Real Life: Get Married, File Form 5471March 3, 2017 - Phil HodgenFriday Edition
Here is a real life problem we1 are solving right now for a real life couple: an American citizen married to a noncitizen, living abroad.
- H formed a corporation in his country of residence, and started a business. It is a “foreign corporation” to the IRS.
- H met W, an American citizen. They married.
- W has never been an officer, director, or employee of the corporation. H continues to be the sole shareholder of the corporation to this day. There are no community property rules that give W a shared ownership in the corporation.
Would it surprise you to learn that W should have filed Form 5471 because she is a “100% shareholder”2 of H’s corporation?
Wherein You Are Encouraged to be an International Tax Expert Through Pain
The U.S. tax system thinks that foreign corporations3 are
the Spawn of Satan used for tax evasion.
Accordingly, U.S. shareholders are obliged to provide a crushing amount of information about their ownership in and the operations of foreign corporations. Form 5471 is how it’s done.
To encourage U.S. taxpayers to prepare and file Form 5471 on time, the IRS hands out $10,0004 (sometimes more) penalties for not filing, filing late, filing a less-than-complete Form 5471. Maybe if you ask they will waive the penalty. Maybe not.
W faces a possible $10,000 penalty. She should have filed Form 5471 for the year when she married H. She didn’t.
What’s Not Yours is Yours
The problem comes from a set of principles in U.S. tax law that treat people as if they are stock owners — W is treated as owning the stock of H’s foreign corporation — even though they do not really own the stock in real life.
The jargon: “constructive ownership”.
These constructive ownership rules say that if your close family member owns something (stock of a corporation, for instance), you will be treated as if you own it, for U.S. tax purposes. For purposes of your tax life, the Internal Revenue Code rejects your reality and substitutes its own (YouTube)..
Treated as if She Acquired Stock At the Moment of Marriage
Let’s now take this concept of constructive ownership and apply it to W. There are four different reasons why a U.S. citizen — like W — might be required to file Form 5471. I will show you three of these four.5
The idea here is that the IRS wants to know about American taxpayers who hit a certain minimum threshold of stock ownership: 10% of the company.6 So, if you acquire stock that brings you above 10% — or get rid of enough stock to take you below 10% — the IRS wants to know.
If you answer “yes” to any one of these questions, you are a “Category 3” person and must file Form 5471:
- You previously owned stock of the foreign corporation and acquired some more. If we add up your old stock and your new stock, your total ownership in the corporation became at least 10%.7
- You did not own stock of the corporation before, but acquired enough stock to own at least 10%.8
- You owned at least 10% of the stock, but got rid of enough stock to bring your total ownership below 10%.9
I am describing some of the filing triggers for Category 3 filers. Not all.10 And I am not describing the filing triggers for the other Categories. (Is that a sufficient disclaimer?)
What does it mean to acquire or own stock of a foreign corporation? Well, stock owned or acquired by your family members is treated as yours:
For purposes of subsection (a), stock owned directly or indirectly by a person (including, in the case of an individual, stock owned by members of his family) shall be taken into account. For purposes of the preceding sentence, the family of an individual shall be considered as including only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants.11
Back to our nonresident alien H who owns 100% of the stock of his foreign corporation. H marries W, an American citizen.
She does not directly own the stock. H does.
But she is treated as if she owns the stock owned by her husband. On the day before her marriage to H, she was safe. She could not be treated as owning H’s stock in his foreign corporation, because H was not her spouse. No family relationship existed.
But as soon as the marriage vows were complete, the special rule treated her as an owner of all of his stock. She just “acquired” (scare quotes are deliberate) 100% of the stock of the foreign corporation. That means she acquired enough stock to be treated as if she is at least a 10% shareholder.
And that, my friends, means the event of marriage added a Form 5471 filing requirement to her life.
And of course she doesn’t know this, and of course she does not file Form 5471. And of course that exposes her to a $10,000 penalty.
Treated As If She Acquired Stock, But Not Treated As If She Owns Stock
The tax rules are batsh*t crazy.
- W is treated as if she acquired 100% of the stock of H’s foreign corporation when she married him. That triggers a one-time filing requirement for Form 5471. (She is a Category 3 filer, for you tax fans).
- W is NOT treated as if she owns H’s stock for other Form 5471 filing purposes. (She is not a Category 4 or Category 5 filer, for you tax fans).
Because sometimes W is treated as if she owns H’s stock, and sometimes she is not.
Don’t Count Stock Owned by Nonresident Aliens #1
I’m not going to tell you what a Category 4 person is, because it is not important for this story. I’m showing you how crazy the constructive ownership rules are. Just trust me: if a U.S. person is a Category 4 person, then Form 5471 is required.12 As you will see, W is not a Category 4 person.
For figuring out if you are an owner of stock in order to be a Category 4 person, tax law treats you as if you own foreign corporation stock that is actually owned by close family members. This is the same constructive ownership idea we have seen before. In the Category 4 context, who counts (or doesn’t) as a “close family member” is defined a bit differently.13
But even more importantly, you are not treated as if you own a family member’s stock, if:14
- You do not personally own any stock in the corporation; and
- the family member who really owns the stock is a nonresident alien.
W cannot be a Category 4 person because she does not own any stock in the foreign corporation (H formed the corporation before they married, and continues to own all of the shares), and H is a nonresident alien.15
Don’t Count Stock Owned by Nonresident Aliens #2
Then there is Category 5. Again, it is not important to define what you need to do or be in order to fall into Category 5.
What is important is the fact that there is a third set of constructive ownership rules16 that apply to W, as we attempt to decide whether she has yet another reason to file Form 5471.
These rules tell us that W should not pretend (for U.S. tax purposes) that she owns H’s stock, because he is a nonresident alien.17 Unlike Category 4’s constructive ownership rules, it does not matter whether W directly owns stock in the foreign corporation.
One Event, Three Different Constructive Ownership Rules
Just to summarize: H and W get married. W must look at three different sets of constructive ownership rules to see if she is required to file Form 5471 to report that she has “pretend” ownership of H’s stock, even though she has zero stock ownership in real life.
|Category||Description||Spouse’s Stock Treated as Yours?||Law|
|3||Did you acquire 10%?||Yes||IRC § 6046(c)|
|4||Did you control the corporation?||No, because he is a nonresident alien and you do not directly own stock||Reg. § 1.6038-2(l)|
|5||Did you own >50% of the corporation?||No, because he is a nonresident alien||Reg. § 1.958-2(b)(3)|
How is a normal person supposed to navigate this treachery?
Here is when you need to have your spidey sense on high alert:
- If foreign entities (corporations, partnerships, trusts, foundations, organizations of any kind, really) touch an American taxpayer, odds are that a form must be filed.
- You don’t have to be directly involved in that foreign entity as an officer, director, or shareholder. You might have some paperwork to file if the foreign entity touches one of your close family members.
- “Close family” has a variety of definitions in different contexts. There is no logic. You just have to know the rules.
- If that form does not get filed, odds are that the penalty is $10,000, at a minimum. Other bad stuff happens, too.
If any of this rings a bell in your brain, figure it out. What kind of foreign entity is this? What paperwork is required for this foreign entity from U.S. taxpayers? Are you one of the people — because of your own activity or ownership or the activity or ownership of close family members — who must file that paperwork?
- And by “we” I mean Haoshen Zhong and Debra Rudd. ↩
- The scare quotes are deliberate. ↩
- This means that the corporation was organized under the laws of a jurisdiction outside the United States or the 50 States. IRC § 7701(a)(5), Reg. § 301.7701-5(a). Oh, and the District of Columbia, too. ↩
- IRC § 6038(b). ↩
- The four reasons why someone might be required to file Form 5471 are called “categories”. They are numbered Category 2, 3, 4, and 5. I am describing Category 3 here, then briefly touching on Categories 4 and 5 to point out some boneheaded inconsistence and unnecessary complexity. See the From 5471 instructions for more information. ↩
- IRC § 6046(a)(2). ↩
- IRC § 6046(a)(1)(B)(i). ↩
- IRC § 6046(a)(1)(B)(ii). ↩
- Reg. § 1.6046-1(c)(1)(ii)(c). ↩
- Yes, be alert for IRC § 6046(a)(1)(C) — U.S. shareholders of captive insurance companies. And never forget the filing requirements triggered for nonresidents who become U.S. residence, at IRC § 6046(a)(1)(D). And I know it’s shocking, but I didn’t even define “U.S. Shareholder” anywhere in this discussion. Yet it is still understandable. I think. ↩
- IRC § 6046(c). See also Reg. § 1.6046-1(i)(2). ↩
- IRC § 6038(a)(1). ↩
- IRC § 6038(e)(2). Here, you are not treated as owning stock that belongs to siblings or grandparents. ↩
- Reg. § 1.6038-2(l). ↩
- A nonresident alien is someone who is not a U.S. citizen (an “alien”), and who is not a resident for U.S. tax purposes (a “nonresident”). Yes, it is a clunky phrase. ↩
- Reg. § 1.958-2(b)(3). ↩
- IRC § 958(b)(1). ↩