p","children":["For U.S. owners of foreign businesses, the choice of legal entity is an essential part of operating efficiently overseas. Most jurisdictions have a variety of entity options (for example, corporation, partnership, trust, etc.) that can offer business owners the desired combination of legal and economic attributes."]},{"component":"p","children":["A U.S. owner of a foreign business, whether he or she lives within or outside of the United States, faces the additional challenge of properly applying the U.S. tax rules, both in terms of substance and in terms of compliance, to a non-U.S. entity."]},{"component":"p","children":["A chief misconception in this regard is that the classification of a foreign business entity for U.S. tax purposes should follow the classification given under the legal or tax rules of the local jurisdiction. While this seems intuitive, and, in fact, does have some relevance in certain areas of U.S. tax law, the general rule is that the U.S. Internal Revenue Code and Treasury Regulations essentially ignore local law and apply a very specific set of rules to determine the entity's classification for U.S. tax purposes."]},{"component":"p","children":["The fallout from this discrepancy can be that a foreign company has one classification for foreign legal and tax purposes and a completely different classification for U.S. tax purposes."]},{"component":"h2","props":{"id":"the-relevance-of-tax-classification"},"children":["The relevance of tax classification"]},{"component":"p","children":["A foreign entity on its own generally should not be impacted by the U.S. tax rules, except mainly in the following two cases:"]},{"component":"ol","children":[{"component":"li","children":[{"component":"p","children":["The foreign entity has U.S. concerns, such as certain U.S. source income or activities within the U.S. that rise to the level of a U.S. trade or business under the U.S. tax rules; or"]}]},{"component":"li","children":[{"component":"p","children":["The foreign entity has a U.S. owner (or member or partner, depending on the type of entity) and such ownership triggers the application of the U.S. tax rules."]}]}]},{"component":"p","children":["If either of these cases is true, then determining the U.S. tax classification of the foreign entity becomes essential in understanding how the U.S. tax rules should apply to the entity and/or its U.S. owners."]},{"component":"h2","props":{"id":"practical-ramifications"},"children":["Practical ramifications"]},{"component":"p","children":["In more practical terms, the tax classification of the foreign entity can have a number of important ramifications, including, for example:"]},{"component":"ol","children":[{"component":"li","children":[{"component":"p","children":["The rate of taxation (which may be higher or lower depending on the company's classification);"]}]},{"component":"li","children":[{"component":"p","children":["The timing of taxation (a company, for example, treated as a partnership will see its income flow-through currently to its partners);"]}]},{"component":"li","children":[{"component":"p","children":["The application of tax deferral regimes, such as controlled foreign corporation and a passive foreign investment company regimes (which can impose harsh rules in the case of foreign entities classified as corporation for U.S. tax purposes); and"]}]},{"component":"li","children":[{"component":"p","children":["The extent and breadth of compliance or reporting obligations (additional forms may need to be filed with the IRS or the Treasury Department depending upon the foreign entity's classification for U.S. tax purposes)."]}]}]},{"component":"p","children":["The tax ramifications of a foreign entity's classification can be particularly tricky when, as described above, the entity has one classification for U.S. tax purposes and another for local foreign tax purposes. In the case of such a so-called “hybrid” entity, the U.S. and foreign tax rules need to be carefully navigated to prevent double taxation or other potentially tax adverse outcomes."]},{"component":"h2","props":{"id":"starting-point-for-tax-classification"},"children":["Starting point for tax classification"]},{"component":"p","children":["While the U.S. tax classification rules are best applied on a case-by-case basis, there are some general concepts that permeate throughout the more specific regulatory provisions. In order to determine a foreign entity's foreign classification, one can follow this three-step process:"]},{"component":"p","children":["First, and most fundamentally, if your business venture involves a co-party, it should be determined whether or not the arrangement between you and the co-party rises to the level of a foreign \"entity\" (as opposed to just a contractual or co-ownership arrangement)."]},{"component":"p","children":["Second, assuming \"entity\" status, you should consider whether the foreign entity should be treated as a trust for tax purposes as opposed to a business entity. In very general terms, Treasury Regulation Section 301.7701-4 describes a trust as an entity the purpose of which generally is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries."]},{"component":"p","children":["Third, assuming \"business entity\" status, a final set of technical rules are employed to determine whether such entity has the status of a: (i) corporation, (ii) partnership, or (iii) a disregarded entity. While a corporation is generally subject to an additional layer of taxation (i.e., taxation at the entity and shareholder levels), the income of a partnership and disregarded entity generally \"passes\" or \"flows\" through currently to its partners or members for tax purposes (i.e., taxation only at the partner or member level)."]},{"component":"h2","props":{"id":"the-classification-rules-in-a-nutshell"},"children":["The classification rules in a nutshell"]},{"component":"p","children":["The U.S. Treasury regulations contain a set of default classification rules for foreign business entities under Treasury Regulation Section 301.7701-3. A foreign business entity is classified as an association/corporation if all of its members have limited liability, and it is classified as a partnership if it has two or more members and at least one member does not have limited liability. If the foreign business entity has a single owner and that owner does not have limited liability with respect to the entity, then the entity is classified as a disregarded entity for U.S. tax purposes."]},{"component":"p","children":["Under the classification regulations, a so-called \"eligible entity\" is allowed to elect its tax classification. This election, which is often referred to as \"check the box\" election (by virtue of checking the box next to the desired classification on the election Form 8832), cannot take effect more than 75 days before the date the election is filed with the IRS, nor can it take effect later than 12 months after the date of the filing. Non-eligible entities are those listed in the regulations that cannot elect out of corporation status."]},{"component":"p","children":["The ability to choose the tax classification of a foreign business entity offers owners quite a bit of flexibility in terms of structuring foreign business operations in a tax efficient manner. It's important to note, however, that if an election effective date is after the foreign entity's incorporation or creation date, adverse U.S. tax implications may arise. In such case, a tax advisor should be consulted to understand the full tax ramifications of the election both currently and moving forward."]}]},"resource":null,"sponsorship":null,"thumbnail":{"path":"https://staging.business.com/images/content/5a3/0502f1039ebaf788b45ab/1500-0-","caption":"Phovoir/Shutterstock","isBlurred":true},"bestPicks":null},"related":{"relatedArticles":[{"title":"PowerShell: Everything You Need to Know","canonical":"https://www.business.com/articles/powershell-everything-you-need-to-know/","slug":"powershell-everything-you-need-to-know","thumbnail":"https://www.business.com/images/content/5b8/998581039eb8f738b457b/1500-0-","dek":"What you need to know to unlock Microsoft PowerShell's full capabilities.","lastModified":"2018-09-05T17:00:00Z","published":"2018-09-05T17:00:00Z","sponsored":false},{"title":"Using Lean Strategies to Achieve Team Synergy and Efficiency","canonical":"https://www.business.com/articles/lean-strategies-team-efficiency/","slug":"lean-strategies-team-efficiency","thumbnail":"https://www.business.com/images/content/5be/480e49c658a51108b458c/1500-0-","dek":"Learn more about lean manufacturing strategies and how to implement them in your business.","lastModified":"2018-11-08T08:00:00Z","published":"2018-11-08T08:00:00Z","sponsored":false},{"title":"How to Hire for Your Business","canonical":"https://www.business.com/articles/how-to-staff-business/","slug":"how-to-staff-business","thumbnail":"https://www.business.com/images/content/5ea/9c8bb9c658aee018b456c/1500-0-","dek":"Sterling Staffing Solutions CEO Stephen Carter shares his tips on staffing your business.","lastModified":"2020-07-31T15:00:00Z","published":"2018-08-16T12:00:00Z","sponsored":false},{"title":"The Ultimate Small Business Guide to Credit Card Processing Fees","canonical":"https://www.business.com/articles/credit-card-processing-fees/","slug":"credit-card-processing-fees","thumbnail":"https://www.business.com/images/content/5d2/346547b437454698b4577/1500-0-","dek":"Learn about credit card processing fees and how to negotiate for lower costs.","lastModified":"2020-06-16T10:08:00Z","published":"2017-12-07T08:00:00Z","sponsored":false},{"title":"What to Do if ICE Serves Your Business With a Form I-9 Audit","canonical":"https://www.business.com/articles/ice-serves-i-9-audit/","slug":"ice-serves-i-9-audit","thumbnail":"https://www.business.com/images/content/5e6/64def7b43740a2a8b456e/1500-0-","dek":"Make sure you're prepared should Immigration and Customs Enforcement come knocking.","lastModified":"2020-03-10T15:00:00Z","published":"2018-09-17T18:00:00Z","sponsored":false},{"title":"Your Guide to Creating a Small Business Marketing Plan","canonical":"https://www.business.com/articles/sample-marketing-plan-outline-and-template/","slug":"sample-marketing-plan-outline-and-template","thumbnail":"https://www.business.com/images/content/5f3/3e1765a215eb62d8b4567/1500-0-","dek":"Follow these templates and guidelines to get started on creating your business's marketing plan.","lastModified":"2020-08-12T12:28:00Z","published":"2018-03-02T13:00:00Z","sponsored":false},{"title":"Are You Paying a Living Wage?","canonical":"https://www.business.com/articles/small-business-living-wage/","slug":"small-business-living-wage","thumbnail":"https://www.business.com/images/content/5a9/4732251ee479b088b4580/1500-0-","dek":"Employees who earn enough to get by improve performance and overall business.","lastModified":"2018-02-27T13:00:00Z","published":"2018-02-27T13:00:00Z","sponsored":false},{"title":"From COVID-19 to Hurricane Season: Disaster Preparedness for Small Business","canonical":"https://www.business.com/articles/business-disaster-prep/","slug":"business-disaster-prep","thumbnail":"https://www.business.com/images/content/5e7/a495e5a215eb11d8b4569/1500-0-","dek":"Natural disasters – whether a hurricane, tornado or outbreak like COVID-19 – can have a disastrous effect on small businesses, but they don't have to. Here's how to weather a disaster successfully.","lastModified":"2020-03-25T15:19:00Z","published":"2018-09-26T07:00:00Z","sponsored":false},{"title":"Resources for Veteran-Owned Businesses","canonical":"https://www.business.com/articles/resources-veteran-owned-business/","slug":"resources-veteran-owned-business","thumbnail":"https://www.business.com/images/content/5b7/425da51ee47e7568b458a/1500-0-","dek":"How to start a business, find funding and gain customers as a veteran business owner.","lastModified":"2018-08-15T12:01:00Z","published":"2018-08-15T12:01:00Z","sponsored":false},{"title":"Is It Time to Hire a CPA?","canonical":"https://www.business.com/articles/hire-accountant-for-taxes/","slug":"hire-accountant-for-taxes","thumbnail":"https://www.business.com/images/content/5e9/4e7de9c658ae9548b4593/1500-0-","dek":"Filing your own small business taxes may not be the best practice for you or your business.","lastModified":"2020-04-14T10:04:00Z","published":"2018-02-09T16:45:00Z","sponsored":false},{"title":"What Is the Triple Bottom Line?","canonical":"https://www.business.com/articles/triple-bottom-line-defined/","slug":"triple-bottom-line-defined","thumbnail":"https://www.business.com/images/content/5e8/c6d029c658a03718b456a/1500-0-","dek":"The triple bottom line is a sustainability-based accounting method that focuses on people, profit and planet. Here's how it works for businesses.","lastModified":"2020-04-10T12:17:00Z","published":"2018-07-26T17:00:00Z","sponsored":false},{"title":"How to Choose the Best Business Loan","canonical":"https://www.business.com/articles/how-to-choose-a-business-loan/","slug":"how-to-choose-a-business-loan","thumbnail":"https://www.business.com/images/content/5db/c5c175a215e47798b456f/1500-0-","dek":"Small businesses have a lot of funding options, but choose wisely.","lastModified":"2020-02-04T14:25:00Z","published":"2020-02-04T14:25:00Z","sponsored":false}],"relatedReviews":[{"doc_type":"category","thumbnail":"https://staging.business.com/images/rz/5e00ccda9c658a423d8b4569/HR_People_fizkes_Getty.jpg","canonical":"https://staging.business.com/categories/best-peo-services/","title":"The Best PEO Service Providers of 2021","dek":"Professional employer organization services can simplify your human resource responsibilities. Learn about the best PEOs available for your small business.","slug":"best-peo-services","lastModified":"2021-03-23T19:45:00Z"},{"doc_type":"category","thumbnail":"https://staging.business.com/images/rz/5dfbca819c658adc118b4568/Payroll_AndreyPopov_Getty.jpg","canonical":"https://staging.business.com/categories/online-payroll-services/","title":"The Best Online Payroll Services of 2021","dek":"Our team has compared the best online payroll services for 2021. See up-to-date reviews and costs for the top services.","slug":"online-payroll-services","lastModified":"2021-03-19T20:05:00Z"},{"doc_type":"category","thumbnail":"https://staging.business.com/images/rz/5d85356c7b43745d448b458d/hroutsourcing_fizkes.jpg","canonical":"https://staging.business.com/categories/best-hr-outsourcing-services/","title":"The Best HR Outsourcing Services of 2021","dek":"Human resource outsourcing services can simplify your human resource responsibilities. Learn about the best HROs available for your small business.","slug":"best-hr-outsourcing-services","lastModified":"2021-03-11T17:15:00Z"}],"relatedSponsoredArticles":null}},"pageContext":{"displayModified":"2017-12-12T08:00:00.000Z","template":"legacy","title":"A Guide to Foreign Business Entities and Their U.S. Tax Classification","meta":{"robots":"index, follow"},"docType":"articles","slug":"guide-to-foreign-entities-and-us-tax-classification","canonical":"https://staging.business.com/articles/guide-to-foreign-entities-and-us-tax-classification/","skipTOC":false}},"staticQueryHashes":[]}