Authored by Pietro Stuardi and Brian Malecki
Effective for tax years beginning after Dec. 31, 2015, the IRS has extended the requirement to report specified foreign financial assets (SFFAs) to certain domestic entities.1
The IRS issued final regulations on the application of the rules that require certain domestic entities to annually report their interest in certain foreign financial assets. Section 6038D of the Internal Revenue Code, enacted in 2010 as part of the Foreign Account Tax Compliance Act (FATCA), requires U.S. persons who own certain foreign investment-type assets to make a disclosure of such assets on their federal income tax return. Under the regulations, the requirement is satisfied by attaching Form 8938, Statement of Specified Foreign Financial Assets, to the applicable federal return.2 These rules impose an additional reporting requirement on U.S. taxpayers with foreign assets, separate and distinct from the reporting of foreign bank accounts (FBAR) on FinCen Form 114.
Under prior law, the reporting of SFFAs on Form 8938 solely applied to individuals, provided that the value of the reportable foreign assets exceeded the prescribed thresholds.3 For tax years beginning on or after Jan. 1, 2016, the reporting requirement is expanded to apply to domestic corporations (including S corporations), partnerships and trusts that meet the definition of specified domestic entities (SDEs).1
Expanded disclosure obligations not to be taken lightly
Generally, an SDE is a closely held U.S. entity owning predominantly passive assets. Determining whether an entity meets the definition of SDE is relatively straightforward in some circumstances, such as in the case of family partnerships holding investment property. In other cases, however, addressing Form 8938 filing requirements may be more complex. Nonetheless, great caution should be exercised in this area in light of the harsh civil penalties that may be imposed for failure to meet the reporting obligations.
1. What corporations and partnerships are subject to the new reporting requirements?
When it comes to corporations and partnerships, the regulations outline two tests that must be considered when determining if an entity is an SDE. A domestic corporation or partnership qualifies as an SDE for a given tax year if (a) it is closely held by a specified individual (closely held test) and (b) it meets one of the following two criteria (passive test): at least 50 percent of the entity’s gross income for the year is passive income or at least 50 percent of its assets are passive assets.4 If an entity is closely held and meets either criteria for the passive test, the entity is classified as an SDE and required to file Form 8938, granted it holds SFFAs valued in excess of the filing threshold.
Specified individuals are individuals otherwise subject to Form 8938 reporting. They include U.S. citizens, resident aliens (under the green card test or substantial presence test) and certain nonresident aliens electing to be treated as resident aliens for purposes of filing a joint income tax return.5
Since the determination of SDE status is made on an annual basis, it is anticipated that entities may have to file Form 8938 in some years, but not others.
2. What is a closely held corporation or partnership for the purposes of Form 8938?
A domestic corporation is considered closely held if at least 80 percent of the total combined voting power of all classes of stock with voting rights, or at least 80 percent of the total value of all the stock, is owned, directly, indirectly or constructively, by a specified individual on the last day of the corporation’s taxable year.6
A domestic partnership is closely held if at least 80 percent of the capital or profits interest is held, directly, indirectly or constructively, by a specified individual on the last day of the partnership’s taxable year.7
For purposes of these tests, constructive ownership is determined under the rules of section 267(c) and section 267(e), with the notable modification that in determining SDE status the family of an individual includes the spouses of the individual’s family members.8
3. What is passive income for purposes of determining SDE status?
The most common items of income in this category include dividends, interest, rents and royalties (not derived in a trade or business conducted, at least in part, by the entity’s employees), annuities and net capital gains from passive assets. However, under the regulations, additional types of income may be considered passive, including net section 988 currency gains.9
4. What are passive assets for purposes of determining SDE status?
Passive assets include any assets that produce, or are held for the production of, the passive income items outlined above.10Common examples include stock, notes and passive rental properties. Rather than providing an exhaustive list, the regulations define passive assets only with reference to passive income. As a result, some uncertainty exists regarding the treatment of assets that do not generate any income or that may generate both passive and nonpassive income, such as cash held as working capital for day-to-day operations. Absent further guidance, taxpayers should seek assistance when valuing passive assets.
Whether passive assets represent at least 50 percent of the total assets’ value is to be determined using the weighted average percentage, measured quarterly. Either the fair market value or the book value of the assets may be used in applying this test.11
5. How does the “passive test” apply to related entities and affiliated groups?
If a group of domestic corporations or partnerships are closely held by the same specified individual through a common parent corporation or partnership, then each entity is treated as owning the combined assets and earning the combined income of all the members of the group (after appropriate elimination of intercompany transactions). Generally, a common parent corporation or partnership will be deemed to exist when member entities within the group are connected by 80 percent or more ownership.12
For example13, assume that A, a specified individual, owns 100 percent of a domestic partnership, DP, and a domestic corporation, DC1. DP solely owns $50,000 of passive assets, which are SFFAs. DC1’s only asset is 80 percent of the stock of DC2. DC2, in turn, owns $40,000 of business assets and $60,000 of passive assets, which are SFFAs.
DC1 and DC2, both closely held by A, are considered related entities owned through a common parent (DC1). Thus, DC1 and DC2 are each tested for passive assets based on the combined passive assets ($60,000, not including DC1’s equity in DC2) over the combined total assets ($100,000, not including DC1’s equity in DC2). Since passive assets are 60 percent of the total, both DC1 and DC2 meet the passive asset test and will be potentially subject to filing Form 8938.
DP, although also closely held by A, is not part of the same “common parent group” as DC1 and DC2. Therefore, DP is subject to the “passive test” on a stand-alone basis.
6. What are the reporting thresholds for SDEs and how are they determined?
The reporting threshold is met if the total value of all the SFFAs held by an SDE is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.14 Notably, if a domestic corporation or partnership owns any SFFAs, it must determine the filing threshold by aggregating the value of all the SFFAs owned by any domestic corporation or partnership closely held by the same specified individual.3 Different from the “passive test” illustrated above, whether related entities are held via a common parent is irrelevant to the determination of the reporting threshold.15
For example16, assuming the same facts of the scenario above, DC2 and DP, while not part of the same “common parent group,” each meets the reporting threshold determined by combining their respective SFFAs (totaling $110,000). On the contrary, since DC1 does not own any SFFA, DC1 is not treated as owning the related entities’ SFFAs, and therefore it does not meet the filing threshold.
The value of certain SFFAs is excluded from the filing threshold determination based on the exception discussed below.
7. What foreign assets are subject to reporting?
SDEs are required to report the same foreign assets reportable by specified individuals under prior law. Examples of reportable assets include financial accounts maintained by foreign financial institutions as well as foreign investment assets not held in a financial account, such as foreign stock and securities, other interests in foreign entities including foreign trusts and estates, notes, bonds and financial instruments with a foreign counterparty.17
8. What if SFFAs are reported on other forms?
Many taxpayers report information regarding SFFAs on other forms included with their federal returns, for example: Form 3520, Form 5471, Form 8621 and Form 8865. As it is the case for specified individuals, the regulations provide that SDEs do not have to duplicate reporting for such assets on Form 8938. Rather, SDEs must identify the form(s) where such assets were reported.18
However, unlike specified individuals, SDEs do not include the value of these excepted assets in determining if they have met the reporting threshold.19 As a practical consequence, an SDE owning only excepted SFFAs would not be required to file Form 8938. Conversely, a specified individual owning only excepted SFFAs would still be required to file Form 8938 and identify the forms where the assets are reported, if the value of excepted assets meets the reporting threshold.
9. How does the filing requirement apply to domestic trusts?
A trust treated as a U.S. person as defined in section 7701(a)(30)(E) is considered an SDE only if the trust has one or more specified persons (either a specified individual or an SDE) as a current beneficiary for the taxable year.20 For these purposes, current beneficiaries for a year include any persons entitled to distributions, or who may receive distributions at the trustee’s discretion, whether or not distributions are actually made in the year. Additionally, any holder of a general power of appointment, whether or not that power is exercised, but was exercisable at any time during the taxable year would also be considered a current beneficiary. This does not include a holder of a general power of appointment that is exercisable only on the death of the holder.21
A trust qualifying as an SDE is subject to the filing thresholds discussed above based on the value of SFFAs it holds; however, rules regarding related entities and affiliated groups are not applicable to trusts.
10. Are any entities excepted from filing Form 8938?
Certain entities that would otherwise qualify as SDEs are exempted from the reporting requirements of section 6038D. Exempt entities include publicly traded corporations and their affiliates, organizations exempt from taxation under section 501(a), banks, REITs, RICs22 and certain trusts that have U.S. banks, SEC-regulated entities or publicly traded corporations acting as their trustees.23
Furthermore, U.S. grantor trusts are exempted from Form 8938 reporting to the extent the grantor who is treated as the owner of the trust under section 671 through 678 is a specified individual.24
The IRS continues to remind U.S. taxpayers of their reporting requirements associated with foreign accounts and assets. One of these requirements may be completing and attaching to their return a Form 8938, Statement of Foreign Financial Assets. Generally, U.S. citizens, resident aliens and certain nonresident aliens must report specified foreign financial assets on Form 8938 if the aggregate value of those assets exceeds certain thresholds. In addition, effective for tax years beginning after Dec. 31, 2015, certain domestic entities are also required to file Form 8938. Taxpayers with foreign accounts should consult their tax advisor to determine their additional reporting requirements.
1 Treas. Reg. Sec. 1.6038D-6, effective for tax years beginning after Dec. 31, 2015, provides the definition of specified domestic entities that are subject to the reporting Under Sec. 6038D. For periods before the effective date, the requirement was not operative with respect to persons other than individuals.
2 Treas. Reg. Sec. 1.6038D-4(a).
3 Treas. Reg. Sec. 1.6038D-2(a).
4 Treas. Reg. Sec. 1.6038D-6(b).
5 Treas. Reg. Sec. 1.6038D-1(a)(2).
6 Treas. Reg. Sec. 1.6038D-6(b)(2)(i).
7 Treas. Reg. Sec. 1.6038D-6(b)(2)(ii).
8 Treas. Reg. Sec. 1.6038D-6(b)(2)(iii).
9 Treas. Reg. Sec. 1.6038D-6(b)(3)(i).
10 Treas. Reg. Sec. 1.6038D-6(b)(1)(ii).
11 Treas. Reg. Sec. 1.6038D-6(b)(1)(ii).
12 Treas. Reg. Sec. 1.6038D-6(b)(3)(iii).
13 See Treas. Reg. Sec. 1.6038D-6(b)(4), examples (1), (2) and (3).
14 Treas. Reg. Sec. 1.6038D-2(a)(1).
15 Treas. Reg. Sec. 1.6038D-2(a)(6)(ii).
16 See Treas. Reg. Sec. 1.6038D-6(b)(4), example (2)(iii).
17 Treas. Reg. Sec. 1.6038D-3.
18Treas. Reg. Sec. 1.6038D-7(a).
19 Treas. Reg. Sec. 1.6038D-2(a)(6)(i) and (ii).
20 Treas. Reg. Sec. 1.6038D-6(c).
22 Treas. Reg. Sec. 1.6038D-6(d)(1) referencing the definitions of Sec. 1473(3).
23 Treas. Reg. Sec. 1.6038D-6(d)(2).
24 Treas. Reg. Sec. 1.6038D-6(d)(3).