Form 8832, Community Property, and Foreign Business EntitiesJune 22, 2018 - Phil HodgenFriday Edition
I received an email from Scott, a good friend who, well, does taxes in Mexico.
He had a question about an American couple in Mexico who are setting up a S de RL (Sociedad de Responsabilidad Limitada), which is similar to a U.S. LLC. One of the features of this type of entity is that it must have two owners. H and W. How convenient.
Mexico has community property laws for married couples, and Scott tells me that this S de RL is a community property asset of H and W.
Will this entity (S de RL) be treated as a corporation, partnership, or disregarded entity for U.S. tax purposes? And if the married couple wishes to change the U.S. tax classification to something else, what are their options?
The way a foreign country treats foreign business entities is its own business. When American taxpayers own foreign business entities, the IRS is keenly interested in what that entity is, and how to apply U.S. tax law to its operations.
We need to classify a foreign business entity for U.S. tax purposes. Here is the quick summary of how it works:
Not a Trust or Per Se Corporation
The first thing to do is deal with a couple of arbitrary knockout punches. Do these rules force a particular classification for the entity?
- Trust: No. Make sure the foreign entity is not a trust (using U.S. tax law definitions).1 If it’s a trust, the rest of this discussion does not apply–you have a trust.
- Per Se Corporation: No. Make sure that U.S. tax rules do not force the foreign business entity to be classified as a corporation for U.S. tax purposes.2 If this particular type of entity is on the list for “corporation only” treatment, that’s the end of the discussion. Jargon alert: this is called a per se corporation because lawyers love Latin.
For a Sociedad de Responsabilidad Limitada, the answer is “no” to both: it is not a trust, and it is not on the list of Mexican business entities that are automatically and always treated as corporations for U.S. tax purposes.
Initial Classification For Eligible Entity
If you get this far, you have a “foreign eligible entity”.3 U.S. tax law tells you how the entity is classified if you do nothing, and it tells you what alternate classifications are available for you to choose from.
The initial classification of the entity is determined by figuring out–under local law–whether all of the owners have limited liability, or whether at least one owner has unlimited liability.4
- Multiple Owners, One Has Personal Liability. If at least one of the owners has unlimited liability, the foreign entity will be treated as a partnership by the U.S. tax system.5
- No Owner Has Personal Liability. If all of the owners (could be one owner or many) have limited liability, the U.S. tax system will treat this foreign entity as an “association” taxable as a corporation.6
- Single Owner has Personal Liability. If the entity has one owner who has personal liability for the entity’s debts, then the entity is disregarded for U.S. tax purposes.7 (Many countries have formal entities for sole proprietorships; that’s what this rule is all about).
For the Sociedad de Responsabilidad Limitada, it has two owners and both have limited liability. Therefore, the initial classification for this entity is “association taxable as a corporation” for U.S. tax purposes.
Change of Classification Rules
A foreign eligible entity can elect to change its classification from the initial classification to something different for U.S. tax purposes. Since a Sociedad de Responsabilidad Limitada is not a per se corporation, it is a foreign eligible entity, and the owners can make this election.
These are your choices, straight from Form 8832, Part I, Line 6:
- Foreign eligible entity electing to be classified as an association taxable as a corporation.
- A foreign eligible entity electing to be classified as a partnership.
- A foreign eligible entity with a single owner electing to be disregarded as a separate entity.
For a S de RL (with two owners) the choices are “corporation” or “partnership”. H and W (seemingly!) cannot choose to have the S de RL disregarded as a separate entity, because it has two–not one–owner.
Foreshadowing the Denouement . . .
Except . . . let’s talk about the application of community property law to entity classification.
Hint: we can treat husband and wife as one person, and choose disregarded entity status for the S de RL.
Community Property: Choose Partnership or Disregarded Entity
The IRS will let a married couple who own a foreign eligible entity (like a Mexican S de RL) as community property choose disregarded entity status or partnership status.
Behold the majesty of Rev. Proc. 2002-69.8 Here is how it works.
First, you need a “qualified entity”,9 which means:
- The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States;
- No person other than one or both spouses would be considered an owner for federal tax purposes; and
- The business entity is not treated as a corporation under T. Regs. § 301.7701-2.
All three of these are true for a Mexican S de RL. Note particularly that “wholly owned by a husband and wife as community property” can mean:
- Ownership by one spouse alone, but the company is a community property asset so the other spouse has a 50% ownership interest even though he/she is not named as an owner; or
- Ownership by both spouses (as is the case with the Mexican S de RL we are discussing).
After that, it’s pretty easy:
- If the married couple “treats” the entity as a disregarded entity, then the IRS will respect that treatment.10
- If the married couple “treats” the entity as a partnership and “file the appropriate partnership tax returns”, then the IRS will respect the treatment of the entity as a partnership.11
No Form 8832 Required (It Seems)
It appears that you do not even need to file Form 8832 in this situation. All you do is start reporting income on Schedule C (for disregarded entity status) or file a Form 1065 (if you want partnership classification).
To see this in action, ponder the wisdom of CCA 200852001.12 This is a purely domestic situation, but the principles apply equally to a foreign eligible entity.
Husband and Wife formed a domestic corporation, and were both equal shareholders. They never did any of the State-required paperwork, so in short order the State dissolved the corporation. Husband and Wife nevertheless kept on
truckin’ doing business in the name of the corporation.13
The IRS audited them. Things got bad, things got worse (YouTube), and they end up in Tax Court.
The couple then files a Form 1040 reporting all of the business income on Schedule C–functionally treating the business entity as a disregarded entity.
The Chief Counsel’s office said that they satisfied the requirements of Rev. Proc. 2002-69. All the couple had to do–in order to force the result of “disregarded entity”–was to file a tax return. And that was the end of the Tax Court case.
Harry Callahan, Intrepid Revenue Agent
For the husband and wife who own the Mexican S de RL, a strict reading of Rev. Proc. 2002-69 would seem to tell us that they need not file Form 8832. They just need to start filing their tax returns the way they want the results to occur:
- Disregarded entity. If they want the S de RL to be treated as a disregarded entity, report its income and expense on Form 1040, Schedule C, and file Form 8858 to tell the IRS that they have a foreign disregarded entity.
- Partnership. If they want the S de RL to be treated as a partnership for U.S. tax purposes, file Form 8865 (U.S. partners in foreign partnerships) and report the income on Form 1040, Schedule E.
But . . . that conclusion seems so . . . incomplete.
Imagine your future self, under audit by IRS Revenue Agent Harry Callahan (YouTube). You earnestly press your case for the application of Rev. Proc. 2002-69. Revenue Agent Callahan squints at you, smirks ever so slightly, and says:
Uh uh. I know what you’re thinking. “Did I make an effective change of classification election or not?” Well to tell you the truth in all this excitement of this audit I kinda lost track myself. But being this is a multiple year failure to file Form 5471 penalty on top of a bunch of other penalties I can pull out of my pocket, which could bankrupt you, you’ve gotta ask yourself one question: “Do I feel lucky?” Well, do ya, punk?
Just File Form 8832
It strikes me that filing Form 8832 is a pretty good idea. And I have a Private Letter Ruling to back up my hunch.
PLR 20115101014 involved a husband and wife with a foreign eligible entity. They forgot to make the entity classification election for their foreign entity, but always treated the entity as a disregarded entity (reporting income on Schedule C).
In due course, the sun rises in the East, and the taxpayers asked for the Commissioner’s consent to make a late entity election. Permission granted. You have 120 days to file Form 8832.
From that, I take note: for whatever reason, the taxpayers felt it appropriate to wear a belt and suspenders. Technically they had satisfied the requirements of Rev. Proc. 2002-69 — and were entitled to treat their foreign entity as a disregarded entity for U.S. tax purposes.
But they felt compelled to file Form 8832, just to be really sure. No talking back to Dirty Harry for them.
Same for me. I would file Form 8832 to elect the specific tax treatment desired for the S de RL. I wouldn’t trust fate and the whims of bureaucracy.
Shhh. Don’t tell anyone, but between you and me . . . this isn’t legal advice to you and I’m not your lawyer. This is just something I did on a Tuesday night because it amused me (and helped Scott). Go hire someone to figure out the answers to your tax questions. Penny wise, pound foolish, etc.
- Regs. §301.7701-4(a), Regs. §301.7701-2(a). ↩
- Regs. §301.7701-2(b)(8) contains a list–by country–of the types of entities that are automatically and always treated as corporations for U.S. tax purposes. You can also find the list in the instructions to Form 8832. ↩
- Regs. §301.7701-3(b)(2)(i) ↩
- Regs. §301.7701-3(b)(2)(ii) ↩
- Regs. §301.7701-3(b)(2)(i)(A) ↩
- Regs. §301.7701-3(b)(2)(i)(B) ↩
- Regs. §301.7701-3(b)(2)(i)(C) ↩
- Rev. Proc. 2002-69, 2002-2 C.B. 831. (PDF) ↩
- Rev. Proc. 2002-69, 2002-2 C.B. 831, Section 3.02. (PDF) ↩
- Rev. Proc. 2002-69, 2002-2 C.B. 831, Section 4.01. (PDF) ↩
- Rev. Proc. 2002-69, 2002-2 C.B. 831, Section 4.02. (PDF) ↩
- CCA 200852001. (PDF). ↩
- Upon advice from noted management consultant Eddie Kendricks (YouTube). ↩
- PLR 201151010. ↩