Confession:  I love wine.

When I lived in the U.S. I visited wineries in Michigan and New York and did a lot of wine tasting.  I love relaxing after a long day with a glass of wine and a good book.  I love that ‘pop’ of the cork when you open a bottle for the first time.  I love how a bottle of wine brings friends together.

Since I’ve been in Australia, I have been itching to visit the wine mecca, Hunter Valley.  Everyone has told me how gorgeous the scenery is and how much there is to do there aside from wine tastings.

On Saturday, a friend and I took advantage of the gorgeous weather and drove down to Hunter Valley for the day.  I didn’t plan the trip as well as I should have.  Mainly because I was unfamiliar with the area and also because there are hundreds of wineries in Hunter Valley – how do I know which one to go to?

A two and a half hour drive led us to the Wyndham Estate where we did a red wine tasting.  The Wyndham Estate is known best for their Shiraz.  Now, I’m not a huge red wine drinker, but I tried four different Shiraz blends and loved all of them.

Our next stop was the McGuigan Winery, closer to the center of Hunter Valley.

Here we did a white wine tasting: Pino Grigio, Muscato, and Semillion.  All three were delicious and reminded me of summertime.  The Autumn Harvest Semillion was my favorite – sweet and very refreshing – and totally worth the $20 investment.

We headed across the street to Tempest Two, a more upscale winery.  I also did a wine tasting at this one, trying a Chardonnay, Pino Grigio, and Muscato.  The Muscato was my favorite at this one – sweet and sparkling – makes for a perfect wine to pull out for a celebration.

Of course, Hunter Valley offers more than just wine tastings.  You can easily spend a weekend there and take advantage of the wine tours, museums, golf courses and spas.  Many of the wineries also make great venues for weddings, birthdays and Buck/Hen celebrations.

Hunter Valley was a great escape from the hustle and bustle of Sydney.  It’s an easy two hour drive (depending on traffic) down the Coastal Highway where you’ll get some great scenery to compliment the drive. I certainly recommend visiting Hunter Valley to experience a different side of New South Wales.  Just be careful when doing the wine tastings as you may return home with more bottles than anticipated.

Somehow I returned to Sydney three bottles richer.

As we have mentioned before, tax deferral is a major reason that people decide to move their corporations abroad.  The idea of avoiding or deferring taxes on investment income or income of another offshore business activity motivates many people to use a foreign corporation.  However, the tax rules are very complex and there are limited circumstances in which a U.S. person is a shareholder of a foreign corporation and not required to pay U.S. income taxes on his income until it is distributed as a dividend.  Even worse news for those who are intrigued with the idea of using a foreign corporation to avoid or defer taxes on investment income, there are hardly any situations in which this is possible (other than for a very small amount).  See “What is a PFIC”

Many times you will hear people offering convincing arguments about tax avoidance or tax deferral schemes that they have created.  As the tax rules for CFCs are so complex, it is extremely difficult to explain them without simply copying different sections of the I.R.C.  However, if someone tells you that all income of a foreign corporation is not currently subject to U.S. income tax, you should probably get a second opinion as this is likely an exaggeration.  On the other hand, it’s also likely an exaggeration to say that all income of a foreign corporation is currently taxable to its U.S. shareholders.

In the past, many people used foreign corporations as a way to avoid taxes as the income of the foreign corporation was not taxed unless it was derived from U.S. sources.  To prevent this, legal changes were enacted that essentially had the effect of imposing taxes on certain U.S. shareholders of a foreign corporation.  These laws apply to specific types of income of the foreign corporation called subpart F income.  We discussed subpart F income extensively in a previous post, but in general it includes most types of investment income and various types of foreign-sourced business income.  If a foreign corporation has subpart F income, the U.S. has taxing authority over the U.S. shareholders of the foreign corporation even if the corporation itself has no U.S. source income and no permanent establishment in the U.S.

A foreign corporation will be subject to U.S. income tax if it has U.S. source business income that is effectively connected with the conduct of a U.S. trade or business or if it has a permanent establishment in the U.S.  It will be required to file Form 1120-F and taxes cannot be deferred.  If the foreign corporation has U.S. shareholders and the profits are later distributed as dividends, the amounts will again be subject to the personal income tax rate of the U.S. shareholder (“double taxation”).

If a foreign corporation does not meet the requirements of being a CFC, then the U.S. owners and shareholders are not subject to U.S. tax unless the corporation is considered a passive foreign investment company (“PFIC”).  There are special rules for a PFIC.   A PFIC is a passive foreign investment company that is organized as a corporation and:

(1) receives 75% or more of its total income from passive investment sources, or

(2) has investment 50% or more of its assets in passive investments that a separate from investment in a trade or business

A foreign partnership is not considered a PFIC even if it is organized to manage investments because it is not a corporation.  This is also the case of most foreign trusts that have beneficiaries unless it is a foreign investment trust that is organized like a corporation (in which case it would be treated as a PFIC).  PFICs will be discussed in more detail in a future article as they are a very important issue to be aware of when evaluating whether it is possible to defer or avoid taxes. See “What is a PFIC”

If the foreign corporation is not a PFIC or a CFC, it is essentially treated the same as a non-resident alien for U.S. tax purposes and is only subject to tax on its U.S. source income (generally at a withholding rate of 30% at the source of the income).  Additionally, the subpart F rules relating to purchases from or sales to related persons will not apply to a non-CFC.  However, transfer pricing rules prohibit the foreign corporation from moving profits out of the U.S. to a low tax jurisdiction and the U.S. shareholders will be able to treat any gain from the sale of stock of the foreign corporation as a capital gain or loss (instead of ordinary income).

Keep in mind, there are other rules (transfer pricing) that will prohibit the foreign corporation from stripping profits out of the U.S. to a low tax jurisdiction.  The U.S. stockholders will be able to treat any gain from the sale of stock in the foreign corporation as a capital gain (or loss) rather than as ordinary income. However, it is important to note that in order to avoid meeting the requirements of a CFC, a foreign person must own at least 50% of the stock of the corporation or unrelated persons who each own less than 10% of the stock own at least 51% of the stock of the corporation.   In this case, one needs to weigh if it is makes sense to give up the ownership and control simply to defer U.S. taxes on the income of the corporation.  The answer may very well be yes, but in this case it is important to weigh both the pros and cons of an offshore corporation which are discussed in detail in a previous post.

As you can see, while tax deferral is a major motivator to work abroad, you need to review your individual situation very carefully to see if you can in fact reap the benefits.

One of my favorite things about living in Australia is learning about Australian culture and participating in the different celebrations that are only exclusive to that country.

Over the weekend, I had the pleasure to join the masses and celebrate Mardi Gras in Sydney.  Now, I know what you’re thinking: what’s the big deal?

Mardi Gras in Australia is not the same as Mardi Gras in the U.S.  Typically, the celebrating in the U.S. is centered in New Orleans where the public drinks an obscene amount of alcohol, women flash anyone around them in the hopes of collecting beaded necklaces.  I have yet to experience Mardi Gras in New Orleans, but I have a feeling I’m not missing out on much.

Mardi Gras in Australia is one massive Gay Pride celebration.  On Saturday night I joined in on the fun and stood in the cold and rain to watch hundreds of gays, lesbians and transgenders dance on themed floats and in the streets.  I wasn’t sure what to expect going into this event.  Everyone kept telling me that Mardi Gras is huge here but I never really understood just how big it gets until I witnessed it with my own eyes:

The parade was huge, the floats were extravagant and I didn’t realize just how many homosexuals live in Australia.  Being at the parade was an incredible experience and it really opened my eyes up to how strongly and passionately other countries are fighting for gay marriage and equality.

One thing that living abroad has really taught me is to always keep an open mind and to embrace a country’s celebrations because it’s the best way to get a rewarding experience.

As part of tax planning, nonresident alien parents often want to want to give gifts to their children who are U.S. citizens or Green Card holders.  According to the IRS, a foreign gift is money or other property received by a U.S. person from a foreign person that the recipient treats as a gift or bequest and excludes from gross income.  A “foreign person” is a nonresident alien individual or foreign corporation, partnership or estate.  As a Green Card holder, a person is considered a U.S. tax resident and must report all income to the IRS.   If the Green Card holder receives a gift from his or her nonresident alien parents, the Green Card holder may be required to file Form 3520 with the IRS.  Form 3520 is simply an information return and is due on the date that your income tax return is due, including extensions.   Not all gifts are required to be reported, however.  According to the filing requirements, Form 3520 must be filed if you are a U.S. person (a Green Card holder would be considered a U.S. person in this case) who, during the current tax year, received either:

1. More than $100,000 from a nonresident alien individual or a foreign estate (including foreign persons related to that nonresident alien individual or foreign estate) that you treated as gifts or bequests; or
2. More than $14,375 from foreign corporations or foreign partnerships (including foreign persons related to such foreign corporations or foreign partnerships) that you treated as gifts.

 If either (a) or (b) applies, the U.S. person would be required to file Part I (identifying information) and Part IV of Form 3520.  

 It is important to note that a gift to a U.S. person does not include any amount paid for qualified tuition or medical payments made on behalf of the U.S. person.

 When calculating the threshold amount ($100,000), you must aggregate gifts from different foreign nonresident aliens and foreign estates if you know (or have reason to know) that those persons are related to each other or one is acting as a nominee or intermediary for the other.  For example, if you receive a gift of $75,000 from nonresident alien individual A and a gift of $40,000 from nonresident alien individual B, and you know that A and B are related, you must aggregate the amounts and complete Form 3520.

Additionally, if you received aggregate amounts in excess of $14,375 in 2011 or $14,723 in 2012 that you treated as gifts from foreign corporations or foreign partnerships (or any foreign persons that you know (or have reason to know) are related to such foreign corporations or foreign partnerships), you must also aggregate the amounts and complete Form 3520.  For example, you would be required to file Form 3520 if during 2011 you received $8,000 from foreign corporation X that you treated as a gift, and $10,000 that you received from nonresident alien A that you treated as a gift, and you know that X is wholly owned by A.

There are penalties if Form 3520 is not timely filed or if the information is incomplete or incorrect.  Under Section 6039F, if the U.S. person fails to report foreign gifts, a penalty equal to 5% of the amount of such foreign gifts applies for each month for which the failure to report continues (not to exceed a total of 25%). No penalty will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect. 

To complicate things even further, there are differences in the tax treatment of cash and property.  According to I.R.C. Section 2501(a);Reg. §25.2501-1, a nonresident alien donor is subject to gift tax on transfers of real and tangible property situated in the United States.  According to the IRS, if you are a nonresident alien who made a gift subject to gift tax, you must file a gift tax return (Form 709) if:

• You gave any gifts of future interests,
• Your gifts of present interests to any donee other than your spouse total more than $13,000, or
• Your outright gifts to your spouse who is not a U.S. citizen total more than $136,000.

The gifts are taxed at the same rates that apply to U.S. citizens.

There’s also the issue of estate taxes to consider.  Basically, the estate tax applies to the estates of U.S. resident aliens in the same way as it applies to U.S. citizens under I.R.C. section 2001(a).  However, non-resident aliens generally are subject to the U.S. estate tax only with respect to real, tangible, and intangible property situated in the United States.  Intangible property situated in the United States includes stock in domestic corporations, bonds, and debt obligations of U.S. obligors, U.S. partnership assets, and U.S. property owned by a trust in which the nonresident alien has an interest.  The estate of a nonresident alien is taxed at the same estate tax rates that apply to U.S. citizens’ estates.  The estate tax return for a U.S. citizen or resident is Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. For non-resident aliens, it is Form 706-NA.

To help illustrate the principles discussed above, we will present two scenarios:

Scenario 1:

Lisa, a U.S. Green Card holder, receives $300,000 in cash from her nonresident alien parents.  Since this amount is over the $100,000 threshold, Lisa is required to file Form 3520 but is not required to pay any tax on the gift amount. 

Scenario 2:

Lisa’s nonresident alien parents decide to buy her a house and pay the developer directly.  Assume again in this case that Lisa is a U.S. Green Card holder.  Since this amount is over the $100,000 threshold, Lisa is required to file Form 3520 and report the FMV of the gift but is not required to pay any tax on the gift amount.  However, in this case, since the donor parents are giving a gift of property, the nonresident alien parents are required to file Form 709 with the IRS and are subject to taxation on the amount of the gift.

 As you can see, the tax rules for giving gifts are extremely complex and vary with individual circumstances.  Before proceeding, it is best to consult with your tax professional.

Even if there is no tax due, it is very important to be aware of the filing requirements related to a foreign corporation because there are some very severe penalties for failing to file a required return or if a return is filed and missing information.

Under I.R.C Section 6651(a)(1), there is a penalty for the failure to file income tax returns (personal or corporate) by their due date (including extensions).  The penalty is 5% of the tax required to be shown on the income tax return for each month (or fraction thereof) during which such failure continues but shall not exceed 25%.  There is no penalty if no underpayment of tax is shown on the return.  However, a separate penalty may apply to each Form 5471 that is filed after the due date of the tax returns and will apply whether or not any tax is due on the tax returns (Personal or corporate)

The information required to be reported on Form 5471 for certain foreign corporations was discussed in a previous post (“What is Form 5471?”).  Under I.R.C. Section 6038(b)(1), there is a penalty of $10,000 for each Form 5471 that is filed after the due date of the income tax return (including extensions).  There is also a penalty of $10,000 if the form is filed on time but does not include complete and accurate information which is described in Section 6038(a).  The $10,000 penalty is imposed for each annual accounting period of each foreign corporation for which it failed to file the form or is missing required information.  If the information is not provided within 90 days after the IRS mailed a notice indicating the failure to file, an additional $10,000 penalty (per foreign corporation) may be charged for each 30-day period (or fraction thereof) during which the failure to file continues after the 90-day period has expired.  For each failure, the additional penalty is limited to a maximum of $50,000.

There is also a 10% reduction of foreign taxes available for credit under I.R.C. Sections 901, 902, and 960 which can be applied in addition to the monetary policy per I.R.C. Section 6038(c).  If the failure continues 90 days or more after the date the IRS mails notice of the failure, an additional 5% reduction of foreign taxes available for credit is made for each 3-month period (or fraction thereof) during which the failure continues after the 90-day period has expired. The amount of the reduction has several limits such as the greater of $10,000 or the amount of the income of the foreign corporation for its annual accounting period with respect to which the failure occurs. Please refer to section 6038(c)(2) for additional limits on the amount of the penalty.

While we won’t go into the details here, it is important to note that criminal penalties may also be imposed for the failure to file certain required information.  Penalties may also be imposed for undisclosed foreign financial asset understatements for tax years beginning after March 18, 2010 under Section 6662(j).  If the taxpayer can demonstrate that the failure to comply was due to reasonable cause and that he or she acted in good faith with respect to the portion of the underpayment, no penalty will be imposed.

It is very important that you trust your accounting professional!  Any person that is required to file Form 5471 and related Schedule J, M, or O who enlists another person to file the form and corresponding schedules for him may be subject to the penalties described above if the other person does not file a correct and complete form and schedule.

In summary, file Form 5471 in a timely matter completely and accurately!  Enlist the help of your trusted tax professional to avoid missing information and incurring severe penalties.

Many people have heard of the benefits of having an offshore corporation.  These benefits, whether true or not, have led people to idealize the idea of an offshore corporation while not taking into account the cons of having an offshore corporation.  In this post, we will highlight both the pros and cons of having an offshore corporation.

People believe that having an offshore corporation will help them save money by avoiding U.S. taxes.  In some cases this is true, but in other cases it is not.  A lot of times people are under the misconception that an offshore corporation is not subject to the taxing jurisdiction of the IRS.  This is true, however, unfortunately the U.S. shareholders (or deemed shareholders) of the offshore corporation are subject to the taxing jurisdiction of the IRS.  Additionally, it is important to note that a foreign corporation essentially allows tax deferral rather than tax avoidance.  The U.S. owners of the foreign corporation will be subject to tax once the profits of the corporation are paid out as dividends or as liquidating distributions or when the stock of the corporation is sold.

One of the most important considerations when deciding whether to start a business abroad is whether the additional profits (if any) generated by the offshore corporation will be enough to compensate for the cost of doing business offshore.

For example, it may be difficult to operate a business from a tax haven country because of limited access to customers, suppliers, trained employees, and technology.  In order to withstand any challenges by the IRS, the foreign corporation must be both self-sustaining and a resident of the country in which it is doing business.  This means that not only must the corporation be formed in the country or have a license to do business in the country, but it is also subject to any taxes imposed by the country of residence.  To complicate things further, most tax haven countries issue a corporate charter for an IBC which prohibits the corporation from conducting business in its country of incorporation.  The charter permits the IBC to have an office in that country where it can perform administrative duties, manage a portfolio, and handle bookkeeping as well as hire local employees, but it is not allowed to compete with the local businesses.  As such, it is not permitted to manufacture, distribute, or provide any products or services.  Some people may not consider this an obstacle and assume that they could just manage the corporation’s activities from the U.S. to make things easier.  However, then the IRS will argue that the corporation’s base of operations is actually in the U.S. and that the U.S. is the source of the income of the foreign corporation. 

As you can see, to be able to withstand a challenge from the IRS and avoid U.S. taxes on a foreign corporation, the corporation must have a standard corporate charter and not be an IBC.  It must be a self-sustaining corporation with an office that is a permanent establishment in the country of incorporation.  While physically within the U.S., the U.S. owners must not engage in any significant operational or management activities (if the corporation is a CFC).  The corporation will also need local employees to manage its operations and market its products or services.  As a result, an offshore corporation requires a substantial capital investment to cover the costs of both the employees and the office in the foreign country.  If the U.S. owner was not already living in the foreign country, it would also require large amounts of time spent traveling to the country as well as incurring the cost to get there.  Before deciding to set up an offshore corporation, one should estimate the costs of doing business in the foreign country versus the cost of doing business in the U.S.  The entrepreneur should ask himself questions like: could I operate my business out of my home in the U.S. with no office expense or employees’ salaries?  Would I need both an office and employees in either location?  Are rent and salaries significantly less expensive in one country versus the other?  Is the foreign country’s currency stable?  The entrepreneur should also attempt to calculate the tax cost of doing business offshore versus the tax cost of doing business from the U.S.

The federal tax rates of a U.S. corporation are as follows:

•             The first $50,000 of taxable profit is subject to a federal tax rate of 15%

•             The next $25,000 of taxable profit is subject to a federal tax rate of 25%

•             The next $25,000 of taxable profit is subject to a federal tax rate of 34%

The average tax rate on the first $100,000 of corporate profit is 22.25%. Above $100,000 of taxable profits, the rates increase to 39% and then decrease to 34%.

In addition to the federal tax rates, the U.S. corporation may be subject to state income tax depending on where it is based as well as where it has employees and offices.  Pennsylvania has the highest state income tax (9.99%) but nine states have zero state income taxes.  Income from foreign sources, however, is not subject to corporate state income taxes.

When considering whether to operate a business through a foreign corporation, the additional cost (if any) of operating the corporation abroad would have to be less than the U.S. tax on corporate profits in order to result in permanent tax avoidance.  For example, if the additional costs of operating a corporation abroad were only $7,500 a year, the corporation would need to make $50,000 of profit to save enough federal taxes to compensate for those added costs.

Most people who own a business expect to convert some of the business profits into personal income.  It is important to note that there is no double tax on the distribution of corporate profits if the income is received as compensation.   Therefore, salaries paid to the U.S. owners would only be subject personal income tax which range from 10% to 35% (federal) and zero to almost 10%.  Both the corporation and employee would be responsible for social security taxes on salaries paid to owners of domestic corporations.  If the U.S. owner actually lived abroad to manage his foreign corporation, he could potentially exclude some (or all) of his income if he met the requirements of the foreign earned income exclusion.

An additional (and significant) cost of operating a foreign corporation is the tax return preparation for the CFC.  The cost of preparing a tax return for a foreign corporation is roughly double the cost of preparing one for a domestic corporation.

From a tax perspective, the main benefit of a foreign corporation is tax deferral.  The foreign corporation can use the tax-deferred dollars to earn extra profits by re-investing the tax savings in the business.  This can generate enough additional income to equal or possibly exceed the taxes that would have been paid.  For example, if $30,000 of taxes is deferred for a year and earns a return of 10%, that represents an additional $3,000 of profit to the foreign corporation.  Without taking into account the impact of compounding, the additional profits gained from deferral would equal the deferred taxes in 10 years.  With compounding, the time required to equal the deferred taxes would be even less. 

As you can see, having an offshore corporation can be beneficial in some cases, but it is very important to consider the cons and obstacles before starting a business abroad.

Tax deferral is a major motivator to work abroad, but subpart F was enacted by Congress to limit the deferral of U.S. taxation of certain income earned outside the United States by controlled foreign corporations (“CFC”).  One of the purposes of Subpart F is to prevent CFCs from structuring transactions in a way that are designed to manipulate the inconsistencies between foreign and U.S. tax systems to inappropriately generate low or non-taxed income on which U.S. tax may be permanently deferred.  Subpart F income is one of the important issues to be aware of when completing Form 5471, but it is also very difficult to determine.  According to I.R.C. Section 952, there are several categories of subpart F income.  These categories are listed below along with the I.R.C. section where you can find the applicable definition of the category:

 (1)  Insurance income (I.R.C Section 953);

(2)  Foreign-base company income (I.R.C. Section 954);

(3)  Income from countries subject to international boycotts (I.R.C. Section 999);

(4)  Illegal bribes, kickbacks, and other similar payments (I.R.C. Section 162 (c)); and

(5)  Income from countries where the United States has severed diplomatic relations (I.R.C. Section 901 (j)).

We will focus on the second category, foreign-base company income, for purposes of this discussion as it is the major category applicable to most foreign corporations.  Foreign-base company income includes:

(1)  Foreign personal holding company (investment) income (I.R.C. Section 954(c)) – this includes income from passive investments (i.e. dividends, interest, royalties, capital gains, and certain rents);

(2)  Foreign-base company sales income (I.R.C Section 954(d)) – in general, this includes income from selling personal property purchased or sold to a related U.S. person (which could be an individual such as a spouse, children, grandchildren, or parents, corporation, partnership, estate or trust that controls or is controlled by the controlled foreign corporation (defined as greater than 50% ownership);

(3)  Foreign-base company services income (I.R.C. Section 954(e)) – per the IRS, this includes income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or “like services” for or on behalf of any related person outside the country under the laws of which the CFC is created or organized.  It also includes services performed by a CFC in a case where substantial assistance contributing to the performance of such services has been furnished by a related person.

Services directly related to the sale or exchange by the CFC of property manufactured, produced, grown, or extracted by it that are performed before the time of the sale or exchange or an offer or effort to sell or exchange such property are excluded. 

Additionally, foreign-base company service income excludes income from services provided by a CFC to an unrelated person with no related person involvement.   It also excludes income received from services performed in the CFCs country of incorporation.  For example, if a consulting company is organized in a tax haven and provides consulting services to unrelated persons, this income would not be considered subpart F income to the U.S. shareholders.

(4)  Foreign-base company shipping income (I.R.C Section 954 ((f)); and

(5)  Foreign-base company oil related income (I.R.C. Section 954 (g))

As shipping income and oil related income are very specific to those particular industries, we will not focus on them in this discussion. 

If a foreign company is determined to have subpart F income, then the earnings and profits of the corporation will be taxable each year to the shareholders owning 10% or more determined by direct ownership (or the attribution rules discussed in I.R.C. Section 958(a)).  The earnings and profits are taxed whether or not they are distributed, but subpart F income is limited to the extent of the earnings and profits each year.  It is important to note that income passes through only to a U.S. shareholder that owns stock in the CFC on the last day in the taxable year in which the corporation is a CFC.

However, in calculating the amount of subpart F income included in the shareholder’s gross income for the year, certain prior year deficits may be taken into account and will reduce the amount of the amount of subpart F income by the shareholder’s pro rata share of any qualified deficit.  In this case, the term “qualified deficit” refers to any deficit in earnings and profits of the CFC for any prior tax year that began after 12/31/1986 for which the CFC was a CFC.  The qualified deficit is limited to the extent it has not previously been taken into account and that it is attributed to the same qualified activity as the activity giving rise to the income in current year.  “Qualified activities” refer to foreign-base company oil related income, foreign-base company sales income, foreign-base company services income, insurance income or foreign personal holding company income in the case of a qualified insurance company, and foreign personal holding company income in the case of a qualified financial institution.  In determining the deficit for foreign-base company sales income and foreign-base company services income, deficits in earnings and profits for taxable years beginning after 1962 and before 1987 can also be considered.  In determining the deficit for foreign-base company oil related income, deficits in earnings and profits for taxable years beginning after 1982 and before 1987 can also be considered.

It is important to note that pro rata share of the deficit is calculated by using the smaller share of the close of the taxable year or the close of the taxable year in which the deficit arose.

Another important issue to note is that international business companies (IBC) formed in most tax haven countries are not allowed to conduct business in that country so any services performed on behalf of any person (shareholder) “related” to the corporation would be considered subpart F income.

Income reported as subpart F income is not treated as qualified dividend income and distributions of previously taxed income are not eligible to be treated as qualified dividend income, and hence do not qualify for the reduced tax rate on dividend income. 

While we won’t go into detail on the several exceptions to the categories of subpart F income discussed above, there is a “de minimus” rule which excludes small amounts of subpart F income from being taxed to the CFC’s U.S. Shareholders.  For example, if the amount of the foreign-base company income plus any gross insurance income is less than $1,000,000 or less than 5% of gross income, then no part of the gross income will be treated as foreign-base company income or insurance income.  Additionally, if the passive income of a CFC is less than 5% of gross sales, the U.S. shareholders will not be taxed on such investment income.  Please refer to I.R.C. Section 954(b) for further details on subpart F income exceptions.

As you can see, subpart F income is a very difficult issue to tackle.  It is important to consult appropriate professional guidance if you think your CFC may have subpart F income!

For purposes of claiming the foreign earned income exclusion, one must have income earned in a foreign territory. Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, lists earned income as salaries and wages, commissions and bonuses, tips and professional fees. It also includes related payments such as vacation, sick leave, severance, certain reimbursements and allowances. The list of unearned income include annuities, alimony, capital gains, dividends, interest, unemployment and social security benefits, and gambling winnings. But what if your means of livelihood is gambling? Will your winnings still be considered unearned?

It is hard to define what it means to be a professional gambler. Every situation is different and the U.S. Tax courts do not have a “one case fits all” template to follow as guidelines for determining whether one is a professional gambler or not.  In the IRS Letter Ruling 8235006, May 21, 1982, a taxpayer was engaged in full-time gambling activities such as playing cards and wagering in various sports games. The taxpayer had a daily routine he followed like studying the games, playing cards, and making bets. Yet according to the ruling, the taxpayer was not considered a professional gambler because his gambling activities were not considered a trade or business within the definition of Code Section 162(a). According to this code section, a deduction of all ordinary and necessary expenses paid or incurred is only allowed for carrying on a trade or business.

In another case, Pansy v. Panages, a taxpayer gambled regularly but only after she was done with her regular work. The tax court ruled that the taxpayer’s gambling activities were not a trade or business as gambling was not her primary means of livelihood. The taxpayer maintained a flower shop business in addition to another wholesale business that occupied most of her time. The courts argued that “for gambling to reach the level of a trade or business activity it must be ‘pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and ***not a mere hobby’”. Commissioner v. Groetzinger , 480 U.S. 23, 35 (1987). As a result, the taxpayer could not deduct her gambling losses on Schedule C, although she may have been able to itemize them on Schedule A.

Just from the above case and ruling we have an idea of how difficult it is to determine what constitutes a professional gambler. In general, you are a professional gambler if you are regularly engaged in full-time gambling with the primary purpose of making a living. Weekend gambling trips to Las Vegas does not make one a professional gambler.

As a professional gambler, one will have earned income reportable on Schedule C. Consequently, as someone engaged in a trade or business of gambling, losses and business expenses are deductible up to the amount of his winnings. Examples of expenses related to gambling include travel, meals and entertainment, interest, telephone and internet, vehicles expenses, and other fees and expenses.

Professional gamblers living outside of the United States will be able to claim the foreign earned income exclusion if they meet the physical presence test or the bona fide residence test. However, they will be subject to self-employment taxes unless the foreign country in which they reside has a totalization agreement with the United Sates.

Much to the taxpayer’s dismay, even if a foreign corporation does not have a permanent establishment in the United States and does not have any U.S. sourced income, the U.S. has taxing authority over certain foreign corporations with involvement by U.S. persons.  If the foreign corporation has U.S. officers, directors, or shareholders who meet certain filing requirements, the U.S. officers, directors or shareholders are subject to U.S. income tax and must file Form 5471.  Form 5471 is an information return for U.S. Persons with respect to certain foreign corporation, and includes mechanisms through which the US Government can tax foreign profits even before they are distributed as dividends.

5471 has five categories of filers which are based upon stock ownership and control of the corporation.  Unfortunately, to complicate things even further for the taxpayer, ownership is not limited to direct ownership and can instead be based above constructive ownership (i.e. attribution of ownership of other entities that are controlled by the taxpayer or certain family members). Interestingly enough, there is no constructive ownership in the case of a non-resident alien spouse.  This may require someone who is an indirect owner to file Form 5471 as well.   The categories of persons potentially liable for filing Form 5471 is very broad and includes U.S. citizens, U.S. resident aliens, U.S. domestic corporations, U.S. domestic partnerships, and U.S. domestic trusts.  However, the definition of a “U.S. person” changes with each category of filer.  The schedules required to be filed also vary with each category of filer, so it is very important to carefully read the IRS General Instructions for Form 5471 for specific descriptions of each category of filer as well as the filing requirements.  We have copied the categories of filers below for your convenience:

Category 1 Filer

This filing requirement has been repealed by section 413(c)(26) of the American Jobs Creation Act of 2004, which repealed section 6035.

Category 2 Filer

This includes a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person (defined below) has acquired (in one or more transactions):

1. Stock which meets the 10% stock ownership requirement (described below) with respect to the foreign corporation or

2. An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.

A U.S. person has acquired stock in a foreign corporation when that person has an unqualified right to receive the stock, even though the stock is not actually issued. Stock ownership requirement – For purposes of Category 2 and Category 3, the stock ownership threshold is met if a U.S. person owns:

1. 10% or more of the total value of the foreign corporation’s stock or

2. 10% or more of the total combined voting power of all classes of stock with voting rights.

U.S. person – For purposes of Category 2 and Category 3, a U.S. person is:

1. A citizen or resident of the United States,

2. A domestic partnership,

3. A domestic corporation, and

4. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

Category 3 Filer

This category includes:

• A U.S. person (defined above) who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement (described above) with respect to the foreign corporation;
• A U.S. person who acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation;
• A person who is treated as a U.S. shareholder under section 953(c) with respect to the foreign corporation;
• A person who becomes a U.S. person while meeting the 10% stock ownership requirement with respect to the foreign corporation; or
• A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.

Category 4 Filer

This includes a U.S. person who had control (defined below) of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation.

U.S. person – For purposes of Category 4, a U.S. person is:

1. A citizen or resident of the United States;

2. A nonresident alien for whom an election is in effect under section 6013(g) to be treated as a resident of the United States;

3. An individual for whom an election is in effect under section 6013(h), relating to nonresident aliens who become residents of the United States during the tax year and are married at the close of the tax year to a citizen or resident of the United States;

4. A domestic partnership;

5. A domestic corporation; and

6. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

Control – A U.S. person has control of a foreign corporation if, at any time during that person’s tax year, it owns stock possessing:

1. More than 50% of the total combined voting power of all classes of stock of the foreign corporation entitled to vote or

2. More than 50% of the total value of shares of all classes of stock of the foreign corporation.

A person in control of a corporation that, in turn, owns more than 50% of the combined voting power, or the value, of all classes of stock of another corporation is also treated as being in control of such other corporation

Category 5 Filer

This includes a U.S. shareholder who owns stock in a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of that year.

U.S. shareholder – For purposes of Category 5, a U.S. shareholder is a U.S. person who:

1. Owns (directly, indirectly, or constructively, within the meaning of sections 958(a) and (b)) 10% or more of the total combined voting power of all classes of voting stock of a CFC or

2. Owns (either directly or indirectly, within the meaning of section 958(a)) any stock of a CFC (as defined in sections 953(c)(1)(B) and 957(b)) that is also a captive insurance company.

U.S. person – For purposes of Category 5, a U.S. person is:

1. A citizen or resident of the United States,

2. A domestic partnership,

3. A domestic corporation, and

4. An estate or trust that is not a foreign estate or trust defined in section 7701(a)(31).

The forms required to be filed by each category of filer are illustrated on the matrix below:

Among other items, Form 5471 requires the filer to report certain details related to the corporation including ownership information, stock transactions, foreign taxes, currency conversions, earnings, and foreign bank and financial accounts.  Unlike domestic corporations that report their taxes using Form 1065, 1120 or 1120s, Form 5471 is more extensive and requires foreign corporations to report and evaluate other important issues such as subpart F income, transfer pricing, and foreign tax credits.  Subpart F income will be addressed in detail in a future post.

When determining if Form 5471 is required to be filed, it is very also important to remember that a foreign limited liability company (LLC) will be treated as a foreign corporation if an election has not been made to classify the entity as a foreign disregarded entity or a foreign partnership (which in itself would have to file a form similar to 5471, form 8865).  Additionally, according to the IRS, a “foreign corporation” also includes an “International Business Company” (IBC) in which a U.S. person has partial ownership.

It is very important to be aware of the Form 5471 filing requirements and make sure you properly assess whether each particular entity needs to file the form.  The stakes are very high as failure to timely file Form 5471 can result in penalties imposed by the IRS of up to $10,000.  This penalty can increase if the form is not filed after a failure to file notification has been issued by the IRS.  Additionally, an incomplete 5471 is deemed unfiled and the same penalties apply.  Just one small mistake can cost you $10,000!  Hire a professional to avoid this costly mistake.

The deadline for most corporations is March 15^th and April 15^th for individuals if an extension has not been granted.  As with most tax forms, the common law “mailbox rule” applies.  That is, as long as the form is postmarked and “in the mailbox” by the deadline, the form is counted as received by the IRS despite the actual receipt date.

Please stay tuned for several more articles highlighting certain aspects and nuances of Form 5471!  These will include topics related to the pros and cons of having an offshore corporation, Subpart F income, what can/cannot be deferred, penalties, and ways to mitigate penalties.

Ever since I stepped foot on this country, I have started to embrace Australian culture.  While the culture shock here is minimal compared to other countries, it’s certainly important – as a foreigner – to respect the country you are in.  Whether it means learning the language (or in my case, jargon and slang), participating in the country’s festivals and celebrations, or honouring a country’s holiday, it’s important to open yourself up to new experiences in a foreign country.

As an American expat, I get very excited when an Australian holiday rolls around because it’s a chance to witness a foreign holiday celebration and a chance to appreciate the country’s culture and history.

I celebrated the Queen’s Birthday in June at a pub with some friends.  Father’s Day in Australia is celebrated in September (as opposed to June in the States), so it was interesting to see cafes and restaurants packed in celebration.

Every year, January 26th marks Australia Day – a day that commemorates the arrival of the First Fleet at Sydney Cove.  Australians celebrate this day with parades, beachside BBQ’s, an awards ceremony, and an amazing fireworks display to cap the night.

I’m looking forward to celebrating Australia Day with the Aussies to honour this great country, celebrate my own life in Australia, and compare celebrations between Australia and the U.S.

My time here over the last eight months has been incredible.  I have discovered a new sense of freedom and happiness in Australia than I ever thought I could find living in the U.S.  I will always be a proud U.S. citizen, I will always celebrate Independence Day regardless of where I am in the world, and I will always scowl at the Aussies who call me a “yank” or a “seppo,” but on January 26 this year, I will don my Australian t-shirt and honour Australia with the other Aussies by celebrating these last eight months (and the next seven) on Bondi Beach, throwing a BBQ with my flatmates and some Aussie friends, and enjoying life in Australia.