January 9, 2017 | Fund Forum

Rise of the Disregarded Entities

3 min

A new U.S. tax regulation is bringing back to life entities the fund community has taken for granted as dead for U.S. tax purposes. It requires U.S. disregarded entities (DEs) to file an additional information return for taxable years beginning on or after January 1, 2017.

As many investors in the fund space know, under the U.S. tax regulations commonly known as the "check-the-box rules" adopted about 20 years ago, a U.S. limited liability company (LLC) with a single member generally is "disregarded" as an entity separate from its owner for U.S. federal tax purposes; meaning that, subject to limited exceptions, a U.S. DE does not file its own tax return or pay its own taxes, and is merely considered a branch or an arm of its owner for U.S. federal tax purposes.

Therefore, an investor could benefit from the limited liability and anonymity associated with a single-member U.S. LLC, without the attendant tax costs, including filing costs. These favorable tax entity classification rules have gradually been adopted by many U.S. states and localities for their own tax purposes, and have led to an explosion in the use of single-member LLCs for business and investment purposes.

The new U.S. tax regulation, finalized in December 2016, now requires a U.S. DE wholly owned by a foreign person to file the IRS Form 5472, as if it were a U.S. corporation, with respect to taxable years when the U.S. DE engages in certain "reportable transactions" (see below) with "related parties," and to maintain records forming the basis for the filing. "Related parties" for this purpose include persons that own, directly or by attribution, 25% or more of the U.S. DE, as well as entities under common ownership or management control with the U.S. DE. Thus, the identities of a fund's major investors and/or the fund's special-purpose vehicles and portfolio companies may be disclosed to the IRS on this form. In addition, a fund interposing a U.S. DE in the ownership chain solely to secure a U.S. venue and law to govern an otherwise all-foreign transaction may be subject to this reporting.

"Reportable transactions" required to be disclosed on the Form 5472 include, among others, any loans outstanding between the U.S. DE and any related party, interest paid, and other items that affect the tax computation of the U.S. DE (as if it were a U.S. corporation). Thus, a typical earnings-stripping transaction using debt as a portion of capital of a U.S. DE (even if motivated for non-U.S. tax reasons) may now have to be reported to the IRS.

If a U.S. DE does not file the Form 5472 for any taxable year with a reportable transaction, it will be subject to a $10,000 penalty per failure, and the statute of limitations for all income tax return items of the U.S. DE (and, indirectly, the foreign owner) will remain open for the IRS's scrutiny. The penalties should not be taken lightly, given the current intensity of the IRS policing of the cross-border reporting and filing failures.

Thus, every fund community member should engage in an extensive analysis of a fund's use of U.S. DEs, in a timely manner, to avoid the penalties and the open statute of limitations. In addition, a fund community member should consider whether using a U.S. DE is an appropriate vehicle for a particular investment structure, given the requirement to disclose the identity of major investors and the identities of a fund's special-purpose entities and portfolio companies.