Reporting of Foreign-Owned U.S. Disregarded Entities May Require Prompt Action
The U.S. limited liability company (“LLC”) has been, for a long time, the entity of choice for multinational business planning. It is a flexible entity which allows for ownership by U.S. nonresidents, and it is a very good example of a hybrid entity taxed either as a flow-through if owned by two or more members, or disregarded for tax purposes, or treated as a taxable C corporation if the appropriate election is made.
This concept of an entity being “disregarded” and thereby transparent for tax purposes caught the attention of the IRS, and in December 2016 Treasury regulations were finalized that changed the LLC as a disregarded entity’s reporting requirements. Beginning in 2017, U.S. disregarded entities that are wholly-owned, directly or “indirectly,” by one foreign person are now treated as domestic corporations for the purpose of reporting, record maintenance and other compliance requirements under IRC Sec. 6038A (“Information With Respect to Certain Foreign-Owned Corporations”).
Previously, compliance with IRC Sec. 6038A only applied to 25% foreign-owned domestic corporations and foreign corporations engaged in a trade or business within the U.S. Since both “direct and indirect” ownership apply to IRC Sec. 6038A reporting, it is important to understand what constitutes “indirect ownership.” Indirect sole ownership is defined as:
- “ownership by one person entirely through one or more other entities disregarded as entities separate from their owners, or
- through one or more grantor trusts, and
- regardless of whether any such disregarded entity or grantor trust is domestic or foreign.”
The above rules apply to taxable years of reporting corporations beginning after December 31, 2016 and ending on or after December 13, 2017. Further, the taxable year of the reporting corporation is deemed to be the same as the foreign owner if the foreign owner has a U.S. income tax or information return filing obligation, or a calendar year tax year if the foreign owner does not have U.S. filing obligations.
Accordingly, entities affected by IRC Sec. 6038A are also required to file IRS Form 5472, to disclose monetary and non-monetary “reportable transactions” with foreign related parties which include the direct or indirect foreign owner. The transaction disclosure rules and coverage are very broad and include sales, assignments, leases, licenses and loans, advances, contribution of tangible or intangible property, and transactions in connection with the formation, dissolution, acquisition and disposition of the entity. For calendar 2017 tax year, the mechanics of Form 5472 reporting are quite simple in that the entity will file a pro forma IRS Form 1120, which is used by U.S. corporations, and include Form 5472 and statements to support transactions as required. IRS Forms 5472 and 1120 and supporting statements are to be remitted to the IRS, via fax or mail, on or before April 17, 2018. Presently there is no opportunity to efile the Form 5472 and accompanying Form 1120 for these disregarded entities and the filings can be extended by using IRS Form 7004. The instructions to Forms 5472 and 7004 describe the specific requirements for filing, including the limited information required on Form 1120. Please refer to https://www.irs.gov/pub/irs-pdf/i5472.pdf and https://www.irs.gov/forms-pubs/extension-of-time-to-file-by-foreign-owned-us-disregarded-entity.
Further, the instructions to Form 5472 provide that a reportable corporation is not required to file Form 5472 if a U.S. person that controls the foreign related corporation files Form 5471 (“Information Return of U.S. Persons With Respect to Certain Foreign Corporations”) and provides reportable transactions between the reporting corporation and the related party on that form (Schedule M). However, this exception does NOT apply to foreign-owned U.S. disregarded entities. Similarly, the final regulations under IRC Sec. 6038A exclude a foreign-owned U.S. disregarded entity from certain exceptions to IRC Sec. 6038A record maintenance requirements (less than $10,000,000 in gross receipts, not more than $5,000,000 of reportable related party transactions that are less than 10% of U.S. gross income).
Observation: To satisfy the disregarded entity requirement, both the entity and the foreign owner will need to include U.S. identification numbers. It is also worth mentioning that these regulations do not affect the disregarded entity’s classification for other purposes.
Failure to timely file Form 5472 (and failure to maintain required records) will result in a $10,000 penalty assessed on the reporting corporation, with additional penalties imposed if the failure continues for more than 90 days after notification by the IRS. In addition, criminal penalties may also apply for failure to submit information or for filing false or fraudulent information; accordingly, noncompliance can be rather expensive. Looking ahead for tax years beginning after December 31, 2017, the penalty increases from $10,000 to $25,000 for each return required to be filed.