Foreign-owned domestic disregarded entities: Why new reporting requirements?

Editor: Valrie Chambers, Ph.D., CPA

Domestic disregarded entities wholly owned by foreign persons are now subject to new reporting obligations. The Treasury Department and the IRS recently issued final regulations (T.D. 9796) that treat such entities as domestic corporations rather than as disregarded entities for purposes of the reporting requirements under Sec. 6038A. The regulations are effective for tax years beginning on or after Jan. 1, 2017, and ending on or after Dec. 13, 2017. Under the new rules, many domestic disregarded entities with foreign owners that previously had no filing obligations will now be required to obtain an employer identification number (EIN) and to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.

Background

The check-the-box entity classification regulations under Regs. Secs. 301.7701-1 through 301.7701-3 treat a domestic business entity with a single owner either as a corporation or as an entity disregarded as separate from its owner (i.e., a “disregarded entity”). The default rules classify a single-owner entity as a disregarded entity for federal tax purposes unless the entity makes a formal election to be treated as a corporation.

Disregarded entities are typically not required to obtain an EIN and generally do not have federal tax filing obligations separate from those of their owner. Therefore, no federal income or information return filing is generally required for disregarded entities owned by foreign persons if neither the disregarded entity nor its owner received U.S.-source income or engaged in a U.S. trade or business during the tax year.

Unlike disregarded entities, however, domestic corporations are generally required to file annual income tax returns. Sec. 6038A also imposes additional information-reporting obligations and record-maintenance requirements on domestic corporations that have a foreign owner with a 25%-or-greater interest. Such 25% foreign-owned corporations are required to file Form 5472 to report “reportable transactions” with related parties. These corporations are also subject to the record-maintenance requirements imposed by Sec. 6001.

Why the changes?

Under the newly finalized regulations, disregarded entities wholly owned by a foreign person will now be treated as domestic corporations for the limited purpose of the reporting, record-maintenance, and other compliance requirements under Sec. 6038A. The changes are part of a multiprong effort to increase financial transparency and improve the IRS’s access to information needed to combat the perceived misuse of U.S. shell companies and to share information with partner tax authorities under various tax treaties, tax information exchange agreements, and other international agreements. Notably, the new rules follow—and, to some extent, bolster—regulations that were finalized in May 2016 under the Bank Secrecy Act that impose new customer due-diligence requirements on certain financial institutions to collect information about the identity of beneficial owners of legal entity customers.

Treasury has noted that the prior absence of reporting requirements for foreign-owned disregarded entities has hindered U.S. compliance with international transparency standards and tax information exchange obligations. For instance, last May, in a letter to Speaker of the House Paul Ryan, R-Wis., then-Treasury Secretary Jack Lew lamented the “loophole in our system that allows foreign persons to hide assets in U.S. accounts.” These perceived shortcomings have also come under criticism by international organizations, including the Financial Action Task Force and the Global Forum on Transparency and Exchange of Information for Tax Purposes. The new rules are designed to address these criticisms and, in the process, allow the IRS to better enforce domestic tax laws as well as increase its ability to share information with other tax authorities.

Some notable rules under the regulations

The new regulations provide that a foreign person wholly owns a domestic disregarded entity if that person has “direct or indirect sole ownership of the entity” (Regs. Sec. 301.7701-2(c)(2)(vi)(A)(2)). For these purposes, the regulations define indirect sole ownership as “ownership by one person entirely through one or more other entities disregarded as entities separate from their owners or through one or more grantor trusts, regardless of whether any such disregarded entity or grantor trust is domestic or foreign” (Regs. Sec. 301.7701-2(c)(2)(vi)(B)(1)).

The final regulations provide that, for these reporting purposes, the domestic entity has the same tax year as its foreign owner if the foreign owner has a U.S. return filing obligation. If the foreign owner does not, the regulations provide that the entity will be deemed to use a calendar year unless otherwise provided in forms, instructions, or future published guidance. These rules could affect applicable filing deadlines under the new regulations.

Finally, the regulations greatly expand the scope of reportable transactions that give rise to a Form 5472 reporting obligation in this context. Such transactions are extended to include any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property or money, as well as the performance of any services for the benefit of, or on behalf of, another taxpayer. As such, a contribution or distribution between a disregarded entity and its foreign owner would constitute a reportable transaction for Sec. 6038A purposes even though it generally may not be characterized as a transaction for other purposes because it involves a disregarded entity.

New compliance requirements

The newly finalized regulations, which are part of a multiprong effort to improve financial transparency and the United States’ ability to share information with partnering tax authorities, will impose new compliance requirements on domestic disregarded entities that are owned by a foreign person. Such entities will now be required to obtain an EIN and to file a Form 5472 to report an expanded scope of reportable transactions.