As an expat or U.S. taxpayer who owns a foreign business or an interest in a foreign business (corporation, partnership or LLC), there are a number of forms that you must complete and file with your standard 1040F income tax return.
These forms are typical “Information Returns,” in that what the IRS wants is an entity and financial information about that foreign business, as well as your level of ownership and involvement.
While these informational returns do not include tax computations per se, the penalties for failing to timely file them can be severe.
This article addresses one such form, IRS Form 8858, “Information Return of U.S. Personals With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs).
WHAT IS A FOREIGN DISREGARDED ENTITY OR A FOREIGN BRANCH?
Your first question may be, “What is a Foreign Disregarded Entity (FDE), and what is a Foreign Branch? (FB).”
The IRS defines an FDE as “an entity that is not created or organized in the United States and that is disregarded as an entity separate from its owner for US income tax purposes.”
In other words, the entity does not file its own tax return. Its income or loss is included on its owner’s 1040F tax return. Partnerships, single-member LLCs (which have NOT elected to be taxed as a corporation) and sole proprietorships are examples of entities that do not file separate returns.
A foreign branch is a branch office representing a company in a foreign country that usually can do commercial transactions on its own.
So, for expats or US taxpayers with an ownership interest in foreign businesses (sole proprietorships, partnerships, and single-member LLCs which do not elect to be taxed as corporations), Form 8858 must be filed with the regular 1040F tax return.
A benefit for US tax purposes is that the Foreign Tax Credit can be claimed on an FDE or FB’s income, resulting in a dollar for dollar reduction of the FDE owner’s personal income tax.
WHO MUST FILE?
US persons who meet the following tests must file Form 8858:
- Tax owners of FDEs of FBs or who operate an FB at any time during their personal tax year, directly or indirectly through a tier of FDEs or partnerships;
- Anyone required to file Form 5471 (Information Return of US Persons With Respect to Certain Foreign Corporations), with respect to a controlled foreign corporation (CFC) that is the tax owner of an FDE or operates an FB at any time during the CFC’s annual accounting period;
- Category 4 filers of Form 5471, which is a US person who had control of a foreign corporation during its annual accounting period. Control means that the US person owned stock which was more than 50% of the total combined voting power of all classes of stock or owned more than 50% of the total value of shares of all classes of stock of the corporation;
- Category 5 filers of Form 5471, which is a US shareholder who owns stock in a foreign corporation that is a CFC at any time during the tax year of the foreign corporation, and who owned that stock on the last day in that year on which it was a CFC. Category 5 filers are NOT required to complete Schedules C-F, nor Schedule M.
BASIC STEPS IN COMPLETING FORM 8858
Form 8858 consists of four pages with several schedules and can be complicated to complete for several reasons.
First, you must determine what type of foreign ownership you hold.
Direct ownership means the taxpayer holds the shares directly in foreign stock.
Indirect ownership means the taxpayer holds the foreign shares through ETFs or Mutual Funds.
Constructive ownership means the taxpayer holds foreign shares based on his or her relation to another party. An example of constructive ownership is if a child owns a foreign stock, the child’s parent has constructive ownership through its relationship to that child.
Second, you must determine what type of entity you are reporting: is it an FDE of a US person or of a controlled foreign corporation (CFC) or of a controlled foreign partnership (CFP)? Is it a Foreign Branch (FB) of a US person, of a CFC or of a CFP?
NOTE: A CFC is any foreign corporation of which more than 50% of the vote or value is owned by US shareholders that own at least 10%. A CFP, which is formed in a foreign country, is controlled by five or fewer U.S. persons who each own a 10% or greater interest in the partnership and also own (in the aggregate) more than 50% of the partnership interests.
A third reason Form 8858 can be complex is that the numbers must not only be reported in the entity’s functional currency in accordance with US GAAP (Generally Accepted Accounting Principles), but these amounts must also be translated into US Dollars (USD), using either GAAP translation rules or the average exchange rate as determined under Section 989. This section says the appropriate exchange rate may be determined by transaction dates (distributions of income or dividends), or the average exchange rate for the taxable year.
EXCEPTION FOR FDEs and FBs USING DASTM
For schedules C-F and H-M, the FDEs or FBs may be utilizing DASTM, the U.S. dollar approximate separate transactions method of accounting.
This method is used if the QBU’s functional currency becomes “hyperinflationary,” which is defined as a currency that has a cumulative compounded inflation rate of at least 100% over three consecutive calendar years.
For any FDEs or FBs using DASTM, the functional currency entered on the Form’s respective schedule in the appropriate column should reflect local hyperinflationary amounts in accordance with GAAP.
WHAT SCHEDULES ARE INCLUDED ON FORM 8858?
Schedule C – the entity’s Income Statement
Schedule C-1 – The business activities of an FDE or FB may give rise to one or more qualified business units (QBU). A QBU is defined as any separate and clearly identified unit of a trade or business of a taxpayer, provided that separate books and records are maintained. A corporation is a QBU. Furthermore, a partnership, trust, or estate is a QBU of a partner or beneficiary.
If the QBU has a different functional currency than its owner, the owner may be subject to the rules under section 987, which basically says that for QBUs with a functional currency other than USD, the taxable income shall be determined by computing the income or loss separately for each QBU, in its functional currency, then translating that income or loss into USD at the appropriate exchange rate.
IMPORTANT: The Treasury Dept. has amended section 987 as of December 2016, but under Notice 2018-57 announced intended amendments which will further delay the application of the Final Section 987 Regulations and certain related provisions of the Temporary Section 987 Regulations by one additional year. This delay gives taxpayers additional time to create and implement the systems and processes necessary to transition to and comply with the Final Section 987 Regulations. The enactment of new rules as part of US tax reform has immediate US federal income tax significance for US owners and CFC owners of Section 987 QBUs.
Schedule F – the entity’s Balance Sheet
Schedule G – other information (all Yes/No questions)
Schedule H – Current Earnings and Profits or Taxable Income. If the FBE or FB is utilizing DASTM as its accounting method, gain or loss when translating to USD is reported on this schedule
Schedule I – Transfer Loss Amount. This schedule should be completed if the FDE or FB is owned directly by a domestic corporation or indirectly by a domestic corporation through a tiered structure of FDEs or FBs. If the FDE or FB is owned by a CFC, this schedule is not required.
Schedule J – Income Taxes Paid or Accrued. This is a complex schedule, with a page and half of instructions. Using an example in the instructions, see how the schedule is completed below: In tax year ending 11/30/2018 (Row 1), a foreign entity owned by a foreign corporation pays or accrues tax of 10u (b1) = $10 (c1-d1) to County X (a1). It also receives that year a refund of 3u (b2) from Country X with respect to the entity’s foreign tax year ending 11/30/2015 (Row 2), which was originally translated to $5 (c2-d2). All taxes related to general category income. (Col g)
Schedule M – Transactions Between Foreign Disregarded Entity (FDE) or Foreign Branch (FB) and the Filer or Other Related Entities
Schedule M must be filed with each Form 8858 if the FDE or FB entered into any transaction(s) with the filer of Form 8858 or other related entities during the annual accounting period of the FDE or FB. Note that a separate Schedule M must be completed for each FDE or FB. Some examples of the types of transactions you would record on Schedule M include sales or purchases of inventory, sales or purchases of tangible property rights, commissions received or paid, rents, royalties and license fees paid or received, interest received or paid, monies borrowed or loaned.
When an FDE is dormant, Form 8858 is still necessary for any individual who meets the filing requirements. However, you may be able to use a simpler procedure known as a “summary filing” for dormant FDEs. If you choose to use the summary procedure, you will only need to complete certain information on the form.
WHAT ARE THE PENALTIES FOR NON-COMPLIANCE OR LATE FILING?
Form 8858 is due at the time your income tax return or information return is due, including extensions. The penalties for late filing or failure to file are steep. There is a $10,000 penalty imposed for each annual accounting period of each CFC or CFP for failure to provide the required information within the time prescribed.
If the information is not filed within 90 days after the IRS has mailed a notice of the failure to file, an additional $10,000 penalty (again per CFC or CFP) is charged for each 30 day period thereafter until the information is filed. The additional penalty is limited to a maximum of $50,000 for each failure.
Additionally, any person who fails to file or accurately and completely report all of the information required on Form 8858 within the time prescribed will be subject to a 10% reduction of the foreign taxes available for credit under sections 901 and 960. If the failure continues 90 days or more after the IRS notifies the person responsible, an additional 5% reduction is made for each 90 day period or fraction thereof after the expiration of the first 90 day period.
So, not only can stiff penalties be imposed, but you can also lose any tax benefits, resulting in a double whammy. Lastly, under certain code sections, criminal penalties may apply, which means the filer may see jail time!
Form 8858 may be filed electronically with the filer’s regular income tax return as long as it and the accompanying schedules conform to all the official forms and schedules. Unfortunately, at this time, the popular Turbo Tax program requires that Form 8858 be paper-filed.
Completing Form 8858 accurately can be a time-consuming and complex procedure. But the stakes are high because failure-to-file or late filing violations carry stiff penalties (and in extreme cases, even criminal penalties) as well as the potential loss of tax benefits you may have received. Make sure you consult a tax professional with experience in international and expat tax law who has the expertise to prepare these forms. The peace of mind will be more than worth it!