Sometimes the IRS treats you as something you’re not. They might think that you own stock of a foreign corporation even if you don’t.
You really aren’t a shareholder:
Yet the IRS says you are a shareholder, at least for some (but not all) requirements of U.S. tax law.
None of the benefits, but plenty of U.S. tax downside potential.
They call these rules “constructive ownership” or “attribution” rules. Really, they are “let’s pretend” rules. Let’s pretend you own stock of a foreign corporation, in today’s example.
Bill T., a CPA I know, emailed me about a situation sitting on his desk. Should he prepare a Form 5471 for a U.S. corporation or not? (Getting this question wrong means a $10,000 penalty).
In pretty short order he emailed me a snippet from the Form 5471 instructions that answered the question (“Nope!”).
But I’m a tax geek. I wanted to know why.
Bill T.’s situation is common. A U.S. person owns 100% of a U.S. corporation (the primary business) and 100% of a foreign corporation (after expanding the business overseas).
Come now with me on a romp through the Internal Revenue Code and the Treasury Regulations.
There are four categories of people who must file Form 5471.1 To keep this short, I will only write about one of these categories: Category 4.
You are a Category 4 person if:2
Back to our example. The individual shareholder and the U.S. corporation are both “U.S. persons”.3 A corporation formed in the United States is a “U.S. person.” So is a U.S. citizen or resident.
Our example satisfies the first requirement.
Control means more than half.
You have control if you “own” stock of the foreign corporation that either has:4
The scare quotes around that word “own” are deliberate.
In tax law, there are three types of ownership:
Back to our example. The individual is a direct shareholder of the foreign corporation: he owns 100% of the stock. He will file Form 5471.
The U.S. corporation is not a direct or indirect owner of the foreign corporation’s stock. But is it a constructive owner of the foreign corporation’s stock?
Remember we are trying to figure out if the U.S. corporation “controls” the foreign corporation.
In order to figure out whether the U.S. corporation “controls” the foreign corporation and is therefore a Category 4 filer of Form 5471 (and only for that purpose)6 we have to figure out if the U.S. corporation “owns” the stock of the foreign corporation.
And to figure out if the U.S. corporation “owns” the stock of the foreign corporatoin, we look at the constructive ownership rules found in another part of the Internal Revenue Code: Section 318(a).7
A corporation can be treated as owning all of the stock of another corporation owned by its shareholder.
If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person.8
A horrible, horrible paragraph. Just ugly. This is prose as crafted by a wood-chipper.
Here is what it says:
If I own more than 50% of Corporation A, then Corporation A will be treated as owning all of the stock of all of the other corporations that I am a shareholder in.
Back to Bill T.’s example (which we are using here):
Any person required to furnish information under this section with respect to a foreign corporation need not furnish that information provided all of the following conditions are met:
(A) Such person does not directly own an interest in the foreign corporation;
(B) Such person is required to furnish the information solely by reason of attribution of stock ownership from a United States person under paragraph (c) of this section; and
(C) The person from whom the stock ownership is attributed furnishes all of the information required under this section of the person to whom the stock ownership is attributed. [ * * * ].
The U.S. corporation — which is required to file Form 5471 because we must pretend that it owns the stock of the foreign corporation — need not file Form 5471 if all three of these statements are true:
The U.S. corporation) does not need to do anything in its tax return to claim the exception: no statement is required.13
Note well the “gotcha” here: if the person who should have filed Form 5471, does not, he incurs a $10,000 penalty.
And the U.S. corporation that should have filed Form 5471 but didn’t (relying on this exception) is now out of luck. The exception does not apply because of failure of the third requirement. The U.S. corporation will have a $10,000 penalty staring at it.
Now you know why Bill T. was so cautious.