S-Corporation & Foreign Income – U.S. Tax | IRS Offshore Reporting
When it comes to an S-corporation, foreign income and IRS offshore reporting, the rules can get very complicated — especially since many S-Corporations are relatively small businesses, and may not have considered Offshore Tax as part of their tax planning.
One of the main reasons why offshore reporting of an S-Corporation is difficult and complex, is because of the nature of an S-Corporation. An S-Corporation (like a partnership or disregarded entity) is a pass-through or flow-through company — unlike a C-Corporation that has two layers of tax — resulting in immediate tax liability to the owners.
S Corporation Basics
An S corporation is a flow-through company. As a result of being a flow-through company, it means that there are not two layers of taxation as there would otherwise be in a C-Corporation.
While the S-Corporation has its own set of books, basis, depreciation, etc. the S corporation does not pay any IRS tax – aside from certain franchise fees and other State taxes.
Rather, the income, deductions, charitable contributions, and other gains and losses flow-through to the individual owners specifically on a K-1, which is then issued to each owner, and each owner pays their own respective taxes based on their own individual progressive income tax rate.
International Tax & Offshore Reporting
If the S-Corporation is operating entirely within the United States, with no foreign income and no foreign accounts or investments, then there is nothing to worry about. But, with the ever increasing globalization of the US economy, it is becoming more common for even small S-Corporations to develop business worldwide.
As a result, the business may have income from overseas – and even if they do not yet have income, they may maintain accounts and other assets abroad, which will significantly impact US tax liability and reporting requirements.
**All members of an S-Corporation must be U.S. Residents — no foreign residents are allowed to be members.
The S Corporation – Worldwide Taxation
When an S-Corporation is a US corporation, it is required to file a US tax return (1120S). Moreover, if the corporation is earning income from overseas, the foreign income must be reported as well.
The Corporation will identify the foreign income on its tax return. This is true, even if the corporation is already being taxed in the foreign country. The Corporation may be able to claim a tax credit of the taxes it already paid abroad, but that does not eliminate the fact that the Corporation must still file a tax return in the US.
There may be some tax benefits, exemptions, and exclusions depending on the specific treaty language with the country(s) that the S corporation is conducting business with (permanent establishment, excluded categories of income, R&D Credits), but it typically does not eliminate the tax; it may reduce the tax or tax it at a different rate, but not eliminate it or exclude it from bring reported to the IRS, even if it is not actually taxed.
Subsidiary, Branch or Registered Company?
If the S-Corporation is operating abroad as the same S-Corporation it operates as in the United States, chances are it will still have to register in the foreign country. By registering in the foreign country, the S corporation will most likely be considered a nonresident Corporation. That may have pros and cons depending on how a particular jurisdiction taxes nonresident companies. Therefore, it is important to conduct significant research first to determine the pros and cons of operating as various different entity forms in a particular country.
Oftentimes, an S corporation may form a wholly owned subsidiary (or multiple subsidiaries) for each particular country that it operates in. For example, if S corporation XYZ is going to form a subsidiary specifically in Ireland, to only conduct business in Ireland, it may benefit the company to form a wholly-owned subsidiary in Ireland. This is because if all the income generated is “same-country” income, there may be some additional tax benefits available.
Depending on the nature and the structure of the foreign corporation, it may limit the ability of the U.S. government to tax the company – although usually it will not benefit a small, flow-through company which is entirely owned by U.S. Persons, or otherwise qualifies as a Controlled Foreign Corporation..
Alternatively, the S corporation may form a branch in the foreign country to operate specifically in that country, instead of a wholly owned subsidiary. There are different tax rules depending on whether the company is a branch (aka Branch Tax), Subsidiary, or simply registered in the foreign country — but that is something to determine on a case-by-case basis.
**Specifically, the application of a Foreign Tax Credit will be different for an S-Corporation operating abroad with a flow-through branch (or otherwise registered the U.S. S-Corp in the foreign country) than it would be for a wholly-owned subsidiary. A wholly owned subsidiary is distinct and separate entity, and it may limit the ability to allow left-over Foreign Tax Credits pass through and then “spread-out” to the other branches.
S Corporation Operating Abroad & Flow-Through Income
When an S-Corporation operates abroad, either as its own entity or as a branch, there is no distinction between the company and the foreign income (as opposed to a wholly-owned subsidiary for example)
Why is this important? Because unlike a corporation such as a C Corporation or foreign equivalent of a C Corporation, an S corporation cannot accumulate income without still being taxed on the money. For example, if S corporation XYZ earned $1 million, and after paying a salary and some distributions still had excess of $200,000, the company will still have to pay tax on the $200,000 even if the money is not distributed.
Excluding issues involving AAA accounts, Excess Accumulations, and BIG Tax — at its most basic level, all annual net income that was generated at the corporation level then flows through or passes-through to the shareholders. Even if it stays within the company and is not distributed, it is still taxed.
Therefore, if you are a S corporation that is operating abroad and earning income, even if you do not move that money back to the United States, the mere fact that the S corporation earned income means it will be immediately taxed on the year is earned. It will be identified in the K-1 for each partner and each partner will pay his or her own tax on the earnings for that year (adjusted for AAA Account issues)
S Corporation and Offshore Reporting
Aside from just the complicated tax scenario of having an S-Corporation and offshore income, are the offshore reporting requirements of an S-Corporation. There could be various different reporting requirements depending on the specific facts and circumstances of the specific company.
With that said, there are certain common themes for reporting, which most companies operating abroad will have to follow:
The FBAR is the Report of Foreign Bank and Financial Account Form. The form is required to be filed by any person that has more than $10,000 in annual aggregate total of foreign account on any given day of the year. Therefore, if the S corporation has foreign accounts that are used abroad (which is typically common to have local currency available), the S corporation is going to have to report the accounts on an annual FBAR statement.
Beyond the corporation itself, the individuals who own the account will also have to report as well.
In other words, if a U.S. S-Corporation has three accounts in Taiwan under the name of the corporation, then the Corporation will have to file the FBAR. Likewise, if members of the S corporation had ownership, joint ownership, or even mere signature authority over the accounts, they will have to file as well. That is true, even if the money is not their money.
FATCA Form 8938
FATCA Form 8938, is a form that is used to report specified foreign financial assets. Depending on the type of business the corporation has abroad, and more specifically the type of assets and accounts that it maintains, the form 8938 will also be required.
When an S corporation is involved, it can be even more complicated. Why? Because under the new rules, S-Corporations (just like partnerships), will have to report ownership of foreign assets. Likewise, the individual owners of the S corporation will also have to file form 8938 along with their specific individual tax return.
In other words, there would be a dual reporting requirement each by the S corporation and the individuals. While some tax professionals may advise that duplicate reporting is not necessary (and an argument could be made for that position), the reality is, the penalties involved with non-reporting are so severe that it is usually better to err on the side of caution and simply duplicate report the foreign assets.
***You should check with your tax adviser before submitting any information to the IRS.
Additional S-Corp Reporting
There are additional reporting requirements, which will vary depending on the type of assets, investments, property, accounts, etc. These reporting requirements are pretty serious, and it is always advised that you speak with an experienced international tax lawyer if you’re going to be conducting business abroad.
The reason why this is important, is because the IRS likes to issue penalties involving offshore reporting. Offshore Tax Evasion is still a key enforcement priority for the IRS and therefore if you get stuck in the IRS crosshairs regarding non-reporting, it could be costly.
The following is a list of Common IRS Penalties:
A penalty for failing to file FBARs. United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the year. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
Beginning with the 2011 tax year, a penalty for failing to file Form 8938 reporting the taxpayer’s interest in certain foreign financial assets, including financial accounts, certain foreign securities, and interests in foreign entities, as required by IRC § 6038D. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A penalty for failing to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048. This return also reports the receipt of gifts from foreign entities under IRC § 6039F. The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A penalty for failing to file Form 3520-A, Information Return of Foreign Trust With a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b). The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046. The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A penalty for failing to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A penalty for failing to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Underpayment & Fraud Penalties
Fraud penalties imposed under IRC §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A penalty for failing to file a tax return imposed under IRC § 6651(a)(1). Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2). If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An accuracy-related penalty on underpayments imposed under IRC § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.
Get Into Compliance with IRS Offshore Disclosure
IRS Offshore Voluntary Disclosure is an effective method for getting into IRS Tax Compliance. At Golding & Golding we represent clients worldwide with safely getting into IRS Tax compliance.