Now is the time to determine whether you must file a foreign entity information return with the rest of your 2012 tax return. These returns must be filed by U.S. citizens, residents, and domestic entities with ownership interests in foreign corporations, partnerships, or other entities. Filers must disclose the foreign entity’s income and balance sheet information, other U.S. owners’ interests, and the amount of any distributions. The IRS uses the information from these returns to monitor the cross-border activities of U.S. and foreign persons.
Who Must File
Determining whether you must file a foreign entity information return can be very complicated. There are multiple categories of persons who must file. Some of these categories seem intuitive: U.S. persons who are officers or directors of a foreign corporation or U.S. persons who “control” a foreign corporation or partnership. Other categories are less intuitive: U.S. persons who contributed over $100,000 in property to a foreign partnership, foreign persons who became U.S. persons while owning shares in a foreign corporation, or U.S. persons who own 10% of the vote in a controlled foreign corporation. To make things more complicated, a number of different constructive ownership rules apply.
Constructive Ownership Rules
Constructive ownership rules attribute the ownership interest of one person to a second person, which means you could “own,” in the IRS’s eyes, something you do not actually own in the traditional sense. For example, John, a U.S. person, can be considered to own stock owned by his spouse, sibling, parent, or child. If you have immediate family abroad, you should determine whether you constructively own any interests that your foreign family member actually owns.
Other constructive ownership rules attribute ownership to or from entities, trusts, or estates. For example, if John is in control of Corporation A, and Corporation A controls Corporation B, then under the constructive ownership rules, John can be considered to have a controlling interest in Corporation B, even though John does not directly own any shares in Corporation B. Under some of the constructive ownership rules, even an option to acquire shares or an interest can be treated as ownership of the shares or the interest.
The constructive ownership rules, applied in the context of foreign entity ownership, can lead to surprising results. For instance, shareholders in a foreign corporation may be required to file a return for constructive ownership of a partially owned subsidiary corporation. If Lauren, a U.S. person, owns more than 10% of foreign corporation X, and X in turn owns more than 50% of another foreign corporation Y, Lauren may have to file a foreign entity return as a shareholder of X and Y. Even though Lauren does not directly own any interest in Y.
The information collected in the foreign entity information returns is becoming easier for the IRS to use for audits and enforcement. In previous years, filers had the option of assigning a unique reference identification number (URI) to the foreign corporation or partnership. But beginning with the 2012 tax year, the URI is mandatory. Using URIs allows the IRS to simplify its audit process and compare information across different tax years.
Penalties are steep for late filing, understatement, or failure to file foreign entity information returns. Late forms are automatically penalized and there is a 40% penalty for any understatement. The failure to file penalty is a minimum of $10,000 per corporation or partnership with additional penalties for continued failure to file, and there is an indefinite statute of limitations. As the IRS’s audit process becomes more efficient, owners of foreign entities must take care to avoid these penalties.