Reduce Exposure to Gains through Proper Entity Classification and Strong Pre-Immigration Tax Planning
When nonresidents immigrate to the United States, they become subject to U.S. taxation as if they were a U.S. citizen or resident. To minimize the potential adverse tax consequences from ownership in a Foreign Eligible Entity (“FEE”), pre-immigration tax planning is essential.
The characterization of an FEE as a corporation, partnership or disregarded entity is determined in accordance with regulations under Internal Revenue Code section 7701. A FEE is classified for U.S. federal income tax purposes pursuant to default classification provisions or by making an election on Form 8832.
A typical issue that is addressed in pre-immigration planning involves a nonresident who owns a FEE that conducts a business outside the United States. Under the default rules, the entity generally is characterized as a corporation. If the nonresident has substantial built-in gain in the FEE and sells the entity after coming to the United States, the individual would be subject to taxation on the amount of the gain. A possible pre-immigration planning technique in this case could be to trigger a liquidation of the entity before the individual comes to the United States.
On April 2, 2021, the IRS released AM 2021-002, which provides guidance on the classification of a FEE prior to it becoming “relevant” for U.S. federal income tax purposes. In this guidance, the IRS states that a FEE owned by a nonresident has a tax classification as a corporation, partnership, or disregarded during the period when the classification is not relevant for U.S. federal income tax purposes. Classification of an entity is “relevant” when such classification affects tax liability or information reporting for U.S. federal income tax purposes.
On the date an entity first becomes relevant, the classification is determined under the default rules and such classification applies to the period for which the entity was irrelevant (i.e., the period before the first date of relevancy). When the election is made on Form 8832 to claim disregarded status for the date the entity first becomes relevant, such election is treated as an initial election. Therefore, a change in entity classification can be made again if needed fewer than 60 months after the initial election.
How Can We Help?
For assistance or questions regarding pre-immigration planning and the concept of “relevancy” for FEEs, please contact a member of Cherry Bekaert’s International Tax practice.