Many foreign investors are unaware of the complexity of tax traps that apply to a Foreign Owned Disregarded Entity (FODE) when they form a Limited Liability Company (LLC) to hold their assets or run their business in the United States. In general, an LLC owned by a single foreign person will be classified as a disregarded entity under the Domestic Tax Code for tax purposes. Still, since 2017, the Internal Revenue Service (IRS) has classified these entities as domestic corporations only for the purpose of reporting and compliance with the provisions of Section 6038A. As a result of these new classifications, every single owner of these entities has a significant amount of new responsibilities related to reporting and compliance that many of these owners do not understand or take into account.
Even if an LLC has no U.S. tax liability, has not engaged in any business activities during the year or is inactive, it must file an annual Form 5472 and attach it to a pro forma Form 1120, reporting on transactions between the LLC and all of its foreign owners and other related parties (reportable transactions). The IRS will penalize an LLC $25,000 per month for each related party that fails to file Form 5472 on time. After 90 days of failure to file Form 5472, in addition to the $25,000 penalty, the IRS may impose an additional $25,000 fine for each month the Form is not filed.
Most foreign investors are shocked to discover that even though they believe their inactive or asset-holding LLC has no filings, the IRS has issued more stringent enforcement measures through the Corporate Transparency Act and through various international agreements with foreign governments to monitor the activities of foreign-owned entities, causing increased scrutiny on foreign-owned businesses.
For entities owned by a foreign individual, detailed records must be maintained documenting the related-party transactions and making sure of accurate classification of the related-party transactions, accurate EIN registration and timely filings with the Internal Revenue Service. Without proactive compliance, a simple holding LLC can quickly become an expensive tax trap, which many investors learn of only when they have accumulated a considerable amount of penalties.
