For U.S. owners of foreign businesses, the choice of legal entity is an essential part of operating efficiently overseas. Most jurisdictions have a variety of entity options (for example, corporation, partnership, trust, etc.) that can offer business owners the desired combination of legal and economic attributes.

A U.S. owner of a foreign business, whether he or she lives within or outside of the United States, faces the additional challenge of properly applying the U.S. tax rules, both in terms of substance and in terms of compliance, to a non-U.S. entity.

A chief misconception in this regard is that the classification of a foreign business entity for U.S. tax purposes should follow the classification given under the legal or tax rules of the local jurisdiction. While this seems intuitive, and, in fact, does have some relevance in certain areas of U.S. tax law, the general rule is that the U.S. Internal Revenue Code and Treasury Regulations essentially ignore local law and apply a very specific set of rules to determine the entity’s classification for U.S. tax purposes.

The fallout from this discrepancy can be that a foreign company has one classification for foreign legal and tax purposes and a completely different classification for U.S. tax purposes.

The relevance of tax classification

A foreign entity on its own generally should not be impacted by the U.S. tax rules, except mainly in the following two cases:

  1. The foreign entity has U.S. concerns, such as certain U.S. source income or activities within the U.S. that rise to the level of a U.S. trade or business under the U.S. tax rules; or

  2. The foreign entity has a U.S. owner (or member or partner, depending on the type of entity) and such ownership triggers the application of the U.S. tax rules.

If either of these cases is true, then determining the U.S. tax classification Read More Here