Any entity that is not recognized for U.S. tax purposes is a disregarded entity. The most typical and widely- used domestic disregarded entity is a single member Limited Liability Company (SMLLC).
If a SMLLC has made the election to be treated as a corporation, the new regulations do not apply as it is no longer disregarded for U.S. tax purposes.
On December 13, 2016, final regulations were issued regarding new reporting requirements for domestic disregarded entities wholly owned by a nonresident, whether the nonresident owner is an individual or an entity. For the purposes of certain IRS reporting requirements, these disregarded entities will be treated as U.S. corporations. These rules are in effect for tax years beginning on or after January 1, 2017, and ending on or after December 13, 2017.
Historically, for tax purposes, a foreign-owned U.S. disregarded entity was just that - disregarded. The reporting taxpayer was the owner of the disregarded entity, whether the owner was an individual or an entity. Previously there had not been any requirement for these disregarded entities to disclose certain transactions that occurred as the entity was disregarded under the tax code. Under the new rules, this is no longer the case.
Under the new requirements, a domestic disregarded entity will have a pro-forma corporate filing requirement with forms that disclose transactions with related parties. The types of transactions that are covered by this reporting relate to amounts paid or received in connection with the formation, dissolution, acquisition and disposition of the entity, including contributions to and distributions from the entity.
The penalty for failure to file when due and in the manner prescribed by the IRS or even the failure to maintain records as required under the law is $10,000. There is also a caveat that filing a substantially incomplete disclosure form is the same as if the form had not been filed and can result in a $10,000 penalty. The IRS gives no guidance on what it considers to be a substantially incomplete form. If a taxpayer is notified by the IRS of a failure to file and the failure continues for more than 90 days after notification by the IRS, an additional penalty of $10,000 will apply. There is the possibility of criminal penalties for failure to submit information or for filing false or fraudulent information.
The form related to this new filing requirement is Form 5472. Under the new regulations, the Form 5472 must be submitted with a corporate tax return.
The U.S. domestic disregarded entity may not have previously obtained a U.S. tax identification number. If this is the case, obtaining this number may be the first step in meeting the compliance requirements. As with many of the situations involving non-residents, even obtaining the required tax identification number is not as simple as it is for residents.
There is the need to maintain the appropriate records in order to comply with the requirements. Under IRC regulation 1.6038A-3, there is a requirement to maintain records to allow for accurate reporting of transactions.
Such records must be permanent, accurate, and complete, and must clearly establish income, deductions, and credits. This requirement includes records of the reporting corporation itself, as well as to records of any foreign related party that may be relevant to determine the correct U.S. tax treatment of transactions between the reporting corporation and foreign related parties. The relevance of such records with respect to related party transactions shall be determined upon the basis of all the facts and circumstances.
Among the type of transactions that will require disclosure are sales, cost-sharing transaction payments, rents, royalties, leases, licenses, commissions, loans, interest, etc. Disclosure is required for any listed type of transaction for which monetary consideration (including U.S. and foreign currency) was the sole consideration paid or received during the reporting corporation’s tax year. Disclosure is also required for any transaction or group of transactions if any part of the consideration paid or received was not monetary consideration, or less than full consideration was paid or received. Transactions with a U.S. related party, however, are not required to be specifically identified on the disclosure form.
A corporate tax return is required to be filed as part of complying with the filing requirements. The filing deadline is the same as for U.S. corporate income tax returns and an extension of time for filing is allowed if the return is not filed by the due date. For a calendar year corporation, the default year for any disregarded entity owned by an individual, the due date is April 15 of the following year with a six-month extension allowed to October 15.
It should be noted that there are potential situations that may result in duplicate disclosure, based on the regulations as currently written.
Failure to disclose information as part of annual filings that are covered by information-sharing agreements, such as FATCA or Common Reporting Standards (CRS), can lead to serious consequences. The risk exposure of not disclosing and the related costs to bring a taxpayer into compliance, such as attorney and accounting fees, are almost always higher than the cost to disclose correctly in a timely manner.
The draft form provided by the IRS currently requires the inclusion of the Foreign Taxpayer Identifying number (FTIN) of the owner of the disregarded entity, if it has one. This seems to indicate that the information will be shared with the taxpayer's home country, if not currently, then in the future.
Scenario #1: A U.S. SMLLC, owned by a foreign individual, holds rental U.S. real estate. In addition to filing his personal tax return, the taxpayer will now have a corporate filing requirement to report transactions with foreign related parties. This increases the cost to maintain this type of structure.
Scenario #2: A U.S. SMLLC, owned by a foreign corporation, holds U.S. real estate for investment purposes (i.e., not rented). Previously, neither the foreign corporation nor the SMLLC had a U.S. tax filing requirement until disposal of the real estate. Under the new rules, the SMLLC has a filing requirement every year to report transactions with foreign related parties.
Scenario #3: A U.S. SMLLC, owned by a foreign corporation, holds U.S. real estate and rents the property. Previously, the foreign corporation had a corporate filing requirement and a related Form 5472, if applicable. Under the new rules, the foreign corporation is still required to file a corporate tax return and a related Form 5472, if applicable. However, the SMLLC has a corporate filing requirement with disclosure of related party transactions on Form 5472 that can be more comprehensive than what is required to be disclosed by the foreign corporation.
This article discusses the new filing requirements of foreign-owned domestic disregarded entities. It is not intended that this article address all possible facts and circumstances nor is it intended to address all the issues related to nonresidents owning disregarded entities. Every situation is unique and it is important to consult a qualified tax advisor who has the requisite experience to assist you with your tax filing and disclosure requirements. We are happy to advise you on how to comply with these requirements.