U.S. persons that are manufacturing and technology entrepreneurs with ambitions to either begin their operations or expand their operations overseas, must take into consideration how their business will be taxed and reported for U.S. income tax purposes. The rules in determining tax classification for entities that are created outside of the U.S. are different from those created within the U.S. For the entities created outside of the U.S., there are three components to consider. We explore below.

Entity classifications:

Foreign Disregarded Entity: A company created outside of the U.S. and is owned 100% by one owner. The items of income, expenses, gains, losses, and credits, including credits for income taxes paid to a foreign country, flow directly to the owners U.S. tax return.

Foreign Partnership: A company created outside of the U.S. and is owned by more than one owner, even if the other owners are non-U.S. persons. U.S. persons are allocated their proportionate share of income, expenses, gains, losses, and credits, to calculate their U.S. income taxes.

Foreign Corporation: A company created outside of the U.S. and the number of owners has no impact on it. The foreign corporation regimen for U.S. taxation and reporting is often much more complex. For example, if the foreign corporation is considered a Controlled Foreign Corporation (“CFC”), U.S. taxpayers are subject to the subpart F income and global intangible income regimens that could mean taxation in the U.S. for income and profits earned by the foreign corporation, even if none of the income was distributed to the U.S. owners. Alternatively, if the company is not a CFC, and operates as a manufacturing or technology company only, the company will not be taxed on its earnings, and you will be taxed only on the dividends made to you by the foreign corporation.

Under U.S. entity classification rules, it is important to note that the company’s entity classification in the foreign jurisdiction has no impact on how the entity is classified for U.S. income tax purposes. For example, your company may be a partnership under the foreign jurisdiction but classified as a foreign corporation for U.S. income tax purposes.

What are the default rules for entity classification for U.S. income tax purposes?

Foreign Disregarded Entity – 1 owner in which the foreign entity provides the owner no limited liability protection.

Foreign Partnership – 2 or more owners, including non-U.S. persons, and at least 1 owner does not have limited liability protection.

Foreign Corporation – 1 or more owners and all owners have limited liability protection.

Are there alternatives to the default rules?

Yes, the Check-The-Box election (“CTB”) is the mechanism that allows certain entities to change their entity classification type for U.S. income tax purposes. The entities that are allowed to change their entity type are known as eligible entities. A non-eligible, or a “Per Se” entity is an entity that is distinguished by the IRS to be a foreign corporation and can be nothing else. These entities are provided on a country-by-country basis. If the company is an eligible entity, the following are eligible elections that new and existing entities may make:

• If there is only 1 owner, a foreign disregarded entity can elect to be classified as a foreign corporation.
• If there is only 1 owner, a foreign corporation can elect to be treated as a disregarded entity.
• If there are 2 or more owners, a foreign partnership can elect to be classified as a foreign corporation.
• If there are 2 or more owners, a foreign corporation can elect to be classified as a foreign partnership.

The election may be made to maximize your U.S. income tax effects, however, before making the election, the company should first be evaluated to ensure that the election will not result in a taxable event.

In determining the entity type that you should be, the rules are complex and there are many variables that are unique to you. At KLR we have the experience, skills, and team to navigate you in the tax structure that best suits you. Contact us.