A Quick Primer on Form 5471 and Some Hidden Pitfalls to Avoid

A Quick Primer on Form 5471 and Some Hidden Pitfalls to Avoid

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Form 5471 is triggered in situations where a “U.S. Person” owns an interest in a “foreign” (non-U.S.) corporation. The specific reporting requirements for Form 5471 are found in Internal Revenue Code Sections 6038 and 6046. Broadly speaking, the purpose of Form 5471 is to identify “U.S. Persons” who:

  • own at least 10% of a “non-U.S.” “controlled corporation”; which
  • earns certain kinds of income, including passive income; that
  • is NOT subject to direct taxation by the IRS.

Form 5471 allocates the income of the “non-U.S. corporation” directly to the individual U.S. shareholder. This is collectively referred to as the “Subpart F Income Regime,” the nuances of which can be found in Internal Revenue Code Section 951.

Form 5471 exists regardless of whether the taxpayer must file a U.S. tax return or not. Conversely, a taxpayer may find himself in the unfortunate position of having to file an income tax return (i.e., 1040 or 1040NR) as a result of having to file Form 5471. This is why Form 5471 can be a thorn in the side of the unwary taxpayer because it has the potential to creep up on taxpayers in the eleventh hour and stir up a tax tsunami the likes of which have never been seen.

If you are the owner of a “foreign corporation,” you must be extra vigilant. As the owner of a foreign corporation, you may have additional reporting obligations and should pay special attention to the attribution rules (you are deemed to own the shares) and to the possibility of “indirect ownership.” By indirect ownership, I’m referring to the situation where you are the shareholder of a foreign corporation that, in turn owns a piece of property.

The classic example is one where the taxpayer is the shareholder of a foreign corporation that owns real estate. In that case, the taxpayer is deemed to own the real estate indirectly through the foreign corporation. The impact this has on reporting is sweeping. The taxpayer’s interest in the entity is considered a “specified foreign financial asset” for purposes of Form 8938. To the extent that the  taxpayer’s interest in the entity exceeds the Form 8938 reporting threshold that applies to him, then it must be reported on Form 8938. For purposes of determining the value of the taxpayer’s interest in the foreign corporation and whether this interest has exceeded the Form 8938 reporting threshold, the value of the real estate is taken into consideration. A careful distinction must be made here. It is not the real estate itself that must be reported on Form 8938, but instead the taxpayer’s interest in the foreign corporation which is calculated by taking into consideration the fair market value of the real estate.

Who would have imagined that owning real estate overseas through a foreign entity could be such a headache — and we haven’t even answered the question of whether gain realized through the sale of foreign real estate is taxable! By the way, the simple answer to this question is “yes.” U.S. expatriates and federal government employees working abroad must report any gain realized through the sale of foreign real estate. Such individuals are taxed just like they own domestic real estate, with the only difference being depreciation, which must be over forty years. Fortunately, expatriates and federal government employees may claim the principal residence exclusion.

Suffice it to say, watch out for the “attribution rules” in Internal Revenue Code S. 318. You may own more shares of that “foreign corporation” than you think!

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