Check-the-Box Relief for Certain Foreign Entities Electing Flowthrough Treatment

Editor: Michael Dell, CPA

Procedure & Administration

The IRS issued Rev. Proc. 2010-32, which provides relief to certain foreign eligible entities that made erroneous entity classification elections (check-the-box elections) based on a mistaken understanding of the number of owners as of the effective date of the election.

In general, when the requirements of Rev. Proc. 2010-32 are met, the IRS will respect the intention of a qualified entity (defined below) to be treated as a flowthrough entity (i.e., as a partnership or disregarded as an entity separate from its owner (a disregarded entity)) rather than treat the qualified entity as an association taxable as a corporation. More specifically, if a qualified entity elected to be a partnership based on the reasonable assumption that it had more than one owner, but then determined it only had one owner as of the effective date of the election, the IRS will treat the original election as an election to classify the qualified entity as a disregarded entity as long as the requirements of Rev. Proc. 2010-32 are met. Similarly, if a qualified entity elected to be a disregarded entity based on the reasonable assumption that it had one owner, but then determined it had more than one owner as of the effective date of the election, the IRS will treat the original election as an election to classify the qualified entity as a partnership as long as the requirements of Rev. Proc. 2010-32 are met.

The relief granted by Rev. Proc. 2010-32 is in lieu of the letter ruling process ordinarily used to obtain relief for a late change of entity classification. As such, user fees do not apply to the corrective actions granted under Rev. Proc. 2010-32.

Rev. Proc. 2010-32 is effective on September 7, 2010. Any qualified entity that meets the requirements of Rev. Proc. 2010-32 as of September 7, 2010, may seek relief pursuant to the revenue procedure.

Definition of “Qualified Entity”

In Rev. Proc. 2010-32, Treasury and the IRS have acknowledged taxpayers’ concerns regarding the validity of certain check-the-box elections when a foreign eligible entity elects to be classified as a partnership or as a disregarded entity but has made an error regarding the number of owners. The concern is a result of the uncertainty that may exist regarding the number of owners of a foreign eligible entity on the effective date of the check-the-box election. To achieve certainty, taxpayers sought permission to file a late election under the letter ruling process.

To alleviate these concerns and simplify tax administration, the IRS has indicated that it will treat a check-the-box election under Regs. Sec. 301.7701-3(c) to classify a foreign eligible entity that is a qualified entity as a partnership or disregarded entity as an election to be treated as a partnership or disregarded entity (as appropriate), rather than as an association taxable as a corporation, if the requirements of Rev. Proc. 2010-32 are met.

In order to avail itself of the relief provided by this revenue procedure, a business entity must be a “qualified entity.” A business entity is a qualified entity if the following conditions are satisfied:

1. The business entity is an eligible entity per Regs. Sec. 301.7701-3(a);
2. The business entity is a foreign entity per Regs. Sec. 301.7701-5(a);
3. The classification of the business entity, either by default under Regs. Sec. 301.7701-3(b)(2)(i)(B) for a newly formed or newly relevant eligible entity, or by election under Regs. Sec. 301.7701-3(c) for an existing relevant entity, would be or was an association taxable as a corporation;
4. The business entity filed an otherwise valid Form 8832, Entity Classification Election, electing to be treated for federal tax purposes (per Regs. Sec. 301.7701-3(c)):
   • As a partnership based on the reasonable assumption that it had two or more owners as of the effective date of the election; or
   • As a disregarded entity based on the reasonable assumption that it had a single owner as of the effective date of the election;
5. For federal tax purposes, either:
   • The business entity and its actual and purported owners (or owner) have treated the entity consistently with the election on the otherwise valid Form 8832 on all filed information and tax returns; or
   • No information or tax returns have been required to be filed since the effective date for the election made on the otherwise valid Form 8832; and
6. The limitation period on assessments (per Sec. 6501(a)) has not ended for any tax year of the business entity or its actual and purported owners (or owner) affected by the election made on the otherwise valid Form 8832.

If a business entity does not qualify for relief under this revenue procedure, the entity may request relief through the letter ruling process in accordance with Rev. Proc. 2010-1 (or its successor).

Process for Obtaining Relief

If a qualified entity files an otherwise valid Form 8832 to be classified as a partnership for federal tax purposes but it is later determined that the qualified entity had a single owner for federal tax purposes as of the effective date of the election, the IRS will treat the Form 8832 as an election to classify the qualified entity as a disregarded entity for federal tax purposes provided that:

• The qualified entity’s actual single owner and purported owners as of the effective date of the election file original or amended returns consistent with the appropriate treatment of the entity as a disregarded entity for any tax year that would have been affected if the election had been made to treat the qualified entity as a disregarded entity for federal tax purposes;
• All required amended returns are filed before the close of the limitation period on assessments under Sec. 6501(a) for any relevant tax year; and
• A corrected Form 8832 is filed with the appropriate IRS Service Center and a copy of the corrected Form 8832 is attached to the single owner’s amended return for the tax year during which the original election was made as required under Regs. Sec. 301.7701-3(c)(1)(ii). The statement “Filed Pursuant to Revenue Procedure 2010-32” must be written across the top of the corrected Form 8832. The corrected form must also satisfy the requirements of Regs. Sec. 301.7701-3(c)(2)(i).

If a qualified entity files an otherwise valid Form 8832 to be classified as a disregarded entity for federal tax purposes but it is later determined that the qualified entity had two or more owners for federal tax purposes as of the effective date of the election, the IRS will treat the Form 8832 as an election to classify the qualified entity as a partnership for federal tax purposes provided that:

• The qualified entity files information returns and its actual owners file original or amended returns consistent with the treatment of the entity as a partnership for any tax year that would have been affected if the original election had been made to treat the qualified entity as a partnership for federal tax purposes;
• All required information and amended returns are filed before the close of the limitation period on assessments under Sec. 6501(a) for the relevant tax year; and
• A corrected Form 8832 is filed with the appropriate IRS Service Center and a copy of the corrected Form 8832 is attached to the owners’ amended returns for the tax year during which the original election was made as required under Regs. Sec. 301.7701-3(c)(1)(ii). The statement “Filed Pursuant to Revenue Procedure 2010-32” must be written across the top of the corrected Form 8832. The corrected form must also satisfy the requirements of Regs. Sec. 301.7701-3(c)(2)(i).

Implications

Rev. Proc. 2010-32 provides welcome relief for taxpayers that misidentified the number of owners of foreign eligible entities electing flowthrough status for U.S. federal tax purposes as of the effective date of the elections. Taxpayers meeting the requirements of this revenue procedure may now avail themselves of this relief process in lieu of requesting relief through the potentially time-consuming letter ruling process and paying a user fee. While Rev. Proc. 2010-32 does not provide guidance for those taxpayers that have filed for relief under the letter ruling process and otherwise could seek relief under this revenue procedure, such taxpayers might consider withdrawing their ruling requests and seek relief under this revenue procedure. The revenue procedure, however, does not provide taxpayers with guidance regarding withdrawing a previously submitted letter ruling request, including the potential for obtaining a refund of user fees upon withdrawal of the ruling request. In the absence of guidance in Rev. Proc. 2010-32 addressing this issue, it appears that the general rules described in Section 15 of Rev. Proc. 2010-1 apply, suggesting that the IRS would not refund user fees except in limited circumstances.

Taxpayers should also be aware that while Rev. Proc. 2010-32 addresses two common errors taxpayers may make when preparing and filing the Form 8832, the revenue procedure does not address other common taxpayer errors affecting the validity of a Form 8832, including, for example, situations in which the signature requirements are not satisfied on the originally filed Form 8832 or the effective date requested on the Form 8832 is not the desired effective date. In such cases, taxpayers should consider whether the Form 8832 as filed is sufficient to make a valid election or whether it is advisable to correct the errors, including requesting relief under the letter ruling process.

Taxpayers should also recognize that Rev. Proc. 2010-32 incorporates a reasonableness standard in its scope. The original election, although later determined to be erroneous, must have been based on a reasonable assumption as to the number of owners as of the effective date of the election. Presumably, an unreasonable assumption as to the number of owners would not qualify for relief under this revenue procedure. However, the revenue procedure does not define the term “reasonable,” and thus the standard may be a potential source of uncertainty in applying the revenue procedure. This may be especially pertinent where there is no U.S. equivalent or analog to the type of foreign entity making the election, making it difficult to determine the number of owners for U.S. federal tax purposes.

The revenue procedure provides guidance only on the classification of the entities within its scope. Taxpayers should be aware of the income tax implications of having partnership status rather than disregarded entity status and vice versa and should consult with their advisers concerning such implications.

Taxpayers required to e-file are reminded that amended returns must also be e-filed. However, the IRS Modernized eFile (MeF) system accepts only three tax years at any point. For example, through December 2010, amended returns for tax years 2007–2009 are accepted, and amended returns for earlier years must be paper filed. As of January 2011, tax year 2007 returns will then have to be paper filed.

Form 1120X, Amended U.S. Corporation Income Tax Return, is submitted to the MeF by e-filing a Form 1120, U.S. Corporation Income Tax Return, with the Form 1120X included in the XML file. A copy of the corrected and signed Form 8832 (including the statement written at the top described above) that was submitted to the IRS Service Center should be attached as a PDF to the e-filed amended return.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington, DC.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.