What You Need to Know About Entity Classification Election

Business entities may elect to be treated as corporations taxed at the entity and member levels or as "flow through" entities taxed only at the member level. However, entities organized as corporations under U.S. state laws and certain foreign entities are treated as corporations, with no optional election.

Corporate tax is imposed in the United States at the federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Federal tax rates on corporate taxable income vary from 15% to 39%. State and local taxes and rules vary by jurisdiction, though many are based on federal concepts and definitions. Taxable income may differ from book income both as to timing of income and tax deductions and as to what is taxable.

There is an entity in charge of regulating the inflow of resources through tax collection in the country: The Internal Revenue Service. The Internal Revenue Service is the revenue service of the United States federal government. Is important to know that the government agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue.

The Internal Revenue Service s responsible for collecting taxes and the administration of the Internal Revenue Code. It has also overseen various benefit programs, and enforces portions of the Affordable Care Act.

Is also important to remember that some entities treated as corporations may make other elections that enable corporate income to be taxed only at the shareholder level, and not at the corporate level. Such entities are treated similarly to partnerships. The income of the entity is not taxed at the corporate level, and the members must pay tax on their share of the entity's income.

An entity which is eligible to make an election is referred to as an eligible entity. Generally, a corporation organized under the United States federal or state statute, and referred to as a corporation, body corporate or body politic by that statute, is not an eligible entity.

Reform business entity classification rules for foreign entities: Under the proposal, a foreign eligible entity may be treated as a disregarded entity only if the single owner of the foreign eligible entity is created or organized in, or under the law of, the foreign country in, or under the law of, which the foreign eligible entity is created or organized.

Therefore, a foreign eligible entity with a single owner that is organized or created in a country other than that of its single owner would be treated as a corporation for federal tax purposes. Except in cases of the United States of America tax avoidance, the proposal would generally not apply to a first-tier foreign eligible entity wholly owned by a United States person. The tax treatment of the conversion to a corporation of a foreign eligible entity treated as a disregarded entity would be consistent with current Treasury regulations and relevant tax principles.

For the record, a business entity is an entity that is formed and administered as per commercial law in order to engage in business activities, charitable work, or other activities allowable. Most often, business entities are formed to sell a product or a service. There are many types of business entities defined in the legal systems of various countries. These include corporations, cooperatives, partnerships, sole traders, limited liability company and other specifically permitted and labelled types of entities.

The following types of business entity are treated as eligible entities:

●     An eligible entity that previously elected to be an association taxable as a corporation.

●     A foreign eligible entity that became an association taxable as a corporation under the foreign default rule.

●     A foreign corporation that is not identified as a corporation under Treasury regulations.

A quick glance at history

Long before 1996 entities both domestic and foreign were classified as corporations or not based on the called "multi-factor test", which looked at limited liability; continuity of life; free transferability of interests; centralized management; associates; objective to carry on business for joint profit.

The initial regulations also included a list of foreign entities which would always be classified as corporations and which could not elect to be disregarded.

The first federal income tax was enacted in 1861 and expired in 1872, amid constitutional challenges. A corporate income tax was enacted in 1894, but a key aspect of it was shortly held unconstitutional. In 1909, Congress enacted an excise tax on corporations based on income. After ratification of the Sixteenth amendment to the United States of America Constitution, this became the corporate provisions of the federal income tax. Amendments to various provisions affecting corporations have been in most or all revenue acts since. Corporate tax provisions are incorporated in Title 26 of the United States Code, known as the Internal Revenue Code. The present rate of tax on corporate income was adopted in the Tax Reform Act of 1986.

Take a look to this article to learn how to reduce your personal and business taxes.

What You Need to Know About Corporate Taxation

Image courtesy GotCredit on Flickr

Becoming a company carries a new range of legal commitments and responsibilities.  One of those responsibilities is corporate taxes.  Whether they like it or not companies are affected by them.  The concept might be alarming at first but understanding its generalities and who it affects helps its management. Corporate taxes have been a frequent topic in the news and the headlines of articles and major publications because it is a major concern for big and small businesses.  Let’s talk about a little more about corporate taxation.

Definition

Corporate taxes are levied on the profits a corporation, large or small, generates by all levels of government.  Corporations are legal entities, not individuals or the owners of a company.  As such, corporate taxes can be considered the equivalent of the personal income tax an individual pays. The rates and laws of corporate taxes vary notably across multiple countries, since different governments and nations perceive corporate taxation differently. This is why companies have chosen to have their headquarters in specific places where corporate taxes are way lower.  One example is seen in companies that have moved to the Republic of Ireland (Irish tax rate is only 12.5%) compared with the rate they would have to pay in the U.K. 

Mobile capital: the example of the U.S.

Another example could be seen in the United States.  This country has one of the highest corporate tax rates in the world. It is 35% and almost 40% when state taxes are added.  For this reason, some American companies have “relocated” outside the country, through mergers with or purchases of a foreign company.  This way they become a foreign entity and can be still managed from the U.S. but because of their headquarters address (at least on paper) they are no longer subject to U.S. corporate taxes. They are taxed according to that foreign country’s rules. Therefore, this business behavior is increasingly seen due to high corporate rates that companies are trying to avoid.

Another reason for this tax behavior in the case of the United States is because its corporate tax system could be considered different compared to most other developed countries systems.   This country taxes corporations based on the profits they make worldwide as opposed to profits they make at home.  On the other hand, other countries tax corporations for the business that takes place in their own territory. So there are American companies earning money overseas, and since they do not have to pay U.S corporate tax until they repatriate these moneys, their profits are sitting overseas as a mechanism to avoid  bringing the money home and paying American taxes.

Corporate taxes are a matter of debate in many countries due to their economic impact.  Thus, there is some concern that being tougher on taxes may do more harm than good. Those who favor higher corporate taxes argue they give governments the assets to fund programs (education, hospitals, security), to raise revenue, to encourage specific investments in specific industries, to stimulate economic growth (basically taxes provide many nations with a large source of income) for the welfare of the nation.  Others argue that lower rates help companies hire employees and producing goods, thus boosting an economy.  Although, the desire for some companies to pay lower taxes and reduce their tax bill is understandable, there are some that simply do not want to pay it at all.  And of course, they are considered by many unpatriotic corporate citizens.

What can be done about the taxation system?

Image courtesy 401(K) 2012 on Flickr

When companies leave, particularly in the case of the U.S., the country loses significant tax revenue, money that would probably be reinvested into the nation through more jobs, more improvements, more infrastructure, and prosperity in general terms.  This situation undoubtedly preoccupies the government and for this reason it is experiencing an increasing pressure to stop it, and the approach do not seem to be yielding the results expected regarding foreign inversion.  It is believed that when companies prefer business overseas to protect their income they are betraying their nation.  This situation has forced the government to implement strategies to close these tax “loopholes”, obligating companies to stay loyal to the U.S. and keep their capital into their jurisdictions. 

The bottom line is that taxes have been affecting decisions in companies concerning location and investment to manage and control their tax obligations. Because corporate taxation plays a special role in economies, nations should consider the complexity of the topic and design reforms that improve the welfare of all the parties affected and reduce the risk associated. As it was said by Kate Elliot from Rahtbone Brothers PLC:  “A total lack of tax planning is bad for investors and evasion is illegal, but we know companies operate in grey areas.  The key thing for investors is to understand where a company sits on this spectrum: how light or dark grey its tax practices are.”