Whether you live abroad or want to expand your business into international markets, forming a company overseas can be an exciting endeavor. However, it can also come with extra tax requirements and complications. For many owners, establishing a foreign disregarded entity can help streamline the tax filing process. Although, it’s important to understand the implications fully before making this important decision for your business.
Understanding Foreign Disregarded Entities (FDEs)
Before learning about the tax implications of owning a foreign disregarded entity, you’ll first need to understand the basic characteristics of this type of entity and how it differs from other business structures. Once you know what a foreign disregarded entity is, you can determine if this business structure is right for you and familiarize yourself with how to navigate the tax responsibilities.
What is a Foreign Disregarded Entity?
A foreign disregarded entity is a flow-through entity that is disregarded by the IRS for tax purposes. Disregarded means that the entity is not taxed directly. Instead, the entity’s earnings flow to the owner who is responsible for all taxes on the business’s earned income.
In contrast, corporations are taxed as separate entities which must file a corporate return directly with the IRS. Owners pay taxes only on the dividends received from the corporation.
Disregarded entities are taxed in the same way as sole proprietorships. However, disregarded entities are considered separate legal entities, offering the owners greater protection from liability.
Foreign Corporations vs. Disregarded Entities
A foreign corporation is one that was not created in the US or organized under United States tax laws. Foreign corporations are taxed as separate entities and must file a corporate tax return with the IRS using Form 5471. Foreign-owned disregarded entities, on the other hand, are not taxed as separate entities and do not need to file a corporate tax return. Instead, the owners of foreign disregarded entities pay taxes on business income via their personal tax returns.
Foreign Disregarded Entity for US Tax Purposes
Whether your foreign business is treated as a disregarded entity depends on its structure and the tax treatment you’ve elected.
Tax Treatment of Foreign Disregarded Entities in the US
Some foreign entities are considered disregarded for tax purposes by default. For instance, when a sole proprietor starts conducting business abroad or a US expatriate forms a foreign single-member entity that does not have limited liability.
In other cases, owners must elect disregarded tax status to receive this type of treatment by the IRS. For example, a single owner with limited liability can opt to have their foreign business treated as a pass-through entity rather than a corporation. Owners will use Form 8832 to make this change. However, it’s a decision you should consider carefully since your tax status can only be updated once every five years.
Impact of FDEs on US Taxpayers
The IRS considers the foreign disregarded entity and its owner as a single taxpayer. Because of this, your foreign business’s income is treated as your personal income. To calculate your total taxable income, you’ll simply add the profits from your foreign disregarded entity to the earnings you generated outside the business. As a result, taxpayers may find themselves in a higher tax bracket.
Foreign Branch vs. Foreign Disregarded Entity
Sometimes, a foreign disregarded entity will function as a foreign branch of a US company. Establishing a foreign branch can help business owners target new markets, expand production, and increase brand recognition.
Comparing Foreign Branches and Foreign Disregarded Entities
A foreign branch refers to the operations of a US business in a foreign country. Foreign branches are treated as a part of the domestic corporation for tax purposes. To be considered a foreign branch, it must be a qualified business unit with separate books and records that is capable of producing income independent of the US-based entity.
If a US company conducts business abroad through a foreign disregarded entity, that entity is also considered a foreign branch. However, not all foreign branches are disregarded entities. A foreign branch may be taxed as a corporation if the US-based company has a corporate tax treatment.
Choosing the Right Structure for Your Business
Business owners often choose between establishing a foreign branch or a foreign subsidiary for their overseas expansion. A foreign subsidiary offers the advantage of being a separate legal entity, which can help limit risk and provide additional tax options. Depending on the situation, a foreign subsidiary that would normally be taxed as a corporation may have the option to elect disregarded tax status. By opting to treat your overseas subsidiary as a foreign disregarded entity, you can avoid filing a corporate tax return and possibly reduce your tax liability.
Foreign Disregarded Entity Tax Form and Reporting Requirements
Foreign disregarded entities must fulfill certain special tax reporting requirements with the IRS. These obligations include filing Form 8858 to provide information on ownership, financials, and any foreign taxes paid. Additionally, if a foreign entity is not considered disregarded by default, it must file Form 8832 to elect this status.
Similarly, foreign owners of US disregarded entities will face unique tax requirements, such as filing Form 5472 to inform the IRS of the relationship between the foreign owner and the US company.
Foreign Disregarded Entities and Form 8858
Owners of foreign disregarded entities must file tax Form 8858 every year to report ownership information and other financial details about the business. Form 8858 is an informational form, which means it does not result in any additional tax. However, it can add time and effort to the tax-filing process.
To file Form 8858, you will need to include the following information:
- Entity tax owner and direct owner names and information, if they are different
- Business name, address, EIN, currency, and tax year
- Organizational chart to detail the FDE’s ownership
- Income statement to report earnings, expenses, and profits
- Balance sheet to detail your assets, liabilities, and equity
- Foreign taxes paid and accrued
A tax owner is the person responsible for the business’s taxes. A direct owner, by contrast, is the legal owner who is responsible for the business’s legal obligations.
Reporting foreign taxes paid is an important part of completing Form 8858. Foreign disregarded entities can claim foreign tax credits to reduce their US tax liability dollar-for-dollar based on the amounts they’ve paid to overseas governments.
Failing to file Form 8858 can be costly for businesses and their owners. The IRS levies steep penalties against foreign disregarded entities that miss the filing deadline. For each accounting period that Form 8858 is late, a penalty of $10,000 is applied. Even worse, if you receive a letter of non-compliance from the IRS with a 90-day notice to file, you’ll incur additional penalties of $10,000 per month (up to $50,000). On top of this, failing to comply with the IRS’s tax rules will cause you to lose 10% or more of your foreign tax credit.
The typical due date for Form 8858 is April 15th. Although, US citizens living abroad receive an automatic two-month extension on this deadline.
Additional Tax Forms for Foreign Owned US Disregarded Entities
Foreign-owned US disregarded entities do not have a US tax return filing requirement. However, they will need to provide certain information to the IRS. Specifically, foreign owners will need to submit a pro forma Form 1120 and Form 5472.
Form 1120 is typically used to file a US corporate tax return. However, foreign owners of domestic businesses will only need to complete a pro forma return, which means only certain sections of the form are required for informational purposes.
If a foreign owner has a 25% stake or more in a US disregarded entity, that individual will need to file Form 5472 by April 15th every year. Foreign owners will use Form 5472 to provide information on their US business’s ownership structure and certain transactions. When submitting Form 5472, overseas owners must submit a pro forma Form 1120 as well.
The penalty for foreign-owned disregarded entities that file to file Form 5472 is $25,000, so it’s important to stay on top of this important requirement.
Get the Facts on US Tax Residency for Foreign Owners
To file Form 5472, foreign owners of US disregarded entities will need to determine their US tax residency. If a foreign owner is considered a tax resident, they will be required to file and pay US income taxes. To learn more, read the full article: Everything You Need to Know about How US Tax Residency Is Determined.
Take Care of Your Foreign Disregarded Entity Taxes
Business taxes are complicated enough; it’s even more challenging to keep track of foreign business tax regulations. Fortunately, with the right information and a little help from a Cleer tax accountant, you can stay compliant and maximize your savings with ease. If you have any questions about foreign disregarded entity taxes or need assistance, feel free to contact us.
Frequently Asked Questions (FAQ)
Can a foreign corporation be a disregarded entity?
Yes, an eligible foreign corporation can elect to be treated as a disregarded entity by filing Form 8832.
How does the IRS determine whether an entity is a foreign disregarded entity?
For the IRS to consider a foreign entity disregarded by default, it must have a single owner that does not have limited liability. Otherwise, eligible foreign entities must elect to have disregarded tax status by filing Form 8832.
What are the penalties for not filing the required forms for an FDE?
Owners of foreign disregarded entities who fail to file Form 8832 will face fines of up to $10,000 for each accounting period past the deadline. The penalty for foreign-owned US disregarded entities that fail to file Form 5472 is $25,000.
Can a foreign disregarded entity be subject to US state taxes?
Foreign disregarded entities may be subject to US state taxation in the places where they conduct business. Typically, corporations are only considered domestic in the state where they were formed. Companies doing business in a state outside where they were incorporated must, therefore, apply for foreign qualification to register legally with that state. Failing to qualify as a foreign corporation can result in additional state taxes and fines.
