Collateral consequences of check-the-box.

The opening words of Sec. 7701, "When used in this title ..." seem to state dearly the principle that the section (including, of course, the "check-the-box" rules contained in Regs. Sec. 301.7701-1) applies to the entire Code. In spite of this seeming clarity, many taxpayers have mistakenly interpreted Regs. Sec. 301.7701-2(c)(2) as applying only for Federal income tax purposes. There may be some potentially unanticipated consequences, both in the income tax and other areas. In the following discussion, it will be assumed that the U.S. has no income tax treaty, Social Security totalization agreement or estate tax treaty with any of the foreign countries involved.

Effect on Source of Interest Income

Assume that U.S. domestic corporation P has formed wholly owned "eligible entity" A under the laws of foreign country E A conducts operations only in F. A borrowed money from a bank (M), located in foreign country T. If A is treated as a corporation, the interest paid by A to M results in no direct U.S. tax consequences, because the interest received by M is not from U.S. sources.

However, assume that a check-the-box election to disregard A is made. Thus, for U.S. tax purposes, A is a branch of P. P is now the payor of the interest in the U.S. tax view. As a result (assuming that P does not itself qualify as an "80-20" company as provided in Sec. 861(a)(1)(A) and (c)), the interest paid by A (as a branch of P) is subject to U.S. taxation and withholding at a 30% rate. There may also be taxation and withholding by F, A's resident country. However, even if a tax treaty between F and T existed providing for zero taxation of the interest paid, it would seem to have no effect on this conclusion.

If (instead of being wholly owned by P) A were owned 90% by P and 10% by P's subsidiary S, A would be considered a partnership and not a disregarded entity, if the check-the-box election for such treatment were made. As such, the interest paid by A would not be subject to U.S. tax, because the interest would not be deemed from U.S. sources. Interest paid by a partnership is from a U.S. source only if the partnership is a U.S. resident (which A is not). However, if A were conducting, for example, 25% of its business in the U.S., a question arises as to whether withholding would be required on any interest paid by A; Regs. Sec. 1.862-2(a)(2)(iv) provides that a partnership is a U.S. resident if it "is engaged in a trade or business in the United States" thus creating a problem of U.S. source.

Effect on FICA Taxes

Returning to the situation in which A is wholly owned by P, further assume that A employs E a U.S. citizen. If A is treated as a corporation, and assuming that Secs. 3121(1) and 176 do not apply, no FICA taxes are imposed, because A is not a U.S. employer. However, if A is disregarded and treated as a branch of P (which is a U.S. employer), P is deemed the employer of the U.S. citizen and FICA taxes will apply.

Effect on Estate Taxes

Assume that B is an eligible entity organized under the laws of foreign country G. B conducts all its business in the U.S. Its sole owner is M, a nonresident alien. On M's death, if B is treated as a corporation, there is no U.S. property deemed owned by M to be subject to U.S. estate tax. However, if B is treated as a disregarded entity, all of B's U.S. assets would be subject to the U.S. estate tax.

These examples illustrate some of the wide range of collateral consequences involved in making a check-the-box election. A review of all ramifications should be made before such elections are made, if proper planning is to avoid possible adverse consequences.

FROM PAUL FARBER, CPA, RICHARD A. EISNER & COMPANY, L.L.P., NEW YORK, NY