Are you an expat who owns a foreign business? Filing taxes can be complicated, but adding a business to the mix can make it even more challenging. If you own a foreign disregarded entity, you may be required to file Form 8858. But what exactly is a foreign disregarded entity? And what happens if you fail to file? In this article, we’ll cover everything you need to know about Form 8858, address some of the common questions, and help you avoid potential penalties.
What is IRS Form 8858?
Form 8858 (Information Return of US Persons with Respect to Foreign Disregarded Entities and Foreign Branches) is an informational tax form that certain US citizens and green card holders need to file to disclose if they own a Foreign Disregarded Entity (FDE) or a Foreign Qualified Business Units (QBUs), and provide the US with financial information about them.
If you’re scratching your head wondering what that even means, don’t worry – we’ve got you covered. A foreign entity is a legal person incorporated in a foreign country that operates a business/activity in its own name. The IRS expanded this definition to include Foreign Qualified Business Units (QBU), meaning activities that might not have an actual legal persona but that maintain their own bookkeeping/their own sets of books. They may be referred to as corporations, but these entities wouldn’t be corporations by a US tax definition since corporations have limited liability, whereas disregarded entities don’t.
While actual corporations are not disregarded entities, they can make a check-the-box election to be treated as such. We’ll get to it in a minute.
Form 8858 only provides information to the IRS and does not trigger additional taxes. However, failure to file may result in substantial penalties, making it all the more important to understand your filing requirement and take steps to become compliant.
What is a Foreign Disregarded Entity?
A Foreign Disregarded Entity (FDE) is a type of business entity that is created in a foreign country and is transparent for US federal income tax purposes, the same way as a US LLC would be. This means that the FDE is not required to file its own tax return, but instead, its income, deductions, and credits are reported on the tax return of its owner, who is usually an individual or another business entity.
Foreign entities that don’t have limited liability would be disregarded entities from the start. It’s pretty rare, but an Alberta ULC is an example of that.
However, those foreign entities that have limited liability would be treated as a corporation and, therefore, would have to file form 5471. But if the corporation makes an election, it would be filing form 8858 instead of form 5471.
The Foreign Disregarded Entities (FDEs) are considered “disregarded” because the IRS treats them as if they do not exist for tax purposes. Instead, the owner reports the FDE’s income and expenses on their personal or business tax return.
In 2022, your personal income was $50,000 of wages, and your Canadian FDE generated another $50,000. In this scenario, the IRS would treat you and your FDE as a single unit, resulting in a taxable income of $100,000. The activities from that Alberta ULC will be reported on Schedule C teh same way as if it had occured through a US LLC.
What’s the difference between a foreign corporation and a disregarded entity?
Foreign companies that enjoy limited liability are generally treated as foreign corporations for US tax purposes. If they are Controlled Foreign Corporations, or if their US owner falls under another filing category, they would trigger a Form 5471 filing requirement. Form 5471 would be attached to the shareholder’s tax return (from 1040 in the case of an individual) to report certain information about their operations and ownership.
On the other hand, a foreign disregarded entity (FDE) is transparent for US tax purposes, and its income, deductions, and credits are reported on the tax return of its owner.
A disregarded entity is a transparent
As would be the case for a US LLC, a disregarded entity is a business entity that doesn’t pay taxes on its income. Instead, the income passes through to the owner or owners of the business, who report it on their personal income tax returns. Examples of pass-through foreign entities include the Alberta US and its income would be reported as a sole proprietorship on schedule C.
Can a foreign corporation make an election to be treated as a disregarded entity?
Yes, a foreign corporation can make an election to be treated as a disregarded entity for US tax purposes. Specifically, a foreign corporation with a single owner (referred to as a “disregarded entity owner”) that is not classified as a corporation for US tax purposes can elect to be disregarded as an entity separate from its owner by filing Form 8832 with the IRS.
This election can be advantageous in certain situations, such as when the foreign corporation is owned by an individual who wants to simplify their tax reporting obligations or when the corporation is owned by another entity that is also disregarded for US tax purposes.
It’s a good way to get around the pitfalls of form 5471. Upon making that election, the subpart F and GILTI income rules wouldn’t apply anymore, which might not seem like a major win given that the corporation’s income will be reported as one’s own income. But the big difference is that after making the election, the corporate income taxes will become creditable at a personal level, thereby allowing the shareholder to offset the liability using a foreign tax credit, which was not possible prior to the election.
How to make the election?
To make the election be treated as a disregarded entity, a foreign corporation with a single owner should follow these steps:
- Complete Form 8832, “Entity Classification Election.” This form is used to elect how a business entity will be classified for tax purposes. The foreign corporation should check the box for “Other Entity” and write “Disregarded Entity” in the space provided.
- Sign and date the form. The form must be signed and dated by a person authorized to make the election on behalf of the foreign corporation, such as an officer or director.
- File the form with the IRS. The completed and signed Form 8832 should be filed with the IRS by mail or electronically.
It’s important to note that the election must be made by the foreign corporation itself, not the owner of the corporation.
Additionally, the election is effective on the date specified on the form, which cannot be more than 75 days before or 12 months after the date the form is filed.
Example: If the corporation is created on June 1, 2022, the election needs to be made before August 15, 2022.
When can the election be made?
The election cannot be retroactive by more than 75 days. For instance, if a corporation is created on June 1, 2022, the election must be made before August 15, 2022. If an individual fails to make the election and contacts a tax professional in February 2023 to prepare their tax returns, the election can only be made effective from January 1, 2023, as this falls within the 75-day limit. However, this would mean that Form 5471 would need to be filed for the 2022 tax year. Additionally, if the effective date of the election is made at any point during the year, both Form 5471 and Form 8858 would need to be filed for that year.
What are the benefits of making an election to treat a foreign corporation as a disregarded entity?
There are several potential benefits of making an election to treat a foreign corporation as a disregarded entity:
- Simplified tax reporting: Generally, creating a foreign corporation triggers an additional filing requirement of form 5471 and the company’s income is subject to SubPart F and GILTI tax regimes. Instead, the owner reports the corporation’s income and expenses on their personal tax return.
- Potential tax savings: If the foreign corporation has a net loss, it can be used to offset the owner’s other income and reduce their overall tax liability. The corporate income tax becomes creditable at the personal level.
- Ability to claim a foreign tax credit on the personal tax return for corporate income taxes paid: This is a major benefit, allowing the shareholder to avoid US tax liability in a way that wouldn’t have been available for subpart F of GILTI income.
- Limited liability protection.
Form 8858 penalty
Failure to file Form 8858 or filing it incorrectly can result in various penalties and consequences.
- Late Filing Penalty: While no such penalty applies for true disregarded entities (Alberta ULC or a QBU), if odes apply in the case of Controlled Foreign Corporations that were previously required to file Form 5471. In the case of Controlled Foreign Corporations having made that election if Form 8858 is not filed by the due date, you may be subject to a penalty of $10,000 for each FDE for which the form is required. The penalty increases to $50,000 for each FDE if the form is over 90 days late.
- Accuracy-Related Penalty: Those who file an incomplete or incorrect Form 8858 may be subject to an accuracy-related penalty of 20% of the net understatement of tax related to the FDE.
- Civil Penalties: Taxpayers who fail to disclose certain transactions or activities related to a foreign disregarded entity or foreign branch may be subject to civil penalties under various provisions of the Internal Revenue Code.
- Criminal Penalties: In cases of willful failure to file or filing false or fraudulent information on Form 8858, criminal penalties may apply. These penalties can include fines, imprisonment, or both.
- Other Consequences: Failure to file Form 8858 or filing it incorrectly can also result in other consequences, such as the denial of foreign tax credits or the disallowance of deductions or losses related to the FDE.
It is important to note that the penalties associated with failure to file Form 8858 or filing it incorrectly can be significant. Taxpayers should take care to ensure that the form is filed correctly and on time, and consult with a qualified tax professional if they have any questions or concerns. Contact us today and get all your questions answered.
Form 8858 Schedules
Form 8858 consists of several schedules that are used to satisfy the reporting requirements of sections 6011, 6012, 6031, and 6038, and related regulations. If you have a filing obligation, you will need to file a correct and proper Form 8858 and all applicable schedules. Let’s take a closer look at them:
- Schedule C is the income statement of the reporting entity. It is used to report a summary income statement for the FDE or FB figured in the foreign disregarded entity’s functional currency in accordance with US generally accepted accounting principles (GAAP).
- Schedule C-1 is used to report Section 987 gain or loss information. Section 987 prescribes the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. The basic approach is to determine the profit or loss of the foreign disregarded entity for the tax year in its functional currency and then to translate the profit or loss at the appropriate exchange rate (the average exchange rate for the tax year).
- Schedule F is used to report a summary balance for the foreign disregarded entity or translated into US dollars in accordance with US GAAP.
- Schedule G is entitled “Other Information.” Schedule G asks a number of questions about the disregarded entity.
- Schedule H should be used to report the foreign disregarded entity’s current E&P income (if the tax owner is a CFC) or the foreign disregarded entity’s taxable income (if the tax owner is a US person or a CFP).
- Schedule I is used to report transferred loss amounts. Schedule I should only be completed if FDE or FB is owned: 1) directly by a domestic corporation; or 2) indirectly by a domestic corporation through a tiered structure of foreign entities. Schedule I should not be completed if the foreign branch or foreign disregarded entity is owned by a CFC.
- Schedule J is used to report foreign income taxes paid or accrued by a foreign disregarded entity. The preparer should report. The preparer should report foreign taxes paid or accrued by a disregarded entity or foreign branch on Schedule J.
- Schedule M is used to report transactions between foreign disregarded entities or foreign branches and the filer or other related foreign entities. Every US person that is required to file Schedule M (Form 8858) has to report the transactions that occurred during the FDE’s or FB’s annual accounting period ending with or within the US person’s tax year.
In summary, filing the IRS Form 8858 is a critical tax requirement for US taxpayers who own foreign entities or operate foreign branches. Failure to comply with the regulations can result in significant penalties and other legal consequences. Due to the complexity of the form, it’s highly recommended to seek the assistance of a qualified tax professional. With our guidance and support, you can rest assured that your Form 8858 is completed accurately and all your tax requirements are met.