Last week’s blog post covered some basics about Form 5472, including how the Form helps the US Internal Revenue Service (IRS) learn about foreign-owned businesses in the US and when to audit them, the meanings of certain terms such as what is meant by a “reportable transaction” with a “related party”, and the situation requiring filing of the Form by a US company that is at least 25% owned by non-US shareholders that has such a reportable transaction. Today’s blog post will cover the situation requiring filing of the Form by single member US LLCs with foreign owners (including the potentially troublesome EIN issue), and by foreign companies that are “engaged in a US trade or business”. It will discuss the penalties for noncompliance and finally, the surprises that can occur if a foreign jurisdiction’s community property rules come into play.
US Disregarded Entity (Foreign-Owned Single Member US LLC)
Special mention is required for single-member US LLCs as these are frequently used by foreign persons. Since these are treated under the US tax rules as so-called “disregarded entities”, they are technically not “corporations” for US tax purposes. Recent IRS Treasury Regulations now subject foreign-owned single-member US LLC’s to a brand new reporting regime.
Foreign-owned single-member US LLC’s must now file Form 5472 and are subject to the same reporting, record maintenance and other related compliance requirements as those imposed on 25% foreign-owned US corporations.
Details, including the identity of the LLC’s non-US owner, will now be revealed when there is a “reportable transaction” occurring in the tax year. Remember, if there is no “reportable transaction” in the particular tax year, the Form need not be filed.
A) Reportable Transaction – No Exceptions Available
Notably, the reportable transaction threshold is easier to reach in the case of a foreign owned single-member US LLC when compared to a US corporation that is 25% foreign-owned. This is so because generally, the intent behind the new regulations was to broaden the scope of reporting for such foreign owned US LLCs. The reporting for these entities was intended to go beyond what would be required to be reported on the Form 5472 for a US corporation that is 25% foreign-owned. As such, certain exceptions that might otherwise apply for Form 5472 purposes, will not apply when there is a foreign owned single-member US LLC.
It’s important to understand that not everything will be a “reportable transaction”. For example, if the US LLC is simply maintaining a foreign bank account, this is not a reportable transaction. If, however, the amount in the foreign bank account reaches USD10,000 at any time in the year, the US LLC entity must still file the FBAR. The two forms reflect completely separate filing requirements!
Typical examples of a “reportable transaction” requiring the foreign owned single-member US LLC to file Form 5472 for the year the transaction occurs would include creation of the LLC and capitalizing it; liquidating the entity; paying expenses on behalf of the LLC (for example, real property taxes or other costs).
B) Obtaining “Employer Identification Number” (EIN)
An impacted disregarded entity is required to obtain a US taxpayer identification number (an employer identification number, or EIN) to identify itself on its Form 5472. This may be easier said than done due to the need for the entity to file a Form SS-4 to get an EIN. The Form SS-4 requires the applicant to indicate a responsible party of the entity and this can get complicated as SS-4 then asks for an EIN, ITIN or SSN of the responsible party. This has generated confusion among professionals when the LLC is wholly-owned by a nonresident alien individual (NRA) who is the “responsible party”. Apparently, an ITIN is not mandatory when the LLC has a single NRA owner-responsible party. More detail here.
Foreign Corporation Engaged in a US Trade or Business
Form 5472 must also be filed when a foreign corporation that is “engaged in a US trade or business” (USTB) has a “reportable transaction” with either a US or a foreign related party.
A) US Trade or Business
A new concept is introduced in this second category of filers – that is, when is a foreign corporation “engaged in a US trade or business?”
Neither the US Internal Revenue Code nor Treasury Regulations clearly define what is meant by being engaged in a USTB. The case law indicates that business activity will not constitute a USTB unless the activity is considerable, continuous and carried out on a regular basis. Unfortunately, the cases are old and ambiguous and despite the case law language requiring considerable, continuous and regular activity, some of the cases find that lower levels of activity satisfy the standard, leaving little real guidance. The IRS has taken a very strict position in published rulings that activities beyond mere passive receipt of income, if conducted in the United States, are sufficient to constitute engaging in a USTB.
Penalties – What Happens if You Don’t Comply?
Failure to file a Form 5472 or maintain the supporting records as required could result in a $10,000 civil penalty for each failure. The penalty is not just a one-time assessment of a $10,000 fine; rather it is $10,000 for every year the form was not filed. If multiple filings should have been undertaken in the same year, the penalty amount can easily skyrocket. Criminal penalties could also apply for failure to submit information or filing false or fraudulent information.
Beware Community Property Rules
Many Latin American and European countries have community property regimes. Application of a foreign country’s community property laws raise serious US tax issues for a married couple, this is especially so when only one spouse is a US person.
In the US LLC context, let’s say that we have a non-US husband, Harry and that he is married to Wilma, a US citizen. The couple are domiciled in a country with a community property regime, let’s say, Switzerland (or even China!). Harry uses funds from his solely titled bank account into which he deposits his salary in order to set up a US LLC. Harry believes that he is the sole member and that as such, the LLC is a “single member disregarded entity”. Harry is wondering if he needs to file Form 5472 based on certain transactions he had with the LLC during the year. He comes to me for advice.
Here’s where we tell Harry the bad news. Harry and Wilma are domiciled in Switzerland. Under the Swiss community property regime, Wilma is deemed to own one-half of the LLC (as well as one-half of Harry’s bank account). The LLC cannot be a “single member” disregarded entity since it has two members (Harry and his wife, Wilma).
Instead, the LLC will be treated under US tax default rules as a “corporation” for US tax purposes. This means double-taxation can result. The first level of US income tax will be at the corporate level. After the corporation pays its US income tax, and distributes a dividend to its owners, Harry and Wilma, another level of income tax will result at their individual levels. As for Harry, a nonresident alien individual, the corporation will be required to withhold tax at a 30% rate unless the lower Swiss Treaty rate applies and Harry files the proper paperwork. As for Wilma, she will be required to report the dividend as income on her US tax return and pay tax on the amount. And, yes, Form 5472 will still be required since US corporations that are at least 25% owned by non-US shareholders must file the form.
Harry and Wilma can try to take the position that under Rev. Proc. 2002-69 they can still treat the LLC as a “disregarded entity” or a “partnership” (rather than a “corporation”) even though they have not made an entity classification election on Form 8832. However, without making this election, it is unclear the IRS would accept this position. Furthermore, even if the position was accepted, US tax consequences will still fall on both Harry and Wilma. No doubt about it, it’s complicated! Each of them will be treated as owners of the business/partnership and depending on the facts, may be required to file tax returns and pay US tax. In addition, if treated as a partnership, the entity itself may have withholding obligations with respect to Harry. Beware community property rules!
Published June 17, 2018
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