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How The IRS Taxes Income From Offshore Companies Paid To U.S. Citizens


Subpart F

If you are involved in a Controlled Foreign Corporation (CFC), then Subpart F is problematic and it is precautious to consult with an international tax lawyer to analyze your situation and to decide whether it remains worth your while to be involved in a CFC.

The reason you should start off by getting professional advice is because Subpart F is very complicated and needs to be analyzed in great detail to prevent unintended consequences.  In this article we endeavor only to provide you with a brief synopsis of the issues you have to take note of and discuss with your tax professional. 

From the outset it is important to take note: Subpart F income DOES include passive income.  Any foreign investment you might have that is making a passive income for you in the current financial year, will in all probability be deemed to be Subpart F income.

So What Is A Controlled Foreign Corporations?

Not all foreign investments nor all foreign corporations are automatically defined as “controlled foreign corporations.”  A Controlled Foreign Corporation is defined by law as a corporation with more than 50% U.S. ownership in which individual U.S. persons each own at least 10% of the corporation.

The 10% rule falls under the rules of attribution. This means that family members fall under closer scrutiny and in some situations, the individual shares of family members can be attributed to one member of the family for Subpart F.

 

For example, a family owned corporation with say twelve members who all own a proportionate share, around 8% each, structurally avoid the 10% rule.  No one owns the statutory 10% for the rule to come into play? 

You would be wrong to make this assumption: this is exactly where attribution will come into play and derail your plans.  Meticulous care should be taken – allow a professional to assess the situation

Can These CFC Rules Be Circumvented?

It is possible to set up a business to navigate around these CFC rules, but this might be a bit more difficult than it sounds, i.e. it will be risky.  It can be done if you register a foreign corporation with assets under $10,000,000 in locations like the British Virgin Islands, Hong Kong or the like.  However, it is imperative that you are the majority shareholder of the business. 

Obviously it will not be precautious at all to start up a foreign corporation and to invest substantial money in doing so with the objective to allow some third party with no real stake in the outcome to control it.  It is common cause that corporation such as these remain in U.S. ownership up to a scale of between 75 and 90% and to allow foreign ownership for the balance as might be prescribed by local law.

Subpart F Income

  • As mentioned, includes passive income
  • Does not even have to be distributed to you. Your undistributed earnings become liable for Subpart F if the CFC has subpart F earnings & profit.
    • According to legislation [I.R.C. 954(a)] Subpart F income includes foreign personal holding company income which includes incomes such as :
      • Dividends
      • Interest
      • Rent
      • Royalties
  • Earnings and profit determination can be a very complex procedure. It is in any event too dangerously complex for a layman to determine.  It is precautious to leave the evaluation and determination of E & P in the hands of qualified tax professionals rather than dawdling with it yourself.
  • Subpart F eliminates deferral of some categories of foreign income tax by taxing some persons on a pro rata basis on their share of earnings in CFCs.
  • As a general rule the United States will not tax foreign corporations that receive no U.S. sourced income nor engages in any U.S. based activities.
    • BUT: the U.S. will always tax all income of U.S. persons irrespective where it was earned. Hence, Subpart F treats U.S. Shareholders of CFCs as if they actually received their proportionate share  of the CFC E&P. The U.S. taxpayer has to report this income irrespective whether the CFC distributes or not. [I.R.C.  951(a)].
    • To be clear: Subpart F does not tax the foreign entity (CFC).
  • Subpart F rules apply to U.S. persons who owns 10% or more of the voting stock of a foreign corporation that is controlled by U.S. persons.
  • The intricacies of Subpart F are daunting. It is filled with technical rules, definitions and exclusions, exceptions and limitations which makes it very hard to navigate without professional assistance.

The IRS Position

The IRS taxes everyone on worldwide income.  With a CFC several factors are considered.  That said, the IRS cannot tax a foreign corporation with no U.S> earnings nor can it tax income a taxpayer is not actually receiving. 

To make it possible to tax CFCs in majority control of U.S. persons who own more than 10% of the same, the Subpart F rule comes into play.  Within this rule, the current year E&P of a CFC is attributed to the income of the U.S. person, and the special rule allows the IRS tot tax this non-distributed Subpart F income.

Of course, as in all cases, there are exceptions and exclusions that you should be aware of and take advantage of if it applies to you at all before filing anything with the IRS. 

Evenso, if you have unreported Subpart F income it is most likely the case that you also filed to disclose foreign investments, bank accounts and more.  It is imperative to get professional assistance in order to become voluntarily compliant in these matters. 

Offshore Company

Offshore Companies

 

Voluntary Disclosure

Simply put, this means that you have to file a U.S. tax return timely in order to remain compliant.  If the IRS finds out that you have not complied yet [are out of compliance] you will suffer perilous consequences that might include severe penalties, seizures and even criminal investigations in some instances.  To prevent this, voluntary disclosure is advisable.

Offshore disclosure is a niche field.  To be clear, any money that is outside the United States is considered offshore.  Despite the fact that offshore money is by no means to be considered with suspicion, the IRS does not care. To the IRS, if it is offshore, it has to be reported in detail if you want to avoid detriment.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

 

Our team is trained to provide you with the necessary information for the formation of your project.

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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA is a Certified Public Accountant, specialized In Tax Planning, International Business, Wealth Management and Offshore Banking. You can email him to fa@fascpaconsultants.com or follow us on Facebook : FAS CPA & Consultants.

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