The so-called ‘check-the-box’ entity classification regulations (§§ 301.7701-1 through 301.7701-3) will cause a classification of a single owner business entity as a “disregarded entity” for federal tax purposes unless that entity elects to be treated as a corporation. This is a common scenario in regard to single member domestic limited liability companies (LLCs), whereby in absence of a timely made entity classification election, the LLC becomes disregarded as separate from its owner and henceforth reports its items of income and expense on Schedule C (an integral part of a personal tax return). Note that a nonresident who reports his or her effectively connected income and expenses from business or practiced profession on Form 1040NR would also use Schedule C to give a detailed report in that regard.
The recent regulations (T.D. 9796) – implemented as of January 1, 2017 – introduce a profound change for one class of disregarded entities.
Why the new regulations?
The U.S. Treasury has long viewed the opportunity for foreign nationals to form U.S. based single member LLCs, while not electing the corporate status for tax purposes, as a fertile ground for shell games. In the more recent years, the Treasury has become far more keen to enter into additional, bilateral Tax Information Exchange Agreements (TIEAs) – the last notable effort in that field being evidenced by the December 2016 agreement with Argentina – and, as a consequence, has become more attuned to the needs of its counterparts. At the same time, many a sovereign player and some international organizations have not hesitated to put a lantern on the weaknesses of the U.S. financial and tax system when it comes to making it more difficult for non-U.S. persons to evade taxes in their home jurisdictions.
Considering that a disregarded entity that does not have U.S. based employees or Form 1099 filing requirements (reporting of payments rendered to an independent contractor) is typically not required to obtain an Employee Identification Number (EIN), the visibility on the LLC’s asset holding activities is substantially reduced. The asset holding activities of such LLCs, in their substance, more often than not, may be indistinguishable from the asset holding activities of their respective owners. With an eye toward reciprocity, the Treasury constructed the new regulations primarily in order to enhance its ability to harvest information that would be useful to treaty and/or TIEA counterparts.
Who will be affected?
Any foreign person that owns, directly or indirectly, a domestic disregarded entity in its entirety. The indirect ownership encompasses ownership via other disregarded entity, as well as ownership via a grantor trust. The definition of a foreign person extends to any foreign corporation, company, partnership or association, as well as to any foreign estate or trust described in §7701(a)(31).
How will the regulations affect this particular class of entities?
In essence, the new regulations throw the foreign-owned disregarded entities into the existing realm of reporting for foreign corporations engaged in U.S. trade or business and domestic corporations with at least 25% foreign ownership interest. This area is governed by §§6038C and 6038A of the U.S. tax code. For the limited purpose of complying with section 6038A of the code and the derived therefrom regulations, a foreign-owned disregarded entity will be treated as a domestic corporation. In practical terms this policy shift will mean the following:
- Foreign-owned disregarded entities will be required to obtain an EIN. The very process of obtaining an EIN will give the IRS a glimpse of what is at the core of that entity’s activities.
- Foreign-owned disregarded entities will be obligated to file, on annual basis, Form 5472 and therein report on a whole host of transactions with foreign related parties. The reportable transactions, whether monetary or for other consideration, include but are not limited to: sales, purchases, commissions (paid and received), rents, royalties, cost sharing payments and receipts, and – more crucially – all contributions, distributions, and amounts loaned or borrowed. The term related party for the purpose of Form 5472 reporting includes all thirteen categories under §267(b), which among other classes of relationship covers spouses and most types of relationship by blood, as well as certain controlled partnerships, as stipulated under §707(b)(1). Lastly, the relationship may be established by operation of §482, which relates to allocation of income and expenses among taxpayers – a somewhat more esoteric concept and perhaps a less likely way to be pulled into the new reporting requirements.
- Foreign-owned disregarded entities will have to adhere to the record keeping requirements of §6001. That will certainly benefit a foreign government’s efforts when seeking information in the U.S. via letters rogatory or other recognized protocol.
Barring one’s ability to show a reasonable cause, noncompliance can be castigated rather harshly by the IRS. This is also the case here. The theme of penalties and the remedies leading to their [potential] abatement may provide enough fodder for a separate article.
The presented here information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
The information contained herein is of a general nature and based on authorities that are subject to change. Moreover, the information is presented here for educational purposes and is not specific to any individual’s personal circumstances. As such, this information should not be used for the purpose of avoiding penalties that may be imposed by law. A determination as to how your specific circumstances may relate to the presented material should be made by means of a consultation with your tax adviser.
Cezary Tchorznicki, CPA does not provide legal or investment advice.