Foreign disregarded entities and Form 8858 - every detail explained

Did you know that the IRS can penalize you up to $50,000 if you fail to file Form 8858 for the Foreign Disregarded Entity (FDE) you own?

But, what is Form 8858?

Like many other foreign asset reporting forms required by the IRS, Form 8858 is a common form US taxpayers must file if they own a foreign disregarded entity and - it is a common form on which numerous costly mistakes are made every year by taxpayers.

In this article you will learn about:

• what is a Foreign Disregarded Entity,
• who needs to file Form 8858, how and when to file it,
• what happens if you fail to comply,

and more...

Enjoy!

What is a Foreign disregarded entity?

A Foreign disregarded entity (FDE) is a flow-through entity located outside the US. This means the business income is taxed as the owner's income. The entity and the owner are considered one.

The corporation is treated as a separate entity from its shareholder for tax purposes. This veil of incorporation protects the personal asset of the company’s owners and investors. It also ensures their liability is limited.

However, the owner of an FDE, similar to the sole proprietorship, is responsible for fulfilling its tax obligations. Unlike the shareholder of a corporation, the owner of an FDE is not taxed twice on their business income.

In corporations, first, the profit is taxed as corporate income. It is taxed again when it is distributed to shareholders as a dividend unless the owner opts for it to be an S-corp.

This is one of the reasons why taxpayers choose pass-through entities for tax purposes.

When is Form 8858 required?

Consider a situation where you decide to set up a limited liability company in a foreign country. For tax purposes, it would be treated as a corporation and you will be required to file Form 5471.

But you can choose to disregard the corporation status.

You will need to file Form 8832 to make this choice. Once you do that your entity becomes considered a foreign disregarded entity for tax purposes.

Your FDE is taxed as a self-employed business. You will be required to file Form 8858 which is an informational return. You will also be liable to pay your self-employment taxes unless there exists a totalization agreement.

This is an agreement between the US and other countries to avoid double taxation with respect to social security taxes.

Who needs to file Form 8858?

You are required to file Form 8858 along with Schedule M (Form 5471) if you are a US citizen who during an annual accounting period or tax year does either of the following:

• Owns FDE for tax purposes,
• Operates an FB (foreign branch),
• Owns interest in entities that are tax owners of FDE or FBs.

Your FDE ownership can be direct or indirect via a tier of FDEs or partnership.

For tax purposes, the IRS distinguishes between the tax owner and the direct owner of the FDE.

• Tax owner. You are a tax owner if you own the FDE assets & liabilities for the tax purpose.
• Direct owner. A direct owner is the legal owner of the FDE. Let’s say you are a US citizen and a 55% partner of a controlled foreign partnership (CFP). The CFP owns an FDE. Legally, CFP is the direct owner of the FDE but you are the tax owner.

Following US persons are required to file Form 8858:

• Filers of Form 5471 or Form 8865 for CFC (controlled foreign corporation) and CFP respectively that own FDE or operate an FB;
• A US partnership that is a direct or indirect tax owner of the FDE;
• A US corporation except for RIC, REIT, or an S corp, that holds an interest in a US partnership that owns an FDE.

IRS defines as a US person any of the following:

• a US Citizen or resident alien,
• a domestic partnership, corporation, or trust,
• any estates other than those foreign estates that are specifically excluded.

Also watch -
Webinar: "More US persons have to file Form 8858. Should I?" with Wendy Christiansen

When is Form 8858 due?

You need to file Form 8858 with your income tax return or when it is due including an extension.

The usual due date is April 15 (the 2022 tax filing deadline is April 18). For US citizens or resident aliens living abroad, the IRS allows an automatic 2-month extension.

NOTE! If you have received a notification from the IRS that the form is due then you have 90 days to submit it before they impose a penalty of 10,000 on you.

What info to include on Form 8858?

Form 8858 requests detailed information about the tax owner, the FDE and other information.

You also need to provide a summary of your FDE’s financial statements.

• The income statement. It reflects your earnings and expenses. The profit you made during the annual accounting period or tax year is reported.
• The balance sheet. It reflects your financial position. It contains the details about your assets, liabilities, and equity.

Furthermore, report your accrued and paid foreign taxes. You can claim any FTC (foreign tax credit) you qualify for to reduce your US tax liability.

Will I be penalized for not filing Form 8858?

The IRS imposes both civil and criminal penalties on tax owners for not filing form 8858 when required.

A $10,000 penalty is imposed for each annual accounting period an FDE (CFC or CFP) fails to report the information within the specified time frame.

NOTE! Once you receive the non-compliance notification you have 90 days to file the form. Failure to do so will result in an additional penalty of $10,000 (per CFC or CFP) for each month which can accumulate up to $50,000.

Moreover, your FTC will be reduced by 10% in the event of non-compliance. This percentage will increase if you fail to submit the information return within 3 months of receiving the IRS notification.

Pro tip: as a tax owner you are solely responsible for filing your tax returns even if you hire someone else to file on your behalf. Individuals are not subject to monetary fines. Only reduction of Foreign tax Credit.

To prevent financial and/or criminal penalties make sure you file form 8858 when it's due.

NOTE! If you are not sure whether you are required to file this form - you can consult a top-rated tax specialist.

How do I file Form 8858?

Following are the identifying information, schedules & financial figures you will need to fill in form 8858, step by step, section by section.

1. Annual accounting period

You need to fill in your annual accounting period at the beginning of the form. This is a time period, typically a year, for which businesses analyze their financial performance and position. Tax authorities assess entities based on a tax year. It could either be a calendar year or a fiscal year.

Your tax year is the year for which you filed your first income tax return. Your tax will be assessed based on your tax year for the FDE.

2. Identifying information of the tax owner and FDE

You need to provide your identifying information including your name, address, tax year, and TIN number which in this case is your SSN.

If some other person owned your FDE within the previous 3 years you are required to provide their name in the parenthesis after writing your name.

An FDE can be owned by a US person, a controlled foreign corporation, or a partnership. Check the relevant box.

Then you need to select whether this is the initial form or the final form.

Suppose you have formed or bought the FDE and sold or terminated it within the same tax year. You are required to file two forms for these separate events. On one form you will check the initial form box and on the second one, you will check the final form box.

The identifying number, also known as TIN, for FDE is its employer identification number (EIN). You also need an EIN while filing Form 8832, for making an election to be treated as an FDE.

3. Schedule C & F - financial statement

Report your profit and loss summary for the FDE on Schedule C. The reported figures will be in functional currency and the US dollar. Functional currency is the primary currency entities use for their business dealings. An FDE operating in Mexico will have pesos as its functional currency.

Report the details of assets, liabilities, and equity on Schedule F. The balance sheet figures should be translated into US dollars.

You need to prepare Financial statements in accordance with the US GAAP (Generally Accepted Accounting Principles).

4. Schedule G

This schedule asks the tax owner to provide a variety of information. For e.g. whether the FDE owns any interest in a partnership or is a part of a consolidation.

5. Schedule I

This is relevant for those FDE that are owned directly or indirectly by a domestic corporation. If the FDE is owned by a CFC skip it. In this schedule, the tax owner is asked to provide if any asset owned by FDE transferred to any foreign corporation.

6. Schedule J

This shows the foreign taxes you paid or are payable for the earnings generated by your FDE. This information will facilitate you to claim any foreign tax credit you are eligible for which will reduce your US tax liability.

7. Schedule H

This schedule reports the current earnings and profits. Adjustment is made to keep the figures in line with the requirement of the United States.

8. Schedule M

It is a separate schedule attached with form 8858 containing all the related party transactions. Related parties are companies or Individuals that do the following:

• Control the FDE,
• Significantly influence the FDE,
• Manage the FDE.

Related party transactions are an area where lies the huge potential for misrepresentation and fraud. It is one of the primary schedules examined by tax auditors during audits.

9. Organizational chart

The IRS requires you to attach an organizational chart containing the details related to the chain of FDE ownership.

Form 8858 preview

 

 

What to do if I failed to file Form 8858?

Don’t panic if you haven't complied yet with the IRS requirement of filing Form 8858. The IRS offers a tax amnesty program that you can benefit from. It is called the streamlined filing compliance procedure & is available to you if your failure to file did not result from wilful conduct.

Under this program, you will file original or amended tax returns. File all the necessary informational returns and pay all the necessary taxes and penalties. You can go back and file 3 years of tax returns. For international information return, you can go back to 6 years.

Generally, you can be a part of it if:

• You didn’t skip your filing obligation intentionally,
• You have a valid TIN number,
• Your tax return for some random tax year is not under the civil examination by the IRS.

You may have additional criteria to qualify for this program.

However, if you are worried that you intentionally failed to file the return to the IRS and want assurance that you will not be subject to criminal penalties you should consider participating in IRS criminal investigation voluntary disclosure practice.

NOTE! Make sure you seek legal advice before making any decision.