Foreign Income & Taxpayers
When electing the entity classification of a newly acquired eligible entity, the taxpayer must consider several procedural issues, including:
- The desired effective date of the election;
- How many members the entity has, which in turn affects the types of classification available to elect; and
- The identification of the individual or individuals who will sign Form 8832, Entity Classification Election.
These issues may be more complicated when a U.S. person acquires a foreign shelf company. A shelf company generally is defined as a ready-made company that has fulfilled all requirements for legal registration under the local laws in the jurisdiction in which it was formed. Shelf companies, which commonly are formed by law firms, may be acquired to bypass lengthy local registration and incorporation processes.
When filing an entity classification election on acquisition of a shelf company, the taxpayer must determine whether the entity’s classification was relevant prior to acquisition. Under Regs. Sec. 301.7701-3(d)(1), a foreign eligible entity’s classification is relevant when its classification affects the liability of any person for federal tax or information purposes. If the shelf company has never been relevant prior to acquisition, the company’s classification initially will be determined upon relevance (i.e., the date of acquisition), as on that date the classification has an effect on the U.S. person’s tax liability or information reporting responsibilities.
In general, shelf companies formed by foreign law firms or organizations are not relevant for U.S. federal income tax purposes prior to the date of acquisition by a U.S. person. However, should conditions exist within the foreign firm or organization that trigger the relevance of its formed shelf companies, this relevance may affect the selection of the election’s effective date and the signature requirements of the election itself.
Under Regs. Sec. 301.7701-3(d)(2), if it is determined that an entity is not relevant for U.S. federal income tax purposes prior to acquisition, an election under Regs. Sec. 301.7701-3(c) is considered an initial classification election. In this instance, an election seeking an initial classification, effective on the date of acquisition, requires a signature from either:
- Each member of the electing entity who is an owner at the time the election is filed; or
- Any officer, manager, or member of the electing entity who is authorized to make the election.
Because the election upon acquisition, and therefore upon relevance, is considered an initial classification election, the prior owner—the foreign law firm or organization—is not required to sign the election.
If the entity is determined to be relevant prior to acquisition, the entity will have possessed a U.S. classification prior to that time as well, by default if not by election. Any postacquisition election is considered a change in classification. If the entity wants to make this change in classification effective on the date of acquisition, additional signature requirements set forth in Regs. Sec. 301.7701-3(c)(2)(i) would apply.
Specifically, Regs. Sec. 301.7701-3(g) provides that because the entity is making an elective change in classification, certain deemed events occurred at 11:59 pm the day before the effective date of the election, such as a deemed liquidation when an entity changes from a corporation to a disregarded entity. In these instances, the owner of the shelf company on the date of the deemed transaction (i.e., the foreign law firm or organization) must also sign the election. If the shelf company and its new owner wish to avoid this additional signature requirement, they must select an effective date later than the date of acquisition, such as the day after acquisition.
Law firms in some foreign jurisdictions have recently formed shelf companies, with the law firm acting as a nominee or as an agent of another party. The law firm holds nominal legal ownership of the company for a short time period as a nominee of the entity (its client). In these instances, it must be determined whether the owner for federal tax purposes is the foreign firm or the party for which it is acting as an agent.
Although the regulations do not provide guidance on this point, certain private letter rulings and other guidance address the nominee relationship in the entity classification context. In this guidance, the IRS considered all facts and circumstances of the situation in determining whether the nominee acted as a mere agent of the principal, had a voice or a vote, and had a right to distributions, if any, and also whether there was a nominee agreement in place. (See Letter Rulings 199914006 and 200201024 and Chief Counsel Advice 200501001.) In other words, the IRS examined the substance of the relationship to determine whether the equity holder was the agent or the principal.
If a foreign firm has formed an entity and has held the interest in that entity on behalf of its client, and if it can demonstrate the characteristics articulated in the guidance addressing this type of relationship, the nominee firm should be considered to “stand in the shoes” of its client. Under that view, the nominee firm would not be considered an owner at any time, and the signature requirements under Regs. Sec. 301.7701-3(c)(2)(i)(A), concerning the signature of existing owners, and Regs. Secs. 301.7701-3(c)(2)(ii) and (iii), concerning the signature requirements for prior owners, would not apply. However, the points discussed above must be reconsidered. If the true beneficial owner is a U.S. person, for example, the entity would be relevant upon formation, and any election should be made effective on that date.
The seemingly simple procedural provisions for valid entity classification elections in fact are complex, and selection of the appropriate effective date and satisfaction of the signature requirements are important to valid and beneficial elections. With the promulgation of Rev. Proc. 2009-41, expanding the availability of retroactive corrections of elections (including changes of elections), these rules should be reexamined and corrections made under this simplified process if necessary.
Editor: Annette B. Smith, CPA
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.