Preface: Tax compliance with foreign interests is increasingly complex and subject to compliance costs and risks that you should assess before investing in a foreign interest.

 

What Tax Compliance Risk Should You Be Aware Of Before Investing In Foreign Interests

With the advent of small business trade being global, entrepreneurs may periodically consider investments in foreign interests, e.g. funding a manufacturer facility in China. An area of tax law that once was only pertinent to multinational businesses, is now increasingly pertinent to small business owners. Before you look to far at these eclectic investments, first, remember this. You can enter foreign interests with the best of intentions, but if you fail to do your due diligence, foreign IRS tax reporting requirements and rules could soon make you think you invested in funding the implementation of the Affordable Care Act. The rules are extremely complicated; and standard compliance costs are high. Entrepreneurs understand better than most the importance of risk; but you should fully understand the risk(s). The fines and costly penalties for noncompliance are often hidden to the unaware. Yet, maybe in some instances, for some, the risks make sense. This blog will help you be aware of IRS foreign reporting requirements, but is not a comprehensive list of foreign tax compliance.

First, any foreign financial accounts must be reported with Foreign Bank Account Reports (FBAR) on form TDF 90-22.1 if the aggregate value of all accounts exceeds $10,000. Failure to file an FBAR could result in a penalty as high as $250,000. IRS enforcement of foreign compliance is serious.

For US Citizens who are officers, directors, or shareholders in certain corporations, e.g. material ownership percentages, the IRS Form 5471 – Information Return of US Persons with Respect to Certain Foreign Corporation – is required. Failure of non-filing can lead to penalties of $10,000 for each report not filed, or filed incorrectly. Failure to file could result in loss of foreign tax benefits, i.e. credits. If you own a disregarded entity you will need to file IRS Form 8858. For foreign partnerships, Form 8865 is required. This form is the equivalent of an entire business tax filing.

If you transfer money or property into a foreign corporation, e.g. you fund a foreign corporation, you will likely need to file IRS Form 926. Penalties for failure to file can be 10% of the fair market value of the property, or as much as $100,000.

Special tax rules apply to US investors owning shares in a foreign corporation that earn threshold balances from passive investments or passive assets. This includes passive income, i.e. rents, interest income, dividends, or passive assets, i.e. land. The thresholds are two fold i) passive income being 75% or more of gross income for the tax year, or ii) the percentage of assets held during the during producing passive income, or assets held to produce passive income, being at least 50% of total assets. These investments are known as a Passive Foreign Investment Company (PFIC). PFIC shareholders are required to file IRS Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund. The 8621 is required when an investor earns income on the PFIC holdings or chooses an income recognition election. You will need your tax professional to assess the investment to determine if it is or is not a PFIC. Compliance with a PFIC is expensive for a small business investment.

Summary: Given the complexity of foreign business investment reporting, the high cost of tax compliance, and costly IRS penalties for error, you should perform proper tax due diligence (with an experienced international tax advisor) before committing cash.