Subpart F Income Reporting (2018) – Subpart F CFC Tax Basics
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. Recalling back to my Master’s in Tax Law program, our professor made it clear that 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%.
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.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.”
It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts. Nevertheless, the IRS still wants to penalize you on the unreported accounts, assets, investments, etc.
We are not tax planning lawyers. If you are thinking about starting a Controlled Foreign Corporation or evaluating which foreign entity may be best for you in preparing to set up a foreign company, we are not the attorneys to call.
We cannot provide an initial consultation on foreign company formation because it is simply not we do – and we are sure there are plenty of experienced and effective attorneys who can help you in this arena.
If on the other hand, your issue is that you are already out of compliance, then feel free to contact us to discuss.
We Can Help You!