What is a corporation?
The classification of a foreign entity.
The key for the default classification for foreign entities is whether the members have limited liability.
- A foreign business entity is a corporation if all of its members have limited liability – this requires the filing of Form 5471. The acronym LTD in the name of business entity is the first indicator of the corporation.
- A foreign business entity is a partnership if it has two or more members and at least one member does not have limited liability – this requires the filing of Form 8865
- A foreign business entity where a single owner does not have limited liability (i.e. his/her personal assets are not protected from business liability) is a disregarded entity – this requires the filing of Form 8858 + Sch C or Sch E.
Understanding the pros and cons of an offshore corporation
Many people are led to believe that owning an offshore corporation will help prevent them from paying U.S. taxes. At times, this statement is true, but there are circumstances in which it couldn’t be farther from the truth. Unfortunately, many people believe that offshore corporations are beyond the jurisdiction of taxation by the IRS. While this is partially true, U.S. shareholders – as well as deemed shareholders – are within the jurisdiction of taxation by the IRS. An important fact of which to be aware, also, is that an overseas corporation doesn’t so much allow for tax avoidance as it allows for tax deferral. If the owner of the corporation is a United States Citizen and it is a Controlled Foreign Corporation (CFC), he/she will owe U.S. taxes once dividends or liquidating distributions payout or when the corporate stock is sold.
One of the largest benefits to operating an overseas corporation is that of tax deferral. You can use tax-deferred money to generate extra profits by re-investing the tax savings amount into the corporation. This practice can produce enough extra income to equal – and possibly surpass – the amount in taxes which would be owed. For instance, if $20,000 is deferred for the time period of 1 year and the return is 10%, the corporation would have earned $2,000 instead of having spent it on tax liability. Over the course of the next 10 years, the minimum value would be $20,000; and that’s not even considering the compounding interest that would begin to take place as the total value of the investment grew.
Foreign Business Reporting Requirements
If you choose to establish your business overseas, you will be required to abide by your host country’s reporting guidelines. Each country has its own deadline for tax returns, which can pose a challenge if differing greatly from the U.S. June 15th deadline. Always check with a tax professional in your host country to be sure of the laws and guidelines. Certain country’s guidelines will require you to file U.S. taxes while filing in your host country as well. Of course, if you are a U.S. citizen, you will always need to report your income to the IRS. But in which way you established your business will affect how you are required to report said income.
As a business owner, it is especially important that you remember that U.S. citizens with foreign bank accounts are required to file FinCen 114 (FBAR) report amounts over $10,000 USD (if this amount is reached at any point during the year) by April 15 (as of 2017) each year. This rule also applies for those with signature authority over foreign bank accounts.
What Information Must be Provided?
The required information starts by listing the identity of the US shareholder and details about the foreign corporation. It must also include data on transactions between you and the foreign corporation, original capital contributions and other relevant data. It is 4 pages long. Several other schedules are required, which can make it a total of 6-7 pages. Among the schedules to be completed are the balance sheet for the corporation and income and expense sheet for the current year of operation.
Depending on which of the five categories apply to the taxpayer (in fact, there are four categories because category one has just been repealed), different schedules must be completed. An officer or director of a CFC who is not an owner of the CFC will be required to file under category 2 where certain U.S. persons have acquired additional stock in the corporation. A category 2 filer is only required to complete page one and schedule G. Where a U.S. corporation is the 100% owner of a foreign corporation that is not a Foreign Personal Holding Company (FPHC), the filer could be classified as a category 3, 4 or 5. Quite often, more than one category can be applied to one filer - all that applies must be checked and required schedules for each category filed.
Taxpayers with the foreign company ownership between 10% and 50% may not have file form 5471 in the years when there was no change in their ownership, as they do not fit any filer category.
The table below summarizes various factors that affect filing requirement. Only if answer to all questions is NO, can the filing be skipped.
|Filing Required||Yes |
(cat 2 and 5 if CFC)
- for all SP years (cat 3)
|1. Change in U.S. Taxpayer Stock Ownership During Tax Year||Yes|
|2. Attribution Rules for Constructive Ownership (NRA spouse, siblings, ancestors)||Yes|
|3. Form 5471 Was Filed in the Previous Year||Yes|
|4. Corporation Has Other U.S. Shareholders||Yes|
|5. Streamlined Procedure Filers||Yes|
Controlled Foreign Corporation
If you, along with other US persons, own more than 50% of a foreign corporation, it is then defined as a Controlled Foreign Corporation (CFC). Then certain types of income (called Subpart F Income) may be taxed and flow through to the US shareholders. This would cause them to pay tax on that income on their US personal tax returns. The rules for determining which types of income are considered Subpart F are rather complex.
Any types of corporate income such as dividends, interest, rental income, insurance income, offshore shipping income and personal service income under certain conditions may be treated as Subpart F income. Subpart F income is taxable on the US shareholder's personal return (or corporate return if a US corporation is the owner) in the year it occurs as ordinary income. This happens regardless whether the income was distributed.
Dividends paid to shareholders of Foreign Corporations are occasionally eligible for reduced qualified dividend rate (same rate as capital gains) when paid from the foreign corporation that is located in a country with which the US has a tax treaty.
What Happens if You Don't File Form 5471 or File it Late?
The penalties for a failure to file the return are severe - and it is not necessary for the corporation to have any profits for the penalties to apply. A return must be filed even if there is no taxable income to report.
Until recently, it was rare even to get a response from the IRS about the filing, even in the event that the form was filed late. However - as of late, the IRS has been vocal about the automatic penalties assessed by the computer for late filing of the Form 5471. The penalty under IRC Section 6038(b)(1) is $10,000 for each late or incomplete Form 5471.
You must remember that this is mostly an informational form, that does not result in any tax due for the taxpayer. So the $10,000 penalty is a "disclosure penalty", unrelated to the actual tax consequences of the information provided on the Form 5471. If the failure continues for more than 90 days after the date the IRS mails notice of failure, an additional $10,000 penalty will apply for each 30-day period. The additional penalty is limited to a maximum of $50,000.
Scanned copy of an official IRS letter informing its recipient about the $20,000 Penalty Assessment for "Failure to File Form 5471":