As we near the end of the taxable year ending December 31, 2017, the thoughts of most people turn to holidays and family gatherings, feasting and celebrations, and reflecting, perhaps, on another year gone-by.
Not so for tax professionals.
Instead of “visions of sugar plums” dancing in their heads, these poor folk dream of proposed legislation, obsess over the effective dates of regulations, struggle to close year-end transactions and to implement last-minute tax planning, and prepare for the upcoming tax filing season.
Speaking of tax filings, there is a new filing obligation that should be of interest to U.S. tax professionals who advise foreigners with U.S. investments or U.S. business interests. This filing requirement went into effect for taxable years beginning on or after January 1st of 2017; thus, the first returns to be filed under the new requirement will be due in early 2018.
Specifically, if a domestic LLC is wholly-owned by one foreign person, and it is otherwise treated as a disregarded entity for tax purposes, then the LLC must comply with certain reporting and record maintenance requirements that were previously limited to foreign-owned U.S. corporations.
In general, a business entity with two or more members is treated, for tax purposes, as either a corporation or a partnership, and a business entity with a single owner is treated as either a corporation or an entity disregarded as separate from its owner (“disregarded entity”).
Certain domestic business entities, such as LLCs, are classified by default as partnerships (if they have more than one owner) or as disregarded entities (if they have only one owner), but are eligible to elect for federal tax purposes to be classified as corporations.
Some disregarded entities are not obligated to file a return or to obtain an employer identification number. According to the IRS, the absence of a return filing obligation (and the associated record maintenance requirements), made it difficult for the IRS to implement and enforce the tax laws applicable to foreigners that invest, or operate a business, in the U.S. through as disregarded entity.
Under the Code, a domestic corporation that is at least 25% foreign-owned (a “reporting corporation”) is subject to specific information reporting and record maintenance requirements.
A reporting corporation is required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, with respect to each “related party” (including, among others, the 25%-foreign shareholder) with which the reporting corporation has had any “reportable transactions” including, for example, sales, leases, services, rentals, licenses, and loans.
The Form 5472 for a tax year must be attached to the reporting corporation’s income tax return for such year by the due date (including extensions) of the return. A separate Form 5472 must be filed for each foreign or domestic related party with which the reporting corporation had a reportable transaction during the tax year.
The reporting corporation must also keep books and records that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of its transactions with related parties.
An Issue for the IRS
When a foreign-owned entity, such as an LLC, was classified as a corporation or a partnership for tax purposes, general ownership and accounting information was available to the IRS through the return filing and EIN application requirements.
Before 2017, however, when a single-member, foreign-owned, domestic LLC was treated as a disregarded entity for tax purposes, it was generally not subject to a separate income or information return filing requirement. Its owner was treated as owning directly the entity’s assets and liabilities, and the information available with respect to the disregarded entity depended on the foreign owner’s own return filings, if any were required.
Thus, if the LLC was wholly-owned by a foreign corporation, foreign partnership, or nonresident alien individual, generally no U.S. income or information return would have been required if neither the disregarded LLC nor its owner received any U.S. source income or was engaged in a U.S. trade or business.
Moreover, if the disregarded entity only received certain types of U.S. source income, such as portfolio interest or U.S. source income that was fully withheld upon at source, its foreign owner would not have had a U.S. return filing requirement.
The IRS found that even in cases when the disregarded entity had an EIN, as well as in cases when income earned through a disregarded entity had to be reported on its owner’s return (for example, income from a U.S. trade or business), it could be difficult for the IRS to associate the income with the disregarded entity based solely on the owner’s return.
The absence of specific return filing, and associated recordkeeping, requirements for foreign-owned, single-member domestic entities, and the resulting lack of ready access to information on ownership of, and transactions involving, these entities, made it difficult for the IRS to ascertain whether the entity or its owner was liable for any federal tax.
New Reporting Obligation
Thus, at the end of 2016, the IRS adopted a new regulation under which a domestic LLC, that is wholly-owned (directly, or indirectly through one or more other disregarded entities) by one foreign person, is treated as a domestic corporation (i.e., as an entity that is separate from its owner) for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) described above. Importantly, it does not alter the framework of the existing entity classification regulations, including the treatment of certain LLCs as disregarded for income tax purposes.
By treating an affected LLC as a foreign-owned domestic corporation, the LLC becomes a “reporting corporation.” Consequently, it is required to file a Form 5472 information return with respect to any “reportable transactions” between the LLC and its foreign owner or other foreign “related parties” (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes) including, for example, sales, leases, services, rentals, licenses, and loans. It is also required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because the foreign-owned LLC has a filing obligation, it is required to obtain an EIN.
To ensure that a wholly-owned LLC reports all of its transactions with its foreign owner and other related parties, even if its foreign owner already has an obligation to report the income resulting from those transactions (for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business), the regulations specify, as an additional reportable category of transaction, any transaction to the extent not already covered by another reportable category. Thus, for example, contributions and distributions (both current and liquidating) are considered reportable transactions with respect to a “reporting LLC.”
Accordingly, any transaction between such an LLC and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the reporting and record maintenance requirements, even though, because the transaction involves a disregarded entity, it generally would not be considered a transaction for other tax purposes.
In order to facilitate the implementation of this reporting requirement, the reporting LLC is treated as having the same taxable year as its foreign owner, if the foreign owner has a U.S. return filing obligation. If the foreign owner has no U.S. return filing obligation, then the LLC is treated as having the calendar year as its taxable year.
The penalty provisions associated with the failure to file the Form 5472 and the failure to maintain records will apply to reporting LLCs. For example, a penalty of $10,000 will be assessed against any reporting LLC that fails to file Form 5472 when due. The penalty also applies for a failure to maintain records as required. If the failure continues for more than 90 days after notification by the IRS, additional penalties will apply.
What Does It Mean?
Ah, the beginning of a new taxable year, and of a new era of transparency for many foreign-owned LLCs. What is one to do?
For starters, the U.S. professionals who advise these entities and their owners should alert them of the new reporting requirements, if they haven’t already done so. They should also be on the lookout for new Form 5472 instructions.
If a reporting LLC does not already have one, it must obtain an EIN as soon as possible. In connection therewith, the LLC will have to identify its “responsible party” (basically, the individual who controls the disposition of the LLC’s funds and assets), which means that the responsible party will itself have to obtain its own U.S. identification number (for example, an ITIN).
In addition, the LLC, its foreign owner, and their U.S. advisers will have to make certain that they have properly documented their 2017 reportable transactions, have maintained sufficient records to substantiate the accuracy of the information return to be filed by the LLC, and have implemented the appropriate internal procedures to ensure future compliance with the new reporting requirement.