What Is A CFC and How Is It Taxed And Reported In The US?
The lure of entrepreneurship is something that many find hard to resist (whether they succeed at it, is another story). Once the entrepreneurship bug bites you, it is hard to let go, and for good reason – the mere thought of building a world-class company and enjoying the fruits of your labor is reason enough to make one consider throwing their hat into the ring. However, imagine being overseas and jumping into the entrepreneurship game as an expat. Now that could be something splendid, from a business perspective. From a tax perspective as a U.S. tax resident, not so much, unfortunately.
If you are reading this now, you might remember the article we shared recently on Form 5471 and its many pitfalls and perils. If so, then you no doubt have some interest in entrepreneurship as an expat. Perhaps you have even decided to brave the waters of international business and open a company overseas. If so, then this article is definitely for you.
Having a minority share (say, a 15 percent ownership) in a foreign company and being subject to a Form 5471 filing requirement is one thing, but if you cross the threshold and your company is considered a controlled foreign corporation, or CFC, it is a whole different ballgame, and not one you would likely find fun or exciting from a compliance standpoint.
So, what is a CFC? Simply put, if an American citizen, green card holder, or U.S. person (by virtue of meeting the substantial presence test), has an ownership in a foreign corporation in excess of 50 percent, then that foreign company is considered a CFC. But even if that person owns less than 50 percent of the foreign corporation, if the foreign company itself is owned more than 50 percent by U.S. owners, the company is considered a CFC.
This is the case whether one owns a company in Japan, the British Virgin Islands, or Djibouti, for that matter. And yes, ownership in an Australian Pty Ltd in excess of 50 percent will trigger this CFC requirement.
But what happens if you own a CFC? Well, not only will you be required to file Form 5471 and its numerous schedules, which, as we discussed in a previous article, is the most complex tax form on the planet, but also, you will be subject to Subpart F and GILTI rules.
Subpart F income consists of passive income (such as dividends, interests, and rents) generated by the CFC, which, even if it is not distributed to the U.S. shareholder, is required to be included in the current year income of the shareholder. On the other hand, the GILTI calculation involves taking all the gross income of the CFC, and then excluding certain items, such as Subpart F income, income connected with a U.S. trade or business, and various other items. It is important to note once again that you may be subject to taxation on this income even if it is not distributed to you, meaning, you may have to pay tax on money you never actually received.
As you can see, this sort of complexity can become criminally insane for your average expat who is just looking to make an honest living overseas. Therefore, what you need in this scenario is the guidance and expertise of advisors who are well-versed in this area and have a passion for helping their clients mitigate the terrors of the CFC world.
To recap what we mentioned in the article on Form 5471, if you, as a U.S. person, own a CFC, then you would be subject to the following Form 5471 filing categories:
- Category 1: A U.S. shareholder who owns 10% or more of a specified foreign corporation
- Category 4: A U.S. person who owns more than 50% of a foreign corporation. In this case, the foreign corporation would be considered a CFC
- Category 5: A U.S. shareholder who owns stock in a foreign corporation that is a CFC at any time during the year
As mentioned in the article on Form 5471, to make things even more complex, as of tax year 2020, Categories 1 and 5 each have subsets, such as Category 1a, 1b, and 1c, and Category 5a, 5b, and 5c.
All this talk about complexity and compliance deserves a discussion about penalties. As we mentioned previously, the penalties for not filing a timely Form 5471, or incorrectly filing the form, are $10,000 for each accounting period for each foreign corporation, not to mention the penalties and interest that can accrue because of not paying any tax associated with the foreign corporation. Therefore, we would not recommend going it alone, even if you have an accounting or tax background.
Of course, this is probably the most complicated topic in the world of taxation, and one could hardly do it justice within a brief article. However, we hope that by sharing with you the promises and perils of operating a CFC, that you will take the correct steps before jumping into the entrepreneurship ring overseas.
If you have ownership in a foreign corporation, and especially if you have ownership in a CFC, please get in touch with us today to discuss your filing requirements for Form 5471. If you are considering starting a foreign company, it is crucial to get the planning and strategy correct. Reach out to us today to get started on the right track as an expat entrepreneur.