Graphics by Anna Gray.
U.S. taxpayers who control foreign businesses must remain vigilant with regard to many responsibilities, including the often-overlooked duty to file informational returns. Four different kinds of taxpayers must inform the IRS of their income and expenses from their ownership of foreign businesses by filing Form 5471 with their annual 1040s. The price tag for failing to do so starts at $10,000 per year, increases $10,000 for continuing violations after 90 days, and may reduce credits for taxes paid to that foreign country. These costs can accumulate quickly, as demonstrated by the 2017 Tax Court case of Flume v. Commissioner of Internal Revenue (CIR), in which a total penalty of $110,000 was upheld.
Four Categories of U.S. Persons Who Own Foreign Companies Must File 5471
Four of the original five categories of U.S. persons (defined below) with control of foreign corporations or partnerships must file form 5471:
Category 2: A U.S. Officer or Director of Foreign Co. with 10% U.S. Owner
A category 2 Form 5471 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired (in one or more transactions):
1. Stock which meets the 10% stock ownership requirement (described below) with respect to the foreign corporation, or
2. An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.
A U.S. person has acquired stock in a foreign corporation when that person has an unqualified right to receive the stock, even though the stock is not actually issued. More details about this can be found by reading C.F.R. Section 1.6046-1(f)(1).
For purposes of Categories 2 and 3, the stock ownership threshold is met if a U.S. person owns:
1. 10% or more of the total value of the foreign corporation’s stock or
2. 10% or more of the total combined voting power of all classes of stock with voting rights.
For purposes of Category 2, Category 3, and Category 5 a U.S. person is:
1. A citizen or resident of the United States,
2. A domestic partnership,
3. A domestic corporation, and
4. An estate or trust that is not a foreign estate or trust defined in IRC Section 7701(a)(31).
For the purposes of Categories 2 and 3 only, more about some exceptions to these sub-categories can be found in C.F.R. Section 1.6046-1(f)(3).
Category 3: U.S. Owner or Acquirer of 10% of Foreign Company
A Category 3, Form 5471 filer is:
● A U.S. person (defined above) who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement (described above) with respect to the foreign corporation;
● A U.S. person who acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation;
● A person who is treated as a U.S. shareholder under IRC Section 953(c)(special rule for certain captive insurance companies) with respect to the foreign corporation;
● Someone who becomes a U.S. person while meeting the 10% stock ownership requirement with respect to the foreign corporation; or
● A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.
Additional details and information about these sub-categories can be found in IRC Section 6046 and C.F.R. Section 1.6046-1.
Category 4: U.S. Person with Control of a Foreign Corp. for at Least 30 Days
A Category 4, Form 5471 filer is a U.S. person who had control (defined below) of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation.
For purposes of Category 4, a U.S. person is defined more broadly than Categories 3 and 4 because some taxpayers may elect to be treated as U.S. taxpayers under IRC Sections 6013(g) and 6013(h). For this category, It includes:
1. A citizen or resident of the United States;
2. A nonresident alien for whom an election is in effect under IRC Section 6013(g) to be treated as a resident of the United States;
3. An individual for whom an election is in effect under IRC Section 6013(h), relating to nonresident aliens who become residents of the United States during the tax year and are married at the close of the tax year to a citizen or resident of the United States;
4. A domestic partnership;
5. A domestic corporation; and
6. An estate or trust that is not a foreign estate or trust defined in IRC Section 7701(a)(31).
There are exceptions, which are detailed further by C.F.R. Section 1.6038-2(d).
A U.S. person has control of a foreign corporation if, at any time during that person’s tax year, the corporation owns stock with:
1. More than 50% of the total combined voting power of all classes of stock of the foreign corporation entitled to vote or
2. More than 50% of the total value of shares of all classes of stock of the foreign corporation.
A person in control of a corporation that, in turn, owns more than 50% of the combined voting power, or the value, of all classes of stock of another corporation is also treated as being in control of such other corporation. For example, Corporation A owns 51% of the voting stock in Corporation B. Corporation B owns 51% of the voting stock in Corporation C. Corporation C owns 51% of the voting stock in Corporation D. Therefore, Corporation D is controlled by Corporation A. More details about the concept of control for this category can be found in C.F.R. Sections 1.6038-2(b) and (c).
Category 5: U.S. Owner of Stock in a Controlled Foreign Corp. for 30 Days or More
A Category 5, Form 5471 filer includes a U.S. shareholder who owns stock in a foreign corporation that is a Controlled Foreign Corporation (CFC, defined below) for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of that year.
For purposes of Category 5, a U.S. shareholder is a U.S. person who:
1. Owns (directly, indirectly, or constructively, within the meaning of IRC Sections 958(a) and (b) rules for determining stock ownership) 10% or more of the total combined voting power of all classes of voting stock of a CFC or
2. Owns (either directly or indirectly, within the meaning of IRC Section 958(a)) any stock of a CFC (as defined in IRC Sections 953(c)(1)(B) and 957(b)) that is also a captive insurance company.
The same four kinds of U.S. persons for Categories 2 and 3 are considered U.S. persons for the purposes of Category 5. However, exceptions to those required to file as Category 5 filers can be found in IRC Section 957(c).
A CFC is a foreign corporation that has U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of IRC Sections 958(a) and (b)) on any day of the tax year of the foreign corporation, more than 50% of:
1. The total combined voting power of all classes of its voting stock or
2. The total value of the stock of the corporation.
$10,000 Penalties for Taxpayers in these Categories who Fail to File 5471
Every U.S. person in one of the four categories must file an informational return with their form 1040 each year. IRC Section 6038(a). A taxpayer who fails to comply with this informational filing requirement will be fined $10,000 for each year they fail to do so. IRC Sections 6038(b)(1); 6679. After having failed to file a 5471, an additional $10,000 penalty is incurred 90 days later for failing to fix the problem. IRC Section 6038(b)(2). Although there are limits to the maximum amounts of fines and reductions in IRC Sections 901 and 960 foreign tax credits, those credits may also be reduced by 10% for failing to file 5471 within 90 days of filing form 1040. IRC Section 6038(c).
Several Penalties Imposed in Tax Court Case of Flume v. Comm’r, 2017 T.C. Memo 21
Edward Flume owned two real estate development and construction businesses in Mexico: Franchise Food Services of Mexico (FFM) and Belizean Wilshire Holdings, Inc. His various interests qualified him as a Category 3, 4, and 5 form 5471 filer, but he failed to file his informational returns for several years. Those mistakes cost him $110,000.
Flume Was a Category 3 & 5 Filer for His Mexican Real Estate Development & Construction Business
Flume served as the president of a Mexican company (FFM), which was formed in 1995 along with a 50% co-owner for the purpose of developing real estate. Thereafter, FFM was only a controlled foreign corporation (under IRC Section 957(a)) during 2001 and 2002. In February 2002, Flume sold all but 9% of his interest in FFM to an unrelated third party who had never been an officer or director of the company. The Tax Court found that Flume was a Category 5 form 5471 filer in 2001 because he owned over 50% of the stock in FFM for the entire year (over 30 days) and a Category 3 filer in 2002 because he disposed of 41% of his stock that year.
Flume Was a Category 4 & 5 Filer for His International Business Company
A second company, Belizean Wilshire Holdings, Inc., was formed by Mr. Flume and his wife, each owning 50% of the bearer shares of stock, to conduct international business. Each served as an officer with Flume also serving as the director. At some unknown time, the articles of incorporation were amended to show that Flume, his wife, and their daughter each owned only 9%, with a third party owning the remainder. This action was backdated, effective April 2001, yet in 2005, Flume and his wife opened a bank account in the name of Belizean Wilshire, with each as the only signatories. The original articles of incorporation, certificate of incumbency, and copies of the bearer shares were provided. The amended articles were never provided. Similarly, the company’s due diligence documents only identified Flume and his wife as owners of this bank account and Flume as the sole owner of the company. The couple directed disbursements from that account, some directly into their personal accounts.
The Tax Court found that Flume was a Category 4 and 5 filer from 2003 to 2009 despite some of his attempts to retroactively dispose of 41% of his ownership in Belizean Wilshire Holdings. Petitioner and his wife each owned 50% of this corporation before and after the purported 2005 disposition of their shares. (The IRC Section 318 constructive ownership rules treat Flume as also owning and controlling his wife’s 50% shares.)
$110,000 of Penalties were Upheld
Flume incurred $40,000 for failing to file two years of informational reports for the real estate business (FFM, though $10,000 was imposed under IRC Section 6679(a) rather than 6038(b)) and $70,000 for failing to file seven years of informational reports for the international business corporation (Belizean Wilshire). He did not provide a reasonable cause for failing to file these returns, so all of these were upheld by the Tax Court.
U.S. taxpayers who fall into the four categories outlined above need to file informational returns with respect to income from their foreign business interests (form 5471). Penalties for failing to file these forms start at $10,000 a year. This may be surprising since the returns are only informational. Large ownership, control, or dispositions of those interests in foreign businesses may add to your informational reporting duties, not just your actual tax liability.