Editor: Kevin D. Anderson, CPA, J.D.
In December 2018, the IRS issued revised instructions to Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), which expanded the requirement to file this form to include the reporting of foreign branch operations of U.S. persons, controlled foreign corporations (CFCs), and controlled foreign partnerships. Previously, this requirement had applied only with respect to foreign disregarded entities. Certain U.S. citizens and U.S. residents doing business abroad can have surprising tax reporting obligations as a consequence of this expanded requirement. The penalties for any missed (or late) Form 8858 reporting can be great, ranging from a $10,000 fine per missed form per tax year, to potentially losing the ability to claim foreign tax credits, to the potential imposition of criminal penalties in certain cases.
U.S. persons that operate a foreign branch or that own (directly or indirectly, through a tier of foreign disregarded entities or partnerships) certain interests in foreign tax owners of foreign branches must now file Form 8858 and Schedule M, Transactions Between Foreign Disregarded Entity (FDE) or Foreign Branch (FB) and the Filer or Other Related Entities, to satisfy their reporting obligations under Secs. 6011, 6012, 6031, and 6038 and related regulations. As defined in Sec. 7701(a)(30), U.S. persons are (1) citizens of the United States or U.S. resident aliens; (2) domestic partnerships; (3) domestic corporations; (4) estates, other than foreign estates (within the meaning of Sec. 7701(a)(31)(A)); or (5) domestic trusts.
A foreign branch is first defined by reference to Temp. Regs. Sec. 1.367(a)-6T(g) as an integral business operation carried on by a U.S. person outside the United States (which, under the Sec. 7701 definitions, seems to be confined to the United States and the District of Columbia, without taking into account U.S. territories). All the facts and circumstances are to be analyzed to determine whether the activities of a U.S. person outside the United States constitute a foreign branch. Evidence supporting the existence of a foreign branch includes the existence of a separate set of books and records and an office or fixed place of business used by employees or officers of the U.S. person in carrying out business activities outside the United States. Activities carried out in a foreign country would constitute a foreign branch if the activities constitute a permanent establishment under the provisions of an income tax treaty entered into by the United States and that foreign country. Temp. Regs. Sec. 1.367(a)-6T(g) also states that any U.S. person, including a corporation, partnership, trust, estate, or individual, may be treated as having a foreign branch.
A foreign branch is also defined by reference to the qualified business unit (QBU) rules in Regs. Sec. 1.989(a)-1. Under Regs. Sec. 1.989(a)-1(b)(2)(ii), a QBU includes a separate and clearly identified unit of a trade or business of a taxpayer, provided that separate books and records are maintained with respect to the unit. While Regs. Secs. 1.989(a)-1(b)(2)(i)(B) and 1.989(a)-1(c) clearly exclude activities carried on by an individual as an employee, under Regs. Sec. 1.989(a)-1(b)(2)(ii), activities conducted by an individual other than in his or her capacity as an employee could give rise to a QBU if the activities constitute a trade or business and a separate set of books and records is maintained with respect to such activities.
Similar to the rules in Temp. Regs. Sec. 1.367(a)-6T, to determine if an activity constitutes a trade or business, one must examine all the related facts and circumstances. Regs. Sec. 1.989(a)-1(c) defines a trade or business as "a specific unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible under [Sec.] 162 or 212 (other than that part of [Sec.] 212 dealing with expenses incurred in connection with taxes). . . . Such group of activities must ordinarily include the collection of income and the payment of expenses. . . . However, activities that are merely ancillary to a trade or business will not constitute a trade or business."
The "facts and circumstances" reference grants the IRS flexibility with respect to the definition of a foreign branch and the scenarios in which it applies. Therefore, while it is generally clear that a U.S. citizen or resident has a Form 8858 and Schedule M filing requirement when he or she owns a foreign branch through a tier of partnerships or through a CFC, it is less evident in which situations a U.S. citizen's or resident's activities outside the United States rise to the level of a QBU and create a Form 8858 and Schedule M filing requirement.
The following examples demonstrate some situations in which individuals living and earning income abroad should consider filing a Form 8858 and Schedule M.
The restless retiree
Taxpayer A, a U.S. citizen and renowned psychologist, decides to spend his retirement years in a warmer climate and moves to the island of Corfu, Greece. He has been consulting for various professional journals, continuing to publish and review articles, and he has also opened a small psychology practice on Corfu for a handful of patients. A is keeping track of the income and expenses from these two activities separately, and he is currently reporting this income on separate Schedules C, Profit or Loss From Business, on his Form 1040, U.S. Individual Income Tax Return.
In this example, A's two activities in Greece (consulting and counseling) should be considered separate foreign branches and therefore should be reported on separate Forms 8858. A can identify the income and expenses separately for each activity and is reporting them on separate Schedules C. Therefore, it can be argued that he keeps separate books and records and that each of the activities constitutes a separate trade or business (as opposed to a hobby).
The enterprising expat
Taxpayer B, a Texas CPA, moved with her spouse, who works as an expat in the Middle East. From her home, she prepares tax returns for a number of expats and some of her U.S. clients, with whom she has regular Zoom calls. B is reporting income and expenses from these activities on a Schedule C on her Form 1040, and she would seem to have the same Form 8858 reporting requirements for her activities as a CPA while residing abroad.
In this example and in the previous example, the frequency and extent of the activities performed abroad and the existence of separate books and records are clear indicators of the existence of separate QBUs for each of these activities. The analysis could be more nuanced, and the conclusion could be different, if these taxpayers perform independent services in the foreign jurisdictions for a short time. However, a three-month consulting/implementation project could still create a Form 8858 filing requirement if the taxpayer tracks the project's income and expenses separately (effectively creating "books and records" for the project). The same could apply if the duration of the project is one week, the separate books and records requirement is met, and the project is significant compared to the taxpayer's other trade or business activities.
While the physical location where the services are being conducted may also be considered (indicating the existence of a fixed place of business), it must be done in relation to all the other facts and circumstances. Whether A and B conduct these services abroad from a separate executive office or from a home office should not affect the conclusions reached, because of the extent and frequency of the activities performed. A home office can be considered a fixed place of business even if the taxpayer does not claim depreciation or deduct electricity bills and other utilities for the section of the home used for conducting business activities. A rental house, hotel room, neighborhood coffee shop, or even a favorite spot on the beach could be considered a fixed place of business and indicate the existence of a QBU if the other facts and circumstances weigh in that direction.
However, what if A's consulting services are always performed in locations that would not be classified as "his" office or a fixed place of business. Would this mean he does not have a Form 8858 filing requirement for the consulting activities?
The industrious immigrant
Taxpayer C is an Irish citizen and a U.S. resident. C markets and sells products in Ireland and in the United States. He leases an office in Ireland. He employs sales personnel to solicit sales leads in Ireland. He maintains a separate set of books and records with respect to his activities in Ireland. Aside from this work, C also maintains a portfolio of foreign currency-denominated investments through an Irish broker. The broker is responsible for all activities necessary to the management of C's investments and maintains books and records with respect to all of C's investment activities. These investment activities generate expenses that are deductible under Sec. 212 (other than that part of Sec. 212 dealing with expenses incurred in connection with taxes). According to Examples 6 and 8 in Regs. Sec. 1.989(a)-1(e), C has a QBU for his marketing and sales activities and a separate QBU for his investment activities. Therefore, C should have separate Form 8858 filing requirements for each QBU.
The existence of separate books and records for each trade or business activity is a key factor, but other factors must be weighed to determine whether an activity rises to the level of a QBU. As it relates to the marketing and sales of products, this example highlights the following items to be considered: (1) ownership of the products; (2) the office lease in Ireland; and (3) employing a salesperson in Ireland. Similarly, as it relates to the investment activities, the considerations include (1) the use of a broker that manages all the investment activities and (2) expenses (other than taxes) incurred for the production of income.
If C's marketing and sales activities are all conducted in the United States and, instead of leasing an office, he leases a warehouse that is only used to distribute the product in Ireland, as well as using independent agents to generate sales leads, it is much less clear that a QBU exists, even if C does keep separate books and records for the Irish activities.
Similarly, aside from keeping separate books and records, Example 6 in Regs. Sec. 1.989(a)-1(e) highlights that even investment activities through foreign brokers can give rise to QBUs. The example indicates C incurs expenses that are ordinary and necessary for the production of income or the management of property held for the production of income. If C uses a broker that does not charge a management fee, would this activity create a QBU? Furthermore, as management adviser fees for tax years 2018 through 2025 are not deductible, if C does not incur other expenses, would the activity still create a QBU?
The cost of freedom
Many freelancers and independent contractors, who are typically working from their home offices, have weighed their options of living their dreams and working from tropical paradises or remote mountain locations abroad (provided they had good internet connections). While 2020 brought more freedom to relocate, there may be unintended tax reporting requirements for what otherwise would not constitute foreign reportable activities.
Experience shows that everyone's facts and circumstances are different. This difference leads to situations where one person may have to file Form 8858 while another person may not. As the penalties for not filing the form are significant, individuals who have business and investment activities outside the United States should seek advice from an experienced tax professional.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Contributors are members of or associated with BDO USA LLP.