Happy Friday from Phil. This is your Friday Edition, the biweekly delivery of international tax info straight to your inbox. If you want this to stop happening, click the unsubscribe link at the bottom of this email.
An email from a CPA friend triggered this topic. (Thanks B). Here’s the situation, loosely based on her question:
This creates a tax paperwork problem for you, and for B, your accountant.
The IRS has a special form for you to file: Form 5471. This is a form designed for U.S. shareholders in foreign corporations. You use this form to report your share ownership and a lot (or a little) of the financial activity in the foreign corporation. This financial activity might (or might not) create some taxable income for you.
Form 5471 has many parts to it. Not everyone has to fill in all of the parts, but if you screw up and do not fill in the parts that you are required to fill in, there is a $10,000 penalty waiting for you. This penalty is a powerful incentive to do a good job.
In the year that you become a U.S. resident, you will file Form 5471 because you satisfy the requirements of Category 3. Just becoming a U.S. resident will do the trick.
In subsequent years, you will not file Form 5471 at all, unless there is a change in the stock ownership of the foreign corporation.
You know which parts of Form 5471 to complete by figuring out whether you fit within one (or more) of four different categories. These are numbered as “Category 2” through “Category 5”. (There is/was a Category 1, but that law was repealed a long time ago, leaving Category 2 as the starting number).
So, when you are a U.S. taxpayer and you own shares of a foreign corporation, your first job is to look at the Instructions to Form 5471 and decide whether you fit into one or more of Categories 2 through 5. This will tell you what you need to do.
Let’s walk through the categories, one at a time. This is how I helped B work through her question about completing Form 5471 for her client.
In order to prepare your Form 5471, you will need to know who all of the shareholders are for the foreign corporation. If partnerships, trusts, or other corporations are shareholders, you will need to look through those companies to determine their true owners (jargon alert: you are looking for “constructive ownership” or “attribution” of stock ownership from one related person to another).
You will also need to have access to financial information about the foreign corporation. You might need a lot of information, or only a little bit. It depends on which of the four categories apply to you.
Categories 2 through 5 can be grouped by key similarities. Not surprisingly, the two groups are created by two different Code sections.
If a foreign corporation is not a “Controlled Foreign Corporation”, then Categories 4 and 5 cannot be used to force U.S. shareholders to file Form 5471 or report information about the foreign corporation’s financial activities. IRC § 6038 (this is where Categories 4 and 5 are born!) only applies when there is a Controlled Foreign Corporation.
A foreign corporation is a Controlled Foreign Corporation if “U.S. Shareholders” own more than 50% of the foreign corporation’s stock.
In the example above, there is no control, and therefore the foreign corporation is not a Controlled Foreign Corporation, because more than 50% of voting power must be in the hands of U.S. Shareholders for a corporation to be a Controlled Foreign Corporation.3
General Rule. A foreign corporation owned 50% by a U.S. person and 50% by an unrelated nonresident person can never be a Controlled Foreign Corporation. The U.S. person will never file Form 5471 because of Category 4 or 5 requirements.
The answer for B’s client is that in the year of immigration (and all subsequent years), Categories 4 and 5 will not apply to require Form 5471 to be filed.
In subsequent years, the same is true. The foreign corporation will never be a Controlled Foreign Corporation, so Categories 4 and 5 will never apply.
But that’s the easy knockout punch. We now turn to Categories 2 and 3. Do they apply? Do they require B’s client to file Form 5471? For this, we turn to IRC § 6046, which spawns Category 2 and Category 3.
Category 2 applies where a U.S. person is an officer or director of the foreign corporation and any U.S. person acquires 10% or more of the foreign corporation’s stock.4 Or, there is another situation: a U.S. person acquires a small amount of additional stock which, when added to the stock previously owned, pushes that person’s stock ownership over the 10% mark.5
Since you are an officer and director of the foreign corporation, Category 2 may apply to you. But remember, it only applies if there is a 10% (or more) stock acquisition involving a U.S. person.
Since there is no ownership change in the year you became a resident of the United States, Category 2 will not apply to you. In short, there was not stock transaction involving a U.S. person acquiring enough stock to trigger the filing requirement for a U.S. person (you) in your capacity as an officer or director of the foreign corporation.
General Rule. If you are an officer or director of a foreign corporation, watch stock transactions carefully, and keep “10%” in mind as an important number as it relates to U.S. shareholders. That’s your warning sign for possible Form 5471 filing requirements.
Category 2 is designed to force officers and directors of foreign corporations to report other U.S. citizens or residents. It’s a “snitch or pay $10,000” incentive clause in the Internal Revenue Code.
This category will not apply in the year of immigration to the United States, or in subsequent years.
Category 3 is another transaction-triggered method for forcing Form 5471 to be filed.
The people who need to worry about Category 3 are the shareholders themselves. And unlike Category 2 (where officers/directors are reporting about other people), Category 3 requires you to self-report anytime there is an increase or decrease of share ownership of 10% or more.6
There is a very important clause buried here. Changing from nonresident status to resident status is a triggering “acquisition” of stock, requiring the immigrant to file Form 5471:7
A return on Form 5471, containing the information required by paragraph ©(4) of this section, shall be made by each person who at any time after January 1, 1963, becomes a United States person while owning 10 percent or more of the total combined voting power of all classes of stock of the foreign corporation entitled to vote or the total value of the stock of the foreign corporation.
This means that B’s client must file Form 5471 and report all of the information required for Category 3 filers in the year of immigration to the United States. But for future years, there will be no change of ownership of stock, so there is no Category 3-triggered filing requirement.
This is interesting. A new immigrant to the United States will file Form 5471 for the first year of being a U.S. taxpayer to report his 50% interest in a foreign corporation. But no Form 5471 is filed after that – unless there is a stock ownership shift that is big enough (remember the magic 10%).
It’s always a bit alarming to me when a scary tax form ceases to be required. I am skeptical. Something must be wrong! But no. In the case of an exactly-50% owner of a foreign corporation, the Form 5471 filing requirement goes away.
Other forms may be required. There are always other things lurking in the background that might apply. Form 8621 (for Passive Foreign Investment Companies) is the most obvious bogeyman lurking underneath the bed. But for an active business, PFIC status is unlikely.
Insert routine disclaimer here. Overview of the law, not careful consideration of relevant laws and application to your known facts. Explanation of complex and baroque rules is rudely truncated, eliminating key subtleties that probably apply to your situation. The author is wildly misled and frequently confused. Grab an adult beverage. Yell for help. 🙂
See you in a couple of weeks.