Planning Opportunities under New Employment Tax Rules for Foreign Disregarded Entities

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By Thomas St.G. Bissell

Celebration, FL 

As a result of IRS regulations that took effect on January 1, 2009,1  all entities with a single owner that are classified as "disregarded entities" (DEs) under the IRS check-the-box regulations are no longer disregarded for federal employment tax purposes – i.e., for purposes of social security tax (FICA), wage withholding of income tax, and unemployment tax (FUTA).  Although the new rules were drafted by the IRS primarily with domestic DEs in mind, they apply equally to non-U.S. entities. As such, they can present significant planning opportunities in an international context.

Since the check-the-box regulations became effective in the 1990s, they have made it much easier for U.S. multinational companies to treat separately incorporated foreign subsidiaries as an integral part of the U.S. parent's U.S. and foreign operations for federal income tax purposes, while at the same time protecting the company that owns the DE from liability for the DE's legal obligations.  In Notice 99-6,2  however, the IRS provided that the owner of a DE incorporated under state law could elect to treat that company as a separate entity for federal employment tax purposes, while still retaining legal liability for any unpaid employment tax.  Because the Notice did not apply to non-U.S. DEs, however, most U.S. multinationals continued to treat their foreign DEs as a "branch" of their single owner for federal employment tax purposes.

In 2007, the IRS issued final regulations in T.D. 9356 changing these rules to require that, effective January 1, 2009, all DEs would henceforth be liable for their own federal employment tax – i.e., they could no longer be treated as DEs for employment tax purposes, and thus implicitly their owners would no longer be personally liable for those taxes. Although the regulations do not expressly mention either U.S. or non-U.S. DEs as such, they clearly apply to U.S. and non-U.S. DEs alike.

The most significant potential saving to U.S. parent companies and their foreign-based employees is clearly under the FICA rules. Those rules provide in effect that if a U.S. citizen or "resident alien" (within the meaning of §7701(b)) works outside the United States as the employee of a foreign corporation, FICA is payable only if the corporation is at least 10% owned (directly or indirectly) by an "American employer" and if an agreement is entered into by that "American employer" with the IRS under §3121(l) to treat U.S. employees of the foreign corporation as if they were employees of the U.S. company.3  Prior to January 1, 2009, if a U.S. citizen was working abroad for a DE that was owned directly by a U.S. parent company, the individual's wages were subject to FICA without the need for a §3121(l) agreement because he was treated as the direct employee of an "American employer."4  However, because the new rules of T.D. 9356 are mandatory, effective January 1, 2009, FICA ceased to be payable on his non-U.S.-source wages unless the U.S. parent entered into a §3121(l) agreement to cover all U.S. employees working abroad for that particular foreign entity. Similarly, if the DE was owned by a CFC (not a DE) that prior to January 1, 2009, was covered by a §3121(l) agreement that its U.S. parent had once entered into, that agreement ceased to be effective with respect to the DE on January 1, 2009, and FICA coverage could be continued only if the U.S. parent entered into a new §3121(l) agreement with respect to the particular DE.

Notwithstanding the rules described above, it is possible that if the DE was once classified as a non-DE and at that time was covered by a §3121(l) agreement,5  the effect of the new rules might possibly be to "reactivate" the original §3121(l) agreement (whether or not the U.S. parent wished it to be reactivated).  It would obviously be helpful if the IRS issued guidance on this particular issue.

It should be stressed that loss of FICA coverage during part or all of a U.S. employee's foreign assignment is often welcomed by both the employer and the employee because of the substantial cost of employer and employee FICA (including the 2.9% "Medicare tax," which has no wage ceiling), especially when FICA is imposed on additional foreign "allowances" such as cost-of-living allowances, private school reimbursements for dependent children, and home leave tickets. However, if the employee is working in a country that imposes high social security taxes on his salary, and if there is a social security "totalization" agreement in effect between the United States and that country so as to avoid double social security tax, it may be cost-effective to keep the employee in the U.S. FICA system so as to avoid the often higher cost of the foreign country's social security taxes.6  Higher social security taxes are imposed in many EU countries, most of which have totalization agreements with the United States. Avoiding FICA is often cost-effective in countries outside the EU, particularly in Canada and in the developing countries of Latin America and Asia, where local social security taxes are often either very low by U.S. standards or non-existent.

If a U.S. parent company wishes to exclude one or more of its foreign DEs from FICA coverage, the company should always consider the ancillary question of whether doing so could result in excluding U.S. employees of those DEs from the U.S. parent's tax-qualified retirement plans. If the DE is directly owned by a U.S. company, it seems likely that the DE will be treated as a foreign branch for all federal income tax purposes, including Subchapter D (§§401 ff., governing tax-qualified retirement plans), so that if employees of foreign branches of the U.S. owner are covered by the U.S. owner's retirement plans under the terms of those plans, U.S. employees of the DE will probably also be covered. If the DE is owned by a CFC whose U.S. employees are covered by the U.S. parent's plans under §406 because of a §3121(l) FICA election that covers the CFC itself but not the CFC's DE "branch," however, the answer is not as clear. Notwithstanding the Code's directive in §406 that a §3121(l) election must be made in order to cover U.S. employees of a foreign company under the U.S. parent's tax-qualified retirement plans, most commentators believe that, under §414(b), a U.S. parent may cover U.S. employees working outside the United States for foreign companies that are not covered by a §3121(l) election, provided that the foreign company is at least 80% owned (directly or indirectly) and that the plan provides such coverage.

The new DE rules are likely to have a much smaller cash-flow impact with respect to federal wage withholding tax under §§3401 ff. Whether a U.S. employee is working abroad directly for a U.S. company or for a CFC, federal wage withholding tax is usually reduced or eliminated because of several special exceptions in the law. Federal wage withholding is eliminated if the employee's wages are subject to wage withholding tax under the laws of a foreign country (even if at a very low rate), and federal wage withholding can be reduced to reflect the so-called "911 exclusion" as well as foreign tax credits against the employee's U.S. tax (as well as, of course, deductions allowed to the employee for federal income tax purposes).7  To the extent that an employee's federal wage withholding tax would have been reduced or eliminated with respect to the DE's owner under the pre-2009 federal employment tax rules for foreign DEs, therefore, the DE's own liability for federal wage withholding tax would usually be similarly reduced or eliminated.

By the same token, liability for FUTA is likely to be affected only in the situation where the DE is directly owned by a U.S. parent company. In that situation, the pre-2009 rules treated the DE as a foreign branch of the U.S. parent for FUTA purposes, and thus FUTA was imposed on the U.S. parent with respect to wages paid to U.S. citizens working outside the United States for the foreign branch. Because there is no FUTA equivalent to the FICA election under §3121(l),8   however, wages paid to U.S. citizens who work outside the United States for a U.S.-owned DE have been exempt from FUTA since the new DE rules took effect on January 1, 2009. Wages paid to U.S. employees of a CFC-owned DE were exempt from FUTA under the pre-2009 federal employment tax rules for foreign DEs, and continue to be exempt from FUTA under the new rules of T.D. 9356.

To the extent that foreign-based U.S. employees of a non-U.S. DE make business trips to the United States, the new rules will impose a direct federal employment tax liability on the DE that did not exist before – although a similar liability was imposed prior to January 1, 2009, on the DE's U.S. or CFC parent.  If the DE is not covered by a §3121(l) election, the DE is nevertheless liable for FICA on wages paid to all of its employees (both U.S. and non-U.S.) who visit the United States on business, although in practice FICA is often paid only with respect to U.S. citizens and resident aliens.9  Similarly, federal wage withholding will usually be imposed on the U.S.-source portion of the employee's wages, as well as FUTA. This means that the DE must obtain an employer identification number (EIN) in its own name and file federal employment tax returns on Forms 940 and 941, and make timely tax deposits with the IRS (although the DE may be able to delegate its FICA and wage withholding responsibility to an "agent" by filing IRS Form 2678).

In many cases a foreign corporation in this situation is reluctant to comply with its federal employment tax obligations – especially if its ultimate owners are foreign persons and not a U.S. company – because of concern that filing federal employment tax forms could trigger a corporate income tax audit that might lead to a federal income tax liability and the required filing of IRS Form 1120F. Because the new IRS employment tax rules for DEs do not change the federal income tax rules that apply to a DE, a foreign DE's visibility vis-a`-vis the IRS for income tax purposes should be no greater than it was under the pre-2009 rules. Thus, if the DE is U.S.-owned, filing Forms 940 and 941 should not risk an IRS audit on the question of whether the DE has its own 1120F filing obligation, because the DE's worldwide income would be "consolidated" with the taxable income of its U.S. parent. Similarly, if the DE is owned by a CFC, the new rules require it to file the same Forms 940 and 941 that its CFC parent would have been required to file under the pre-2009 rules, and any Form 1120F filing that the CFC might have been required to file as a result of U.S. business trips by the DE's employees will continue to be required without regard to which entity files federal employment tax returns under the new rules.

As a final note, the state and local employment tax filing rules must always be considered. In its Preamble to T.D. 9356, the IRS stated that the new rules would bring the federal employment tax rules for DEs more in line with the applicable state employment tax rules, which in most cases impose a filing obligation on the DE itself rather than on its owner. In the case of U.S. employees working outside the United States for a DE, however, the state employment tax rules in most cases have a very limited impact. There is usually no state counterpart to the U.S. FICA tax, and state wage withholding tax rules often mirror the federal rules,10  which as noted above often provide for a de facto withholding exemption for U.S. employees working abroad. The new rules could have an ancillary impact in some states on the state unemployment tax (SUTA) rules, however, if a state's SUTA law mirrors the federal FUTA rules. As noted above, if a DE is directly owned by a U.S. parent, FUTA that was imposed prior to January 1, 2009, ceased as of that date, and presumably any corresponding SUTA that mirrored the FUTA rules ceased as well.

This commentary also will appear in the March 2011 issue of BNA's Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, Bissell, 916 T.M., International Aspects of U.S. Income Tax Withholding on Wages and Service Fees, Bissell, 917 T.M., International Aspects of U.S. Social Security and Unemployment Taxes,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Income.

1 T.D. 9356, 72 Fed. Reg. 45894 (8/16/07), amending §301.7701-2(c)(2)(iv)(B), so as to provide that a wholly-owned entity "that is otherwise disregarded as an entity separate from its owner … is treated as a corporation with respect to taxes imposed under Subtitle C – Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24 and 25 of the Internal Revenue Code)." Note that this regulation has been subsequently revised in 2009 by T.D. 9462, 74 Fed. Reg. 46903 (9/14/09), by issuing a temporary regulation. 

2 1999-3 I.R.B. 12. 

3 The agreement between the "American employer" and the IRS is made on IRS Form 2032. See the discussion in Bissell, 917 T.M., International Aspects of U.S. Social Security and Unemployment Taxes, at VI, C, 2. 

4 See 917 T.M. at VI, C, 1. 

5 For example, the foreign entity may have been classified as a corporation for federal income tax purposes for a number of years, and, at some time after the check-the-box regulations took effect, the U.S. parent company took steps to convert it into a DE for U.S. tax purposes (an action that would generally have been characterized as a deemed liquidation of the entity for U.S. tax purposes). 

6 See 917 T.M. at VII. 

7 See the discussion of these rules in Bissell, 916 T.M., International Aspects of U.S. Income Tax Withholding on Wages and Service Fees, at VII, B. 

8 See 917 T.M. at XI, D. 

9 The reason why FICA in practice is often not collected and paid with respect to nonresident aliens who visit the United States on business is because it is usually not possible to obtain a social security number for those employees, thus making it impossible to match up FICA collections with those particular employees. See the discussion in 917 T.M. at VI, A, 3. 

10 In practice, many U.S. employees working abroad cease to be income tax residents of the state where they lived prior to starting their foreign assignment, and as such they often remain subject to wage withholding tax in that state only on wages for business trips back to that particular state, or on deferred compensation paid in a later year for work done while they were resident in that state. 

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