Check-the-Box Elections as an Anti-Form 5471 Damage-Control TechniqueMarch 3, 2023 - Phil HodgenAmerican Business Abroad, Americans Living Abroad, Form 5471, Minimultinationals
A nonresident owns 100% of the stock of a foreign corporation, which holds highly appreciated foreign real estate.
- Real estate FMV $4,000x, basis $400x.
- Basis of shareholder in stock $400x.
The nonresident plans to become a U.S. resident (and therefore taxpayer) starting on January 1, 2024. He wants to keep the real estate, and for tax and expense reasons in his home country, dissolving the corporation that owns the real estate is not an option.
Make a check-the-box election (Form 8832) for the foreign corporation before the nonresident becomes a U.S. taxpayer on January 1, 2024.
The major benefits are:
- No Form 5471, ever. (File Form 8858 instead).
- Basis in the real estate stepped up to current fair market value, at zero tax cost.
- Legal and tax structure in the foreign country is unchanged.
The Preconditions for the Election
The election itself is made by filing Form 8832.
I will draw your attention to the two most important questions you must answer before committing yourself to this path:
- First, is the foreign corporation an “eligible entity“? See the definition at Reg. §301.7701-3(a).
- Second, does “relevancy” exist? See Reg. §301.7701-3(d)(1).
People try to get clever here. Especially about the “relevancy” point. Don’t. Just read the Regulations and create a reality that satisfies the requirements.
A third precondition: you can absolutely, definitively define the starting date for the individual’s residency status in the United States.
Tax Effect of the Election Generally
Using the Form 8832 election to convert an entity taxable as a corporation into an entity disregarded as separate from its owner is treated as if a “make pretend” transaction occurred:
Pretend that the corporation distributed its assets to its sole shareholder in a liquidating distribution.
Reg. §301.7701-3(g)(1)(iii) says:
Association To Disregarded Entity. If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this section to be disregarded as an entity separate from its owner, the following is deemed to occur: The association distributes all of its assets and liabilities to its single owner in liquidation of the association.
Excellent. Now we know how to figure out the tax consequences of this strategy. We look at the impact of the liquidating distribution:
- For the shareholder: IRC §331
- For the liquidating corporation: IRC §336
Tax Effect on the Shareholder: Capital Gain That Will Never Be Taxed
A liquidating distribution is treated as if the shareholder received it in return for the stock he owned. In other words, pretend that the corporation bought its own stock from the shareholder, and paid for the stock by giving the contents of its balance sheet to the shareholder.
IRC §331(a) says:
Distributions in complete liquidation treated as exchanges. Amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock.
Excellent. This is a capital gain transaction. Amount recognized minus basis equals capital gain for the shareholder.
In this situation, the amount recognized is easy: it’s the fair market value of the real estate, $4,000x. And we assume basis is $400x.
Thus, making the check-the-box election creates taxable capital gain of $3,600x for the shareholder — for U.S. income tax purposes.
Don’t worry. We don’t care. All of this capital gain is going to be irrelevant for U.S. tax purposes. It will never be subjected to U.S. income tax.
Pick an Effective Date for the Election
The carefully-executed check-the-box strategy will make sure that the “pretend” capital gain transaction occurs before the shareholder is a U.S. resident for income tax purposes. Even the Great American Empire’s guns are not long enough to force nonresidents with foreign source income to render unto Caesar.
We do this by carefully coordinating the effective date of the check-the-box election with the date on which the individual becomes a U.S. resident alien for income tax purposes.
Since the shareholder will become a U.S. resident on January 1, 2024, let’s pick an effective date for the check-the-box election of January 1, 2024. (That’s cutting it a bit too close and cute for my tastes, but I pick that date to demonstrate the point in bright relief.)
On January 1, 2024, you will be a U.S. resident taxpayer. On December 31, 2023, you will be a nonresident alien for U.S. income tax purposes.
So we pick January 1, 2024 as the effective date for the check the box election. Here is the timing impact of that effective date:
- The first day of disregarded entity status is January 1, 2024 — when you are a U.S. resident alien taxpayer.
- The liquidating distribution (and therefore the capital gain income recognition) happens on December 31, 2023 — when you are a nonresident alien and therefore don’t have to pay U.S. income tax on the capital gain from the liquidating distribution.
Why? Because Reg. § 301.7701-3(g)(3)(i) says so:
In General. An election under paragraph (c)(1)(i) of this section that changes the classification of an eligible entity for federal tax purposes is treated as occurring at the start of the day for which the election is effective.
This means when you elect January 1, 2024 as your effective date for disregarded entity status, the very first moment of “it’s a disregarded entity” is 00:00:01 on January 1, 2024.
What Happens Just Before the Effective Date?
Just before the effective date for the election, a “pretend” taxable event occurs.
The regulations tell us exactly when the “pretend” liquidating distribution occurs. This, in turn, tells us when the capital gain recognition event occurs for the shareholder.
The “pretend” liquidating distribution occurs on the day before the effective date of the check-the-box election.
Reg. § 301.7701-3(g)(3)(i) is where we learn this:
Any transactions that are deemed to occur under this paragraph (g) as a result of a change in classification are treated as occurring immediately before the close of the day before the election is effective.
The liquidation distribution in my example is deemed to occur under Reg. §301.7701-3(g)(1)(iii), so it is treated as occurring just before the close of the day before the effective date: 23:59:59 on December 31, 2023.
Summary so far for timing:
- Liquidating distribution: December 31, 2023 at 23:59:59.
- This means the capital gain recognition is reported in the 2023 tax year’s income, while the shareholder is a nonresident alien.
Timing Example from the Regulations
Reg. § 301.7701-3(g)(3)(i) gives an example of how it works. The example describes conversion of a corporation into a partnership, which I have changed to reflect conversion to disregarded entity:
For example, if an election is made to change the classification of an entity from an association to a
partnershipdisregarded entity effective on January 1, the deemed transactions specified in paragraph (g)(1) (ii)(iii) of this section (including the liquidation of the association) are treated as occurring immediately before the close of December 31 and must be reported by the owners of the entity on December 31.
The Taxable Event Occurs While the Shareholder is a Nonresident Alien
So on December 31, 2023, while the shareholder is still a nonresident alien of the United States tax system, he has capital gain from the deemed liquidation of your foreign corporation. This transaction is out of reach of the U.S. income tax system, so no U.S. capital gain tax is payable.
And the capital gain is not going to get taxed in the shareholder’s home country, either. A check-the-box election for U.S. tax purposes is not a taxable event in any other country’s tax system.
From the point of view of the other country, nothing changed. On December 31, 2023 and January 1, 2024, the shareholder is still the same, the corporation is still the same, and the real estate asset is still the same.
Fresh Start in the United States
This strategy works. I’ve done it a bunch of times.
The strategy does not require (tax) rocket surgeon skills. It requires solid, journeyman-level earnest dedication to details, timing, and paperwork.
- Nail down the start date for U.S. residency. If this is debatable, your tax strategy is “YOLO!”
- Ensure that the entity is eligible for the check-the-box election. “Eligible entity.” No assumptions: get the corporation’s organizational documents, then look at the Regulations or Form 8832 Instructions.
- Ensure that the entity has “relevancy” to support the check-the-box election. If this is debatable, your tax strategy is “YOLO!”
- Prepare Form 8832 correctly. I confess I still have to read the instructions every time. It’s not as brain-dead simple as you’d like.
- Meet/beat the filing deadline for the effective date that you select.
If you get it all right, the U.S. tax system will reward you as a new resident. No Form 5471 required. Demonstrable, stepped-up basis in the real estate asset. Many other wonderful door prizes.
The gruesome details of this strategy (The Meaning of Relevancy, for instance) are tantalizingly waiting for you in a future episode of the Form 5471 series. Sign up and watch the shows. They’re free.