Over the course of my career, I have seen people get themselves into all kinds of sticky tax situations, and the reasons why can be as bizarre as the situations themselves. However, one of the more common reasons is that a U.S. person sets up a foreign entity without seeking any U.S. tax advice.
Foreign entities have their advantages and can be very beneficial if setup, used, and reported properly. If not, get out your checkbooks because it is likely going to cost you.
Let me illustrate the problem using a fictitious U.S. citizen named Scott. Scott decides that he wants to purchase a vacation home in Panama. He, his wife, and children take a trip down to Panama to look at properties and quickly find a house they love. Their realtor refers them to an attorney to assist them in finalizing the purchase.
While meeting with the attorney, Scott asks him about how the property would be passed to his wife and kids in the event of his death. The attorney immediately recommends that Scott set up a Panamanian foundation to own the property.
The Panamanian attorney explained to Scott that in civil law countries, such as Panama and most of Europe, there is an entity called a foundation. The foundations are entities that are not owned by anyone, they exist in their own right. Although terminology varies from country to country, foundations are generally founded by a founder, controlled by a foundation council, and can have beneficiaries. In civil law countries, foundations are often used in place of trusts because most civil law countries don’t have trusts.
Scott takes the attorney’s advice and sets up a foundation. Scott and his wife were the founders. Scott, his wife, and their eldest son made up the foundation council. Scott, his wife, and all their children were the beneficiaries. The management of the foundation, including deciding when and to which beneficiaries distributions are to be made, was vested in the foundation council.
Fast forward 2 years, Scott and his wife decide to sell the property and the foundation makes a $500K gain on the sale. What a great investment!
While meeting with his U.S. accountant, Joe, to get his taxes done Scott mentions that he sold his vacation home in Panama and made a handsome profit. He also explains to Joe that the property had been owned through the foundation he had set up and asked if that made any difference; when Scott saw the look on Joe’s face he knew the answer before Joe replied..
Joe informed Scott that he has a serious tax problem because foundations generally need to be reported to the IRS, and failure to do so can result in substantial penalties.
Joe went on to explain that for U.S. tax purposes foundations are treated as either foreign corporations or foreign trusts, depending on which it more closely resembles based on its charter and regulations. If the foundation were to be treated as a foreign corporation Scott should have been filing Form 5471 each year. If the foundation were to be treated as a foreign trust Scott should have been filling Forms 3520-A and 3520 each year. Failing to file these forms can result in stiff penalties.
And that’s not all; foreign corporations and foreign trusts are taxed quite differently. If Scott’s foundation were to be treated as a foreign trust it would be tax transparent and it would be as if Scott had personally sold the property; i.e. the gain would be taxed at the preferential 20% long-term capital gain tax rate. If, however, Scott’s foundation was treated as a foreign corporation the gain would be taxed as a dividend and subject to ordinary income tax rates – as high as 39.6%.
Scott’s situation gets more complex because it is up to Joe to read the foundation documents and make the determination as to whether the foundation should be treated as a foreign corporation or foreign trust. But, the IRS can always disagree with Joe’s determination and claim that it should be taxed differently. It would then be up to Scott to fight the IRS and defend his position.
All of Scott’s problems could have been avoided if he would have sought proper international tax advice from knowledgeable U.S. international tax advisor. The advisor could have advised Scott of the challenges that foundations can present and informed him of his compliance obligations. Most importantly, however, the advisor could have assisted in the drafting of the foundation documents to ensure that the foundation was taxed as Scott intended.
So what are you supposed to do?
According to the IRS, a foreign foundation will either be treated as a foreign corporation or a foreign trust, depending on which one it most closely resembles. The person who will make this decision is the U.S. person’s tax advisor which means this advisor better understand U.S. tax codes. Suppose the tax advisor determines that the foundation should be taxed as a trust. Now also suppose the IRS challenges that decision, wins, and decides it should be treated as a corporation. Foreign corporations are taxed much differently from foreign trusts and as the example above illustrates, the difference can be costly.
Foundations are great entities and have many uses, but they need to be setup properly. So, if you are planning on setting up a foundation, or have already set one up, make sure you have solid U.S. international tax advice to ensure you don’t wind up in a situation like Scott’s, or worse!
Contact Esquire Group if you have any questions regarding the formation of a foreign foundation or a foundation you have already set up… We can serve as an international U.S. tax advisor to your attorney to ensure you don’t end up owing the IRS more than you anticipated.