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Subpart F Income Reporting (2018) – Subpart F CFC Tax Basics

Subpart F Income Reporting (2018) - Subpart F CFC Tax Basics (Golding & Golding)

Subpart F Income Reporting (2018) – Subpart F CFC Tax Basics (Golding & Golding)

Subpart F Income Reporting (2018) – Subpart F CFC Tax Basics

Subpart F Income and Subpart F Income Reporting is tough. This is because there are many preliminary questions that must be dealt with first, before determining whether Subpart F will even apply. 

Typically, the basic threshold questions include the following:

  • Is the Company a CFC?
  • Is the Client a U.S. Person?
  • Is there Subpart F “Type” Income?
  • Is there Current Year E&P?

Subpart F Income

Subpart F Income is codified in Internal Revenue Code (IRC) 952. For most individuals, Subpart F Income is linked directly to having ownership in a CFC (Controlled Foreign Corporation) and earning Passive Income (Interest, Dividends, Capital Gains, Rents, Royalties, etc.)

Does Subpart F Income Apply to Me?

The reality is, subpart F income is very complex and requires a comprehensive analysis. The purpose of this article is to provide you a relatively brief summary of Subpart F and CFC law, so you can identify and assess the issue, especially when it comes to your offshore income.

CFC (Controlled Foreign Corporation)

Corporate tax law is very tough and the CFC Rules (aka Controlled Foreign Corporation) are a very complicated area of Corporate/International Tax Law.

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

  • What is a Controlled Foreign Corporation?
  • Controlled Foreign Corporation – What is Subpart F Income
  • Controlled Foreign Corporation – Form 5471
  • Controlled Foreign Corporation – Ordinary Income Reporting
  • Controlled Foreign Corporation – IRS 5471 Penalties
  • Controlled Foreign Corporation – Attribution Rules

What is a CFC?

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 Controlled Foreign Corporation.

A Controlled Foreign Corporation is a very common issue 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 Controlled Foreign Corporation (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 Controlled Foreign Corporation 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 Controlled Foreign Corporation. 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 Controlled Foreign Corporation.

**Important to note, that even if your business can successfully sidestepp 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.

We Specialize in Safely Disclosing Foreign Money

We have successfully handled a diverse range of IRS Voluntary Disclosure and International Tax Investigation/Examination cases involving FBAR, FATCA, and high-stakes matters for clients around the globe (In over 65 countries!)

Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.

Examples of areas of tax we handle

Who Decides to Disclose Unreported Money?

What Types of Clients Do we Represent?

We represent Attorneys, CPAs, Doctors, Investors, Engineers, Business Owners, Entrepreneurs, Professors, Athletes, Actors, Entry-Level staff, Students, Former/Current IRS Agents and more.

You are not alone, and you are not the only one to find himself or herself in this situation.

Sean M. Golding, JD, LL.M., EA (Board Certified Tax Law Specialist)

Our Managing Partner, Sean M. Golding, JD, LLM, EA  earned an LL.M. (Master’s in Tax Law) from the University of Denver and is also an Enrolled Agent (the highest credential awarded by the IRS, and authorizes him to represent clients nationwide.)

Mr. Golding and his team have successfully handled several hundred IRS Offshore/Voluntary Disclosure Procedure cases. Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.

He is frequently called upon to lecture and write on issues involving IRS Voluntary Disclosure.

Less than 1% of Tax Attorneys Nationwide are Board Certified Tax Law Specialists 

The Board Certified Tax Law Specialist exam is offered in many states, and is widely regarded as one of (if not) the hardest tax exam given in the United States for practicing Attorneys. Certification also requires the completion of significant ethics and experience requirements.

In California alone, out of more than 200,000 practicing attorneys (with thousands of attorneys practicing in some area of tax law), less than 350 attorneys are Board Certified Tax Law Specialists.

Beware of Copycat Law Firms

Unlike other attorneys who call themselves specialists or experts in Voluntary Disclosure but are not “Board Certified,” handle 5-10 different areas of tax law, purchase multiple keyword specific domain names, and even practice outside of tax, we are absolutely dedicated to Offshore Voluntary Disclosure.

*Click here to learn the benefits of retaining a Board Certified Tax Law Specialist with advanced tax credentials.

IRS Penalty List

The following is a list of potential IRS penalties for unreported and undisclosed foreign accounts and assets:

Failure to File

If you do not file by the deadline, you might face a failure-to-file penalty. If you do not pay by the due date, you could face a failure-to-pay penalty. The failure-to-file penalty is generally more than the failure-to-pay penalty.

The penalty for filing late is usually 5 percent of the unpaid taxes for each month or part of a month that a return is late. This penalty will not exceed 25 percent of your unpaid taxes. If you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax.

Failure to Pay

f you do not pay your taxes by the due date, you will generally have to pay a failure-to-pay penalty of ½ of 1 percent of your unpaid taxes for each month or part of a month after the due date that the taxes are not paid. This penalty can be as much as 25 percent of your unpaid taxes. If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5 percent failure-to-file penalty is reduced by the failure-to-pay penalty.

However, if you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax. You will not have to pay a failure-to-file or failure-to-pay penalty if you can show that you failed to file or pay on time because of reasonable cause and not because of willful neglect.

Civil Tax Fraud

If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.

A Penalty for failing to file FBARs

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.

A Penalty for failing to file Form 8938

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

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

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

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

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

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

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.

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

Possible Criminal Charges related to tax matters include tax evasion (IRC § 7201)

Filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322.  Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).

A person convicted of tax evasion

Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000.  A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000.  A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.

What Should You Do?

Everyone makes mistakes. If at some point that you should have been reporting your foreign income, accounts, assets or investments the prudent and least costly (but most effective) method for getting compliance is through one of the approved IRS offshore voluntary disclosure program.

Be Careful of the IRS

With the introduction and enforcement of FATCA for both Civil and Criminal Penalties, renewed interest in the IRS issuing FBAR Penalties, crackdown on Cryptocurrency (and IRS joining J5), the termination of OVDP, and recent foreign bank settlements with the IRS…there are not many places left to hide.

4 Types of IRS Voluntary Disclosure Programs

There are typically four types of IRS Voluntary Disclosure programs, and they include:

Contact Us Today; Let us Help You.