Expats with local or cross-border business interests commonly establish foreign business entities (e.g., corporations, sole proprietorships). Unfortunately, many US expats are caught off-guard when they learn about the filing requirements associated with ownership stakes in foreign business entities. The IRS demands to know how US expats who own businesses abroad are deriving their income. The premise is the same as with financial account reporting (FBAR, FATCA-related Form 8938).

Foreign Business Entities

Below, we discuss the two popular types of foreign business entities utilized by US expats.

Foreign Corporations

American expats who own 10% or greater stake in a foreign corporation (or who is an officer or director of a foreign corporation in which a US person owns at least a 10% stake) must file Form 5471 along with their individual income tax return. One of the schedules within Form 5471 requires the filer to identify all other US shareholders of the foreign corporation. This allows the IRS to be able to cross-check names, and identify people that are not compliant.

Important to note: The IRS will likely treat any foreign entity that confers limited liability as a foreign corporation. It does not matter what nomenclature the entity is referred to in the local country.

The penalties for non-compliance are severe. The IRS can assess a $10,000 penalty for each year that the information is not provided. If the IRS has sent you a notice regarding non-compliance, and you do not respond quickly, additional penalties can reach up to $50,000.

Foreign Disregarded Entities

A foreign disregarded entity is an entity created outside the US and is “disregarded as an entity separate from its owner for US income tax purposes.” In the US, single-member LLCs and sole proprietorships are disregarded (not regarded) as an entity separate from its owner for income tax purposes. When similar foreign entities are owned by a US person, the IRS requires Form 8858 to be filed. A US person includes: US citizens, resident aliens, US corporations, partnerships trusts and estates.

The main thrust behind this filing requirement is to prevent US persons with ownership in foreign corporations or partnerships from utilizing additional entities (FDEs) to mask income. To illustrate, John Smith owns 60% of a foreign corporation. The US majority ownership stake puts the corporation into a category known as CFC (controlled foreign corporation). The CFC owns an FDE that generates $1M of income; however, the FDE does not pay dividends to CFC. Without the disclosure, John Smith could falsely report zero income.

The penalties for non-compliance are similar to as described above (Form 5471). In addition, failure to disclose an FDE could also reduce any available foreign tax credit.

Important to note: Expat entrepreneurs who have established some form of a “foreign sole proprietorships” are subject to the FDE disclosure requirement. Many of these businesses are small-in-scale. Nevertheless, their owners are subject to the same requirements.

For general information on US expat taxation, please read: US Taxes for Americans Living Abroad – Ultimate Guide.