An In-Depth Look at Reporting Requirements for Transfers from U.S. Taxpayers to Foreign Corporations

An In-Depth Look at Reporting Requirements for Transfers from U.S. Taxpayers to Foreign Corporations

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Technology has led to large changes in the way the world works, from the general public’s obsession with social media to improved opportunities for international communication. And, as such, the world of business has been among the most affected. Communication is easier, international trade is easier, and, of course, operating branches and subsidiaries overseas is easier, too. This has led to an influx of Americans expanding into the wide world of offshore operations.

There are plenty of advantages to be had in moving into international business, but there are many limitations to consider as well. If you’re planning on moving your business to another country or have already made the leap, gaining a familiarity of IRS Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation should be at the top of your to-do list.

The Reporting Obligations for Large Property Transfers

So, you’re planning on transferring significant property to an overseas company. That’s fine – countless taxpayers do the same every year. However, simply handing over assets and walking away isn’t going to be acceptable in the eyes of the government. Depending on the size of the asset or assets in question and the situations surrounding the transfer, an information return may be warranted. But what does that mean?

Form 926 is what the IRS considers an information return, or a form that is for informational purposes only rather than one that exists to determine a tax liability. Form 926 essentially exists to keep the IRS in the loop regarding tangible or intangible property transfers that would be considered non-recognition transactions according to Code Sections 332, 351, 354, 355, 356, 361, and 367. This form can simply be attached to a taxpayer’s federal income tax return, giving it the same April 15th deadline as all other standard tax forms. All transactions should be reported at fair market value.

If you’re wondering if this is yet another way for the IRS to get involved in affairs outside of its jurisdiction, you’re not alone, but the logic behind required reporting is fairly sound. Without a filing obligation, it becomes far too easy for taxpayers to transfer large assets overseas and sell them there, thus avoiding the tax consequences that can accompany the domestic disposal of assets. This way, taxpayers can’t avoid taxation on assets that are transferred and sold simultaneously in another country.

Who Needs to File Form 926?

Form 926 isn’t necessarily required for all transfers; instead, only transactions that fit a specific set of criteria require a little extra time and preparation during tax season. They include:

  • A U.S. company that is liquidated and absorbed into its offshore parent corporation (Section 332)
  • A U.S. taxpayer who exchanges cash or other assets in return for stock and takes a controlling interest (Section 351)
  • A U.S. taxpayer and current shareholder of a foreign company who exchanged security or stock as a part of a corporate reorganization (Section 354)
  •  A U.S. taxpayer who transfers property to an offshore company in the tax-free division (Section 356)
  • A U.S. company that transferred property to an offshore company as part of a reorganization plan
  • A U.S. taxpayer who transfers intangible assets covered under Sections 351, 361, or 367d
  • A U.S. company that transferred property to an offshore company in the tax-free division (Section 367e)

These code sections cover most situations, but there are a few other circumstances that may require the filing of Form 926:

  • The recategorization of debt to equity as it is deemed a property transfer
  • Purchasing the shares of a foreign corporation during an IPO through an underwriter
  • A transfer of intangible property in which either the foreign corporation disposes of this intangible property or the U.S. company sells the foreign corporation’s stock holdings
  • Transfers to foreign corporations a taxpayer does not own or control as in Section 351 above

In some cases, the transfer of cash must also be included. If, for example, a U.S. taxpayer transfers cash and comes to hold at least 10% of voting stock after the transfer or if $100,000 or more is transferred over any 12-month period, cash must be included.

In the case of married taxpayers, one copy of Form 926 will suffice. For partnerships or LLCs taxed as a partnership, all partners must individually file Form 926.

Who Does Not Need to File Form 926?

While the above list is fairly exhaustive, there are a number of circumstances in which Form 926 is not required.

  • Section 354 and 356 stock exchanges, or the transfer of stock under a tax-free recapitalization or a non-indirect stock transfer
  • Certain Section 355 distributions of corporate stock
  • Certain Section 357 stock transfers depending on ownership percentage and amount transferred

The IRS, Form 926, and Section 6038B

If you’re transferring property to an offshore entity and your transfer falls into the rules illustrated above – and, based on the comprehensive nature of the list of requirements, it probably does – Form 926 is unavoidable. And, in typical IRS fashion, “almost” isn’t good enough. Under Section 6038B, Form 926 needs to be filed properly, or the IRS considers taxpayers to be non-compliant. This means that there’s no substantial compliance doctrine that applies here; if you file Form 926, it needs to be handled properly. Including information on other parts of your return isn’t good enough, either – the required data needs to be on Form 926, or Section 6038B-based penalties can, and likely will, apply.

Once you’ve filed Form 926, the hard part is over, but the waiting begins. Unlike many other aspects of returns that are verified digitally, the IRS has an actual division, known as the International Practice Unit, to review the requisite information. This examination usually begins with verification of forms Form 5471 or Form 8938 to demonstrate an interest in a foreign corporation. If an interest is indicated, the IRS will then send document requests to determine involvement in a reportable transaction covered under Section 6038B. Should the documents requested indicate that the answer is yes, the IRS will then move on to make sure Form 926 was filed correctly. If it was, you’re good to go – but if it wasn’t, the IRS will open a penalty case. Any penalties assessed will be presented on Form 8278, Assessment and Abatement of Miscellaneous Penalties.

If you think this process is unnecessarily complex, it gets even better. Unlike most tax penalties that must be assessed within three years, failure to properly complete Form 926 has no statute of limitations, and the IRS can pursue penalties at its leisure. This applies to both a failure to file and a failure to file properly. Bottom line? If you don’t follow the policies to the letter, the IRS has the freedom to demand penalties from you at any time.

Section 6038B Penalties

Due to the seriousness with which the IRS treats Form 926 filings, it should be no surprise that the penalties associated are substantial. These penalties also exist in multiple forms, providing plenty of ways for the IRS to demand additional money from those who can’t play by the rules.

Choose to roll the dice and neglect Form 926? That means a penalty of 10% of the amount of the transferred asset or assets. The cap on this penalty for those who truly were unaware of the filing requirement is $100,000, but the sky is the limit for those who intentionally neglected to file. The establishment of a reasonable cause defense may result in this penalty being waived.

To add insult to injury, failing to file can also result in the IRS considering the transfer in question to become a taxable event under Section 367, leading to a potential gain on any appreciated property and thus an additional tax liability.

This, of course, is not the end. If a deficiency is determined due to the assessment of any additional liability, penalties under Section 6662(j) can apply. This penalty, which applies to underpayment attributable to foreign financial assets, can amount to 40% of the amount due.

Reasonable Cause Defense

As mentioned above, some or all penalties may be waived under a reasonable cause defense. However, this isn’t an avenue upon which taxpayers should rely. The IRS is generally skeptical of reasonable cause defenses in Section 6038B penalties. This point is further driven home by the fact that “reasonable cause” is not clearly defined, leaving all related judgments in the hands of the IRS.

The IRS has predictably made this kind of defense a significant challenge. They refuse to hear cases based on the claim that the deadline is not listed on Form 926, and also require all unfiled international information returns to be completed before a defense can move forward. The reason? The cost to avoid a failure to file penalty means disclosing everything necessary for the IRS to levy additional tax – in essence, the government wins either way.

If a taxpayer chooses to move forward, he or she must provide a written statement describing all related reasons for missing the mark. Should the IRS choose not to accept whatever reasoning is given – and they likely won’t – this statement can then be used to demonstrate intentional disregard, thus lifting the $100,000 failure to file penalty cap.

Challenging Section 6038B Penalties

For taxpayers not thrilled about any penalties related to Section 6038B and have no grounds for a reasonable cause defense, there are a few different paths available.

First, challenging in tax court is a possibility. Taxpayers who receive information about their penalties on Form 8278 are encouraged to file a Freedom of Information Act request to ensure all procedures on the IRS’ side were in accordance with the managerial approval requirements outlined in Section 6751(b). After receiving CP 15 or 215, Notice of Penalty Charge upon completion of the assessment, a standard appeal process can begin.

Before heading off to court, taxpayers also have the option of attempting a First Time Penalty Abatement. While rarely granted to incomplete international information returns, there’s always a possibility, particularly if your request is accompanied by a complete, correct copy of Form 926. Taxpayers also have the option of preparing a qualified offer under Section 7430(g), which makes a taxpayer eligible for an award of costs. These cases can be complicated, so a pro or plenty of reading on the relevant procedures is a must.

If these options aren’t suitable, going to court may be the best path forward. If the amounts offered on CP 15 or 215 are not paid, the IRS will follow up with Letter L-1058, Notice of Intent to Levy and Notice of Your Right to a Hearing. Upon receipt, taxpayers can then prepare Form 12153, Request for a Collection Due Process or Equivalent Hearing to formally argue a stated liability with the Appeals Office.

Some tax pros believe that because Section 6038B penalties are included in Section 61 rather than Section 68 of the code and aren’t mentioned in Sections 6677 and 6679, they are not actually assessable without a notice of deficiency and thus should be contested under the verification requirement in Section 6330(c). To date, however, no one has yet filed a case using the specific logic pertaining to this potential situation. This is actually true of all instances of challenges of Section 6038B; while audits by the International Practice Unit have occurred and are occurring, nothing has yet resulted in a trial under the most current rules. Until this time, there’s little information and no existing opinions to guide taxpayers and tax attorneys as to how to best proceed in fighting back against these penalties.

The Delinquent International Information Return Submission Procedure (DIIRSP)

If you’ve made mistakes or unintentionally neglected filing requirements and are now panicking about the small fortune you will owe the government, there are some measures in place for those seeking to become compliant with Section 6038B reporting requirements. Under the Delinquent International Information Return Submission Procedures, also known as DIIRSP, taxpayers who meet a narrow set of circumstances can submit delinquent returns without the assessment of a penalty related to a failure to file. These include:

  • Failure to file one or more international information returns
  • A reasonable cause for failing to file all missing returns
  • No current ongoing criminal or civil IRS investigations
  • No contact as of yet from the IRS regarding the delinquent returns

As with most IRS workarounds, this method isn’t without the potential for risk. If the IRS does not accept any reasonable cause provided, they will continue to assess penalties as normal, potentially using any information provided to force additional tax liabilities.

The Importance of International Information

As the harsh penalties associated with Section 6038B as well as the severe punishments that accompany other foreign financial situation rule violations, like FBAR requirements, imply, the IRS’ feelings on those failing to play along with rules related to international information are quite clear. Omitting anything required will not slide below the radar, and taxpayers who don’t comply will likely find themselves facing steep penalties with no recourse. If you have made transfers to foreign entities, are planning on starting an overseas company, or otherwise have anything to do with business transactions or banking overseas, it’s best to stick to the letter of the law. Should you choose to proceed by keeping transactions a secret, know that the IRS will find out – and they probably won’t be too nice about it.

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