August 10, 2020
PART I: NEW FORM 8858 FILING REQUIREMENT FOR FOREIGN REALTY RENTALS AND BUSINESS INCOME WITH TAX CREDIT PENALTY
The U.S. implemented a new filing requirement for 2018 and later tax years that requires U.S. persons to file IRS Form 8858 if they own certain foreign real estate rental properties or businesses. Failure to timely comply can result in a reduction in the allowable foreign tax credits, potentially increasing your U.S. income tax. Financial penalties also apply in some cases.
Specifically, the tax code requires all U.S. persons, (i.e. U.S. citizens and residents, and domestic corporations, partnerships, trusts, and estates), to file IRS Form 8858 with respect to “any foreign business entity” which such person controls1. IRS Form 8858 is also separately required for owners of “foreign disregarded entities” (FDEs), and the same potential penalties apply.
Foreign Business Entity
For purposes of IRS Form 8858, the tax code states a foreign business entity means a foreign corporation or foreign partnership.2 However, under the authority of sections 6011, 6012, 6031, and 6038 of the Internal Revenue Code, and Treasury Regulation §1.367(a)-6T(g), the instructions to IRS Form 8858 state that Form 8858 must also be filed for a foreign branch3. In other words, a foreign business entity includes a foreign branch. For IRS Form 8858, a foreign branch includes a foreign “qualified business unit” (QBU).4
The tax code does not define a “foreign branch”. However, in a different tax context, the regulations state:
The term “foreign branch" means an integral business operation carried on by a U.S. person outside the United States. Whether the activities of a U.S. person outside the United States constitute a foreign branch operation must be determined under all the facts and circumstances. Evidence of the existence of a foreign branch includes, but is not limited to, the existence of a separate set of books and records, and the existence of an office or other fixed place of business used by employees or officers of the U.S. person in carrying out business activities outside the United States. Activities outside the United States shall be deemed to constitute a foreign branch for purposes of this section if the activities constitute a permanent establishment under the terms of a treaty between the United States and the country in which the activities are carried out. Any U.S. person may be treated as having a foreign branch for purposes of this section, whether that person is a corporation, partnership, trust, estate, or individual.5
Those regulations also state if there is more than one foreign branch, they are each treated separately.6
Qualified Business Unit (QBU)
The activities of an individual, corporation, partnership, trust, or estate qualify as a QBU if:7 8
- The activities constitute a clearly identified unit of a trade or business of a taxpayer, and
- A separate set of books and records is maintained with respect to the activities.
Definition of Trade or Business
The regulations state:
“The determination as to whether activities constitute a trade or business is ultimately dependent upon an examination of all the facts and circumstances. Generally, a trade or business for purposes of section 989(a) is a specific unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible under section 162 or 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes). Such group of activities must ordinarily include the collection of income and the payment of expenses.9
Activities carried out outside the United States that constitute a permanent establishment under the terms of an income tax treaty between the United States and the country in which the activities are carried out, are treated as a trade or business conducted outside the United States.10 (i.e., the activities are treated as a foreign QBU).
Some Examples of a Foreign Trade or Business (QBU)
Self-Employed U.S. Citizens and Green Card Holders Living Outside the U.S.
U.S. citizens and green card holders who live outside the U.S., and operate businesses in the form of sole proprietorships, apparently are treated as owning QBUs, and thus require a timely filing of IRS Form 8858.
Again, the regulations specifically state that if the activity constitutes a permanent establishment (under a tax treaty) a foreign branch (QBU) exists.11
Foreign Real Estate Rental Property Owned by a U.S. Individual
For a U.S. individual, the ownership and operation of foreign real estate rental property constitutes a QBU if the activity meets the principles set out in the “Definition of a Trade or Business” above. Thus, many, if not most, foreign real estate rentals might constitute QBU’s. Normally, one might believe a trade or business does not exist if there is no significant activity by the owner. For example, a foreign rental property subject to a triple net lease, which is managed solely by a foreign property manager, might not constitute a business. However, Example 1 above from the Treasury Regulations suggests otherwise, especially if the foreign property manager maintains all the records, and they are maintained in the foreign currency.
Business income does not include income which is properly assigned to the “passive income” category.12 The tax code states passive income includes income received or accrued by any person that is of a kind that would be foreign personal holding company income (for example, rental income) if the taxpayer were a controlled foreign corporation13.
However, passive income specifically excludes active rents that are derived in the active conduct of a trade or business14. Among other circumstances, rents will be considered to be derived in the active conduct of a trade or business if such rents are derived by the lessor from leasing real property with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased15.
Please refer to the tax code and regulations for the complete set of rules.
Foreign Investment Activities of a U.S. Individual
From the IRS example 1 below, it appears U.S. residents who own foreign securities that are held in foreign banks or brokerage firms should review whether that investment activity constitutes a foreign branch, especially if the investment portfolio is denominated in a foreign currency, and is being managed abroad.
Example 1. From Treasury Regulations.
“Taxpayer A, an individual resident of the United States, is engaged in a trade or business wholly unrelated to any type of investment activity. A also maintains a portfolio of foreign currency-denominated investments through a foreign broker. The broker is responsible for all activities necessary to the management of A's investments and maintains books and records as described in paragraph (d) of this section, with respect to all investment activities of A. A's investment activities qualify as a QBU under paragraph (b)(2)(ii) of this section to the extent the activities engaged in by A generate expenses that are deductible under section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes)”.16
Example 2. From Treasury Regulations.
“Taxpayer A, an individual resident of the United States, is the sole shareholder of a foreign corporation (FC) whose activities are limited to trading in stocks and securities. FC is a QBU under paragraph (b)(2)(i) of this section”.17
Specific Filing Requirements from the Instructions to IRS Form 8858
As indicated above, IRS Form 8858 must be filed for “foreign disregarded entities” (FDEs) in addition to foreign branches (FBs). An FDE is an entity that is not created or organized in the U.S., and that is disregarded as an entity separate from its owner for U.S. income tax purposes.
The following abbreviated descriptions from the instructions to IRS Form 8858 list “Who Must File” Form 8858 with respect to foreign disregarded entities and foreign branches. Please refer to the instructions for each complete description.
- A U.S. person that is a tax owner of a foreign disregarded entity (FDE), or operates a foreign branch (FB).
- A U.S. person that directly (or indirectly through a tier of FDEs or partnerships) is a tax owner of an FDE, or operates an FB.
- Certain U.S. persons that are required to file IRS Form 5471 with respect to a controlled foreign corporation that is a tax owner of an FDE, or operates an FB.
- Certain U.S. persons that are required to file IRS Form 8865 with respect to a controlled foreign partnership that is a tax owner of an FDE, or operates an FB.
- A U.S. partnership that directly (or indirectly through a tier of FDEs or partnerships) is a tax owner of an FDE, or operates an FB.
- A. U.S. corporation that is a partner in a U.S. partnership, which is required to file a Form 8858 because the U.S. partnership is the tax owner of an FDE or an FB.
A separate Form 8858 and all applicable schedules are required for each FDE or FB.
Exceptions to filing IRS Form 8858 exist where there are multiple filers and Forms 5471 and/or 8865 are also required. See instructions to Form 8858.18
A penalty of $10,000 applies for failure to timely file IRS Form 885819 . The penalty escalates if a related IRS Notice is ignored. However, the Instructions to Form 8858 state that the penalty applies to controlled foreign corporations (CFCs) and controlled foreign partnerships (CFPs) that are noncompliant. The instructions do not mention a financial penalty to individuals for failure to file Form 8858.
A separate penalty of not more than $25,000 ($100,000 for corporations) and possible criminal penalties apply for willful noncompliance.20
Foreign Tax Credit Reduction Penalty
Any person who fails to timely file a required IRS Form 8858 with respect to a foreign branch or foreign disregarded entity may be subject to a reduction of 10% of the current foreign tax credit available under the tax code.21 Carrybacks and carryovers are excepted. The penalty accelerates if a related IRS Notice is ignored. But see limitations of this penalty under sections 6038(c)(2) and (c)(3). Also, because of the introduction of the “foreign branch income” tax credit category, there may be complexities to address with respect to prior carryovers of foreign tax credits and losses from the general and passive tax credit categories.
Part II will discuss the carryovers and carrybacks of unused foreign tax credits.
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1 IRC §6038(a)(1)
2 IRC §6038(e)(1)
3 Instructions to IRS Form 8858
4 Instructions to IRS Form 8858
5 Treas. Reg. §1.367(a)-6T(g)(1)
6 Treas. Reg. §1.367(a)-6T(g)(2)
7 Treas. Reg. §1.989(a)-1(b)(2)(ii)
8 Note that an individual is not a QBU (but an individual can possess one or more QBUs); a corporation is a QBU; a partnership, other than a section 987 aggregate partnership as defined in Treas. Reg. §1.987-1(b)(5), is a QBU; a trust or estate is a QBU of a beneficiary.
9 Treas. Reg. §1.989(a)-1(c)
10 Treas. Reg. §1.904-4(f)(3)(vii)(B)
11 Treas. Reg. §1.367(a)-6T(g)
12 IRC §904(d)(2)(J)(ii)
13 Treas. Reg. §1.904-4(b)(2)(i)A)
14 IRC §954(c)(2)(A) and Treas. Reg. §§1.954-2(b)(6), and 1.954-2(c).
15 Treas. Reg. §1.954-2(c)(1)(ii)
16 Treas. Reg. §1.989(a)-1(e), Example (6)
17 Treas. Reg. §1.989(a)-1(e), Example (7)
18 IRC §6038(d) and Instructions to IRS Form 8858
19 IRC §6038(b) and IRC 6679(a)(1) for failure to file under sections 6046 and 6046A
20 IRC §6038(f)(1) and 7203
21 IRC §6038(c)(1)(A) and (B)