Are you an expat who owns a foreign business? Filing taxes can already be complicated, but adding a business to the mix can make it even more challenging. If you own a foreign business, you may be required to file Form 8858, the Information Return of US Persons With Respect to Foreign Disregarded Entities and Foreign Branches. But what exactly is a foreign disregarded entity? And what happens if you fail to file? In this article, we’ll cover everything you need to know about Form 8858, address some of the common questions, and help you avoid potential penalties.

What Is IRS Form 8858?
Form 8858 (Information Return of US Persons with Respect to Foreign Disregarded Entities and Foreign Branches) is an informational tax form that certain US citizens and green card holders need to file to disclose if they own a Foreign Disregarded Entity (FDE) or a Foreign Branch (FB), and provide the US with financial information about them.

If you’re scratching your head wondering what that even means, don’t worry – we’ve got you covered. Owning a foreign entity simply means that you own or operate a company in a foreign country. That’s why we will be using the terms entity and company interchangeably.

Form 8858 only serves to provide information to the IRS and does not trigger any additional taxes. However, failure to file may result in substantial penalties, making it all the more important to understand your reporting requirements and take steps to become compliant.

What Is A Foreign Disregarded Entity?
A Foreign Disregarded Entity is an entity that is not established or organized in the United States and is disregarded as an entity separate from its owner for US income tax purposes under Regulations sections 301.7701-2 and 301.7701-3. To be disregarded as a separate entity simply means that your company is not being taxed as a corporation.

So an FDE is a company formed outside of the US that is not being taxed as a foreign corporation. Instead, the owner and the company are treated as a single entity under US law. In other words – the income generated by your FDE is viewed as your own taxable income.

Example: Let’s say that you are a US citizen who owns a small business based in Canada that operates as a single-member LLC. Since the Canadian single-member LLC is not taxed as a corporation, it qualifies as an FDE.

In 2022, your personal income was $50,000 from your job in the US, and your Canadian FDE generated another $50,000. In this scenario, the IRS would treat you and your FDE as a single unit, resulting in a taxable income of $100,000.

US persons that are owners of foreign disregarded entities (or that own certain interests in tax owners of FDEs ) must file Form 8858 and Schedule M (Transactions Between Foreign Disregarded Entity (FDE) or Foreign Branch (FB) and the Filer or Other Related Entities) to satisfy their reporting obligations.

Direct Owner Versus Tax Owner Of FDE
The IRS makes a distinction between a tax owner and a direct owner with respect to an FDA:

A Tax Owner is someone who owns the assets and liabilities of the foreign disregarded entity for US income tax purposes.
Direct Owner, on the other hand, refers to the true legal owner of the disregarded entity
Example: Let’s assume you are a 60% partner in a foreign partnership (CFP). CFP owns FDE 1, which is a foreign disregarded entity. And FDE 1 owns FDE 2 – another foreign disregarded entity.

In this case, CFP is the direct owner of FDE 1, while FDE 1 is the direct owner of FDE 2. As for tax ownership, CFP is considered the tax owner for both FDE 1 and FDE 2. In this situation, you would be required to file 2 separate Forms 8858 for each FDE (along with Form 8865 that’s filed for CFP).

If you are the owner of a business that is based in a foreign country and is not taxed as a corporation, there is a high chance that it meets the criteria of an FDE. Businesses such as single-member LLCs, sole proprietorships, and partnerships fall under this category.

How Do I Know If My Entity Is Disregarded?
To determine how your foreign business will be classified for federal tax purposes, you will need to complete form 8832, Entity Classification Election. You can use form 8832 (also known as the “check the box election”) to confirm your choice to be treated as a disregarded entity, avoiding the status of a foreign corporation. But why would you choose this option?

By default, if you set up a company outside of the US, it would be treated as a foreign corporation (and trigger the need for you to file an even more complex Form 5471). Many taxpayers will seek to avoid being categorized as a foreign corporation since they find FDE tax treatment to be more advantageous.

Setting up an FDE is easier and requires less record-keeping and formalities than a foreign corporation. Additionally, an FDE is not subject to US federal income tax, but instead, the income and losses are reported on the owner’s personal tax return. This can potentially result in a lower overall tax burden compared to a foreign corporation, which is considered a separate legal entity and is subject to corporate income tax.

What Is A Foreign Branch?
A foreign branch for US tax purposes is an integral business operation carried on by a US person, which operates in a foreign country and maintains a separate set of books and records. These records may include anything, from basic spreadsheets or receipts to more complex accounting software and applications. In addition to maintaining a distinct set of books and records, proof of the existence of a foreign branch includes an office or fixed place of business that is used by employees of the US person for conducting business operations abroad.

A foreign branch can be a division of a US company, which operates a trade or business in a foreign country and maintains separate records. Aside from companies, any US person, including individuals, partnerships, trusts, or estates, can be classified as a foreign branch.

Example: Let’s say you’re an entrepreneur from the US who decides to expand their business to France. You incorporate a new company in France and begin selling your products through an online store. You also establish a physical storefront in Paris and hire a small team to manage the business operations in France.

You keep separate records for your online and storefront sales, tracking income and expenses separately for each operation. Since both of your stores are considered separate foreign branches, they should be reported on separate Forms 8858.

A foreign branch is also defined by reference to the qualified business unit (QBU). Although it’s generally understood that US citizens or residents must file Form 8858 when owning a FB through partnerships or CFCs, it’s not always easy to determine when an individual’s activities outside of the US rise to the level of QBU.

What Are Qualified Business Units?
A Qualified business unit is any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records, according to the rules of Section 989(a) of the Internal Revenue Code.

A foreign branch operation of a US corporation would in most cases qualify as a QBU. If a branch is deemed an integral part of a US operation that cannot generate income on its own (e.g., a financing vehicle), it will not qualify as a QBU. Consequently, any transactions conducted by the FB would be treated the same as other transactions of the corporation to which it belongs.

Although having separate books and records for each trade or business activity is significant, determining whether an activity qualifies as a QBU involves various factors.

Let’s say you own a corporation that manufactures products in the US and sells them worldwide. All of the sales functions are conducted exclusively in the United States.

Example 1: You decide to employ an individual in France to work solely as a courier and deliver sales documents to your French customers. You maintain a separate set of books and records with respect to your new employee’s activities. However, the courier’s activities in France do not constitute a QBU as they are merely ancillary to your main US business of manufacturing and selling.

Example 2: The circumstances are the same as in Example 1 except that the courier function is the sole activity of a wholly-owned French subsidiary of your US corporation. In this case, the French subsidiary would be considered a QBU.

What Qualifies As A QBU?
Within the category of foreign branches, you would typically expect to see large companies that may operate globally, with certain components of the company located outside of the United States. However, there may also be much smaller entities that qualify as QBU for US tax purposes. The self-employed and individuals who own investment property overseas are among the most significantly impacted groups.

For example, if you are a freelancer or run a small business and generate more than $400 per year through self-employment, you will be categorized as a QBU and obligated to complete Form 8858. Likewise, if you have an investment property located in a foreign country that produces rental income, you will be required to complete Form 8858. Deciding whether an activity carried out in a foreign location qualifies as a QBU/FB for US tax purposes requires an analysis of the facts and circumstances of each individual case.

When And Where To File Form 8858?
If you are the tax owner of a foreign disregarded entity or operate a FB, you need to submit Form 8858 and, if applicable, the separate Schedule M (Form 8858) to your tax return.
Form 8858 is due at the same time as your federal tax return. For most taxpayers, the due date is April 18, 2023, but US expats are granted an automatic two-month extension for filing, moving the deadline to June 15th.

Filing extensions apply to Form 8858 the same way they apply to your federal tax return. In case you request an additional filing extension (until October 15), it will also apply to Form 8858. Don’t forget to give yourself enough time to get your documents sorted before the filing deadline. You don’t want to end up with any late filing penalties, so make sure to plan ahead.

Form 8858 Penalty
What are the consequences of not filing an 8858? Failing to file the form along with your tax return within the designated timeframe can lead to the IRS imposing penalties or taking legal action against you at any time.

Penalties For Not Filing Form 8858
Financial Consequences – The penalty for non-filing or late filing is $10,000 for each annual accounting period of each CFC or CFP. So penalties start at $10,000 per year per company, but they can easily reach $60,000 or more. Here’s how:
If you are required to file Form 8858 but fail to do it in time, the IRS will send you a Failure to File letter. Once you received the letter, you have a 90-day period to submit the form. If you fail to meet this deadline, you will be charged an extra $10,000 on top of your original penalty for every 30-day period that the form remains overdue. These additional penalties are limited to a maximum of $50,000.

FTC Reduction – One significant advantage of conducting business overseas is the ability to use the Foreign Tax Credit (FTC) to offset any US tax liability. This can be done by claiming a credit for the amount of income tax paid to a foreign country. If you fail to file Form 8858, your FTC benefits will be reduced by 10%. If you fail to file within the 90-day period, the IRS will further reduce your foreign tax credit by 5% each month.
Criminal Penalties – in certain cases, the IRS can also charge you with criminal penalties under sections 7203, 7206, and 7207 of the US Tax Code. This can lead to additional fines or even imprisonment.
To avoid the penalties for failing to file, the best approach is to submit the form by its due date. If you’re concerned about filing delinquent forms or unsure about your filing requirements, it’s highly recommended to seek guidance from an experienced tax professional.

Who Must File Form 8858?
The US person filing Form 8858 is any US person that:
Is the tax owner of an FDE,
Owns a specified interest in an FDE indirectly or constructively through a CFC or a CFP, or
Operates (directly or indirectly through a tier of FDEs or partnerships) an FB.
The following US persons must file Form 8858 and Schedule M (Form 8858):

A US person that is a tax owner of a foreign disregarded entity or operates a foreign branch at any time during the tax year (or annual accounting period).
A US person that is either a direct or indirect owner (through a chain of FDEs or partnerships) of a foreign disregarded entity, or is operating a FB.
Certain US persons that are required to file Form 5471 for a controlled foreign corporation (CFC) that either holds an FDE as a tax owner or operates a FB at any point during the CFC’s annual accounting period.

Certain US persons are required to file Form 8865 with respect to a controlled foreign partnership (CFP) that is a tax owner of an FDE or operates an FB at any time during the partnership’s annual accounting period.
-A US partnership that is direct or indirect (through a tier of FDEs or partnerships) tax owner of an FDE or operates a FB.
-A US corporation that is a partner in a US partnership, which is required to file a Form 8858 because the US partnership is the tax owner of an FDE or a FB. This does not include a real estate investment trust (REIT), a regulated investment company (RIC), or an S corporation.
-A US person for tax purposes is a citizen or resident alien of the United States, a domestic partnership or a domestic corporation, any domestic trust, and any estate (other than a foreign estate).

Every type of business conducted outside the United States by US individuals is required to file a distinct business return, with no exceptions. Corporations (CFC) are reported on Form 5471 and partnerships (CFP) on Form 8865. Unincorporated businesses, regardless of whether the owner has limited (LLC) or unlimited liability, are reported on Form 8858.

Exceptions To Filing Form 8858
There are cases where you could be exempt from the obligation to file Form 8858. This may happen when multiple filers report the information for the same FDE or indirect FB for the same period. For instance, if you and another US taxpayer are either Category 4 or Category 5 filers of Form 8865, it’s possible that only one of you will be required to file 8858. However, as previously mentioned, failure to file could result in significant penalties. That’s why it’s essential to verify whether you’re required to file the form before choosing to exclude it from your tax filings for the year.

Form 8858 Schedules
Form 8858 consists of several schedules that are used to satisfy the reporting requirements of sections 6011, 6012, 6031, and 6038, and related regulations. If you have a filing obligation, you will need to file a correct and proper Form 8858 and all applicable schedules.

Let’s take a closer look at them:

Schedule C is the income statement of the reporting entity. It is used to report a summary income statement for the FDE or FB figured in the foreign disregarded entity’s functional currency in accordance with US generally accepted accounting principles (GAAP).
Schedule C-1 is used to report Section 987 gain or loss information. Section 987 prescribes the regime for dealing with a foreign branch that is a QBU using a foreign functional currency. The basic approach is to determine the profit or loss of the foreign disregarded entity for the tax year in its functional currency and then to translate the profit or loss at the appropriate exchange rate (the average exchange rate for the tax year).
Schedule F is used to report a summary balance for the foreign disregarded entity or translated into US dollars in accordance with US GAAP.
Schedule G is entitled “Other Information.” Schedule G asks a number of questions about the disregarded entity.
Schedule H should be used to report the foreign disregarded entity’s current E&P income (if the tax owner is a CFC) or the foreign disregarded entity’s taxable income (if the tax owner is a US person or a CFP).
Schedule I is used to report transferred loss amounts. Schedule I should only be completed if FDE or FB is owned: 1) directly by a domestic corporation; or 2) indirectly by a domestic corporation through a tiered structure of foreign disregarded entities. Schedule I should not be completed if the foreign branch or foreign disregarded entity is owned by a CFC.
Schedule J is used to report foreign income taxes paid or accrued by a foreign disregarded entity. The preparer should report. The preparer should report foreign taxes paid or accrued by a disregarded entity or foreign branch on Schedule J.
Schedule M is used to report transactions between foreign disregarded entities or foreign branches and the filer or other related entities. Every US person that is required to file Schedule M (Form 8858) has to report the transactions that occurred during the FDE’s or FB’s annual accounting period ending with or within the US person’s tax year.

In summary, filing the IRS Form 8858 is a critical tax requirement for US taxpayers who own foreign disregarded entities or operate foreign branches. Failure to comply with the regulations can result in significant penalties and other legal consequences. Due to the complexity of the form, it’s highly recommended to seek the assistance of a qualified tax professional. With our guidance and support, you can rest assured that your Form 8858 is completed accurately and all your tax requirements are met.

WRITTEN BY
Kasia Strzelczyk, EA
A certified accountant and IRS enrolled agent with over 8 years of experience working with US expats. With a deep understanding of the unique financial challenges faced by expats, Kasia is dedicated to helping clients navigate complex tax laws and regulations.

Have a question? Contact Olivier Wagner And Team, 1040 Abroad.