April 26, 2021 / North America
In the tax realm, as in life, there are very few opportunities in which we get a do-over. In the case of entity classification, business entities are generally permitted to choose or change their entity classification for U.S. income tax purposes by making a Check-the-Box election. However, unless the election is made effective as of formation (or, in the case of foreign entities, as of the date it is first relevant), an entity may generally make only one election in a sixty-month period. In the absence of such election, the taxpayer retains its default classification, as determined under the applicable Treasury Regulations.
While the determination of the default classification for domestic entities is often straight-forward, the same cannot always be said for foreign entities. This is because it is necessary to determine the potential liability exposure of the entity’s members under local law. Due to the potential complexities, many foreign entities choose to file protective elections (e.g., the foreign entity believes it defaults to a corporation and elects to be treated as a corporation) so as to ensure its US tax classification is what it desires.
There may be situations where an entity (foreign or domestic) files an election but then later regrets having done so. Due to the sixty-month limitation, it is possible that the entity may not be able to file a new election to change its classification. Even if it is permitted to file a subsequent election, the subsequent election does not generally retroactively override the prior election.
Revoking a Check-the-Box Election
Under certain circumstances, the IRS may allow a taxpayer to withdraw or rescind a Check-the-Box Election that was filed in error. The process allows a taxpayer to file a new election within sixty months of the prior (withdrawn) election. Under this process, which must be initiated by the due date of the tax return for the taxable year in which the election was effective, the entity returns to its pre-election classification status. Note that it is unclear whether extensions are taken into account for these purposes.
For example, assume a foreign entity is acquired by a US parent and its classification is now relevant for US federal income tax purposes. The entity filed a protective election on February 3, 2020 to be treated as a corporation for US income tax purposes. It made the election effective as of January 1, 2020. During the Summer, the US parent determines that it would rather treat the foreign entity as a disregarded entity. Under the IRS procedure, the taxpayer may submit a request to withdraw or rescind the election by the due date of its 2020 return. Once the revocation is finalized, the entity’s status reverts to its default classification and the entity is treated as if it never filed a Check-The-Box election. The entity may now file a new Check-The-Box election to be treated as a disregarded entity.
If the due date of the initial tax return has passed, it may still also be possible for an entity to return to its default status under a similar procedure. However, there is uncertainty as to how it applies in certain circumstances.
A&M TAXAND SAYS: As we see tax reform initiatives returning to the national stage, it is seeming increasingly likely that at least some tax rates will increase. This leaves the question of when such increases will be effective. Because of a quirky provision, even if the rate changes are not retroactive, the higher rates may be blended with the existing rates to subject “pre-effective date” income to higher tax rates. As a result, some taxpayers may be wondering if the entity classification that they chose for their entities will be the most efficient. The revocation procedures discussed in this alert may give some taxpayers peace of mind when making structuring decisions. While the above procedures do not completely eliminate the risk of making and sticking to an election, it certainly does provide some flexibility. A&M Taxand has assisted clients through this process and is well-equipped to assess the risks/benefits associated with changing US income tax classifications.
Please contact your trusted A&M Taxand adviser if you have any questions regarding the proposed tax reform or would like discuss the possibility of revoking a previously filed Check-The-Box election.