On Dec. 12, 2016, the Treasury Department and the Internal Revenue Service announced final regulations (issued in proposed form on May 5, 2016) requiring domestic disregarded entities with foreign owners to file Form 5472 information returns with the IRS identifying their foreign owners and reporting certain related party transactions.1 Such entities will continue to be disregarded for most federal tax purposes, but they’ll be treated as corporations for purposes of the reporting, record-keeping and other compliance requirements imposed on certain domestic corporations with foreign owners under Section 6038A of the Internal Revenue Code.2 These new reporting requirements arise against a backdrop of increasing multilateral efforts to combat tax evasion and money laundering across borders and growing pressure on the U.S. government from other countries to make it harder for foreign nationals to use U.S. shell companies to hide assets from tax authorities back home.
Background and Reasons for New Reporting Requirements
The United States has had considerable success with its efforts to combat offshore tax evasion and other financial crimes overseas, in large part due to cooperation from other countries. As of Dec. 5, 2016, the Treasury Department has entered into intergovernmental agreements (IGAs) or announced agreements in substance with more than 100 governments to collect and remit information on U.S. beneficial owners of foreign accounts to the IRS.3 These IGAs have been critical to the Foreign Account Tax Compliance Act’s implementation. However, Congress hasn’t enacted implementing legislation allowing the Treasury Department to fully reciprocate, increasing tensions with IGA partners. Moreover, the United States has declined to participate in the automatic exchange of information under the Organisation for Economic Co-operation and Development’s Common Reporting Standard. There’s even been discussion among members of the Financial Action Task Force (FATF), an intergovernmental organization tasked with combating money laundering and tax evasion, as well as members of the European Union, about designating the United States as a tax haven.4
A significant point of contention with other countries is the ability of foreign nationals to anonymously park large amounts of cash in limited liability companies (LLCs) in Delaware and other states with minimal disclosure requirements. Foreign investors often use LLCs to buy real property or other assets in the United States. If the LLC has only one owner, it will be disregarded for most federal tax purposes unless it files an election to be treated as a corporation. If the foreign buyer is simply buying and holding the property and doesn’t rent it out, then, without more, the buyer won’t have any occasion to enter the U.S. tax system unless and until the property is sold.5
There’s nothing inherently abusive about a non-U.S. person using a wholly owned LLC to buy U.S. real property or other assets. Many foreign buyers do this simply for liability protection and privacy purposes. However, the absence of an IRS reporting obligation, coupled with the general lack of public disclosure of ownership of trusts and entities formed in many states, can create opportunities for less scrupulous individuals to hide large amounts of wealth of sometimes questionable provenance, essentially using the LLCs as money-laundering vehicles. Additionally, there have been concerns that foreign taxpayers could exploit this lack of transparency (and general lack of income tax consequences of using a disregarded entity) by setting up LLC holding companies in the United States to hide assets and income from tax authorities in their own countries. It’s in this context that the IRS and Treasury Department have imposed these and other new reporting requirements for foreign-owned disregarded entities.
Under the final regulations, disregarded entities formed and funded in the United States by foreign owners will be required to file Form 5472 information returns with the IRS. The new reporting requirements apply whether the disregarded entity is owned directly by the foreign owner or through one or more foreign or domestic disregarded entities or grantor trusts. The final regulations mostly follow the proposed regulations issued last year, with a few additional modifications.
Reportable transactions. Domestic corporations that are 25 percent foreign-owned already are required to file Form 5472 reporting the name, address and other identifying information of the foreign owner, as well as information on certain “reportable transactions” with the foreign owners and other related parties. It’s the reportable transaction that triggers the filing obligation.
Like 25 percent foreign-owned corporations, disregarded entities with foreign owners will be required to file Form 5472 when there’s a reportable transaction. However, the final regulations significantly expand the class of reportable transactions that can trigger a Form 5472 filing obligation for a domestic disregarded entity to include, among other things, property sales, licenses, leases, loans, assignments and remunerated services, as well as any amounts paid or received in connection with the formation, dissolution, acquisition and disposition of the entity. Simply funding the LLC, whether by loan or contribution, would trigger a Form 5472 filing obligation.
Record maintenance requirements. The disregarded entity is required to keep permanent books and records sufficient to establish the correct U.S. tax treatment of any transactions with related parties, including information, documents and records of the foreign owner that may be relevant. The final regulations exclude domestic disregarded entities from exceptions to the record maintenance requirements for small corporations and de minimis transactions.
Requirement to obtain an employer identification number (EIN) and identify a responsible person. Because an EIN is required for the Form 5472, a disregarded entity subject to these rules has to file Form SS-4 and obtain an EIN. The Form SS-4 instructions require the applicant to identify a “responsible party” for the entity. For an entity that isn’t publicly traded or registered with the Securities Exchange Commission, a responsible party is “the individual who has a level of control over, or entitlement to, the funds or assets in the entity that, as a practical matter, enables the individual, directly or indirectly, to control, manage or direct the entity and the disposition of its funds and assets.” For a typical Delaware LLC, this could be the owner or manager (or both).
Disregarded entities not eligible for certain filing exceptions. The final regulations disqualify domestic disregarded entities from certain Form 5472 filing exceptions available to U.S. corporations, including: (1) where the owner is a foreign corporation reported on Form 5471 and the reportable transaction is duly reported, and (2) where the foreign corporation qualifies as a foreign sales corporation for the taxable year and files a Form 1120-FSC.
When the new rules go into effect. The new reporting requirements go into effect for taxable years beginning on or after Jan. 1, 2017 and ending on or after Dec. 13, 2017. For purposes of the filing requirements, a disregarded entity is deemed to have the same taxable year as its owner if the owner is required to file a U.S. tax return. If the foreign owner has no U.S. return filing obligation, then the taxable year of the disregarded entity is the calendar year unless otherwise provided in forms, instructions or published guidance.
The Treasury Department, IRS and Financial Crimes Enforcement Network (FinCEN) have introduced other measures in the past year to combat foreign tax evasion and money laundering, including:
- New customer due diligence requirements imposed on banks, brokers, mutual funds and futures commission merchants to collect information about beneficial owners of accounts held by legal entities.6
- Geographic targeting orders requiring title insurers to determine the identities of the owners of LLCs that buy residential real property in all-cash transactions above specified dollar thresholds in certain metropolitan areas.7
It remains to be seen how these efforts will be impacted by the change of administrations. However, there’s little question that the United States will continue to face pressure from other countries to improve transparency.
1. See T.D. 9796, 81 FR 89849 (Dec. 13, 2016).
2. This isn’t the first instance of disregarded entities being “regarded” for specific tax purposes. For example, disregarded entities have been treated as separate corporations for federal employment tax purposes, as well as for purposes of certain excise taxes, since 2009. See T.D. 9356, 72 F.R. 45893 (Aug. 16, 2007).
3. See Treasury Department FATCA Resource Center, treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA.aspx (updated Dec. 5, 2016).
4. See, e.g., Lucy Komisar, “Will the U.S. Be Branded a Tax Haven?” The American Interest (May 26, 2016); Joe Kirwin, “EU Targets U.S. for Tax Haven Blacklist Screening,” Bloomberg BNA’s Daily Tax Report (Dec. 9, 2016).
5. If the buyer is an individual, the property would be includible in his estate as a U.S. situs asset. For this reason, many foreign buyers use foreign holding companies or trusts to acquire U.S. real property. The foreign holding company or trust will often use a wholly owned limited liability company to buy the property.
6. See 81 F.R. 29397 (May 11, 2016).
7. See news release, U.S. Treasury Department, “FinCEN Expands Reach of Real Estate ‘Geographic Targeting Orders’ Beyond Manhattan and Miami” (July 27, 2016), https://fincen.gov/news/news-releases/fincen-expands-reach-real-estate-geographic-targeting-orders-beyond-manhattan.