2017 Tax Return Trap—More Reporting for Nonresident Taxpayers with Limited Liability Companies (LLC)

With recent tax reform dominating the news, many nonresident alien taxpayers may be unaware that other, older legislation has resulted in additional reporting requirements on their 2017 tax returns (and that failure to meet these requirements may result in steep penalties, of course).

As part of the Protecting Americans from Tax Hikes (P.A.T.H.) Act of 2015,[1] new IRS regulations were issued and finalized under TD 9796[2] resulting in additional tax filing requirements for nonresident alien owners of U.S. disregard entities.

In layman’s terms, this issue affects non-U.S. individuals who conduct business through a U.S. limited liability company (LLC) that is a disregarded entity for U.S. tax purposes.  Typically, the income from these businesses is reflected on Schedule C or Schedule E of the Form 1040NR filing.

Let’s look at some examples to understand how this works.

Example 1:

Taxpayer X is a G-4 dependent visa holder who is not employed.  Her spouse, Taxpayer Y, is a G-4 visa holder working for an international organization in Washington, DC.  Taxpayers X and Y live in the State of Virginia.  Because Taxpayer Y is a full-time employee of an international organization, his days in the United States do not count toward the substantial presence test.  For U.S. tax purposes, both spouses are considered nonresident aliens.

Taxpayer X creates an LLC in Virginia on July 1, 2017.  On the Application (Form SS-4[3]) for Employer Identification Number (EIN), Taxpayer X checks the type of entity as a “sole proprietor.”  The LLC is a service business and at the end of 2017 has gross income.  The LLC is treated as a disregarded entity and reported on Schedule C.

For 2017, Taxpayer X must file a Form 1040NR and Schedule C to report the gross income of the LLC.  Because Taxpayer X is using the LLC to conduct business, Taxpayer X must file a Form 5472[4] to report the transactions between the LLC and Taxpayer X on Page 2, Part IV.  Taxpayer X must also provide an attachment describing the monetary transactions (articles of organization fee, registration fee, capital contributions, etc.) Taxpayer X conducted to form the LLC.

Example 2:

Let’s assume the same facts as Example 1, but now assume Taxpayer Y provides services to Taxpayer X’s business and is paid compensation for those services.  As Taxpayer Y is the spouse of Taxpayer X, there is attribution between the two taxpayers.  Now, both Taxpayer X and Taxpayer Y must file a Form 5472.  Taxpayer Y, in particular, will report the compensation for services received on Form 5472, Page 2, Part IV, line 20.

Example 3:

Taxpayer Z is a nonresident alien with no U.S. ties living and residing in France.  Taxpayer Z desires to purchase vacation property in Miami, Florida.  To alleviate potential U.S. Estate Tax[5] issues related to nonresidents, Taxpayer Z is advised not to hold the property directly.  Taxpayer Z forms a Foreign Corporation (FCo) in the British Virgin Islands and is the 100% sole owner.  FCo then opens an LLC in the State of Florida as the sole owner.  The LLC is treated as a disregarded entity when it registers for its EIN.  The LLC then purchases the vacation property in 2017.  FCo and the NRA sole owner must disclose the amounts paid in connection with the formation of the LLC on Form 5472, page 2, Part V.  Both FCo and the NRA must file separate 5472 forms.  In the future, if the vacation home were to be turned into a rental property, then annual filing requirements would be needed under Form 5472 to list the rents paid to FCo.  This would be documented on page 2, Part IV, line 18a.

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Let’s discuss the logistics of actually filing Form 5472.  This is not as easy as it sounds.  The IRS has developed a special method for filing this form.  Here is a breakdown of the process:

1. Prepare Form 1120,[6] Page 1
   1. Complete the informational section by inputting the name of the LLC and address
   2. Complete Section B on page 1 – Employer Identification Number
   3. Complete Section E on page 1 – Return Status
   4. Notate as a “Foreign Owned US DE”
   5. Sign and date the Form 1120 at the bottom of Page 1.
      • NOTE: You are signing under penalty of perjury just like a normal U.S. Form 1040.
2. Prepare Form 5472
   1. Pay careful attention to all the moving parts of the form as there several tax traps throughout that can trigger an audit.
3. You cannot e-file this form. It can either be mailed to a special IRS address or faxed to a special IRS fax number.[7]

 

When To File: The instructions indicate that the form must be filed by the “corporation’s” income tax return due date (including extensions) of the return.  The Form 1120 due date is April 17, 2018.  The IRS has not yet indicated if an extension under Form 7004 will be allowed for individuals who have disregarded entities.

Takeaway: Failure to timely this form will trigger an automatic penalty of $10,000.  If the form is filed timely but is materially incomplete or inaccurate, that may also generate a penalty of $10,000.  As the 2017 tax year is the first year that this requirement has been put in place, there will be many individuals who will not understand or expect this filing.

If you think you may have a Form 5472 filing requirement, we strongly urge you take a very proactive approach to completing the form timely and utilizing a tax professional well versed in this area to assist with the preparation and execution of the forms.