Today, I’m going to say something nice about the IRS. Really!
Thousands of Americans have tax reporting obligations they don’t know about for various offshore transactions. Among the most common of these are unreported interests in particular, foreign corporations.
Forming a foreign corporation is one of those things that, at first glance, would appear not to raise an IRS reporting obligation.
After all, simply buying shares in a foreign corporation doesn’t generally create such an obligation. For instance, if you buy shares of Bayer on the Frankfurt exchange, your only reporting obligation is to let the IRS know when you receive a dividend, or sell the shares for a capital gain. (However, if you purchase the shares through a foreign bank account, you must report the existence of the account.)
Logically speaking, wouldn’t the same treatment apply to shares of your own foreign corporation? The answer, unfortunately, is in many cases "no."
In virtually all cases in which Americans form a foreign corporation to hold assets that generate passive income, they become entangled in the "controlled foreign corporation" or "CFC" rules.
These extremely complex regulations exist to prevent U.S.-based multi-national corporations from diverting profits into foreign subsidiaries, where they can be tax deferred indefinitely.
If U.S. shareholders own 50% or more of the shares in a foreign corporation (e.g., an international business company or IBC), by vote or value, the foreign corporation is a CFC. U.S. shareholders are defined as U.S. natural persons, partnerships, corporations, trusts, and estates that own, respectively, 10% or greater interests in the foreign corporation.
Anyone defined as a U.S. shareholder in a CFC is required to file an extremely complex information return each year with the IRS—Form 5471.
What’s more, if the CFC holds passive assets, the income generated is currently taxable to the U.S. shareholder. The income need not be distributed as a dividend to be taxable.
Problem is, the offshore companies that form foreign corporations for Americans know little or nothing about U.S. reporting obligations. Many of them simply tell their U.S. clients what seems obvious—that no reporting obligation exists until the client sells the shares or the corporation issues a dividend.
Bad advice. A U.S. shareholder who fails to file Form 5471 when required is subject to a US$10,000 civil penalty. Harsher penalties, including possible imprisonment, may also apply in aggravated circumstances.
This situation may also apply to wealthy immigrants who own a foreign business "back home." They go to a U.S. tax advisor who knows nothing about international tax law. The advisor tells them that since the foreign business files taxes "back home," it has no U.S. tax obligations.
Again, bad advice. While it’s true that the company itself may have no U.S. tax obligations, it’s now-U.S. shareholders may well need to file Form 5471.
And here’s where the IRS has played "Mr. Nice Guy." Well, at least a little.
I recently received correspondence from a CPA specializing in international tax compliance who says he files more than 30 delinquent Form 5471s each year. And not one of these clients has ever been subjected to the US$10,000 civil penalty.
There are no guarantees, of course. But especially if the foreign corporation didn’t generate any income taxable to its U.S. shareholders, it seems the IRS generally won’t impose a penalty.
If you’re a U.S. shareholder in a foreign corporation with delinquent reporting obligations, this is very good news indeed. You should still obtain professional tax advice before you file the delinquent returns. But absent aggravating circumstances, the IRS probably won’t fine you for this lapse.
Thanks, IRS.
On December 7, 2007, I’ll be attending a CFC "boot camp" in Las Vegas designed to shed some clarity on these complex rules. It’s intended to provide a non-technical briefing on CFCs, along with creative ways to avoid CFC tax traps, and will be taught by leading experts in the field of international tax.
For more information on this event, click here. Hope to see you there!
Copyright © 2007 by Mark Nestmann, LL.M.
