Top 6 Challenges for Expat Business Owners Filing the Form 5471
For U.S. expat owners of foreign companies, U.S. tax compliance can feel particularly onerous when it comes to filing the infamously difficult IRS Form 5471. The Form 5471 is considered by many to be one of the most challenging forms to file with a U.S. tax return.
It comes as no surprise that the IRS estimates that it should take taxpayers between 30-40 hours to fill out this single form. The time investment can be extraordinary in the case of a U.S. person owning multiple foreign corporations.
In this blog, we briefly describe 6 major challenges facing U.S. business owners attempting to tackle the Form 5471.
Challenge #1 – Properly classifying your company for Form 5471 purposes
For the Form 5471 to be relevant to your filing, it is first required that your foreign entity be considered a corporation for U.S. tax purposes. With years of international tax practice under our belts, we’ve come to discover a common classification trap for the unwary in this regard.
In many instances, the classification of your company in your country of residence will not align with its classification under U.S. tax law. While a company’s legal classification is one element of determining U.S. tax classification, the U.S. tax regulations have very specific and nuanced classification rules that can alter its classification.
An entity classified as a trust in your country, for instance, may be classified as a corporation for U.S. income tax purposes, triggering a Form 5471 requirement.
Without knowing the ins and outs of the classification rules, the Form 5471 requirement can be missed, which can lead to severe penalties if discovered through audit.
Challenge #2 – Determining your requirement to file the Form 5471
As a general rule, the Form 5471 is required to be filed when there is at least one 10% U.S. shareholder in the relevant foreign corporation. The precise rules, however, can be exceedingly complex.
The following is a brief description of the categories of taxpayers who are required to file the Form 5471 (certain schedules are required depending on which category applies to you):
Category 1 – This category includes a U.S. shareholder of a foreign corporation that is a section 965 “specified foreign corporation” at any time during any tax year of the foreign corporation, and who owned that stock on the last day in that year on which it was an SFC.
Category 2 – U.S. citizen or resident who is an officer or director, and a U.S. person has acquired stock that meets a 10% ownership requirement or a U.S. person has acquired an additional 10% of stock.
Category 3 – U.S. citizen or resident who acquires a 10% ownership interest, sells stock and drops below 10%, or becomes a U.S. person while owning 10%.
Category 4 – a U.S. person who had control (defined below) of a foreign corporation during the annual accounting period of the foreign corporation. For this purpose, “control” is considered to be ownership of more than 50% of the foreign company.
Category 5 – a U.S. shareholder who owns stock in a foreign corporation that is a controlled foreign corporation (CFC) at any time during any tax year of the foreign corporation, and who owned that stock on the last day in that year on which it was a CFC. A U.S. Shareholder is defined as an individual owning 10% or more (vote or value) of the corporation’s stock. A CFC is defined as any foreign corporation where U.S. Shareholders own more than 50% of the vote or value of the corporation.
While the categories themselves have a number of inherent nuances, they are also subject to a number of attribution and constructive ownership rules that can complicate matters, to say the least. For instance, if you have a spouse or other family member, attribution of ownership through them can trigger a Form 5471 requirement that may otherwise not exist.
Challenge #3 – Gathering the information required on the Form 5471
Once you’ve determined that you do have a Form 5471 requirement, tackling the reporting requirements themselves can be difficult simply from the vantage point of having to produce and/or gather information about your company.
The types of information requested include the following, among others:
- Description of the stock of the foreign corporation
- Description of certain U.S. shareholders of the foreign corporation
- The foreign corporation’s income statement
- The foreign corporation’s balance sheet
- The foreign corporation’s current earnings and profits
- A summary of shareholder’s income from the foreign corporation
- Information regarding related party transactions
- Information regarding the organization or reorganization of the foreign corporation, and certain acquisitions and dispositions of its stock (Schedule O)
Challenge #4 - Classifying your company’s income for the Form 5471
While gathering information about your company can be challenging, understanding the CFC rules and how they classify your company’s income is difficult on an entirely different level.
Under the CFC regime, your company’s income can be classified in a number of ways, either as Subpart F income, GILTI, a Section 956 investment of earnings in U.S. property, among others. Each classification can have drastically different consequences from a substantive perspective and from a Form 5471 reporting perspective. With GILTI in particular, a new set of challenging schedules has been added for reporting this new category added as part of the Trump tax reform.
The proper classification of your income turns on a complex and intricate web of international tax statutes, regulations, and IRS guidance that requires a certain level of mastery in order to fully and properly analyze your company’s activities. These rules are also subject to subtle but important changes from time to time, so staying informed about the latest CFC tax news is important to properly file the Form 5471 from year to year.
Challenge #5 – Comprehending other tax concepts inquired about on the Form 5471
At the risk of sounding too dramatic, even understanding how to classify your company’s income leaves a number of other conceptual challenges for the Form 5471 filer. The U.S. CFC rules are replete with tax rules and concepts that are inquired about on the Form 5471.
These rules include, among others:
- Current and accumulated earnings and profits
- Previously taxed income (PTI) rules
- PTI ordering rules
- GILTI deduction rules
- CFC stock sales
- Factoring income
With each concept, a new layer of complexity is added, which can expand depending on the activities of your company and its filing history.
Challenge #6 – Risking harsh penalties for misreporting information on the Form 5471
This sixth challenge comes from a different angle – and that is what taxpayers risk by not filing, late filing, or even incorrectly filing the Form 5471.
In terms of compliance, Form 5471 must be attached to your income tax return and must be filed by the due date (including extensions) for that return.
The following penalties, among others, may apply for failure to accurately file Form 5471 (or Schedule O to Form 5471 regarding corporate reorganizations, if required):
- Civil penalty of $10,000 for each year’s failure. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign corporation) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure.
- 10% reduction in any foreign tax credits claimed from the relevant foreign corporation.
- Failure to file keeps the audit statute of limitations open indefinitely when information is required to be reported
- Criminal penalties may also apply in certain circumstances.
The harshness of these penalties shows the IRS’s deep concern that they know all about your foreign company to ultimately prevent the deferral or avoidance of U.S. tax through a corporate shield overseas.
The Takeaway for U.S. Expats
At the end of the day, aside from the case of a very simple overseas business, complying with the Form 5471 on an annual basis is a very difficult, if not impossible, task for even a sophisticated business person if he or she is not grounded and experienced in U.S. international taxation.
For this reason, the Form 5471 is normally best left to the experts. Due to the difficulties involved in reporting your foreign corporation, even if you do obtain the help of a professional, we recommend gathering your company information earlier rather than later so your preparer has the information necessary to timely and accurately prepare your Form 5471.
We also recommend that you gain some familiarity with the U.S. tax basics and the international tax provisions applicable to foreign companies. This will help you better communicate your company’s background and activities to your preparer to ensure an accurate filing, and even better, discover ways to improve your corporate structuring to optimize your company’s tax profile.