Entity classification elections, or ‘check-the-box’ (CTB) elections as they are so affectionately known in the US/UK tax community, allow certain foreign entities to change their default tax treatment for US tax purposes.

For example, the US tax treatment of a non-US entity may be different to the local treatment. The most common example we see is a UK limited liability partnership (LLP). The US default tax treatment of the UK LLP is a UK company rather than a partnership. So, for tax purposes, without a CTB election, this creates a mismatch between US and UK tax treatment.

A UK company is taxed on its profits in the UK, which considers it to be opaque for tax purposes. For US tax purposes, by making a CTB election, that company can elect to be treated as tax transparent or flow-through. The owners of the company electing to be treated as flow-through are now considered to own the assets, liabilities, income and expenses of the company directly for US tax purposes.

There are a few reasons why you would undertake a CTB election. Most commonly, it is to bypass anti-avoidance rules affecting US owners of UK companies.

The Internal Revenue Service (IRS) has a keen eye for Americans using non-US companies and has specific rules that apply dependent on whether the company is controlled by US people, and the nature of the trade or business of the company.

The Passive Foreign investment company (PFIC) rules apply to companies which are not controlled by US people, and primarily generate passive investment income, or hold assets that generate passive income.

Companies that are controlled by US people are subject to different tax rules designed to stop deferring US tax on profits by using a non-US company. The US treats them as having distributed their share of profits in the year the profits arise. The Subpart F provisions focus on passive income, and personal service contracts, and GILTI is the ‘catchall’ provision which captures all other companies controlled by US people.

Making a CTB election means your UK company will no longer be viewed as a company for US tax purposes, so these issues will no longer exist

Sounds great: what is the catch, though?

First, a CTB election triggers a deemed sale at fair market value of the UK company. US owners can have a US taxable capital gain on making the election. Any tax will need to be paid out of pocket. This may also create a future US and UK mismatch on future sale of company shares. Therefore, the timing of the election should be considered as part of any planning.

Second, as the UK company is passthrough, the US shareholders are required to pay US tax on their share of the company income. They can claim a credit for the corresponding UK Corporation Tax. However, the US Income Tax rate (current top rate of 37%) is significantly higher than the UK Corporation Tax rate (currently 25%).

This can make the election unattractive to businesses that are working capital intensive or looking to invest. They typically are not in a position to distribute money to their shareholders to be able to pay the additional US tax bill. Where there are dividends being paid, it is possible to manage the UK taxes paid to bridge the gap in tax rates. This will require management and planning on an annual basis to ensure that sufficient personal UK income and taxes are being paid and able to be claimed in the right period.