Foreign corporations

In the global economy, it is common for U.S. persons to have investments in corporations organized outside of the United States.  In fact, most investment professionals recommend and “international” component to most investment portfolios. Where the interest in the foreign corporation is significant, meaning at least a 10% interest, there are significant United States tax reporting issues that are accompanied by large financial penalties for failure to comply. Reporting is done on Form 5471.

The most common situations I have seen are where a U.S. person owns a portion of the family business that is located in another country, a U.S. Citizen living in a foreign country and operating a business through a corporation organized in that country, or using a foreign corporation to hold real estate in that country.

A basic rule of international taxation is that income earned in a foreign corporation is properly taxed by the country in which it is earned, and is not taxed by the United States until it is paid to the U.S. investor.  There is a major exception where foreign income is passive investment income, rather than active business income.  The passive income of the controlled foreign corporation may be taxed currently to the U.S. investor.

Form 5471 must be filed by a U.S. taxpayer if certain conditions are met — generally ownership of 10% or more of the combined voting power of a foreign corporation, plus the existence of certain other facts.   To be timely filed, this form must be attached to a timely filed income tax return for each applicable year.  Failure to timely file Form 5471 can lead to a few substantial penalties, the minimum being $10,000 per year for each year the form is late or delinquent.  Penalties can be imposed within three years of the form being filed, not three years from the date the underlying income tax return is filed.  Consequently, a penalty for a Form 5471 that has never been filed can be assessed at any time by the IRS.  Historically, the assertion of penalties for delinquent, or late-filed, returns was made at the discretion of the IRS but, as of January 1, 2009, the IRS will begin to automatically assert these penalties.

It is possible that an automatic assessment can be eliminated, under proper circumstances (i.e., reasonable cause), by filing a Form 5471 late, making a request to the IRS to waive late-filing penalties, and receiving IRS approval of that request.  However, the chance that a penalty will ultimately be imposed if Form 5471 is filed late or is discovered by the IRS to be delinquent is less when a penalty is not automatically assessed by the IRS than when it is automatically assessed and an effort is then made to get the IRS to waive the penalty.

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