Form 5471, Constructive Ownership, and ExceptionsMarch 31, 2017 - Phil HodgenFriday Edition
“You Don’t Own It But the IRS Treats You as if You Do”
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:
- You cannot exercise the voting power that a shareholder has — because you are not a shareholder.
- You do not receive dividends — because you are not 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.
A Detour Through the Law
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.
Who Must File Form 5471?
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
- You are a U.S. person;
- Who controls a foreign corporation;
- For at least 30 days in a row in the tax year.
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 Own More than Half
Control means more than half.
You have control if you “own” stock of the foreign corporation that either has:4
- More than 50% of the voting power of all possible classes of voting stock; or
- More than 50% of the value of all classes of stock.
The scare quotes around that word “own” are deliberate.
Three Types of “Own”
In tax law, there are three types of ownership:
- Direct ownership means you really own the thing. Example: your name is on the stock certificate, so you are a direct shareholder of a corporation.
- Indirect ownership means you own something that owns the thing. Example: Your corporation owns another corporation.5 You are the indirect owner of that second corporation.
- Constructive ownership means you are closely related to the real owner — so closely, in fact, that the IRS thinks you should be treated like a owner, even if you are not one in real life. Example: Your spouse owns 100% of the stock of a corporation. You are treated as the constructive owner of your spouse’s stock.
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 “Owns” the Foreign Corporation
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.
At First Glance, the U.S. Corporation Must File Form 5471
Back to Bill T.’s example (which we are using here):
- (Fact 1). One person, an American citizen, owns 100% of the U.S. corporation.
- (Law). Therefore, the U.S. corporation is treated as owning all of the stock of all of the other corporations that our one person owns.9
- (Fact 2). The person also owns 100% of the stock of the foreign corporation, and owned it for more than 30 days in a row.
- (Conclusion). The U.S. corporation constructively owned more than 50% of the voting control and value of the foreign corporation.10
- (Consequence). The U.S. corporation had control of the foreign corporation for more than 30 days in a row and is therefore a Category 4 person required to file Form 5471.11
But on Closer Inspection, It Doesn’t Have to File
In fact, the U.S. corporation is not a Category 4 filer, and need not file Form 5471. The Instructions to Form 5471 say so, but let’s back it up with the actual law:12
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 is not a direct shareholder of the foreign corporation (true in our example);
- The only reason that the U.S. corporation has a filing requirement is because the constructive ownership rules of Reg. § 1.6038-2(c) made this a requirement (true in our example); and
- The real shareholder (the person who owns 100% of the stock of both corporations) reports everything on a Form 5471 (we hope this is true).
The U.S. corporation) does not need to do anything in its tax return to claim the exception: no statement is required.13
Failures are Spectacular
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.
- The four categories are cursorily described in the Instructions to Form 5471. ↩
- Reg. § 1.6038-2(a). ↩
- IRC § 7701(a)(30), Reg. § 1.6038-2(d). ↩
- Reg. § 1.6038-2(c). ↩
- This happens a lot, for business or tax reasons. It isolates risk, for instance. Westinghouse, for instance, can put all of its nuclear power plant business in one corporation, and its appliance manufacturing business in another. If things go badly for the nuclear power plant business, it can go bankrupt without affecting the appliance manufacturing side of the company. Lawyers call this a parent-subsidiary structure. You own all of the stock of a corporation (the parent), which in turn owns all of the stock of the second corporation (the subsidiary). ↩
- “The constructive ownership rules of section 318(a) apply only for purposes of determining control as defined in paragraph (b) of this section.” Reg. § 1.6038-2(c), flush language. ↩
- Reg. § 1.6038-2(c). ↩
- IRC § 318(a)(3)(C). ↩
- IRC § 318(a)(3)(C). ↩
- Reg. § 1.6038-2(b). ↩
- Reg. § 1.6038-2(a). ↩
- Reg. § 1.6038-2(j)(2)(i). ↩
- A statement is required for someone who claims the exemption from filing Form 5471 using Reg. § 1.6038-2(j)(1). Reg. § 1.6038-2(j)(3). But here, the U.S. corporation is claiming the Reg. § 1.6038-2(j)(1) exemption from the Form 5471 filing requirement. ↩