Proposed regulations would require more transparency for certain wholly owned domestic disregarded entities

Tax Hot Topics newsletterThe Treasury Department and the IRS released proposed regulations (REG-127199-15) that would treat a domestic disregarded entity wholly owned by a foreign person as a domestic corporation separate from its owner for limited information-reporting purposes. Specifically, such treatment would apply to reporting, record maintenance and associated compliance requirements that otherwise apply to 25% foreign-owned domestic corporations under Section 6038A. The proposed regulations would expand the IRS’s ability to collect information from foreign-owned disregarded entities, many of which are currently not obligated to file a return or obtain an employer identification number (EIN) under current law.

The proposed regulations would require certain domestic disregarded entities to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, to report transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes. The proposed regulations would also require certain domestic disregarded entities to maintain records sufficient to establish the accuracy of the information return and determine the correct U.S. tax treatment of reported transactions. Because these domestic disregarded entities would have a filing obligation, they would also be required to obtain an EIN by filing a Form SS-4, Application for Employer Identification Number, which would include responsible party information.   

The preamble to the proposed regulations noted that these changes are intended to improve the IRS’s access to information it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar international agreements, as well as to strengthen the enforcement of U.S. tax laws. The regulations follow certain news reports detailing the use of limited liability companies by foreign investors and mounting pressure from other countries to help combat potential tax evasion.

The proposed regulations specifically state that the exceptions for small corporations and for de minimis transactions, which normally apply to 25% foreign-owned corporations, will not apply to domestic disregarded entities required to comply under the proposed amendments. Carving out these exceptions significantly expands the scope of domestic disregarded entities that may need to comply with the proposed regulations when made final.

Finally, the proposed regulations expand reportable transactions to include amounts paid or received in connection with the formation, dissolution, acquisition or disposition of the entity, including contributions to and distributions from domestic disregarded entities by including all transactions as defined under Treas. Reg. Sec. 1.482-1(i)(7). Effectively, the proposed regulations would require certain domestic disregarded entities to compute and report all related-party transactions under the transfer pricing provisions of the regulations under Section 482.

The proposed regulations, if made final, will apply to taxable years ending on or after the date that is 12 months after the date the rules are published as final in the Federal Register.

Many domestic disregarded entities affected by these rules aren’t obligated to file returns under current law and may not otherwise maintain books and records in accordance with U.S. GAAP or compute adjustments as would be required under Section 482 or other general U.S. tax principles. Conversely, the proposed regulations would significantly increase the compliance burden of many foreign persons operating in the U.S. through such domestic disregarded entities and would penalize those that abstained.   

The proposed regulations remain largely silent on how the IRS intends to administer these rules (for example, whether a Form 1120, U.S. Corporation Income Tax Return, would be required as part of the procedure to submit the information returns).

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