Planning for Foreign Corporations

US citizens or residents who own shares in a private foreign corporation may have additional tax reporting obligations.  They may also incur adverse tax consequences.  Shareholders of US domestic corporations, publicly traded or private, are generally taxed on dividend distributions made to them by the corporations.  They are not required to recognize the net operating income of the corporation on their US income tax returns in the absence of a dividend payment.  In contrast, US citizens have to be aware of a special set of tax rules that govern ownership of stock in some private foreign corporations.  These rules create an obligation to annually report the operations of the foreign corporation, recognize income from the foreign corporation even if no dividend distribution is made, and be subject to adverse tax rates and interest charges on distributions when made by the foreign corporation.

A foreign corporation which has US citizen shareholders who collectively own more than 50 percent of the stock of the company are classified for US tax purposes as “controlled foreign corporations” (“CFC’s”) as long as US citizen shareholders each own at least 10% of the shares.  Thus, 10 US citizen shareholders each of whom owns 8% of the stock of a foreign corporation, would not result in the foreign corporation being classified as a CFC.  If 4 US citizen shareholders each owned 15% of the stock of the foreign corporation, it would be a CFC.

The consequence of being a CFC is that certain income of the corporation is taxed directly to the US citizen shareholders even if the corporation does not distribute any dividends.  This is a particularly troublesome area for dual citizens who operate businesses in other countries.  If you are a US citizen, you need to be aware of the CFC rules.  As importantly you need to be sure that you file the correct tax forms, report income as required, and that maintain proper accounting for the corporation’s income, so that you are not taxed a second time on a later distribution on income already taxed to you.  You also need to be aware of the deferred tax rules that apply which may allow you to defer US tax on the CFC’s earning and profits until they are repatriated.

A foreign corporation with at least 75 percent of its income consisting of income from passive activities or at least 50 percent of its assets generating passive income is classified for US tax purposes as a passive foreign investment company (“PFIC”).  A US citizen shareholder of a PFIC is subject to a deferred tax on certain distributions from the PFIC at adverse tax rates.  In addition to the deferred tax, interest is added to the deferred tax using the federal underpayment rate.  It is beneficial for US shareholders of a foreign corporation to avoid having their stock classified as PFIC stock.  Depending on the circumstances, this may be done by making certain elections or through proper planning prior to the stock in the foreign corporation becoming PFIC stock.

Failure to comply with your US tax filing obligations relating to a foreign corporation can result in significant penalties (civil and criminal).  You will benefit from straightforward guidance on the legal, tax, and accounting implications of your ownership interest in a foreign corporation.