On October 22, 2008, the IRS announced on its Web site that it would begin to automatically assess penalties on certain officers, directors and shareholders who fail to timely file required information returns regarding their interests in foreign corporations starting January 1, 2009.1 Under Section 6038 of the Internal Revenue Code,2 every U.S. person must furnish information with respect to any foreign corporation that the person controls.3 Additionally, under Section 6046, every U.S. citizen or resident must file an information return if he becomes a 10 percent shareholder in a foreign corporation, or if he becomes an officer or director of a foreign corporation in which a U.S. person is a 10 percent shareholder.4 The form the IRS has prescribed for such returns is Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations.5
Late Reporting Penalties are Significant
This automatic penalty program was born out of an audit conducted by the Treasury Inspector General for Tax Administration (TIGTA) that was finished and released in May 2006.6 The audit focused on the Service’s assessment and enforcement of the penalties for late filing of informational returns, including Form 5471.
The monetary penalty for late filing a Form 5471 is substantial. Every incidence of late filing can bear a $10,000 fine, unless the taxpayer can show reasonable cause for the late filing.7 One item of particular focus in the TIGTA audit was that 76 percent of the late filers reviewed in their small sample of 50 taxpayers could offer no reasonable cause for their lack of timely filing. Under the new automatic penalty system, it appears that all untimely filers would be immediately assessed. While the new assessment procedure cannot override the Code’s provision staying the penalty for reasonable cause, it does appear that taxpayers will now be forced to make their case for reasonable cause post-assessment, and thus potentially be required to go through the full IRS administrative appeal process.
In its audit report, TIGTA took the position that the Form 5471 and its attendant penalties play “an important role in promoting compliance in the international tax arena,” as evidenced by the severity of the penalties for untimely filing. Yet the audit came to the conclusion that by using a manual penalty assessment system the IRS was “missing opportunities to promote better compliance.” As evidence, TIGTA identified nearly $80 million in potential late filing penalties that could have been asserted in 2002, but were not. Based on the information collected in its audit, TIGTA recommended that the IRS convene a study group to explore developing an automated penalty system, which has apparently resulted in the system being rolled out at the start of the year.
Who Is Required to File These Reports?
In general, a Form 5471 is an information statement provided to the IRS as an attachment to income tax returns of businesses and individuals. The form reports the results of foreign operations and amounts gained or lost due to transactions with foreign parties that are related to the taxpayer.
As stated above, under Section 6038, every U.S. person must furnish information with respect to any foreign corporation that the person controls. A person has “control” if:
(1) the person owns more than 50 percent of the total voting stock in a foreign corporation
(2) the person owns more than 50 percent of the total value of shares of all classes of stock in a foreign corporation, or
(3) the person owns more than 50 percent of the total combined voting power of all classes of stock, or more than 50 percent of the total value of the shares of all classes of stock, of a corporation that is itself in control of a foreign corporation.8
Additionally, under Section 6046, U.S. citizens or residents must file a Form 5471 if:
(1) the person acquires a 10 percent stake in total combined voting power of all classes of stock, or the total value of the shares of all classes of stock voting rights in a foreign corporation
(2) the person is a 10 percent shareholder and becomes a U.S. citizen or resident
(3) the person becomes an officer or director of a foreign corporation in which a U.S. person is a 10 percent shareholder, or
(4) the person is an existing officer or director of a foreign corporation in which a U.S. person becomes a 10 percent shareholder.9
A crucial rule under both Sections 6038 and 6046 is that the percentage stock ownership requirements are measured by both the taxpayer’s direct ownership of stock and the taxpayer’s indirect ownership by attribution.10 The attribution rules can cause a taxpayer to be considered the constructive owner of stock held by his family members, or of stock held by entities.
In its Web site announcement, the IRS strongly encourages taxpayers to submit delinquent Form 5471 reports prior to the first of the year. The IRS began sending letters in August 2008 to taxpayers to alert them to this change in the penalty procedure. However, certain taxpayers may not have received such a letter and yet be unaware of their need to file. Moreover, because of the attribution rules mentioned above, taxpayers that hold no direct interest in a foreign corporation, but who are related to parties holding significant interests in foreign corporations still may be required to file. Therefore, taxpayers should carefully inspect their holdings so that they are not hit with an unexpected penalty in January. This is especially important given that it appears that taxpayers no longer can argue reasonable cause prior to an assessment.
Additionally, the 2006 TIGTA audit and the Web site notice seem to indicate that the automatic penalty program covers only the monetary lateness penalties that attach to untimely filed Forms 5471 under IRC Section 6038(b)(1). However, the monetary lateness penalty is not the only arrow in the Service’s quiver. The IRS also has the ability to assess penalties for inaccuracy or incomplete reporting, as well as reduce foreign tax credits available to late filers by up to 10 percent of the available credit.11 Many practitioners believe that automating the administration of late penalties will free up agents to apply greater scrutiny to Forms 5471, and perhaps increase the exposure to all of the other penalties. Therefore, on a going-forward basis, taxpayers that regularly and timely report should continue to place strong emphasis on ensuring the accuracy and completeness of their reporting.
1 “Forms 5471 – Automatic Assessment of Penalties under IRC Section 6038(b)(1),” http://www.irs.gov/businesses/corporations/article/0,,id=188039,00.html.
2 Unless otherwise stated, all references to “Section” or “IRC” are to the Internal Revenue Code of 1986 (“the Code”), and all references to “Treas. Reg. §” are to the Treasury Regulations promulgated thereunder (“the Regulations”).
3 IRC § 6038(a)(1).
4 IRC § 6046(a)(1)-(2).
6 TIGTA, “Automating the Penalty-Setting Process for Information Returns Related to Foreign Operations and Transactions Shows Promise, but More Work is Needed,” Reference No. 2006-30-075 (May 2006), available at http://www.treas.gov/tigta/auditreports/2006reports/200630075fr.html.
7 IRC §§ 6038(b), (c)(4).
8 IRC § 6038(e)(2).
9 IRC §§ 6046(a)(1)-(2).
10 IRC § 6038(e)(2); Treas. Reg. § 1.6046-1(h)-(i).
11 IRC §§ 6038(b) & (c).
Steven D. Bortnick and Marc D. Nickel