Overview
Introduction
On May 5, the US Department of the Treasury (Treasury) announced proposed regulations to increase the reporting and record maintenance requirements of US disregarded entities owned by foreign persons. If these proposed regulations are finalized, such disregarded entities would also be required to obtain an employer identification number (EIN) by filing an IRS Form SS-4 and disclosing significant information to the IRS about their ownership.
This is not the first time that the Obama Administration has proposed to require certain US disregarded entities to obtain an EIN. The Administration’s Fiscal Year 2016 and 2017 Revenue Proposals (Greenbook) contained legislative proposals that would require all entities formed in the United States to apply for an EIN. The budget proposal would also impose penalties for failure to obtain an EIN or to update responsible party and other information contained in the application, and would allow the IRS to share responsible party information with law enforcement without a court order to combat financial crimes.
Concurrent with the release of the proposed regulations, Treasury announced final Financial Crimes Enforcement Network (FinCEN) regulations increasing customer due diligence requirements for financial institutions and proposed legislation that would require a company to know and report beneficial ownership information to Treasury at the time of the company’s creation. Together with proposed regulations, these items are part of a multi-pronged effort to increase financial transparency and disclosure of beneficial ownership. In a letter to House Speaker Paul Ryan, also on May 5, Treasury Secretary Jacob J. Lew stated that these items are intended to address gaps in existing law “that allow bad actors to deliberately use U.S. companies to hide money laundering, tax evasion, and other illicit financial acts.” Secretary Lew also requested that Congress take further action by approving pending tax treaties and providing full reciprocity to its Foreign Account Tax Compliance Act (FATCA) partners.
Background
Current regulations under section 7701 classify a business entity with two or more members as either a corporation or a partnership, and a business entity with a single owner as either a corporation or an entity disregarded as separate from its owner (disregarded entity). This classification affects the way the entity is treated throughout the tax code, including for certain reporting requirements. While the proposed regulations would not change how an entity’s classification is determined, they would subject foreign-owned US disregarded entities to information reporting and disclosure rules under section 6038A currently applicable only to UUS corporations meeting a certain foreign ownership threshold.
When an entity, such as a limited liability company (LLC), is classified as a corporation for tax purposes, general ownership and accounting information is available to the IRS through the return filing and EIN application requirements. For example, all corporations organized in the US must file annual income tax returns, which may include schedules requiring the identification of owners exceeding specified ownership thresholds. In addition, section 6038A subjects US corporations that are at least 25% foreign-owned to specific information and record maintenance requirements. Such corporations are required to file an annual return on IRS Form 5472, Information Return of a 25% Foreign-Owned US Corporation or a Foreign Corporation Engaged in a US Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code), with respect to each related party with which the reporting corporation has had any “reportable transactions.” See Treas. Reg. § 1.6038A-2. In addition, such corporations must keep permanent books of account or records as required by section 6001 that are sufficient to establish the accuracy of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct US tax treatment of transactions with related parties. See Treas. Reg. § 1.6038A-3.
Generally no US income or information return must be filed for a disregarded entity that is formed in the United States and wholly owned by a foreign person if neither the disregarded entity nor its owner received any US source income or was engaged in a US trade or business during the taxable year. Moreover, if a disregarded entity only receives certain types of US source income, such as portfolio interest or US source income that is fully withheld upon at source, its owner may not have a US return filing requirement. Because a US single-member LLC is classified as a disregarded entity by default rather than by election and has no separate federal tax return filing requirements, there is typically no federal income tax requirement for it to obtain an EIN (although there may be non-income tax reasons to do so).
Proposed Regulations
In the preamble to the proposed regulations, the IRS indicated that “the absence of specific return filing and associated recordkeeping requirements for foreign-owned, single-member domestic entities hinders law enforcement efforts and compliance with international standards of transparency and cooperation in the area of tax information exchange,” making it “difficult for the United States to carry out the obligations it has undertaken in its tax treaties, tax information exchange agreements, and similar international agreements to provide other jurisdictions with relevant information on U.S. entities with owners that are tax resident in the partner jurisdiction or otherwise have a tax nexus with respect to the partner jurisdiction.” Moreover, the IRS states that “the lack of ready access to information on ownership of, and transactions involving, these entities also makes it difficult for the IRS to ascertain whether the entity or its owner is liable for any federal tax.”
The proposed regulations would treat a US disregarded entity wholly owned by a foreign person as a US corporation separate from its owner for the limited purposes of the reporting, record maintenance, and associated compliance requirements that apply to 25% foreign-owned domestic corporations under section 6038A. The proposed regulations would also add an additional catch-all category of “reportable transactions” for section 6038A purposes, which would include any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property or money, whether or not formally documented, as well as the performance of any services for the benefit of, or on behalf of, a related foreign person.
As a result, under the proposed regulations, foreign-owned US disregarded entities would be required to file an IRS Form 5472 information return and maintain records with respect to all transactions with foreign related parties. A transaction between a US disregarded entity and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the section 6038A reporting and record maintenance requirements, even though, because it involves a disregarded entity, it generally would not be considered a transaction for other income tax purposes. The proposed regulations would also provide that the exceptions to the record maintenance requirements in Treas. Reg. § 1.6038A-1(h) and (i) for small corporations and de minimis transactions will not apply to such entities.
Because foreign-owned US disregarded entities would have a filing obligation under the proposed rules, they would be required to obtain an EIN by filing an IRS Form SS-4 and disclosing significant information to the IRS about their ownership. On the Form SS-4, the entity would be required to identify the entity’s “responsible party,” generally the individual who has a level of control over, or entitlement to, the funds or assets in the entity that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the entity and the disposition of its funds and assets. The form also requires the responsible party to provide his or her social security number (SSN), individual taxpayer identification number (ITIN), or EIN. If the responsible party does not have an SSN/ITIN/EIN, he or she would first be required to complete a separate application to obtain one for him or herself before applying for the EIN for the entity. An entity applying for an EIN is required to update the IRS when there is a change in the responsible party, but there is no penalty for the failure to do so. However, the annual requirement to file the Form 5472 imposed by the proposed regulations will effectively require disregarded entities to provide current ownership information to the IRS.
The preamble notes that the IRS is also considering modifications to corporate, partnership, and other tax or information returns (or their instructions) to require the filer of these returns to identify all the foreign and US disregarded entities it owns.
Final FinCEN Regulations and Proposed Legislation
In a press release announcing the proposed IRS reporting regulations, Treasury also announced final FinCEN regulations increasing customer due diligence requirements for financial institutions and proposed legislation that would require companies to know and report beneficial ownership information to Treasury at the time of the companies’ creation. The proposed legislation also contains technical amendments to the current Geographic Targeting Order (GTO) authority which would clarify FinCEN’s ability to collect information under GTOs, such as bank wire transfer information.1 The most recent GTOs temporarily require certain US title insurance companies to record and report the beneficial ownership information of legal entities making “all-cash” purchases of high-value residential real estate in the Borough of Manhattan in New York City, New York, and Miami-Dade County, Florida. It is possible that Treasury will expand the GTOs to other areas that attract significant foreign investment in US real estate, such as other parts of New York City and Los Angeles.
Recommended Steps
The proposed IRS reporting regulations, final FinCEN regulations, and proposed legislation are part of a trend towards increased disclosure of cross-border entities and transactions. Given Secretary Lew’s comments and global trends toward increasing financial transparency and disclosure of beneficial ownership, additional US action in this area is likely. Foreign owners of US disregarded entities should consider what actions they would need to take to enable them to comply with the new level of reporting, disclosure and record-keeping burdens that would result if the proposed regulations are finalized in their current form. Comments on these proposed regulations are due August 8, 2016.
1 A GTO is an order issued by the Treasury Secretary requiring US financial institutions that exist within a certain geographic area to report on certain transactions any greater than a specified value. See 31 U.S.C. § 5326.
