How to fix a problematic check-the-box election

Hello and welcome to The Friday Edition, an every-other-Friday international tax newsletter. I’m Phil Hodgen, and international tax lawyering is what I do in my day job.

Check-the-box elections gone wild

Let’s talk about fixing messes. In particular, fixing a mess made by a check-the-box election. How can you hit the “reset” button?

It’s easier to fix than you think. Or, at least, it’s easier than I thought when I saw this for the first time.

How a check-the-box election can increase tax liability

A domestic corporation is allowed a deduction equal to 37.5% of its foreign-derived intangible income. This reduces its effective tax rate on that type of income from 21% (normal corporate tax rate) to 13.125%. IRC §250(a)(1)(A).

That’s free money from Uncle Sam and the first rule of tax law is to take free money when Uncle Sam is giving it away. You want the IRC §250 deduction.

A domestic corporation doing business through a foreign disregarded entity will (almost certainly) treat the foreign disregarded entity’s income as foreign branch income. Crucially, you subtract foreign branch income from gross income when you calculate foreign-derived intangible income.

See how it works on Form 8993: gross income (line 1) minus foreign branch income (line 2f) equals gross deduction-eligible income of $0 (line 4).

I won’t bother you with the details of how you get from deduction-eligible income to foreign-derived intangible income on Form 8993. Too much gratuitous complexity.

But trust me–when you start from a base of $0 for gross deduction-eligible income, it is impossible to have foreign-derived intangible income greater than $0.

And 37.5% of $0 is $0.

Goodbye to the IRC §250(a)(1)(A) deduction. The check-the-box election caused the foreign disregarded entity’s income is taxed at 21%, not at an effective rate of 13.125%.

The question then becomes: can you reverse a check-the-box election when you discover it’s suboptimal?

The 60-month limitation

When you think of check-the-box elections, you probably remember the 60-month rule: when an entity makes an election to change its classification, you can’t make another election to change its classification again for 60 months. Reg. §301.7701-3(c)(1)(iv) says:

“If an eligible entity makes an election under paragraph (c)(1)(i) of this section to change its classification (other than an election made by an existing entity to change its classification as of the effective date of this section), the entity cannot change its classification by election again during the sixty months succeeding the effective date of the election.

However, an exception exists. Let’s exploit it if we can.

A check-the-box election effective on an entity’s formation date does not count

You would think that any election to change the tax classification of an entity would trigger the 60-month prohibition against a new election. You would be wrong.

An election to change an entity’s classification–if it is effective as of the formation date for the entity–does not start the 60-month clock running. Reg. §301.7701-4(c)(1)(iv) states:

“An election by a newly formed eligible entity that is effective on the date of formation is not considered a change for purposes of this paragraph (c)(1)(iv).”

In other words, a check-the-box election effective from the moment an entity is formed does not change the entity’s tax classification–it is the starting classification.

And since a check-the-box election that is made effective on the date of formation of an entity is not a change in tax classification, the 60-month limitation rule does not apply. You could file another Form 8832 a month later, make another check-the-box election, and it would be valid–not barred by the 60-month limitation rule.

A foreign entity’s first day of “relevance” = the date of formation

This is where the magic happens.

The IRS takes the position that if a foreign eligible entity makes a check-the-box election that is effective on the date that the election became “relevant,” then that’s the same as an election that is effective at the date of formation.

It then follows that the 60-month limitation rule does not apply to that foreign entity that made a check-the-box election effective on its first day of relevance. It can file a new Form 8832 a month later and the tax classification change will be valid.

AM 2021-002 (April 2, 2021) says:

Further, Treas. Reg. § 301.7701-3(d)(2) should be interpreted such that an elective classification that is effective on the date the classification first becomes relevant is treated solely for purposes of the 60-month limitation rule as if it were effective on the date of formation and the election does not preclude a subsequent election within 60 months to change the classification election does not preclude a subsequent election within 60 months to change the classification.”

The authors of AM 2021-002 should be given some type of award for conjuring up a coherent and practical solution to a problem created by a horribly-written Regulation. Their logic reminds me of medieval theologians writing proofs of the existence of God–hard, noble work.

Internal Revenue Manual confirms the 60-month rule does not apply

The Internal Revenue Manual confirms that a foreign entity’s check-the-box election that is effective on the first day that it is “relevant” will not start the clock on the 60-month limitation.

IRM 3.13.2.27.10(5) says (emphasis added):

Once an eligible entity makes an election to change its classification, the entity generally cannot change its classification by election again during the 60 months after the effective date of the election. Note: The 60-month limitation does not apply (1) if the previous election was made by a newly formed eligible entity and was effective on the date of formation or (2) if the previous election was made by a foreign eligible entity whose classification was not relevant prior to the effective date of the previous election.

This means that if the check-the-box election you want to reverse was made effective as of the first day that the election was “relevant,” then you can change it at any time. You don’t have to wait for 60 months.

This now means it is important to identify the moment at which a check-the-box election is “relevant.”

When is a foreign entity’s classification “relevant”?

A foreign eligible entity’s classification is relevant when one of two things occurs:

The entity’s classification affects the liability of any person for federal tax or information purposes. Reg. §301.7701-3(d)(1)(i).
The effective date of a Form 8832 check-the-box election. Reg. §301.7701-3(d)(1)(ii)(A)

Yes, a foreign eligible entity can file a valid check-the-box election even if the entity never touches the U.S. tax system (no U.S. owners, no U.S. activities).

So all you need to know (in order to determine the first day of relevance), is whether the foreign entity had a U.S. owner, U.S. assets that trigger a reporting requirement, or U.S.-source income that trigger an information requirement (e.g., Form W-8BEN), tax return requirement, or tax liability.

If yes, and if that day is before the effective date of the Form 8832 check-the-box election causing you so much trouble, you are screwed: the 60-month limitation applies, and you cannot make another check-the-box election to fix the problem.

If no (relevance started on the effective date of the problematic check-the-box election), then you are in heaven: the 60-month limitation does not apply, and you can make a second check-the-box election to solve the problem created by the first check-the-box election.

Timing and effect of fixing a check-the-box election

OK. You have decided that you can make a second check-the-box election, and you aren’t barred from doing this by the 60-month limitation.

What is the effect of that that remedial check-the-box election? Well, that depends on its effective date.

Before the initial tax return due date (without extension)

A letter requesting rescission of a Form 8832 check-the-box election, if received by the IRS before the first year’s tax return due date, will rescind the election entirely, returning the entity to its default status.

Per IRM 3.13.2.27.10(2):

For the taxpayer to withdraw/rescind the election, the request must be received by the due date of the initial tax return. A withdrawal/rescission is a request to treat the entity as if the classification election had never been input or applied.

IRM 3.13.2.27.10(4) provides an example:

TC 076 effective date is 01-01-2024 election and/or request to withdraw must be received by 04-16-2025.

Personally, I think there is an argument to be made that you could send a letter rescinding the first check-the-box election that caused you so much trouble, and then file a second check-the-box election using the late-filing procedures of Rev. Proc. 2009-41.

But that’s maybe a little too clever, and anyway, simply reverting to default classification (“association taxable as a corporation”) is probably what you want anyway.

After the initial due date but before the extended due date

If you attempt to rescind the original check-the-box election after the filing date but before the extended due date (assuming a valid extension of time to file the return), the answer is unclear.

IRM states in 3.13.2.27.10(2) that the request must be “received by the due date of the initial tax return” but doesn’t explicitly specify whether this includes extensions.

Tax procedure is replete with instances going both ways. Sometimes, the filing date deadline is assumed to mean the extended deadline. Sometimes, the filing date deadline is the filing date deadline without extension.

Who knows what would happen here if you attempted to rescind the original check-the-box election if you did so after the default filing deadline but before the extended filing deadline.

Well, I know, but with a sample set of n = 1. It works. Anecdote or data? You be the judge, and your mileage may vary. You miss 100% of the shots you don’t take, etc. etc.

This again should have the effect of rescinding the original check-the-box election as if it didn’t happen, and revert the foreign entity back to its default classification (probably “association taxable as a corporation”).

After the extended due date

If you want to fix the problematic check-the-box election after the extended deadline, the only hurdle to surmount is the 60-month limitation. And assuming that limitation away, you will file a new Form 8832, with a new check-the-box election for the foreign entity.

This is a change of classification, and you look at Reg. §301.7701-3(g) to see the tax effect of that election. If you have a disregarded entity and you wish you had a corporation (which is the case for the FDII problem that I identified at the beginning of this discussion), it’s treated as a contribution of all assets and liabilities to a corporation in return for stock. Reg. §301.7701-3(g)(1)(iv). That may well be a tax-free event, e.g., under IRC §351.

Conclusion

So there you have it. The takeaway points are:

Don’t assume that a check-the-box election is a good thing. It might increase taxes.
If a check-the-box election for a foreign entity has an effective date of the first date on which the entity has “relevance,” then you’re not locked into that tax classification for 60 months. You can fix the problem anytime you want by making a new election.
How fast you fix the check-the-box problem will determine the tax consequences of fixing the problem. Do it before the original filing date of the first year’s tax return for which the election is effective–if you can.