AMERICAN EXPATS AND FOREIGN CORPORATIONS
American Expats and Foreign Corporations Early in 1996, HR was audited by the Internal Revenue Service for failing to file information returns on three foreign corporations which he controlled. As a US citizen residing in Europe for thirty years, HR had set up three foreign corporations: one for his exporting business, another for wine growing and still another for property development. His foreign accountant had advised him that doing business as a foreign corporation would not only protect his personal assets from legal claims but also facilitate transfers of ownership shares to his heirs. Nearing retirement he wanted his children to acquire the business enterprises he had worked for so many years to build up. Now he was faced with the threat of stiff penalties unless he promptly filed the required returns for years 1993, 1994 and 1995.
IRS considered that HR controlled these corporations because he owned more than 50% of the total value or amount of the existing stock. While dutifully filing his tax returns each year by the due date, HR little realized that Form 5471 - INFORMATION RETURN OF US PERSONS WITH RESPECT TO CERTAIN FOREIGN CORPORATIONS - must also be filed at the same time. See www.controlledforeigncorporation.com.
A $10,000 penalty applies for failure to file the required Form 5471, applied to the foreign corporation for each annual accounting period. If IRS audits a US person for failure to file Form 5471 and accompanying schedules, the Service can assess additional $10,000 penalties for each 30 day period during which the negligence continues. Maximum penalties per failure are $50,000.
As HR rather anxiously immersed himself in complying with the audit, he learned that Form 5471 is required by US citizens and residents who are officers, directors or shareholders in a foreign corporation. HR fit all three of these designations. He soon discovered that Form 5471 included twelve distinct schedules. Now the question was which filing category or categories applied to him.
Category 1 Filer: A US citizen or resident who is an officer, director or 10% shareholder of a foreign personal holding company. A 10% shareholder is a person who owns directly or indirectly 10% or more in value of the outstanding stock of the company. (Form 5471 with Schedules A, B, G & N) (This filing requirement has been repealed.)
Category 2 Filer: A US citizen or resident who is an officer or director of a foreign corporation in which a US person has acquired stock which meets the 10% ownership requirement or an additional 10% or more of the outstanding stock of a foreign corporation. A US person can be a citizen or resident of the United States, a partnership or a corporation that is domestic, or an estate or trust that is not foreign. (Form 5471 with Schedules G & O)
Category 3 Filer: A US person who acquires stock in a foreign corporation which meets the 10% stock ownership requirement. The amount and type of any indebtedness of the foreign corporation with related persons as well as identifying information pertaining to each subscriber to the foreign corporation's stock must also be included. (Form 5471 with Schedules A, B, C, E, F, G & O)
Category 4 Filer: A US person who had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation. (Form 5471 with Schedules A, B, C, E, F, G, H, I, J & M)
Category 5 Filer: A US shareholder who owns stock in a controlled foreign corporation for an uninterrupted period of 30 days or more during the foreign corporation's tax year or who owned the stock on the last day of the year. (Form 5471 with Schedules G, H, I & J)
Bewildered by these complex filing requirements, HR turned to a US international tax accountant for help. The Information Returns were duly prepared and filed with IRS, fortunately avoiding all penalties. HR then set out to reduce his ownership shares in the three foreign corporations to below 50%.
Married to a US non-resident alien for twenty-eight years, HR and his wife had two adult children who were citizens of both the foreign country and the United States. According to IRS Code Section 318: 'An individual is generally treated as constructively owning the stock actually owned by his spouse (and) children' unless the spouse is not a US citizen. What this meant was that the combined value or amount of stock owned by HR and his children needed to be reduced to below 50% to avoid annual filings of Form 5471. Therefore HR in a series of transfers made his wife the majority shareholder. He also made sure that he was removed as a director and officer in the three foreign corporations.
The plan worked well in the ensuing years. After 1997 with the transfers completed and no additional shares of stock being acquired thereafter by the children, no more Information Returns were required. Unfortunately Mrs HR divorced her husband in 2001, frustrating his plans to pass the remainder interests of the three foreign corporations to his children.
Note: On January 1, 2009, the IRS announced an automatic penalty of $10,000 for each Form 5471 filed with a delinquent Form 1120 series return.
FOREIGN PARTNERSHIPS -
You Do If I Do
Years ago in west Texas, we used to watch in eager anticipation any of the sixteen Dean Martin and Jerry Lewis movies that came out during their ten year career together. They were highly successful comedic partners who at one time were regarded as the hottest stars in the world. In one of their last movies, the duo sang some silly song about being partners, and so we were delighted that they would continue to entertain us for years to come. What we didn't know was that in the last ten months of their partnership, they barely spoke to each other.
As it turns out, a partnership is the most complicated of legal entities to perpetuate. In fact, accounting for partnerships involves an entire set of rules that is at times conflicting, sometimes unclear, but always challenging. For tax purposes, the partners must show their share of partnership income, gains, losses, credits, and deductions on their personal income tax returns. Partners' bases in a partnership must account for the capital account, the inside basis, the outside basis and the at risk basis. Debts are separated between recourse and non-recourse. A partnership agreement should define each partner's share of capital, losses and profits. Complex elections must be discussed and decided.
Some advantages accrue to partnership entities such as an unlimited number of partners, avoidance of gain recognition for contributed and distributed property, and special profit and loss allocations. But operating a partnership basically means defining and then monitoring what each partner does or agrees to do.
Whenever one or more U.S. persons set up a foreign partnership, they are subject to complex reporting requirements. Internal Revenue Code Section 6046 mandates that such U.S. persons file Form 8865 - Return of U.S. Persons with Respect to Certain Foreign Partnerships - whenever they have a reportable event during the tax years. Reportable events include acquisitions, dispositions or changes in proportional interests of at least 10% in a foreign partnership.
Code Section 6038 requires that U.S. persons having a controlling interest in the foreign partnership file Form 8865 annually. Control implies direct or indirect interest of at least 50%. Form 8865, which is an information and not a tax return, requires reporting 1) taxpayer identifying details, 2) ownership interest, 3) foreign entities owned by the partnership, 4) details of reportable events, 5) fair market value of interests acquired or disposed, 6) other ownership interests of the partnership, 7) income and balance sheet details in U.S. currency, 8) other essential information.
In determining exactly what should be included in the 10 pages of Form 8865, filers have to decide between four reporting categories. Category 1 is a U.S. person who controlled the foreign partnership at any time during the partnership's tax year. Category 2 is a U.S. person who at any time during the tax year of the foreign partnership owned a 10% or greater interest in the partnership while it was controlled. Category 3 is a U.S. person who contributed property during that person's tax year to the foreign partnership. Category 4 is a U.S. person that had a reportable event during the tax year. Multiple categories can also apply.
Naturally the Internal Revenue Service can penalize those who fail to comply with Form 8865 filing requirements. Category 1, 2 or 4 filers are subject to a $10,000 penalty for each tax year of non-compliance. Additional penalties can apply for further delays once a taxpayer is notified by IRS. Category 3 filers may be subject to as much as a $100,000 penalty.
Dean Martin and Jerry Lewis each had their own vision of their careers, and so separated in 1956 after ten highly successful years of entertaining as a team. Afterward they only saw each other publicly three times: The Eddie Fisher Show in 1958, the MDS Telethon in 1976, and Las Vegas in 1989. Their partnership, like a marriage gone sour, could not be sustained by any form of agreement or understanding. Both decided in the end and in the years ahead that I do as he does.