Form 8858 and Foreign Disregarded Entities: Every detail explained

Did you know that the IRS can penalize you up to $50,000 if you fail to file Form 8858 for the Foreign Disregarded Entity (FDE) you own?

But, what is Form 8858?

Like many other foreign asset reporting forms required by the IRS, Form 8858 is a common form US taxpayers must file if they own a foreign disregarded entity and - it is a common form on which numerous costly mistakes are made every year by taxpayers.

In this article you will learn about:

• what is a Foreign Disregarded Entity,
• who needs to file Form 8858, how and when to file it,
• what happens if you fail to comply,

and more...

Enjoy!

What is Form 8858?

Form 8858 is an informational tax form required by the IRS for U.S. persons who own or operate a Foreign Disregarded Entity (FDE) or a Foreign Branch (FB).

These entities are considered extensions of the taxpayer for US tax purposes, meaning their income, expenses, and financial activity must be reported on the owner’s tax return.

Purpose of Form 8858

The primary purpose of Form 8858 is to ensure transparency and compliance in reporting income from foreign entities.

It helps the IRS:

• Monitor the global operations of US taxpayers.
• Prevent tax avoidance strategies involving foreign entities.
• Track foreign earnings, profits, taxes paid, and related party transactions.

Filing Form 8858 is critical for maintaining compliance with US international tax laws and avoiding potential penalties.

What is a Foreign Disregarded Entity?

A Foreign Disregarded Entity (FDE) is a flow-through entity located outside the US. This means the business income is taxed as the owner's income. The entity and the owner are considered one.

The corporation is treated as a separate entity from its shareholder for tax purposes. This veil of incorporation protects the personal asset of the company’s owners and investors. It also ensures their liability is limited.

However, the owner of an FDE, similar to the sole proprietorship, is responsible for fulfilling its tax obligations. Unlike the shareholder of a corporation, the owner of an FDE is not taxed twice on their business income.

In corporations, first, the profit is taxed as corporate income. It is taxed again when it is distributed to shareholders as a dividend unless the owner opts for it to be an S-corp.

This is one of the reasons why taxpayers choose pass-through entities for tax purposes.

When is Form 8858 required?

Consider a situation where you decide to set up a limited liability company in a foreign country. For tax purposes, it would be treated as a corporation and you will be required to file Form 5471.

But you can choose to disregard the corporation status.

You will need to file Form 8832 to make this choice. Once you do that your entity becomes considered a foreign disregarded entity for tax purposes.

Your FDE is taxed as a self-employed business. You will be required to file Form 8858 which is an informational return. You will also be liable to pay your self-employment taxes unless there exists a totalization agreement.

This is an agreement between the US and other countries to avoid double taxation with respect to social security taxes.

Who needs to file Form 8858?

You are required to file Form 8858 along with Schedule M (Form 5471) if you are a US citizen who during an annual accounting period or tax year does either of the following:

• Owns FDE for tax purposes,
• Operates an FB (foreign branch),
• Owns interest in entities that are tax owners of FDE or FBs.

Your FDE ownership can be direct or indirect via a tier of FDEs or partnership.

For tax purposes, the IRS distinguishes between the tax owner and the direct owner of the FDE.

• Tax owner. You are a tax owner if you own the FDE assets & liabilities for the tax purpose.
• Direct owner. A direct owner is the legal owner of the FDE. Let’s say you are a US citizen and a 55% partner of a controlled foreign partnership (CFP). The CFP owns an FDE. Legally, CFP is the direct owner of the FDE but you are the tax owner.

Following US persons are required to file Form 8858:

• Filers of Form 5471 or Form 8865 for CFC (controlled foreign corporation) and CFP respectively that own FDE or operate an FB;
• A US partnership that is a direct or indirect tax owner of the FDE;
• A US corporation except for RIC, REIT, or an S corp, that holds an interest in a US partnership that owns an FDE.

IRS defines as a US person any of the following:

• a US Citizen or resident alien,
• a domestic partnership, corporation, or trust,
• any estates other than those foreign estates that are specifically excluded.

Also watch -
Webinar: "More US persons have to file Form 8858. Should I?" with Wendy Christiansen

When is Form 8858 due?

You need to file Form 8858 with your income tax return or when it is due including an extension.

The usual due date is April 15. For US citizens or resident aliens living abroad, the IRS allows an automatic 2-month extension.

NOTE! If you have received a notification from the IRS that the form is due then you have 90 days to submit it before they impose a penalty of 10,000 on you.

What info to include on Form 8858?

Form 8858 requests detailed information about the tax owner, the FDE and other information.

You also need to provide a summary of your FDE’s financial statements.

• The income statement. It reflects your earnings and expenses. The profit you made during the annual accounting period or tax year is reported.
• The balance sheet. It reflects your financial position. It contains the details about your assets, liabilities, and equity.

Furthermore, report your accrued and paid foreign taxes. You can claim any FTC (foreign tax credit) you qualify for to reduce your US tax liability.

Penalties and compliance strategies

Failing to file Form 8858 when required can result in severe consequences.

The IRS imposes both civil and criminal penalties on tax owners for non-compliance.

Potential penalties

1. Monetary fines: A $10,000 penalty applies for each annual accounting period an FDE (CFC or CFP) fails to report the required information within the specified timeframe.
   NOTE! After receiving a non-compliance notification, you have 90 days to file. Failure to do so results in an additional penalty of $10,000 per month (per CFC or CFP), up to a maximum of $50,000.
2. Reduction of Foreign Tax Credits: Non-compliance can lead to a 10% reduction of your FTC, with the penalty increasing if the return is not submitted within three months of the IRS notification.

Compliance strategies

1. Timely filing: Ensure Form 8858 is filed on time to avoid penalties. Mark your calendar to align the filing with your annual tax return.
2. Addressing late filing: Use the Streamlined Filing Compliance Procedures if you qualify as a late filer. This program helps taxpayers who were unaware of their filing obligations come into compliance without facing criminal penalties and with reduced fines.
3. Seek professional guidance: Work with a professional to ensure you meet all requirements for these procedures. NOTE! While hiring a tax preparer can help, remember that you, as the tax owner, are ultimately responsible for your filings.

Pro tip: Individuals may not face monetary fines for non-compliance, but they can still lose valuable Foreign Tax Credits, which could increase their overall US tax liability.

To avoid financial or criminal penalties, prioritize accurate and timely filing of Form 8858. If you're unsure about your obligations, consulting with an experienced expatriate tax advisor is the best way to stay compliant.

How do I file Form 8858?

Filing Form 8858 requires careful attention to detail.

This step-by-step guide outlines each section of the form, providing tips and examples to clarify the process.

Step 1: Fill out the annual accounting period

Start by entering your annual accounting period, which is the tax year you’re reporting for the FDE.

The accounting period could be either a calendar year (January–December) or a fiscal year (any 12-month period ending in a month other than December).

Pro tip: Your tax year is the same as the one you’ve been using to file your personal or corporate tax returns. For example, if you filed your first tax return based on the calendar year, this will apply to the FDE as well.

Step 2: Provide identifying information

Include details about yourself (the tax owner), such as your name, address, tax year, and Taxpayer Identification Number (TIN) – this is typically your Social Security Number (SSN).

Provide information about the FDE, including its Employer Identification Number (EIN) (which you’ll also need when filing Form 8832 to elect FDE status).

Indicate whether this is the initial or final form for the entity.

Example: Suppose you formed an FDE in January and sold it by November of the same year. You’ll need to file two forms:

• Check "initial form" for the setup.
• Check "final form" for the termination.

Pro tip: If someone else owned the FDE within the past three years, you must include their name in parentheses after yours.

Step 3: Report the financial statement (Schedules C & F)

• Schedule C: Summarize the profit and loss of the FDE. You’ll need to report figures in both the functional currency (the currency the FDE operates in) and US dollars.
  For example, if your FDE operates in Mexico, pesos would be the functional currency.
• Schedule F: Report the FDE’s assets, liabilities, and equity. These figures must also be translated into US dollars.

Pro tip: Ensure that the financial statements are prepared according to US GAAP (Generally Accepted Accounting Principles) to meet IRS standards.

Step 4: Answer Additional Questions (Schedule G)

Provide details about whether the FDE owns an interest in any partnership or is part of a consolidated group.

Be prepared to disclose any partnerships or relationships that affect ownership or operations.

Step 5: Complete Schedule I (for domestic corporations only)

If the FDE is directly or indirectly owned by a domestic corporation, report any assets transferred to a foreign corporation.

Skip this section if the FDE is owned by a Controlled Foreign Corporation (CFC).

Step 6: Track foreign taxes paid (Schedule J)

Use this section to report foreign taxes paid or payable on the income generated by the FDE.

This information is crucial for claiming the Foreign Tax Credit, which can help reduce your US tax liability.

Pro tip: Properly reporting foreign taxes can save you thousands of dollars in US taxes by preventing double taxation.

Step 7: Report current earnings and profits (Schedule H)

Use this schedule to adjust the FDE’s earnings and profits to align with US tax laws.

Step 8: Disclose related party transactions (Schedule M)

Report all transactions with related parties, such as entities or individuals that:

• Control the FDE,
• Have significant influence over the FDE,
• Manage the FDE.

Examples of transactions include loans, sales, or management fees between related entities.

Pro tip: Related party transactions are heavily scrutinized by auditors, so be thorough and transparent to avoid penalties.

Step 9: Attach an organizational chart

The IRS requires you to submit an organizational chart that clearly shows the ownership structure of the FDE, including all entities and individuals in the chain of ownership.

Example: If you own a US corporation that owns the FDE, the chart should show this structure, including any intermediate entities.

Form 8858 preview

 

Additional tips for filing Form 8858

• Double-check deadlines: Form 8858 is typically filed with your US tax return. Missing deadlines can result in significant penalties.
• Avoid errors: Incorrect or incomplete information could trigger IRS inquiries or audits.
• Consult a professional: If you’re unsure about any part of the filing process, work with an expatriate tax advisor or CPA experienced in international tax compliance.

What to do if I failed to file Form 8858?

Don’t panic if you haven't complied yet with the IRS requirement of filing Form 8858. The IRS offers a tax amnesty program that you can benefit from. It is called the streamlined filing compliance procedure & is available to you if your failure to file did not result from wilful conduct.

Under this program, you will file original or amended tax returns. File all the necessary informational returns and pay all the necessary taxes and penalties. You can go back and file 3 years of tax returns. For international information return, you can go back to 6 years.

Generally, you can be a part of it if:

• You didn’t skip your filing obligation intentionally,
• You have a valid TIN number,
• Your tax return for some random tax year is not under the civil examination by the IRS.

You may have additional criteria to qualify for this program.

However, if you are worried that you intentionally failed to file the return to the IRS and want assurance that you will not be subject to criminal penalties you should consider participating in IRS criminal investigation voluntary disclosure practice.

NOTE! Make sure you seek legal advice before making any decision.