Private U.S. manufacturing and technology businesses choose specific types of entities to conduct business, often because of the tax advantages they offer. This guide explores the tax implications of utilizing “flow-through” entities such as limited liability companies (LLCs) or subchapter S corporations for U.S. businesses and the critical importance of entity tax classification in an international context.
Flow-Through Entities and Tax Efficiency
Many U.S. businesses favor flow-through entities like LLCs and Subchapter S corporations because of the income tax advantages they offer. These entities are not directly taxed. Instead, the income they generate flows through to shareholders who report the results for tax purposes (net operating losses also flow through). Thus, there is a single level of tax imposed on the profits of the business. In contrast, if a C corporation is employed, business profits are subject to an initial corporate-level tax (currently at a 21% rate) and are subsequently taxed as dividends when distributed to shareholders.
The effective tax rates produced by both flow-through and C corporation structures may change if the Trump Administration is successful in extending the favorable tax provisions introduced by the Tax Cuts and Jobs Act (TCJA) in 2017 and enacting further taxpayer-friendly provisions. For example, an extension of the TCJA provisions could mean that the Qualified Business Income Deduction of up to 20% remains available to individuals with pass-through business income. Furthermore, the top individual income tax rate would remain at 37% instead of reverting to 39.6%. For C corporations, President-elect Trump has indicated a desire to drop the income tax rate from 21% to 15% for companies that produce and manufacture domestically. Such developments could materially change effective tax rate arithmetic and may lead business owners to reconsider the efficacy of their legal structures.
Unique Tax Considerations for Owners
Every individual tax situation is unique due to factors such as the tax bracket of the owner with respect to ordinary income and dividends, the availability of the Section 199A Qualified Business Income Deduction, the potential application of the Net Investment Income Tax (NIIT), the state tax profile of the individual, etc. Despite individual differences, flow-through structures often provide owners with more favorable tax outcomes, making an LLC or Subchapter S corporation the vehicle of choice.
Domestic LLC Classification and Default Treatment
Flow-through treatment for a domestic LLC is automatic and does not require action from owners. The default treatment of an LLC is flow-through—it is disregarded as a separate entity if there is a single owner or treated as a partnership if there are multiple owners. Under the so-called “check-the-box” income tax regulations, owners can elect corporate treatment for an LLC if desired. An election must be filed no later than 75 days after the date it is to be effective. The ability to choose the characterization of eligible entities dates back to rules enacted under the Clinton Administration to simplify tax administration and avoid disputes between taxpayers and the IRS.
International Entity Classification and Challenges
When expanding internationally, entity classification rules become more complex. In many non-U.S. jurisdictions, there are companies similar to U.S. LLCs, with names that denote the limited liability enjoyed by owners. In Mexico, for example, a Sociedad De Responsabilidad Limitada De Capital Variable (S. de R.L. de C.V.) is such an entity. In Canada, corporations are not eligible entities; they are always treated as C corporations. However, several Canadian provinces offer unlimited liability companies (ULCs). Foreign limited liability companies and Canadian ULCs are generally eligible entities for purposes of the check-the-box regulations, meaning they can choose their characterization. Default classifications differ based on owner liabilities – unlimited liability leads to flow-through, while limited liability results in C corporation treatment.
Avoiding International Entity Classification Errors
In the international context, the entity classification rules contain traps for the unwary, primarily due to the rules governing default classification. For non-U.S. eligible entities, the owners’ liabilities are of critical importance. Where at least one owner has unlimited liability, the default classification is flow-through (disregarded or partnership as described earlier). If all owners have limited liability, the default classification is C corporation. The confusion arises due to the liability criterion that guides default characterization in an international context. Taxpayers frequently assume that a foreign limited liability company is automatically treated as a flow-through because U.S. LLCs are so treated, and the required election for such treatment is missed. Conversely, with Canadian ULCs taxpayers sometimes assume that corporate treatment automatically applies when, in fact, it is the reverse. The misclassification of a foreign entity can produce materially different U.S. tax results than those that were planned and modeled.
Entity classification errors are relatively common. The IRS issued Rev. Proc. 2009-41 to provide taxpayers with relief from a late entity-classification election without having to obtain a letter ruling. To obtain relief, the entity must have filed all income tax returns on time and consistent with the requested classification (unless those due dates have not yet passed); the entity must have reasonable cause for the failure to file; and the request for relief must be made before three years and 75 days from the requested effective date of the classification election. Form 8832, Entity Classification Election, allows a request for relief to be made on Part II of the form. If a taxpayer is not eligible for relief under Rev. Proc. 2009-41, a prospective entity classification may be an alternative, but the tax implications of the entity change must be carefully evaluated.
Tax Complexity in International Expansion
International expansion introduces a new layer of tax complexity for U.S. businesses. Achieving desired tax results involves many considerations and the accurate classification of foreign business entities is critical. Understanding and navigating the check-the-box rules is pivotal for a successful international expansion strategy.
Content provided by LBMC tax professional Dennis Metzler.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.