By: Hemant Patel
With the increased globalization of talent and investments, it is common to see U.S. citizens and residents living outside U.S. for extended periods or holding foreign investments outside U.S.
U.S. citizens and residents are subject to taxes on their worldwide income. They are also subject to extensive information reporting requirements of their foreign investments and assets.
With the introduction of Foreign Account Compliance Act (FATCA), the IRS has access to more information on U.S. persons’ foreign financial assets, and may assess penalties to those who fail to comply with foreign reporting obligations.
The following summarizes various information reporting obligation of U.S. individuals and discusses various options for individuals with delinquent international information returns to become compliant.
INTERNATIONAL REPORTING OBLIGATION FOR U.S. INDIVIDUAL OWNING INTEREST IN FOREIGN ENTITIES:
Information reporting is required when U.S. individuals make direct or indirect investments in foreign entities. Foreign corporations or partnerships are those that are organized under the laws of a foreign country and not organized under the laws of U.S. or any State thereof.
- Form 8865 (Return of U.S. Persons with Respect to certain Foreign Partnerships)
A U.S. person qualifying under one or more of the Categories of Filers (see below) must complete and file Form 8865.
Category 1 filer, is a U.S. person who controlled the foreign partnership at any time during the partnership’s tax year. Control of a partnership is ownership of more than a 50% interest in the partnership.
Category 2 filer is a U.S. person who at any time during the tax year of the foreign partnership owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons each owning at least a 10% interest.
Category 3 filer, is a U.S. person who contributed property during that person’s tax year to a foreign partnership in exchange for an interest in the partnership if that person either owned directly or constructively at least 10% interest in the foreign partnership immediately after the contribution or the value of property contributed to the partnership by such person, or any related person, during the 12 months’ period ending on the date of the transfer exceeds $100,000.
Category 4 filer. A Category 4 filer is a U.S. person that had a reportable event under section 6046A during that person’s tax year. There are three categories of reportable events under section 6046A: acquisitions, dispositions, and changes in proportional interests.
A $10,000 penalty is imposed for each tax year of each foreign partnership for failure to furnish the required information within the time prescribed.
- Form 5471 (Information return of the U.S. persons with respect to certain Foreign Corporation)
A U.S. individual owing an interest in a foreign corporation may require filing Form 5471. There are multiple categories of filers, or more than one category may apply to same individual in a year.
Category 1 filers, is repealed by section 413(c) (26).
Category 2 filers, is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired 10% or more stock ownership or an additional 10% or more of the outstanding stock of foreign corporation.
Category 3 filers, is a U.S. person who acquires 10% or more ownership interest (in value or voting power) in a foreign corporation; acquires stock that when added to existing stock, brings the individual ownership interest to at least 10% or larger.; has 10% or larger ownership interest, disposes of stock during year and after disposition he or she owns less than 10% of the ownership.
Category 4 filers, is a U.S. person who had control of a foreign corporation for an uninterrupted period of at least 30 days during annual accounting period of the foreign corporation.
A foreign corporation is Controlled Foreign Corporation (CFC) if more than 50% of the value is owned by U.S. shareholders on any day during its tax year. A U.S. shareholder for this purpose is a U.S. person who owns (directly, indirectly or constructively) 10% or more of the total combined voting powers of all classes of voting stock or owns (either directly or indirectly) any stock of CFC that is also a captive insurance company. Any 10% U.S. Shareholder of CFC is required to file Form 5471 annually and is taxed currently on their pro rata share of the ‘Subpart F income’ earned by the CFC.
Form 5471 should be filed with the individual’s federal income tax return. A minimum penalty of $10,000 per form may be imposed for failure to timely file Form 5471.
- Form 8858 (Information Return of U.S. Persons with Respect to Foreign Disregarded Entities)
A foreign disregarded entity (FDE) is an entity that is not created or organized in the U.S. and that is disregarded as an entity separate from its owner for U.S. income tax purposes.
A U.S. individual that is the tax owner of an FDE or owns a specified interest in an FDE indirectly or constructively through a CFC or a CFP is required to file Form 8858.
Form 8858 should be filed with the individual’s federal income tax return. A minimum penalty of $10,000 per form may be imposed for failure to timely file Form 8858.
If an FDE is owned via a CFC or CFP, Form 8858 may be included as an attachment to Forms 5471 or 8865, respectively, filed on behalf of others with the same filing requirements for the same period.
- Form 8621 (Information return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund)
A Passive Foreign Investment Company (PFIC) is a foreign corporation where at least 75% of the corporation’s gross income for its tax year is passive income or at least 50% of the average percentage of assets held by the foreign corporation during the tax year are assets that produce passive income or that are held for the production of passive income.
Passive income is typically defined as interest, dividends, royalties, rents, annuities, and excess gains over losses from the sale or exchange of property.
If a PFIC also meets the definition of a CFC, the CFC rules override the PFIC rules. In this case, Form 5471 is filed rather than Form 8621.
Once a PFIC, always a PFIC. The PFIC determination is made on an annual basis. However, once a foreign corporation becomes a PFIC, it will generally always be considered a PFIC for U.S. federal tax purposes.
Once a corporation is determined to be a PFIC, the first U.S. person in the ownership chain is eligible to make one of several elections (if applicable) to report the income associated with the PFIC on a current basis.
Qualified Electing Fund (QEF) election:
The QEF election requires that the shareholder annually include his or her pro rata share of ordinary income and net capital gain of the PFIC in taxable income, regardless of whether distributions are made from the PFIC. The QEF election can only be made, if the shareholder receives an annual information statement from the PFIC indicating the amount of ordinary income and long-term capital gain required to be reported as shareholder of the PFIC.
Mark to Market (MTM) election:
If the PFIC does not provide the PFIC annual information statement, or the shareholder chooses not to make a QEF election, a U.S. shareholder may be able to make an MTM election if the PFIC stock is considered marketable.
Once an MTM election is made, the U.S. shareholder is required to report any excess of the fair market value of the PFIC stock as of the end of the year over its adjusted basis as ordinary income.
Basis is adjusted each year to include income reported under the MTM method.
Losses from an MTM PFIC stock can be reported only to the extent equal to or less than prior years’ income included under the MTM method.
Any U.S. shareholder of a PFIC if do not make election, he or she is subject to the ‘1291 fund’ rules upon receipt of a distribution from a PFIC.
An ‘excess distribution’ is the portion of the distribution received from a 1291 fund in the current year that is greater than 125% of the average distributions received during the three preceding years (i.e., compare the current year distribution with the sum of the distributions from the PFIC received in the prior three years, divided by 3, and multiplied by 125%).
If there is an excess distribution, this amount is ratably allocated to each day of the shareholder’s holding period. Portions allocated to the current year, and to any year before the foreign corporation qualified as a PFIC, are included on the shareholder’s income tax return as ordinary income in the current year.
Portions allocated to prior PFIC years are taxed at the highest rate in effect for those years. The tax and interest relating to the prior year portions are added to the current year tax liability of the U.S. shareholder.
U.S. individual that is a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year if he or she receives certain direct or indirect distributions from a PFIC, recognizes gain on a direct or indirect disposition of PFIC stock, or is making a QEF or MTM election with respect to the PFIC.
Under Section 1298(f), for years ending on or after 12/31/13, U.S. individuals are required to file Forms 8621 annually to report ownership of PFICs.
Form 8621 should be filed with the individual’s federal income tax return. There is no specific penalty for failure to file Form 8621. If a PFIC required to be reported on Form 8938 is not reported, then a Form 8938 penalty may be imposed. In addition, the statute of limitations will remain open for the tax year for which Form 8621 was not included.
The most common PFIC investment is a U.S. person making investment in mutual fund organized or managed by foreign entities.
- Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation)
A U.S. individual is required to file Form 926 to report certain direct and indirect transfers of cash or property to a foreign corporation.
If an individual is a partner of a partnership that transferred property to a foreign corporation, the individual is treated as having transferred his/her proportionate share of the property.
Reportable transfers include those described in Section 6038B(a)(1)(A), 367(d), or 367(e):
- liquidation of a U.S. corporation into a foreign parent corporation;
- transfers to a controlled foreign subsidiary corporation;
- reorganizations in which stock in a U.S. corporation is exchanged for stock in a foreign corporation; and
- transfers made in connection with certain corporate reorganizations or spinoffs in which no gain or loss is recognized.
For transfer of cash, Form 926 is required only if (1) immediately after the transfer the individual holds directly or indirectly at least 10% of the total voting power or the total value of the foreign corporation or (2) the amount transferred by the person to the foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000.
Form 926 is required to be attached to the U.S. individual’s federal income tax return. A penalty equal to 10% of the fair market value of the property at the time of the transfer may be imposed for failure to timely file Form 926.
REPORTING OBLIGATION RELATED TO FOREIGN TRUSTS
A foreign trust is a trust that fails either the court test or the control test. A trust is a domestic trust if a court within the U.S. can exercise primary supervision over the administration of the trust (court test) and one or more U.S. persons have the authority to control all substantial decisions of the trust (control test).
- Form 3520 (Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts)
Form 3520 must be filed by a U.S. individual who is treated as the owner of a foreign trust, who contributes to or receives a distribution from a foreign trust, engages in loan transactions with a foreign trust or receives certain gifts from a foreign individual, estate, corporation, or partnership.
Form 3520 is filed separately from and is due on the same date as the individual’s federal income tax return (including extensions).
A penalty may be imposed if Form 3520 is not timely filed or if the information is incomplete or incorrect. The minimum penalty is equal to the greater of $10,000 or either (1) 35% of the gross value of any property transferred to or distributions received from a foreign trust for failure to report the transfer or the distribution, or (2) in the case of a U.S. individual treated as the owner of the trust, 5% of the gross value of the portion of the foreign trust’s assets treated as owned by the U.S. individual.
Form 3520-A (Annual Information return of Foreign Trust with a U.S. Owner)
U.S. individual who directly or indirectly transfers property to a foreign trust is treated as the owner of the portion of the trust attributable to such property if the trust has a U.S. beneficiary in the year of the transfer.
A trust is treated as having a U.S. beneficiary for the year, if under the terms of the trust, part of the income or corpus of the trust may be paid or accumulated during the year to or for the benefit of a U.S. person, and if the trust were terminated at any time during the tax year, part of the income or corpus of such trust could be paid to or for the benefit of a U.S. person.
A U.S. individual may also be treated as the owner of a foreign trust if he or she is the grantor of the trust.
A U.S. owner of a foreign trust is responsible for ensuring that the foreign trust files Form 3520-A and furnishing the required annual statements to its U.S. owners and U.S. beneficiaries.
Form 3520-A is filed separately from the individual’s income tax return and is due on March 15th following the (calendar) year end.
If Form 3520-A is not timely filed or the information furnished is incorrect or incomplete, the U.S. owner may be subject to a minimum penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the end of the year.