By Anthony Diosdi
There is a perception by many countries that the United States is the world’s largest tax shelter. This is because unlike many countries, the United States does not require public disclosure of ownership of its entities, (in particular Limited Liability Companies (LLCs)), or publishing of year-end financial statements for public viewing. The lack of transparency has allowed nonresidents of the United States to form domestic shell to avoid paying foreign income taxes, hide money or commit other acts of wrongdoing. Historically, nonresidents established shell companies in the United States as a domestic disregarded entities.
The Treasury Department and the Internal Revenue Service (“IRS”) recently published regulations to combat perceived misuse of U.S. shell companies. On December 13, 2016, the Treasury Department and the IRS issued final regulations regarding new reporting requirements for domestic disregarded entities wholly owned by a nonresident of the United States. For the purposes of reporting requirements under Internal Revenue Code Section 6038A, a disregarded entity will be treated as U.S. corporations.
In the past, for tax purposes, a foreign-owned U.S. disregarded entity was just that-it was disregarded. Prior to the finalization of the new regulations issued by the Treasury Department and IRS, there was no requirement for disregarded entities most of its transactions to the IRS. Under the new requirements, a domestic disregarded entity owned by nonresidents will be required to obtain an Employer Identification Number (“EIN”), prepare a pro-forma Form 1120 and file Form 5472, Information Return of a 25% Foreign Owned US Corporation or a Foreign Corporation Engaged in a US Trade or Business. A disregarded entity will also need to disclose certain transactions to the IRS and maintain records of these transactions. These transactions 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 IRS believes that these finalized regulations will allow them to better enforce the tax laws, increase financial transparency, better combat perceived misuses of U.S. shell companies, share information with treaty partners, and support Bank Secrecy Act regulations.
Penalties for Noncompliance
The new regulations authorizes the IRS to impose penalties for failure to file a pro-forma Form 1120 and Form 5472. A penalty of $25,000 could be assessed on any disregarded entity that is required to file a Form 5472 but fails to timely file such a report or files a substantially incomplete Form 5472. This penalty is assessed annually. The Failure to timely file a substantially complete Form 5472 can also result in criminal referral to the Department of Justice.
What Must be Done to Comply
Under the new regulations, if a domestic disregarded entity is owned by a nonresident(s), whether the nonresident owner is an individual or an entity, disregarded entity must timely file an accurate Form 5472. The Form 5472 must be attached to a U.S. corporate tax return. Nonresident owners of disregarded entities must also understand that there is now the need to maintain the appropriate records in order to comply with new regulations. In particular, Treasury Regulation Section 1.6038A-3, requires nonresident owners of disregarded entities to maintain records to allow for accurate reporting of transactions. 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 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.
Any nonresident that holds an interest in a disregarded entity must understand they now have additional filing and record keeping requirements. Failure to understand and comply with these rules may be costly.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.