What Is a Check the Box Election and Why Is it Relevant to New Residents?

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

Are you a foreign business owner who is moving to the U.S. for the first time? If so, you will soon become taxed as a U.S. resident and therefore, you should beware of some pitfalls that may await you if you do not make what is called a “check the box” election.

A check the box election allows an entity to be classified differently from the default classification it would normally have in the U.S.

Going back to the foreign business owner coming to the U.S., let us suppose that they own a foreign entity. The question then becomes, what is the default treatment of this foreign entity in the U.S.?

A foreign entity is treated as a corporation if all of its owners have limited liability, a partnership if it has two or more owners and at least one owner does not have limited liability, and a disregarded entity if it has a single owner that does not have limited liability. 

The risk with a foreign entity that does not make a timely check the box election is that the foreign earnings may be double taxed when the entity is taxed as a U.S. entity, as part of a one-time transition tax. Why? Because after the 2017 Tax Cuts and Jobs Act, U.S. shareholders of foreign corporations will need to include on their U.S. tax return the profits of the foreign entity even if no dividend has been distributed to them and even if the profits are not repatriated to the U.S. To make matters worse, in this scenario, the U.S. shareholder may have already paid taxes in the foreign country and will be unable to take a foreign tax credit in the U.S. To avoid this double taxation and at the same time ensure that a credit can be applied in the U.S. for taxes paid overseas, a check the box election needs to be made, during which the foreign entity chooses to elect their U.S. tax status at the point in time in which the U.S. tax system becomes relevant to it. This event can occur when the foreign entity derives U.S.-sourced income, it is required to file a U.S. tax return, or when the owner of the entity becomes a U.S. tax resident.

But how does this apply to the foreign business owner who comes to the U.S.? Because when the business owner becomes a U.S. tax resident, and if he or she does not make a check the box election for their foreign corporation, then the entity would be subject to the controlled foreign corporation (CFC) rules, which means that the earnings of the foreign entity would be taxed at ordinary income rates in the U.S. (as explained in the previous paragraph). In addition to this, it would require the business owner to file Form 5471 and its associated schedules. As discussed in a previous article, Form 5471 is the most complex tax form in the U.S. tax system. In this scenario, therefore, the business owner should make a check the box election to be taxed as a disregarded entity and not a corporation, thereby being able to avoid the CFC filing rules and at the same time receive a foreign tax credit in the U.S. for taxes paid overseas.

A check the box election is made by filing Form 8832. However, even though the form may appear to be simple, the tax implications of changing an entity’s default classification can be enormous, and the effects long-lasting. Additionally, there are various entities that are not able to change their default entity classification. Also, as in many other areas of U.S. tax law, exceptions apply. Finally, the check the box election needs to be made within a year before it becomes effective, or within 75 days after it becomes effective, which means that with a new entity, Form 8832 needs to be filed within 75 days of the start of the entity’s fiscal year. Therefore, if you are a non-U.S. person with a foreign entity and you are planning on becoming a U.S. tax resident in the future, please get in touch today to start the planning process, as the steps you take today may have a huge influence on both your company’s profitability and your tax situation in the near future.