Under regulations finalized in late 2016, a foreign-owned U.S. disregarded entity will be required to obtain an Employer Identification Number and file annual information returns with the IRS. A disregarded entity is a wholly owned single-member limited liability company (LLC). To avoid substantial monetary penalties, foreign owners of a U.S. disregarded entity will need to review their filing obligations pursuant to those new rules.
Rules Prior to 2016 Regulations
U.S. corporations and partnerships are usually required to file annual income tax returns with the IRS, as are foreign corporations that engage in a U.S. trade or business or receive certain U.S. source income. In addition, U.S. corporations that are at least 25% foreign-owned are subject to additional reporting and recordkeeping requirements and typically would need to file Form 5472 — Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.
Prior to the 2016 change in regulations, a foreign-owned disregarded entity was not treated as an entity separate from its owner and had no separate U.S. reporting obligations. Their owner was treated as owning the entity’s assets and liabilities directly, and was not required to file a separate return in the U.S. This provided the foreign owner with a measure of anonymity, allowing them to conceal non-U.S. asset and bank accounts.
Anonymity No More
The final regulations are intended to enhance transparency, strengthen enforcement of tax laws, and satisfy U.S. obligations to exchange financial information with its treaty partners. To achieve these goals, the regulations treat a disregarded entity with a single foreign owner as a separate entity solely for information reporting and recordkeeping purposes. As such, a disregarded entity will be required to comply with the same requirements as 25% foreign-owned U.S. corporations. But unlike those corporations, a disregarded entity won’t benefit from exceptions for small corporations and de minimis related-party transactions.
Foreign owners will no longer be able to hide behind U.S. “shell” companies. Going forward, a disregarded entity must file Form 5472, identifying their foreign owners and disclosing “reportable transactions,” which include contributions and distributions to or from their foreign owners.
Among other things, a disregarded entity that is required to file the Form 5472 must:
- Disclose their foreign owners and report certain related-party transactions
- Maintain certain related records
- Obtain an Employer Identification Number
For purposes of the new rules, a foreign person “wholly owns” a disregarded entity if that person has “direct or indirect sole ownership” of it. Indirect ownership means “ownership by one person entirely through one or more other entities disregarded as entities separate from their owners or through one or more grantor trusts, regardless of whether any such disregarded entity or grantor trust is domestic or foreign.”
The final regulations provide that a foreign-owned disregarded entity has the same tax year as its foreign owner or, if the owner has no U.S. return filing obligation, the calendar year.
Determination of Filing Obligations
The final regulations apply to entity tax years beginning on or after January 1, 2017, and ending on or after December 13, 2017. Therefore, the earliest filing deadline would be in early 2018.
Foreign owners of a U.S. disregarded entity should determine their reporting and record-keeping obligations under these new regulations. Obtaining an Employer Identification Number of a disregarded entity will require the “responsible party’s Employer Identification Number, Social Security Number, or Individual Taxpayer Identification Number (ITIN).” If that party is a foreign individual located outside the U.S. and doesn’t already have an ITIN, obtaining one can take several months so it’s a good idea to plan now.
If you have questions about foreign-owned Disregarded Entities, please contact your Untracht Early advisor.