CFC & IRC 957 for Shareholders of Overseas Business Entities

CFC & IRC 957 for Shareholders of Overseas Business Entities

What is a CFC for Tax & Reporting?

What is a CFC: A CFC is a specific type of legal entity. It refers to a foreign company that is primarily owned by U.S. persons (aka more than 50%). In addition, each U.S. person shareholder must own at least 10% and attribution rules apply. The IRS has recently updated the rules involving CFC, Subpart F and GILTI.

There are six main questions to consider when dealing with a CFC. We will list and summarize each consideration below.

  • What is a CFC
  • What are CFC Attribution Rules
  • When is Subpart F Income Included?
  • How do I report Ordinary Income?
  • Do I File Form 5471
  • What are the Penalties for not Filing Form 5471?

When it comes to corporations and U.S. Tax Law, even the slightest change in facts or circumstances may result in two wildly divergent tax results. And, when it comes to international tax and business, one of the most important issues to understand is the basics of a CFC.

CFC tax and reporting are very common issues for both U.S. based residents and foreign residents who are considered U.S. persons (U.S. Citizens, Legal Permanent Residents, and Foreign Nationals Subject to U.S. tax under the Substantial Presence Test).

Defining a CFC

A CFC is a corporation which is “Foreign” (aka incorporated under a foreign country’s rules and meets certain U.S. ownership requirements). The following is a summary of the threshold requirements for being deemed a CFC (ownership attribution rules apply, see below).

More than 50% Ownership

The basic requirements are relatively simple: the first requirement is that the business is more than 50% owned by U.S. persons. Unfortunately, many individuals receive bad legal advice regarding CFC.  Specifically, they incorrectly believe they are the owner of a CFC because they own the business 50%/50% with a foreign person — when in fact they are not the proud investor of a CFC.

Remember, you must be more than 50% owner of a CFC.

For example: if a US person and a non-US person each own 50% of a foreign corporation, it is not a CFC. Why? Because a U.S. person does not own more 50% of the corporation.

To complicate ownership rules further, there are attribution rules which apply – which means if you happen to own a subsidiary which owns a foreign corporation, the ownership can be attributed back to you so that no matter how sneaky you believe you are. Attribution rules also apply to family relationships (children, spouses, grandparents, etc.), and if ownership is ultimately “attributed” to you, then you will be deemed the de facto owner of the foreign corporation – even if your name is nowhere to be found on title.

But in the common example in which you (U.S. Person) and her (non-U.S. Person) each own 50% of a foreign corporation, that does not, per se, make you the owner of a CFC — and thereby subject you to complex Subpart F Income rules.

At Least 10% Ownership

The next issue is the level of ownership, and again attribution rules apply. For example, assuming that U.S. persons own more than 50% of the foreign corporation, the next issue is to determine whether each U.S. Person owner meets the threshold requirements.

In order to meet the basic minimum requirements, a U.S. owner must have at least a 10% ownership of the Corporation. For example, if a foreign corporation was owned entirely by U.S. persons but each person owned less than 10% of the foreign corporation, then none of the owners would be considered to meet the threshold requirement and thus the business would not be a CFC.

**Important to note, that even if your business can successfully sidestep CFC status, you may still be considered PFIC (Passive Foreign Investment Company), and are still subject to reporting under Internal Revenue Code section 1291 et seq. which is reported on IRS form 8621.

Subpart F Income Basics

The most important idea to keep in mind for most individual investors — is that subpart F income usually includes passive income. In other words, if you have a controlled foreign corporation that is only earning money through passive means, with current year E&P, than most likely is going to be considered subpart F income.

It Does NOT Need to be Distributed to You

This is where it starts to get complex.

Let’s assume that you and your two partners own 100% of the foreign corporation. You are all US persons and thus it is a CFC. Moreover, let’s say you earn sufficient income so that you have $300,000 of current earnings and profit at the end of the year.

At its most basic function, since it is considered subpart F income, in a year where there is current E&P, the individuals will each be required to book $100,000 of income (subject to deductions) as a result of subpart F income being generated in the controlled foreign corporation in a year in which there is current earnings and profit.

To add insult to injury, it is not as if this money has to even be distributed to any of the US persons. Rather, the mere fact that a CFC has subpart F income vis-à-vis earnings and profit, makes it enough that these individuals will have to book the income.

What Type of Income Does it Include?

While there many different types of subpart F income, one of the main categories which impacts US persons is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a):

As Provided by the IRS: “Subpart F income is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a), which includes foreign personal holding company income, or FPHCI, which consists of investment income such as dividends, interest, rents and royalties.”

E&P (Earnings & Profit)

Earnings and profit is a very complex analysis. It would be nice if it was just as simple as these two words would make it seem, but there’s a lot that goes into E & P. therefore, and therefore it is important to evaluate controlled foreign corporation financials before determining whether the actual earnings or income result in E & P.

Subpart F – Technically

As provided by the IRS: 

“The Subpart F provisions eliminate deferral of U.S. tax on some categories of foreign income by taxing certain U.S. persons currently on their pro rata share of such income earned by their controlled foreign corporations (CFCs). This approach is based on the principles underlying the United States’ taxing jurisdiction. In general, the United States does not tax a foreign corporation if the foreign corporation neither receives U.S.-source income nor engages in U.S.-based activities.

However, the U.S. does generally tax all income, wherever derived, of U.S. persons. The Subpart F rules operate by treating a U.S. shareholder of a CFC as if it actually received its proportionate share of certain categories of the corporation’s current earnings and profits (E&P). The U.S. shareholder is required to report this income currently in the United States whether or not the CFC actually makes a distribution (I.R.C. § 951(a)).

Subpart F, therefore, does not purport to tax the CFC. Rather, its rules apply only to a U.S. person who owns, directly or indirectly, 10% or more of the voting stock of a foreign corporation that is controlled by U.S. shareholders. The provisions of Subpart F are exceedingly intricate and contain numerous general rules, special rules, definitions, exceptions, exclusions and limitations, which may reduce or eliminate the Subpart F Income tax liability.

Can’t I Just Form a Business Around CFC Rules?

Yes, but it comes at a risk. In reality, if you are going to open a relatively small (Under $10M) foreign corporation such as a BVI, Hong Kong Pvt. Limited, or Sociedad Anonima, you are going to want to be the majority owner of the business – especially when it is overseas.

Most astute US persons investing significant time and money into a foreign corporation (unless it’s a major conglomerate) are not going to let go of the reins so much so as to allow someone they do not know to maintain majority ownership and control over a foreign corporation.

In a typical situation, the US person  will own (either individually or through an investment group) around 75 to 90% of the foreign corporation, with 10 to 25% being owned by locals (usually required by local law)

Me & My 12 Family Members Own Less than 10% Each

Very smart, but there’s something to keep in mind – attribution. Therefore, if you and your siblings form a foreign corporation and each own about 8%, technically nobody owns at least 10% and therefore you would qualify as a non-CFC, right?

…No. That is what attribution rules come to play. Thus, if you’re considering forming a foreign corporation and using US persons like trying to circumvent and navigate CFC formation rules, be sure to speak with an experienced international tax. Lawyer.

Important Takeaways From the IRS Summary

IRS is Not Directly Taxing the Foreign Corporation

Is important to note, that the IrRS does not have the authority to tax a foreign corporation unless certain rules apply such as US source income, which is not otherwise exempt by way of a Tax Treaty. Rather it is the Subpart F Income being attributed to the U.S. Person that is being taxed.

IRS Taxes on Worldwide Income

When someone is considered a US person, then the IRS taxes them on their worldwide income. When it involves a CFC, there are a few key issues at play. First, is a foreign corporation so it is not subject to US tax law (exceptions apply). Moreover, if the US person is not actually receiving income, then there is nothing to be taxed by the IRS (presuming cash basis).

With that said, if a person is a US person, a controlled foreign corporation has current year earning profits, and there is subpart F income attributed to the U.S. Person – then a special rule applies which allows the IRS to tax the non-distributed subpart F income that is attributed to the US person (even if it is not distributed)

Exceptions, Exclusions, and Limitations

Whenever there is a complex law such as subpart F income, there are always exceptions and exclusion – so it is very important to determine if you qualify for any of these exceptions, exclusions or limitations before submitting any payment or informational returns to the IRS on his.

Out of Compliance – IRS Offshore Disclosure

If you have on reported subpart F income, the chances are you may also have undisclosed foreign accounts, foreign investments, foreign corporation form 5471 reporting responsibilities, etc..

At Golding & Golding, where one of the only international tax law firms worldwide that focuses exclusively on offshore voluntary disclosure in situations such as these.

What Can You Do?

Presuming the money was from legal sources, your best options are either the Traditional IRS Voluntary Disclosure Program, or one of the Streamlined Offshore Disclosure Programs.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. 

We are the “go-to” firm for other Attorneys, CPAs, Enrolled Agents, Accountants, and Financial Professionals across the globe. Our attorneys have worked with thousands of clients on offshore disclosure matters, including FATCA & FBAR.

Each case is led by a Board-Certified Tax Law Specialist with 20 years of experience, and the entire matter (tax and legal) is handled by our team, in-house.

*Please beware of copycat tax and law firms misleading the public about their credentials and experience.

Less than 1% of Tax Attorneys Nationwide Are Certified Specialists

Sean M. Golding is one of less than 350 Attorneys (out of more than 200,000 practicing California Attorneys) to earn the Certified Tax Law Specialist credential. The credential is awarded to less than 1% of Attorneys.

Recent Golding & Golding Case Highlights

  • We represented a client in an 8-figure disclosure that spanned 7 countries.
  • We represented a high-net-worth client to facilitate a complex expatriation with offshore disclosure.
  • We represented an overseas family with bringing multiple businesses & personal investments into U.S. tax and offshore compliance.
  • We took over a case from a small firm that unsuccessfully submitted multiple clients to IRS Offshore Disclosure.
  • We successfully completed several recent disclosures for clients with assets ranging from $50,000 – $7,000,000+.

How to Hire Experienced Offshore Counsel?

Generally, experienced attorneys in this field will have the following credentials/experience:

  • 20-years experience as a practicing attorney
  • Extensive litigation, high-stakes audit and trial experience
  • Board Certified Tax Law Specialist credential
  • Master’s of Tax Law (LL.M.)
  • Dually Licensed as an EA (Enrolled Agent) or CPA

Interested in Learning More about Golding & Golding?

No matter where in the world you reside, our international tax team can get you IRS offshore compliant. 

Golding & Golding specializes in FBAR and FATCA. Contact our firm today for assistance with getting compliant.