How to Avoid a Big Problem with the IRS when you Start a Foreign Business

If you have an ownership interest in a foreign corporation you should be aware of the IRS Form 5471.

You wake up to tropical bird songs, slip on your sandals, step outside, and deeply inhale the freshest air that your lungs have ever experienced. After years of hard work and sacrifice, you have finally begun to live out your dream of starting a new life in paradise. As part of your new life, you naturally want to start a business to contribute to the local economy and support your family. Your intentions are pure and your work ethic cannot be questioned. You’ve finally made up! But wait a minute, despite leaving the house, did you remember that you are still in a long-term relationship with Uncle Sam? Unfortunately, the enthusiasm of starting a business in a foreign country often blinds many expats to the myriad of reporting obligations that the U.S. Government continues to impose upon them despite their change of location.

Before you go down the road of self-shame about your unfamiliarity of the various reporting requirements, try to keep in mind that the vast majority of accounting and tax professionals are nearly as unaware. It cannot be overstated that international taxation for U.S. persons is a very different animal than domestic taxation and is a major reason many practitioners avoid this idiosyncratic tax discipline altogether. Perhaps one of the scariest boogeymen of international taxation is Form 5471, which is required for most individuals that have an ownership interest or managerial role in foreign corporations.

In this article, we will show you how to avoid a big problem with the IRS when you start a foreign business by providing the basics of this complex and labor-intensive form in order for you to get a better understanding of whether you are required to file Form 5471.

Why does this report exist?

If you are or have been a business owner in the United States and are accustomed to filing well known and relatively straightforward schedules and forms such as Schedule C, Form 1120-S, Form 1120, or Form 1165, you are probably wondering why there is such a higher reporting threshold for foreign corporations. The short answer is because the IRS can. But the longer rationale does make sense if you keep in mind that the United States is one of only two countries in the world whose tax system is based upon citizenship rather than residence. In a nutshell, if you are a U.S. person, no matter where you live in the world, you are still subject to U.S. taxation on your worldwide income. Logic dictates that since the Government cannot track your international financial activities as easily as they could domestically, a much heavier reporting burden is placed on the U.S. person to provide an extraordinary amount of detail in order to prevent potentially nefarious activity. This same logic applies when considering the much heftier reporting penalties that foreign corporations are subject to versus their domestic counterparts.

The weighty Form 5471 reporting requirements also ensures that U.S. persons with controlling ownership interests in foreign corporations comply with the Subpart F income and Net CFC Tested Income (NCTI) (Formerly known as GILTI) tax requirements. These two tax regimes will be discussed in more detail in a future article. In short, if you start a foreign corporation, you cannot escape this reporting requirement as it is an extra ordinary tax form that essentially serves as a matrix for several other requirements.

When do you need to Complete Form 5471

Understanding whether you need to complete the Form 5471 is the first and most important step in the process. Unfortunately, it is also the step that many people get wrong, and what subsequently triggers a chain reaction of penalties and vulnerabilities for taxpayers. If you are a U.S. person and fall under at least one of the five categories that are outlined by the IRS, you must file a Form 5471. If you have an ownership interest in a foreign corporation (even if it is not a controlled foreign corporation (CFC)), it is advisable to assume that there is a good chance that you need to complete Form 5471.

What is a Controlled Foreign Corporation and a U.S. Shareholder?

One of the key factors for most of the categories is whether the company meets the criteria to be regarded as a Controlled Foreign Corporation (CFC). A CFC is a foreign corporation in which U.S. shareholders possess more than 50% of the total combined voting power or value of stock of the foreign corporation. In order to qualify as a U.S. shareholder, a U.S. person must possess at least 10% stock ownership or 10% of the combined voting power of all classes of stock with voting power. For example, if Timothy owned 40% of a Costa Rican company and Leslie owned 11%, their combined total of 51% ownership would qualify the company as a CFC. If however, Timothy’s interest remained at 40%, but Leslie’s was only 5%, and another U.S. person named Paul owned 12%, the company would still qualify as a CFC, but Leslie would not qualify as a U.S. shareholder because she has an ownership interest below the 10% threshold.

The IRS has a rather inclusive definition of a U.S. person that includes United States citizens and residents; domestic partnerships; domestic corporations; or domestic estates and trusts. For the purposes of Category 4 (explained below), the U.S. person definition is expanded to also include those non-resident aliens married to U.S. citizens or residents that elect to be treated as U.S. residents.

The 5 Categories for Filers

Many taxpayers will meet the requirements for more than one of the categories below and will be required to file for each category. Each category also has accompanying schedules that must be completed along with the primary sections of 5471. Fortunately, it is important to note that there are a number of situations that may qualify as exceptions to these requirements.

Category 1: If a foreign corporation qualifies as a CFC, and a U.S. person holds a minimum of a 10% voting power or stock ownership interest, a Form 5471 must be filed.

              Required Schedules: 1a: B Part II, E, E-1, J, P

                                             1b: E, E-1, P

                                             1c: B Part II, E, G, G-1

Category 2: If you are a U.S. person that serves as an officer or director of a foreign corporation in which a U.S. person has acquired a 10% ownership interest of stock or a 10% voting power (U.S. shareholder), you qualify as a Category 2 filer. The officer or director does not have to be a U.S. shareholder of the foreign corporation. It is also important to note that the foreign corporation does not have to be a controlled foreign corporation.

              Required Schedules: O Part 1

Category 3: If you are a U.S. person that: 1) Acquires stock ownership or voting power that amounts to 10% of a foreign corporation; 2) Disposed of stock in a foreign corporation that lowered your ownership below 10%; or 3) Became a U.S. person while owning 10% of stock of a foreign corporation, you qualify as a Category 3 filer.

              Required Schedules: A, B Part I, B Part II, C and F, G, G-1, O Part II

Category 4: If a U.S. person had control of a foreign corporation during the annual accounting period, then they would qualify under Category 4. As aforementioned, an ownership interest by a U.S. person of more than 50% of a foreign corporation, makes said corporation a CFC.

Required Schedules: A, B Part I, B Part II, C and F, E, E-1, G, G-1, H, H-1, I, I-1, J, M, P, Q, R

Category 5: If you are a U.S. shareholder that owned stock in a CFC at any point during the year, you qualify under Category 5. Remember that a U.S. shareholder is a U.S. person that owns a 10% or more of the voting power or value of stocks of a CFC.

              Required Schedules: 5a: B Part II, E, E-1, G, G-1, H, H-1, I, I-1, J, P, R

                                                      5b: E, E-1, H-1, I, I-1, P, Q

                                                      5c: B Part II, E, G, G-1, I-1,

Penalties

Because the 5471 is such a critical, non-standalone reporting form that it is necessary for  the proper accounting of several other tax regimes, the IRS takes very seriously the timely and accurate filing of it. Late and inaccuracy penalties can quickly mount and cause a severe financial strain. Some of these penalties include a $10,000 failure to file penalty for each annual accounting period where filing does not occur. Additionally, if the taxpayer does not file after 90 days of the IRS issuing a failure to file notice, a $10,000 penalty can be assessed for every 30 day period that a taxpayer fails to file (not to exceed $50,000 for each failure).

Tips for Staying on top of your 5471 Obligations

• Maintain good corporation records -Keeping good records for every aspect of the foreign corporation is the difference between sleeping well at night because you are in compliance and being hit with major penalties that may significantly and negatively impact you and your business.

• Keep Clean Financial Records-Ensure that you are practicing recognized bookkeeping and accounting practices, as poor financial records often are the cause for major problems with the IRS.

• Reach out to a Tax Professional with expertise in international taxation-Don’t think that you have to figure this out on your own. As importantly, do not rely on a CPA, EA, or other tax professional without expertise in international taxation. This is a very specialized area of taxation, and you should seriously consider working with a professional that focuses on this area.

• Start Preparing Your Reports Early- As these reporting requirements can be complex, labor intensive and time consuming, your best bet is starting the process as early as possible.

• Whatever you do, don’t stick your head in the sand. You cannot wish these issues away. If you are on the fence, be conservative and report anyway.

If it isn’t obvious by now, the final takeaway from this short summary is that the Form 5471 is a non-negotiable requirement if you fall under any of the aforementioned categories. Most tax experts do not advise ‘DIYing’ this form due to its complexities and steep error penalties. It can be complex and should be navigated by a knowledgeable and steady hand. If you need assistance, please reach out to a qualified tax professional for assistance. We are happy to explore discussing whether we can help you. Just click here to set up a discovery call.

The information in this article is for education and informational purposes only and does not constitute professional tax, legal, or financial advice. Because tax laws are complex and subject to change, it is always best to consult with a qualified tax professional regarding your specific situation.