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IRS Form 5471, Cross Border Business

Updated Posted

"Own" is Such a Difficult Word

Portrait of Phil Hodgen

Phil Hodgen

Attorney, Principal


Form 5471 is hard because, among other reasons, you have to figure out the meaning of the word "own."

There's your understanding of the word. You certainly know what it means to own something. And then there's the Federal government's belief about what it means to "own" something for tax purposes. Uncle Sam's view of ownership is a bit more . . . expansive . . . than yours.

The three meanings of "own"

Form 5471 is all about how many shares of stock you own. There are three ways you can "own" stock, according to the Internal Revenue Code:

  • Direct ownership;
  • Indirect ownership; and
  • Constructive ownership.

Direct ownership

Direct ownership of shares of a corporation's stock is not a difficult intellectual exercise. There are share certificates and a share registry maintained by the corporation.

The hard part of direct ownership is a people problem. Maybe the share registry is not up-to-date. Maybe the "real" owners are hiding behind nominees whose names appear on the stock certificate.

You are a highly-trained tax professional. You do the best you can to smoke out the bullshit. The criminally under-appreciated Christy Hays says something about a similar situation in Ribbon of Highway:

That song, by the way, has another painfully straight-to-the-heart lyric:

Dear reader, is that you? Are you metaphorically singing someone else's song? (It'sa me!)

And then you wake up tomorrow and repeat a facsimile of someone else's dream -- because you believed the story they told you in  school? And you believe you are stuck, inadequate, and will never achieve your heart's desire? (It ain't me! And I thank God daily for this.)

Please. Own your own life.

How many artists are out there, producing gems like Ribbon of Highway, and never finding an audience? Please listen to the bands on Spotify who only have a few hundred listeners each month. Support them. You don't need to hear to Katy Perry or Pink Floyd yet again.

I hope Christy is fanning that ember of secret dreams in her heart -- whether she rekindles her music career or not.

But I digress.

Indirect ownership

Indirect ownership just means stacked entities. Holding structures. You own stock in a corporation that owns owns stock in a corporation that owns stock in a corporation.

If I were to hazard a guess, I would guess that the Internal Revenue Code cares about your indirect ownership of a lower-tier corporation because:

  • The chain of ownership means you can extract economic value from the indirectly-owned corporation, and that means the potential for taxable income.
  • The chain of ownership means that you can exert indirect control over the lower-tier corporation.

I'm going to skip the whole discussion of indirect ownership in the newsletter this week. I want to talk about constructive ownership.

Constructive ownership

Or a subset of constructive ownership, actually.

Constructive ownership just means that someone else owns the stock of a corporation but the Internal Revenue Code pretends that you own it.

In a sense, indirect ownership of stock is constructive ownership (and the Code and the Regulations are indiscriminate in their use of the word "constructive") but I want to focus on situations where there is no economic ownership at all. Some other human being, fair and square, is the direct owner of a share of stock, yet the Internal Revenue Code pretends that you, fair and square, own that share of stock.

This happens with family members.

The reason is pretty easy to understand. Go back to the idea of "control" and "economic benefits" from owning stock.

If your Mom (who loves you) owns a share of stock instead of you, she will do whatever you ask her to do. You control that share of stock and therefore the corporation.

Perhaps your Mom (who loves you) will even take a dividend from the corporation and give you the money. This especially happens when Mom (who loves you and wishes you would visit more frequently) lives in another country and the corporation is in another country, too. Now you have functional economic ownership of the corporation, in addition to functional control over the corporation.

So, I get it.

The problem with constructive family ownership rules for Form 5471

The problem, for Form 5471, is that there are three different sets of rules that you must use (depending on context) to decide "Do I 'own' that share of stock that my family member owns?"

And the definition of "family" varies from one rule set to the next.

The big (and little) differences

The big differences are:

  • Brothers and sisters. The normal assumption (yours and mine both) is that if your brother owns stock, you are NOT treated as the owner of that stock. But you are treated as the owner of your brother's stock for Category 2 and 3 purposes.
  • Nonresident family members. The normal assumption is that it doesn't matter whether your family member is a U.S. taxpayer or not. We pretend that you own that family member's stock. But that doesn't work for Category 5: we do NOT pretend that you own a nonresident family member's stock.

The little differences (in the Pareto Principle sense) apply to Category 2 and Category 3 only:

  • "Ancestors" and "descendants." Category 2 and Category 3 will ask you to look at the whole family tree for generations older than your grandparents and younger than your grandchildren.
  • Grandparents. Category 2 and Category 3 also treat you as owning your grandparents' shares. The other categories of filers? Nope.

Example of how the differences work

Here's a simple example: your father, a nonresident of the United States, owns 95% of the stock of a foreign corporation. You own 5% of the stock, and you're a U.S. citizen.

There are no transactions in stock during the year, so Categories 2 and 3 do not apply. Let's heroically assume that Category 1 does not apply, either.

Are you a Category 4 filer or a Category 5 filer of Form 5471? Yes and no, respectively.

Category 4

The constructive ownership rules for Category 4 start with the default rules of IRC §318(a), as modified by IRC §6038(e)(2). There are two modifications to the IRC §318(a) rules in IRC §6038(e)(2), and neither modification applies to attribution of stock ownership from family members. Therefore, in the situation I describe, we apply the plain vanilla IRC §318(a)(1) rules, as-is.

IRC §318(a)(1)(ii) tells us to pretend that a child owns corporate stock owned by a parent. Therefore, your father's 95% stock is treated as owned by you. Combined with your own 5% stock position, the Internal Revenue Code treats you -- for Category 4 purposes -- as owning 100% of the stock of that foreign corporation.

You are a Category 4 filer.

Category 5

Compare this to Category 5. Here, we do NOT pretend that you own your father's 95% of the stock of the foreign corporation. Why? Because he is a nonresident alien.

For Category 5 purposes, we again start with the default IRC §318(a) rules, as modified. This time the modifications are in IRC §958(b).

And IRC §958(b)(1) says "don't pretend that a U.S. person owns a nonresident alien's shares."

Thus, if we apply the rules in sequence it works like this:

  • You own your father's 95% stock position in the foreign corporation because of IRC §318(a)(1)(ii); however
  • IRC §958(b)(1) says you can only pretend that you own your father's stock if he is a U.S. person--not if he is a nonresident alien.
  • Your father is a nonresident alien.
  • Therefore we cannot pretend that you own your father's stock.

This leaves you with 5% stock ownership in the foreign corporation.

A Category 5 filer is someone who is a "United States shareholder" of a "controlled foreign corporation." Among other things, a "United States shareholder" is someone who owns a minimum of 10% of the stock of a foreign corporation. IRC §951(b).

You only own 5% of the stock of this foreign corporation. You are not a Category 5 filer.

Lesson learned

So what do we take away from all of this?

First, good music is good. Cosmic American Music is special. So is regular American Music.

Second, subtle differences matter. Learn the basic principles, but -- AND! -- have a checklist to ensure that the subtle differences don't trip you up.