Complex Foreign Reporting Rules Make Compliance Difficult for Individual Taxpayers

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Foreign Income & Taxpayers

For several years, the IRS and Treasury have been aggressively pursuing taxpayers who willfully conceal foreign bank accounts and income derived from them. Because of this, many taxpayers should by now be well aware of the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), and the steep penalties and possible criminal prosecution that could accompany failing to do so.

Other foreign reporting requirements may not be as well-known by less sophisticated individual taxpayers; therefore, these reporting requirements may be overlooked, causing those individuals to bear heavy penalties for noncompliance. These include reports required by Sec. 6038, such as reports of ownership of and transactions with controlled foreign corporations on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation; reports of foreign partnerships on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and reports of ownership interests in and income from passive foreign investment companies (PFICs) on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.

There are two reasons individual taxpayers often overlook the reporting requirements for the above forms. One is that the filing requirements are complex and often confusing. An individual taxpayer, without proper advice from an experienced tax professional, may not be aware that he or she is subject to certain filing requirements. Another reason is that individual taxpayers often invest in foreign corporations, partnerships, and/or PFICs indirectly through one or multiple investment partnerships and are not aware of reportable events entered into by the investment partnerships during the tax year. In addition, although Schedules K-1 from investment partnerships will disclose information regarding reporting requirements in their footnote sections, a taxpayer may not be aware that he or she needs to aggregate reportable amounts that are included on multiple Schedules K-1 to determine if he or she meets a filing threshold.

Certain filing requirements are fulfilled by the investment partnership the individual taxpayer invests in. The taxpayer, however, must be cautious because he or she may still need to fulfill filing obligations under one or more reporting requirements that are not covered by reporting done by the investment partnership.

Constructive Ownership

Reporting requirements for Forms 5471 and 8865 largely depend on the individual taxpayer’s ownership of the foreign corporation or partnership during and at the end of the tax year, including shares or interests that the taxpayer owns constructively. Therefore, for reporting purposes, an individual taxpayer cannot simply determine the interests or shares in a foreign corporation or partnership that the taxpayer directly owns during and at the end of the tax year. Constructive ownership is defined in Sec. 267(c), which states that an interest owned directly or indirectly by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its owners, partners, or beneficiaries. Also, an individual taxpayer is considered to own an interest that is owned directly or indirectly by or for his or her family, which includes his or her spouse, brothers, sisters, ancestors, and lineal descendants.

Transfers of Cash or Property to a Corporation or Partnership

A taxpayer must report certain transfers of property by the taxpayer or a related person to a foreign corporation on Form 926, including a transfer of cash of $100,000 or more to a foreign corporation in a transfer described in Sec. 6038B(a)(1)(A), which includes Sec. 351 transfers. For purposes of this rule, transfers made to the same foreign entity, directly or indirectly, over the course of the 12-month period ending on the date of the transfer are aggregated to determine whether the filing requirement is triggered. Therefore, it does not necessarily matter if each individual cash transfer to the same foreign corporation is less than $100,000. If the total of the taxpayer’s cash investments during the 12-month period ending on the date of transfer equals or exceeds $100,000, the filing requirement is triggered.

Furthermore, the individual taxpayer—not the foreign entity—is responsible for reporting his or her share of the transfer on Form 926. Similarly, an individual who contributes property with a fair market value (FMV) of over $100,000 (when added to the value of any other property contributed to the partnership by that person or by any related person during the 12-month period ending on the date of transfer) to a partnership in return for an interest in the partnership must report the contribution on Form 8865.

PFIC Reporting Requirements

Form 8621 reporting requirements for individual taxpayers that own direct or indirect investments in PFICs are another complex area. Most individual taxpayers’ filing requirements for PFICs result from investments they have made in a domestic or foreign partnership or corporation that invests in PFICs. Regardless of whether the taxpayer’s ownership in the PFICs is direct or indirect, the individual taxpayer generally must file Form 8621 if he or she receives a direct or indirect distribution from a PFIC and/or recognizes gain on a direct or indirect disposition of PFIC stock and in several other situations. A Form 8621 must be filed for each PFIC in which the individual taxpayer owns a direct or indirect interest. If the individual taxpayer owns a PFIC through a foreign partnership, then as the “first U.S. owner,” the taxpayer generally must file Form 8621.

Sec. 6038 includes severe penalties for filing late or with incomplete information. Filing Forms 5471 and 8865 late or with incomplete information can result in a $10,000 penalty for each tax year for each foreign entity and additional penalties of up to $50,000 for a continuing failure to file. A late or incomplete filing of Form 926 can result in a penalty equal to 10% of the property’s FMV at the time of transfer. This penalty is limited to $100,000, unless the failure was due to intentional disregard. For Form 8621, there is no explicit penalty for nonreporting if there is no distribution from the PFIC; however, if the taxpayer does not file a required Form 8621, the statute of limitation may be suspended on the taxpayer’s entire tax return until the form is filed.

For tax professionals, it is important to comb through all the footnotes in a Schedule K-1 from a foreign entity and ask clients about potential constructive ownership. It is also a best practice to aggregate applicable reportable amounts from all Schedules K-1 to determine whether they exceed the reporting thresholds.

EditorNotes

Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.