On Dec. 12, 2016, the IRS issued final regulations (T.D. 9796) that treat a domestic disregarded entity that is wholly owned by a foreign person as a domestic corporation separate from its owner for reporting, recordkeeping, and compliance purposes under Secs. 6038A and 7701. The regulations serve to provide the IRS with additional information needed to satisfy its obligations under tax treaties and information exchange agreements.
Prior to the issuance of these regulations, the entity classification election regulations would have treated this type of entity as disregarded from its owner (other than for employment and excise taxes) unless an election was made to treat it as a corporation for U.S. tax purposes. Therefore, this type of entity, generally, would not have had separate income tax or information-reporting requirements because its assets and liabilities were treated as belonging to its sole owner outside the United States. In addition to the new annual reporting requirement, the new regulations require a foreign-owned U.S. disregarded entity to apply for a federal employer identification number and retain permanent records regarding related-party transactions.
The final regulations amend Regs. Sec. 301.7701-2(c), adding a special rule that treats any domestic disregarded entity that is wholly owned (directly or indirectly) by one foreign person as a domestic corporation separate from its owner for purposes of reporting and record maintenance under Sec. 6038A. Under Sec. 6038A and Regs. Secs. 1.6038A-1 and 1.6038A-2, a domestic corporation that is 25% foreign-owned must maintain records regarding its transactions with related parties and submit information to the IRS on an annually filed information return, Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. For these purposes, a related party is considered to be any direct or indirect 25% foreign shareholder; any person who is related to the reporting corporation or 25% foreign shareholder under the rules of Sec. 267(b) or Sec. 707(b)(1); or any other person related to the reporting corporation under Sec. 482 and the related regulations.
The final regulations provide additional guidance regarding some of the compliance matters associated with this new reporting rule. If the foreign owner already has a U.S. tax return filing obligation, the tax year of the reporting corporation is the same as the tax year of its foreign owner. However, if the foreign owner does not have a U.S. tax return filing obligation, the tax year of the reporting corporation is the calendar year. The regulations apply to tax years beginning on or after Jan. 1, 2017, and ending on or after Dec. 13, 2017. For any foreign persons with sole ownership of a U.S. disregarded entity, this means the recordkeeping requirements of Regs. Sec. 1.6038-3 apply as of the 2017 tax year.
In addition, the final regulations exclude a foreign-owned disregarded entity from certain exceptions to the reporting or recordkeeping requirements available to other entities. Regs. Sec. 1.6038A-1(h) provides a small corporation exception that removes the requirement for record maintenance on reporting corporations with less than $10 million in U.S. gross receipts. Regs. Sec. 1.6038A-1(i) provides a safe-harbor exception for reporting corporations with related-party transactions of de minimis value (less than $5 million and less than 10% of U.S. income). Neither of those exceptions is extended to foreign-owned disregarded entities under the final regulations. Similarly, foreign-owned disregarded entities are not entitled to the exceptions for submitting Form 5472, which are otherwise available under Regs. Secs. 1.6038A-2(e)(3) and (4) in circumstances when a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, or Form 1120-FSC, U.S. Income Tax Return of a Foreign Sales Corporation, is filed by related persons.
As this is a brand-new filing obligation, it is important to review organizational structures in detail to determine if any new filings are required by the new regulations. Under Sec. 6038(d), failure to maintain the proper records or file a required Form 5472 may result in a $10,000 penalty for each failure per tax year. Additionally, if a failure to file continues for more than 90 days after notification of a failure to file by the IRS, an additional $10,000 penalty may apply for each 30-day period, or fraction thereof, the failure continues. However, these penalties are subject to abatement due to reasonable cause at the IRS's discretion. (For more on this topic, see "Foreign-Owned Domestic Disregarded Entities: Why New Reporting Requirements?")
Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.
For additional information about this item, contact the author at Brian.Hayes@rsmus.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.