The “Rise of the ‘disregarded entities'” may sound like the title of some 1950s horror film involving the un- or not-quite-fully-dead, but in fact, according to Sung Hyun Hwang, a partner in the tax and wealth planning practice of Venable LLP, it has to do with US tax regulation coming into force in 2017.
In particular, it concerns a new set of rules that he says is about to bring back to life entities that the fund community has long taken for granted as dead, for US tax purposes. This is potentially very significant for wealth managers who look after cross border portfolios with American exposures, and has its origins in a global move in the direction of greater transparency on the part of financial services institutions, in response to such triggers as the 2008 global financial crisis and last year’s Panama Papers expose.
Hwang, pictured above explains…
Possibly little-noticed by the international/cross border wealth management community, a new US tax rule requires so-called disregarded entities, or DEs, to file an additional information return for taxable years beginning on or after January 1, 2017.
As many investors in the fund space know, under the US tax regulations commonly known as the “check-the-box rules” adopted about 20 years ago, a US limited liability company (LLC) with a single member (ie, owner) is generally “disregarded” as an entity separate from its owner for US federal tax purposes. This has meant that, subject to limited exceptions, a US DE has not had to file its own tax return, or pay its own taxes, and has been considered merely a branch or an arm of its owner, as far as the US tax authorities have been concerned.
Therefore, an investor could benefit from the limited liability and anonymity associated with a single-member US LLC, without the attendant tax costs, including filing costs.
Favourable tax entity
These favourable tax entity classification rules have gradually been adopted by many US states and localities for their own tax purposes, and have led to an explosion in the use of single-member LLCs for business and investment purposes.
The new US tax regulations, however, which were finalised in December, require a US disregarded entity which is wholly owned by a foreign person to file an IRS Form 5472, as if it were a US corporation, with respect to taxable years when the US disregarded entity engages in certain “reportable transactions” (see below) with “related parties”. This US disregarded entity is also now expected to maintain records, forming the basis for the filing.
“Related parties” for this purpose include persons who own, directly or by attribution, 25% or more of the US DE, as well as entities under common ownership or management control with the US DE.
Thus, the identities of a fund’s major investors and/or the fund’s special-purpose vehicles and portfolio companies may be disclosed to the IRS on this form. In addition, a fund interposing a US DE in the ownership chain, solely to secure a US venue and law to govern an otherwise all-foreign transaction, may be subject to this reporting.
“Reportable transactions” required to be disclosed on the Form 5472 include, among others, any loans outstanding between the US DE and any related party; any interest paid; and other items that would be seen to affect the tax computation of the US DE (as if it were a US corporation).
Thus, a typical earnings-stripping transaction, using debt as a portion of capital of a US DE (even if motivated for non-U.S. tax reasons), may now have to be reported to the IRS.
If a US DE does not file the Form 5472 for any taxable year with a reportable transaction, it will be subject to a US$10,000 penalty per failure. What’s more, the statute of limitations for all income tax return items of the US DE (and, indirectly, the foreign owner) will remain open for the IRS’s scrutiny.
These penalties should not be taken lightly, given the current intensity of the IRS policing of the cross-border reporting and filing failures.
Thus, every fund community member should engage in an extensive analysis of a fund’s use of US DEs, in a timely manner, to avoid the penalties, and the open statute of limitations.
In addition, a fund community member should consider whether using a US DE is an appropriate vehicle for a particular investment structure, given the requirement to disclose the identity of major investors and the identities of a fund’s special-purpose entities and portfolio companies.
Sung Hyun Hwang is a partner in the tax and wealth planning practice in Venable LLC’s New York office. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. He was appointed as a joint General Reporter for Investment Fund Topic of the International Fiscal Association London 2019 Congress.