By Anthony Diosdi
Over the past couple of decades, there have been substantial changes to the U.S. tax law which can adversely affect any U.S. citizen, U.S. income tax resident alien, or domestic corporation, partnership, estate, or trust (hereinafter “U.S. Person”) that transfers assets to a foreign entity such as a foreign corporation, a foreign partnership, or a foreign trust. This article will briefly describe the U.S. tax consequences that could result from such transfers and the forms that must be filed with the Internal Revenue Service (“IRS”) as a result of such transfers. This article will also discuss the potential reporting consequences of such transfers.
General Rules of Taxation
In general, contributions to a corporation, transfers to “controlled” corporations, certain reorganizations, and contributions to partnerships are tax-free events for federal income tax purposes. However, in certain cases, the IRS may reverse the “tax-free” nature of such transactions. The IRS may deny a “tax-free” transfer of property to prevent the avoidance of U.S. taxes (e.g., the tax-free removal of appreciated property to a foreign entity in a “no” or “low” tax jurisdiction). Consequently, any transfer of property by a U.S. Person, whether directly or indirectly to a U.S. or foreign entity, should be reviewed in light of the possible U.S. tax consequences.
In addition, except as provided in the Income Tax Regulations, any transfer of property by a U.S. Person to a foreign trust shall be treated as a sale or exchange for an amount equal to the fair market value of the property transferred, and the U.S. Person transferor shall recognize as gain the excess of the fair market value of the property so transferred, over the adjusted basis of such property in the hands of the U.S. Person transferor. However, the above rule does not apply to a transfer to a foreign trust by a U.S. Person to the extent that any person is treated as the owner of such trust under the U.S. income tax grantor trust rules. Thus, the formation of any trust structure should be analyzed in order to determine what, if any, U.S. tax implications may arise.
In addition to the income tax implications of transfers to foreign entities, may be subject to a number of international miscellaneous penalties for failing to timely disclose a transfer to a foreign entity on an information return or failing to disclose an ownership interest in foreign entity on an informational return.
International Miscellaneous Penalties
U.S. Persons transferring property to offshore entities or with interests in foreign entities have been subject to an expanding universe of reporting requirements and penalties. “International Penalties” may be assessed against any U.S. Person for the unexcused failure to disclose a foreign transaction or an interest in a foreign entity. The monetary element of International Penalties can be substantial. Most tax penalties associated with the noncompliance of the Internal Revenue Code and its regulations reside in Chapter 68 of the Code. However, most International Penalties are found in Chapter 61. Besides the difference in geography, most if not all International Penalties are “assessable penalties,” which means that these penalties can be assessed and collected without the IRS having to resort to the deficiency procedures of Subchapter B of Chapter 63 of the Internal Revenue Code. In other words, in most cases, the IRS can potentially assess and collect International Penalties without affording a U.S. Person the opportunity to contest the assessment of International Penalties before the United States Tax Court.
The penalty assessable against U.S. Persons pursuant to Internal Revenue Code Section 6038(b) is an example of an International Penalty assessable under Chapter 61. Internal Revenue Code Section 6038(a) requires U.S. Persons to submit annual reports disclosing any interests in and transactions with controlled foreign corporations. These reports are required to be submitted on IRS Forms 5471 “Information Return of U.S. Persons With Respect to Certain Foreign Corporations” attached to the U.S. Person’s individual income tax return. Failure to comply with Internal Revenue Code Section 6038(a) can result in substantial monetary penalties. The Internal Revenue Code also requires any U.S. Person who transferred property or cash to a foreign corporation or partnership to report the transfer on a Form 926 “Return by a U.S. Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership” and attach it to that year’s U.S. income tax return. Potentially severe penalties may apply to a U.S. Person that fails to properly comply (i.e., files untimely or provides false or inaccurate information) with the obligation to file Form 926 and/or other required statements.
Internal Revenue Code Section 6048(a) requires U.S. Persons to provide written notice to the IRS upon the occurrence of certain events involving transfers of property interests to a foreign trust by a U.S. Person, either through the initial settlement of the foreign trust or by a subsequent grant. The disclosure must be made on an IRS Form 3520 “Annual Return To Report Transactions With Foreign Trusts And Receipt of Certain Foreign Gifts.” If the U.S. Person fails to submit a timely, complete, and accurate report of the event, a penalty of up to 35 percent of the gross reportable amount (i.e., the value of the trust) could be assessed under Internal Revenue Code Section 6677(a).
As discussed above, the transfer of property/money to a foreign business entity or trust is filled with potential U.S. tax implications and/or reporting requirements. As the failure to file the appropriate forms reporting such transactions can result in significant penalties, we strongly suggest that before a U.S. Person proceeds with any contemplated transfer such person contact appropriate U.S. tax counsel in order to properly review the tax and reporting requirements that may arise therefrom.
Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: Anthony Diosdi – 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.