For U.S. expats owning a foreign corporation, reporting on the Form 5471 can be particularly challenging.
The consequence of not filing, or filing inaccurately, can be severe. If a taxpayer files a late, inaccurate, or substantially incomplete Form 5471, then the IRS may assert a penalty of $10,000. The penalty increases on a monthly basis, to a maximum of $50,000, if the problem persists after the taxpayer is notified by the IRS.
In some cases of egregious and fraudulent non-compliance, criminal penalties can be imposed.
For that reason, it’s important to understand what defenses are available in the case that the IRS claims that a 5471 violation has occurred and penalties should result.
Penalty Abatement Strategies
In some cases, the IRS will abate a penalty if the taxpayer can show that it’s the first time a penalty has been imposed.
The first-time-penalty-abatement policy, however, does not apply to (i) returns with an event-based filing requirement, and (ii) information reporting that is dependent on another filing, such as various forms that are attached to an income tax return. As such, the IRS will typically reject 5471 penalty abatement requests based on these parameters.
If first-time-penalty abatement is not available, the next key strategy is to claim that the taxpayer had “reasonable cause” for the violation.
IRS Approach to Reasonable Cause Standard
The IRS states in its Internal Revenue Manual that reasonable-cause relief is generally granted when the taxpayer exercised ordinary business care and prudence in determining his or her tax obligations but was nevertheless unable to comply with those obligations.
In the past, the IRS has looked at the following factors in determining whether reasonable cause exists.
- Death, serious illness, or unavoidable absence
- Fire, casualty, natural disaster, or other disturbance
- Inability to obtain records
- Mistake was made
- Erroneous advice and reasonable reliance
- Ignorance of the law
- Undue hardship
- Advice from the IRS
- Advice from a tax advisor
- Official disaster area
Tax Court Accepts Reasonable Reliance Defense
In a very recent Tax Court case, M.R. Kelly, TC Memo. 2021-76, the reasonable cause standard was analyzed in the context of a misfiled Form 5471.
The taxpayer in the case formed a corporation in the Cayman Islands for the purpose of buying a commercial yacht from a distressed seller at a discounted price. The taxpayer was the sole owner of the Cayman corporation. Apparently, this was the only foreign entity owned by the taxpayer, although he owned a number of U.S. companies treated as disregarded for U.S. tax purposes.
When the taxpayer established the foreign entity, he already had a longstanding professional relationship with an accounting firm. Despite receiving an email that the new entity was foreign and was wholly owned by the taxpayer, the firm treated the corporation as a domestic disregarded entity, reporting it on a Schedule C, and did not file the Form 5471. This may have been because the taxpayer owned several other companies that had this tax classification.
Under these facts, the Tax Court held that the IRS could not impose penalties because the taxpayer had reasonable cause for his non-compliance.
The Tax Court reasoned that the firm had been diligently preparing the taxpayer’s forms for many years, the preparer did not have a disciplinary record, the taxpayer timely notified the firm about his ownership of the foreign entity, and the situation did not involve some tax or financial result that was significantly beneficial for the taxpayer. The Court also explained that the firm’s lack of prior experience with the Form 5471 was not detrimental to the taxpayer’s reasonable reliance position.
The Tax Court also clarified, citing to Supreme Court precedent, that taxpayers do not need to question advice they receive from tax professionals, nor do they need to obtain additional opinions. The Court recognized that the taxpayer could have done more himself to ascertain his filing obligations, but it was reasonable for him to rely on his accounting firm to do this for him.
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 tax 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.
