Over the past decade, it’s come as no surprise that the government has ramped up its enforcement of laws that require U.S. persons to disclose sensitive foreign financial information with the filing of their federal income taxes. We have extensively covered the requirement of U.S. residents to comply with Foreign Bank Account Reporting (FBAR) laws that require the disclosure of foreign bank accounts. Failure to comply can result in substantial penalties and a federal prison sentence. But notifying the federal government about your overseas bank account isn’t all. Federal law also requires U.S. persons to file (sometimes yearly) disclosures of interests in foreign corporations. And as a U.S. taxpayer recently learned, the consequences of non-compliance can be harsh.
The Basics of Form 5471
U.S. persons that fall into one of the categories below are required to make certain disclosures and provide information to the IRS with regard to the foreign corporations that they have an interest in or a relationship to:
Category 2
U.S. citizens or residents who are an officer or director of a foreign corporation in which a U.S. person has acquired 10% or more of the stock with respect to the foreign corporation or has acquired an additional 10% or more of stock of the outstanding stock of the foreign corporation.
Category 3
U.S. persons who acquire stock in a foreign corporation which, when added to any previously owned stock, meets or exceeds 10% of the stock ownership with respect to the foreign corporation. A Category 3 Filer may also be a previously non-U.S. person with 10% or more stock ownership who becomes a U.S. person during a particular year. Finally, a Category 3 Filer includes a U.S. person who disposes enough stock in a foreign corporation to bring their ownership interest to below 10%.
Category 4
U.S. persons that have control of a foreign corporation. Control, for the purposes of Category 4 reporting means owning more than 50% of the total combined voting power or total value of all classes of stock in a foreign corporation.
Category 5
U.S. persons who own (directly, indirectly, or constructively), 10% or more of the total combined voting power of all classes of voting stock of a Controlled Foreign Corporation (a foreign corporation with U.S. Shareholders (U.S. persons owning 10% or more of the voting power of such foreign corporation) that own greater than 50% of the vote or value of the foreign corporation).
In general, Form 5471 requires the filing party to provide information about the foreign corporation. Although the information required changes based on the category of filer the particular taxpayer falls into, typical required information includes the taxpayer’s percentage of ownership in the corporation, income that the particular taxpayer derived from the corporation throughout the tax year, and in some situations, a balance sheet for the foreign corporation.
Recent Form 5471 Litigation
In a case recently decided by the U.S. Tax Court, Mr. Flume (the taxpayer) lost his challenge against the IRS regarding penalties assessed due to his failure to file Form 5471’s for two of his foreign corporations. Flume, a U.S. citizen that was living in Mexico incorporated FFM, a Mexican corporation created to hold Mr. Flume and co-investor, Mr. Adams’ interest in a fast food business. Although the fast food business was sold in its entirety in 1998, FFM remained a controlled foreign corporation. In 2001, Flume still owned 50% of FFM and in 2002, he sold the majority of his interest in the company and was left with only 9% of FFM stock.
Meanwhile, in 2001, Flume and his wife incorporated Wilshire-Belize, a Belizean corporation. Flume and his wife each owned 50% of the stock of Wilshire-Belize. They served as President and Vice President, respectively. Though, in April of 2001, Wilshire-Belize changed its articles of incorporation to reflect a different stock ownership. In the amended articles of incorporation, Flume, his wife, and daughter each owned 9% of the shares. Mr. Tornell, a business associate of Flume and Mexican citizen, owned the remaining 73%. In 2005, Flume opened a bank account with UBS. He used the original articles of incorporation that indicated that he owned 50 percent of the corporation.
In 2001, Flume was a Category 5 Filer with regard to FFM because he owned at least 10% in a controlled foreign corporation for an uninterrupted period of 30 days or more. In 2002, Flume was a Category 3 Filer because he disposed of 41% of his interest, dropping him below the 10% ownership threshold. In 2013, Flume filed delinquent Form 5471’s that related to FFM. When the IRS examined Flume’s delinquent 5471’s, they imposed the statutory penalty of $10,000 per late filing. Flume argued that he should not be subject to the penalty because he did file the 5471’s, albeit delinquently. The IRS countered with the argument, and the Tax Court agreed, that Flume was required to file Form 5471 with his individual tax return in the respective tax years and that because the 5471 filings were delinquent, the penalties were appropriate.
Additionally, the IRS discovered the Wilshire-Belize ownership and assessed penalties for the failure to file 5471’s in relation to that foreign corporation from tax years 2001 through 2009 (when Flume and his family disposed of their interest in the corporation). The IRS asserted that the amendment to the articles of incorporation should be disregarded and contended that Flume and his wife truly owned 50% each of Wilshire-Belize. At trial, Flume argued that the amended articles of incorporation evidenced that Tornell was the majority owner of the foreign corporation. In ruling for the IRS, the Tax Court emphasized the documents provided to UBS in Flume’s setting up of their business bank account. The IRS produced evidence that indicated that Flume and his wife controlled the UBS account throughout their ownership tenure. Furthermore, in applying the constructive ownership rules of Internal Revenue Code §318, Flume was treated
as owning both his and his wife’s stock. Thus, the Tax Court held that for years 2001 through 2009, Flume owned at least 50 percent of a foreign corporation, making him a Category 3 Filer.
Ensure that you are compliant with your U.S. filing obligations. Contact an experienced tax attorney, today.
As one can easily see from the case involving Mr. Flume above, it is easy to trigger filing requirements in the U.S. by investing in a corporation in a foreign country. Even if the foreign corporation is not profitable, the IRS will attempt to assess penalties for the failure to file a Form 5471 when appropriate. At present, the federal government has focused primarily on tracking down U.S. residents who have undeclared foreign bank accounts through legislation like the Foreign Account Tax Compliance Act (FATCA). It is only a matter of time until the IRS and Department of Justice move on to target another group of taxpayers. If you have an interest in a foreign corporation and are either unsure of the tax compliance requirements or aware that you have failed to comply with them, an experienced tax attorney may be able to assist in coming into compliance while minimizing penalties and other negative consequences of filing noncompliance.
The Tax Law Offices of David W. Klasing have extensive experience in representing taxpayers with varying investment portfolios. From taxpayers living domestically to those living abroad, all investors should be cognizant of the U.S. reporting requirements with regard to investments in foreign corporations. Don’t let your potential noncompliance and the threat of substantial tax penalties keep you awake at night. Contact the Tax Law Offices of David W. Klasing today for a reduced-rate consultation.
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