Want to be tax-exempt? This is what it takes

Date November 16, 2022
Categories
Article Authors
HBK Nonprofit Solutions

You’ve decided to form a nonprofit. Just like forming a for-profit business, you have a lot of decisions to make upfront, many of which will require outside counsel from an accountant, a consultant, or an attorney. Without experienced counsel, your startup will face difficult challenges and could be doomed to failure.

First Step: Create Your Legal Entity.

For the IRS to recognize a nonprofit’s exemption from taxation, it must be organized as a trust, a corporation, or an association. (An unincorporated association can gain recognition as a tax-exempt organization, but this form of organization is not typically recommended for various reasons). Nonprofit incorporation or formation creates your nonprofit entity in your chosen home state. Your Articles of Incorporation/Formation will be required when applying for exempt status. This is also the first place where you will identify your nonprofit’s purpose.

Write Your Bylaws

Bylaws are legal documents, which means there are legal requirements for what should be included. These requirements vary depending on the state in which your nonprofit operates. To ensure your bylaws are in accordance with state laws, get assistance in drafting or amending your bylaws from a qualified professional experienced in nonprofit matters.

Your bylaws are your organization’s operating manual. Typically, they will include:
  • Size of the board and how it will function
  • Roles and duties of directors and officers
  • Rules and procedures for holding meetings, electing directors, and appointing or removing officers
  • Conflict of interest policies and procedures
  • Other essential corporate governance matters
  • As a governing document, your bylaws need to be included in your exemption application. The IRS looks for two key provisions to be included in either your Incorporation/ Formation Document or your bylaws:

  • A purpose clause: What are you going to do, and who will benefit from what you do? The purpose clause will help the IRS determine your organization’s exact exemption code.
  • A dissolution clause. How will you “go out of business” if the organization is not sustainable?
  • If you anticipate filing for 501c3 status, the IRS has specific requirements that apply to your purpose and dissolution clauses.

    The bylaws may be quite different depending on the organization. Is the goal to gain status as a public charity, a private foundation, or some other type of exempt organization such as a membership organization?

    Even with counsel, it’s still the board’s responsibility to provide input throughout the process and to vote to adopt the final product. Although bylaws are not considered public documents, making them public and easily available increases the organization’s accountability and transparency to donors, beneficiaries, and the general public.

    Develop a Business Plan

    Every nonprofit seeking tax-exempt status must have an Employer Identification Number (EIN), whether or not it has employees. File a Form SS-4 with the IRS to obtain your EIN.

    This is the time for the organization to act like a business and develop its business plan. The business plan should address/include the following:

  • Past, present, and planned activities and programs
  • Any planned compensation of directors, officers, trustees, and certain highly paid employees and contractors (“Close Personnel”)
  • Any planned compensation of Close Personnel from related organizations
  • Existing or planned sales and/or contracts between the organization and any Close Personnel (including any organizations they have certain affiliations with)
  • Discussion of family and business relationships among directors, officers, and trustees
  • Goods, services, and/or funds (grants) to be provided to individuals or organizations
  • Fundraising programs planned
  • Conflict of interest policy or explanation of how the organization manages conflicts of interest
  • Financials (actual and/or projected) for three or four years
  • Besides being a business best practice, gathering much of this information will be necessary if you are required to complete a full Form 1023 or 1024 for exempt status.

    Seek Exempt Status

    Incorporating a nonprofit in the state of formation only establishes it as a legal business entity. Creating a nonprofit corporation does not guarantee the organization will be granted tax-exempt status by the Internal Revenue Service (IRS). You must apply for tax-exempt status with the IRS and be approved. There are currently 40 different types of exempt organizations in the Internal Revenue Code. Only organizations that meet the requirements of Internal Revenue Code Section 501(a) are exempt from federal income taxation. And charitable contributions made to some Section 501(a) organizations by individuals and corporations are deductible under Section 170.

    Other benefits may include access to certain grant monies and income and property tax exemptions.

    Determining the correct exempt status for the organization will depend heavily on who will benefit from the mission or its purpose, whether the assets will be dedicated to the mission, and where funding will come from.

    Public Charities and Private Foundations

    Every exempt charitable organization is classified as either a public charity or a private foundation. Generally, organizations classified as public charities are:

  • Churches, hospitals, qualified medical research organizations affiliated with hospitals, schools, colleges, universities, and other organizations that benefit the general public;
  • Have an active program of fundraising and receive contributions from many sources, including the general public, governmental agencies, corporations, private foundations, and/or other public charities;
  • Receive income from the conduct of activities in furtherance of the organization’s exempt purposes; or
  • Actively function in a supporting capacity to one or more existing public charities.
  • Private foundations usually have a single major source of funding, typically a gift from one family or a corporation, and most have as their primary activity the making of grants to other charitable organizations and individuals rather than the direct operation of charitable programs. Some private foundations, called private operating foundations, do directly operate their own charitable programs.

    Political Organizations

    A political organization subject to Section 527 is a party, committee, association, fund, or other entity (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.

    Other Organizations

    Organizations that meet certain requirements may qualify for exemption under subsections other than 501(c)(3). These include social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues.

    Application for Exemption

    Certain types of organizations are automatically considered exempt without actually filing an application with the IRS, most notably, churches, their integrated auxiliaries, and conventions or associations of churches. Others must file either Form 1023, 1023-EZ, 1024, or 1024-A with the IRS seeking status. All applications are now filed online.

    Organizations seeking status under 501c(3) apply using a 1023 or 1023-EZ form. Others seek status by filing Form 1024 or 1024-A.

    When filing for a 501c3 determination, smaller organizations may file the simpler EZ Form— Streamlined Application, 1023-EZ. These applications are much easier and take less time complete, and the filing fee is smaller. Larger organizations will file full 1023 or 1024 forms and require much of the information in your “business plan.”

    To get the most out of your tax-exempt status, file your Application Form within 27 months of the date you file your nonprofit Articles of Incorporation. If you file within this time period, your nonprofit’s tax exemption when granted takes effect on the date you filed your Articles of Incorporation, and all donations received from the point of incorporation forward will be tax-deductible. If you file later and can’t show “reasonable cause” for your delay, your tax-exempt status will begin as of the date on your IRS Application.

    Once You File

    Once you submit your application, you will receive an acknowledgment notice from the IRS confirming receipt of your application. If the IRS needs more information, an Exempt Organization specialist may request further information and will contact you and/or your power of attorney. If you have counsel or another representative assisting you with your application, contact them immediately regarding the additional information being requested. Do not try to answer their questions without their assistance.

    Once the IRS completes its review of the exempt application, they will send you a determination letter, which will either grant your federal tax exemption or issue a proposed adverse determination, a denial of tax exemption that becomes effective 30 days from the date of issuance. If you receive a proposed denial of tax-exempt status, you have the right to appeal and should seek expert advice immediately. Do not delay; waiting to reply will risk the denial of your exemption.

    The IRS review process typically takes several months or longer. Be prepared to wait. The IRS is currently processing 95,000 applications annually. Applicants can review current wait times by going to the IRS website: https://www.irs.gov/charities-non-profits/charitableorganizations/wheres-my-application-for-tax-exempt-status. You can also contact the IRS by phone at 877-829-5500; by fax at 855-204-6184; or by regular mail at:

    Internal Revenue Service

    EO Determinations; Attn: Manager, EO Correspondence;

    P.O. Box 2508; Room 6-403; Cincinnati, OH 45202.

    Compliance Begins Immediately

    Unless you qualify for an exception from the requirement to file an annual return or notice, your filing obligations begin as soon as you are formed. If you have an annual information return or tax return due while your application is pending, complete the return by checking the “Application Pending” box in the heading Item B, and submit the return as indicated in those instructions. You should also determine when you are required to begin your state’s compliance filings, as each state has its own set of requirements.

    Setting up an exempt organization can be confusing, to say the least. The HBK Nonprofit Solutions team is here to help.

    Read the full Fall issue of Insights, the HBK Nonprofit Solutions quarterly newsletter.

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    Post Wayfair: Economic Nexus and Sales Tax Compliance

    Date December 13, 2021
    Categories
    Article Authors

    In 2018, in South Dakota vs. Wayfair (“Wayfair”), the U.S. Supreme Court denied a challenge to South Dakota’s law requiring remote sellers who sell into the state to collect sales tax if they exceed the state’s economic nexus threshold. The decision has materialized into new laws—every U.S. state that imposes a sales tax has passed “economic nexus” legislation—that require out-of-state businesses selling to customers in their states to collect and remit sales taxes on those sales once they have reached the certain sales or transaction thresholds. Before Wayfair, businesses were required to collect and remit sales taxes only if they had a physical presence in a particular state. Physical presence could refer to an office or other property, or to an employee entering the state to sell or provide services. But in the wake of Wayfair, a physical presence is no longer required for a state to compel sales tax collection. Economic nexus is sufficient and triggered when a business from outside the state sells a product or taxable service into the state. Economic nexus laws on remote sellers generally require out-of-state sellers to register, then collect and remit sales taxes when the sellers meet sales or transaction count thresholds, which are set independently by the each state. Some use strictly a dollar amount as a threshold, others a dollar amount and/or a number of transactions. Many states have chosen $100,000 in sales or 200 transactions as the levels of activity that trigger economic nexus, but each state has its own thresholds, rules, and guidelines. What Nexus Means to Businesses Many small and mid-size businesses have been slow to react to the new economic nexus laws. Complying can be cumbersome as well as expensive, especially if the business sells into several states, as each state may have different nexus requirements and sales tax rules. The sales tax nexus thresholds apply to annual activity, but sales tax filings are typically required on a monthly or quarterly basis, which can require the seller to add employees, make modifications to its accounting or resource planning systems, or engage an outside consultant or resource to keep up with all their sales tax compliance requirements. Despite complexity and cost, businesses small as well as large clearly are obligated to determine what additional states they will have to file in. They will have to register with the revenue departments in those states, collect sales tax from their customers, then file returns and remit the taxes. As well, some states have begun to apply the economic nexus standards to corporate income taxes, which could require sellers into their states to file and pay income taxes. Still, there are subtleties that require examination to determine where and even whether to register. Some states count only taxable sales towards their thresholds; others include gross sales or receipts. For example, a manufacturer that sells parts to a wholesaler for resale will not include those “sales for resale” in states where exempt sales are excluded from the threshold measure. However, that manufacture should ensure it receives an exemption certificate from its customer. Tracking and maintaining exemption certificates is key to avoiding any issues with a state that might later challenge the manufacturer’s nexus or filing determination. There are also the matters of materiality and practicality. A business could technically have an obligation to register and file sales tax returns, but will it do so if no tax liability exists and no taxable sales are planned? It is not uncommon for these businesses with minimal exposure to eschew registration. Often the minimal exposure is manageable compared to the administrative burden and costs associated with registering and regularly filing sales tax returns. HBK SALT Solutions How do you measure all those thresholds to determine where you need to register for sales tax? If a state economic nexus law went into effect in 2018, but your business hasn’t registered yet, what do you owe for prior years? There is often more than one solution to the economic nexus puzzle and more than one answer to the question of how to address the related sales tax compliance. The solution for your business needs to consider the quantified tax liability and associated risk. HBK can review your business activity and provide a concise economic nexus analysis. The HBK SALT professional team has been helping businesses address economic nexus and resolve their sales tax compliance issues with state revenue departments since Wayfair broke in 2018. We have sales tax nexus and compliance conversations with clients on a daily basis. We help clients evaluate their sales tax nexus and quantify their exposure. Identifying where your business has sales tax nexus is simply the first step on the road to compliance. There are many factors to consider in assessing sales tax nexus and what steps to take. HBK asks the right questions to craft a solution tailored to your business and its resources. There are many factors that go into determining the best course for addressing sales tax issues arising as a result of economic nexus. Our discussions with you will clarify your company’s issues and needs. The following questions provide a sense of the nuance involved in sales tax and also help identify the options available to taxpayers as they plan for sales tax compliance.
    • Is your product or service taxable in states where nexus has been established?
    • Does your business have a process in place to obtain exemption certificates from customers?
    • Does your business have past tax liability that is best addressed through a voluntary disclosure agreement?
    • Does your business have the resources to handle sales tax registrations in multiple states?
    • Does your business have the resources to file sales tax returns in multiple states?
    • Are your systems capable of calculating sales tax rates and reports in all jurisdictions?
    • Does your business need a sales tax software solution?
    • Has your activity in other states created nexus or filing obligations for income/franchise or gross receipts taxes?
    HBK will evaluate your obligations based on your response to these and other questions and provide an efficient solution. We will develop a plan with your input to address your sales tax responsibilities in an effective manner while considering risk and materiality. Our plan will consider a number of solutions from voluntary disclosure agreements to prospective registrations. A voluntary disclosure agreement is a proactive approach that allows us to contact a state without disclosing the taxpayer’s identity and typically results in the abatement of penalties and a limited lookback period in exchange for payment of tax and interest. If the economic nexus has been more recently established, we may put together a plan for prospective sales tax registration and documentation of prior periods. Through our experience and work, we have established relationships with state and local revenue departments throughout the nation. Our expertise and these relationships have allowed us to save our clients millions of dollars in reduced obligations while also increasing our clients tax compliance. As state and local governments seek to generate more revenue, they are leaving few stones unturned. We expect a substantial increase in state sales tax examinations in the coming years. States spent freely to combat the COVID pandemic and as business returns to normal they will be seeking to refill their coffers. Economic nexus is a tool they can use to generate substantial revenue and its primary target is out-of-state businesses. It is imperative that taxpayers engage their state and local tax expert to help them negotiate the current sales tax landscape and prepare to protect their bottom lines.
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    IRS Issues Draft 2019 Partnership K-1s with New Reporting Requirements

    Date November 5, 2019
    Categories
    Article Authors

    The IRS recently released the draft 2019 Form 1065 Schedule K-1. The draft includes significant changes which place new disclosure requirements on partnerships.

    According to the IRS release, the changes are intended to “improve the quality of the information reported by partnerships both to the IRS and the partners,” and “aid the IRS is assessing compliance risk” by identifying potential noncompliance. If finalized, these changes will create a significant compliance burden for partnerships.

    New Required Reporting

    Tax Basis Capital Accounts
    Perhaps the most impactful of these changes is the requirement that a partner’s capital account be reported on the tax basis. Historically, the responsibility for keeping track of a partner’s basis has belonged to the individual partners, not the partnership. In prior years, partner capital accounts could be reported using tax, GAAP, Section 704(b), or any other basis. For partnerships reporting capital on something other than tax basis, recreating partner basis schedules may be a time consuming and costly process.

    Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss)
    Section 704(c) requires the built-in gain or loss (differences in value and basis) of property contributed to a partnership be tracked and specifically allocated amongst the partners using one of several acceptable methods. Previous rules required the partnership to disclose the amount of gain or loss at the time of contribution, and when pre-contribution gain was recognized. The draft K-1 includes lines for reporting each partner’s beginning and ending share of unrecognized Section 704(c) gain or loss.

    Separate Reporting of Guaranteed Payments for Services and Capital
    Guaranteed payments to partners will be broken out and reported on two separate lines of the K-1, one for services, and one for capital. A third line is added to the K-1 to report the total guaranteed payments. The new requirement may be linked to the IRS interpretation that guaranteed payments for the use of capital are subject to the new Section 163(j) limitation on the deduction for business interest.

    Section 751 Gain (Loss)
    Gain on the sale of a partnership interest, which is generally taxed at favorable capital gains rates, is reclassified as ordinary if the partnership owns Section 751 “hot assets.” Under the current rules, partnerships must file Form 8308 to report a sale or exchange of a partnership with Section 751 assets. The draft K-1 includes a requirement to report Section 751 gain or loss on the face of the K-1.

    Additional Disclosures
    • The K-1 for a partner that is a disregarded entity must identify the name of its beneficial owner
    • Whether or not the allocated liabilities amounts include amounts from lower tier partnerships
    • A special code for reporting income and deductions associated with Section 743(b) adjustments
    • Whether a decrease in a partner’s profit, loss or capital is due to a sale or exchange of the partnership interest
    • If the partnership aggregated or grouped activities for at-risk or passive activity purposes

    Impact on 2019 and Beyond
    Compliance with the numerous changes will require substantial effort from both tax professionals and partnership owners, adding time and complexity to the tax preparation process. HBK suggests taxpayers and their advisors start gathering the needed data now to ensure timely and complete filings for 2019 and beyond. For questions, please contact a member of the HBK Tax Advisory Group at 330-758-8613.

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    DoD Contractors Must Demonstrate Cybersecurity Maturity Soon

    Date October 17, 2019
    Article Authors
    HBK CPAs & Consultants

    The Department of Defense (DoD) has released a draft of its Cybersecurity Maturity Model Certification (CMMC) framework. It comes as part of the DoD’s initiative to assess and enhance the cybersecurity posture of its supply chain.

    Currently DoD contractors must comply with the National Institute of Standards and Technology (NIST) SP 800-171 via the Defense Federal Acquisition Regulation Supplement (DFARS) clause 252.204-7012. To date, the regulation does not provide a mechanism for demonstrating compliance, which has been based on assumed good will and trust. However, the CMMC will soon start enforcing verification on a contractual basis; this will solidify a company’s compliance.

    The DoD’s intent is to improve the identification (and subsequent notifications) of cybersecurity risk by having independent third-party organizations conduct audits to demonstrate contractors’ compliance with the CMMC.

    The proposed CMMC combines various cyber security standards and best practices and maps these controls and processes across five maturity levels. With each level of maturity, the required controls and processes grow more sophisticated. For example, Level 1 maturity will encompass basic cyber hygiene requirements whereas Level 5 will require an advanced degree of controls and processes. Each level will clearly define the controls and processes necessary for compliance.

    All companies conducting business with the DoD will require certification —albeit at varying maturity levels as dictated by the DoD and its specific contractual requirements. The main component or driver of maturity will likely be contractors’ services and exposure to DoD data. But regardless of the focus of the audits, the CMMC introduces a new level of compliance that DoD contractors must prove they are meeting through external audits and certification.

    As of now the DoD has not set the date for when contractors must demonstrate compliance with the CMMC. The final version of the framework is expected to be released in January 2020. The DoD said it will be used in new solicitations starting in Fall 2020. However, with the December 31, 2017 deadline for compliance with NIST 800-171 long passed, most contractors should be well on their way to being able to demonstrate some level of cyber security maturity.

    Although the NIST SP 800-171 controls are referenced in the CMMC model—and “coverage” of all NIST SP 800-171 security controls is a requisite for meeting Level 3 certification—the framework has been influenced by other sources, such as ISO 27001:2013. Consequently, even the most mature contractors may have some work to do and should plan accordingly.

    We recommend starting with an assessment of your current controls and processes. Understanding where you are is pivotal to determining where you want to be and how you are going to get there. An assessment will serve to identify gaps or weaknesses in your current controls and processes and help us develop a plan of action to correct the deficiencies in a timely and scheduled manner.

    Getting a head start can be the difference between meeting contractual obligations or being in breach — the difference between winning and losing.

    For more information or to schedule an appointment, call (724) 934-5300; or email me at MSchiavone@hbkcpa.com.

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    A (Technological) Change Will Do You Good

    Date October 15, 2019
    Article Authors
    HBK CPAs & Consultants

    Adapting to technological change is a challenge all businesses face. Some changes force the matter — like required compliance with privacy and cyber regulations — while others, such as implementing a vendor risk management program, may seem less urgent. Regardless, businesses must recognize the need for a particular change and act accordingly.

    A recent study conducted by the Information Systems Audit and Control Association (ISACA) and the global consulting firm Protiviti revealed the top five technology challenges faced by businesses today as:

    1. IT security and privacy/cyber security
    2. Data management and governance
    3. Emerging technology and infrastructure changes
    4. Resource/staffing/skills
    5. Third-party/vendor risk management

    While all organizations face the same challenges, small and medium-sized businesses can find them more difficult to overcome, especially as they relate to number four on the list: a lack of resources, staffing and skills.

    Monetary considerations aside, it is difficult to find qualified personnel. Addressing security, privacy, governance and infrastructure (effectivel, numbers one through three on the list) requires professionals with sophisticated skill sets. The difficulty and expense associated with trying to meet these demands internally make it more reasonable to outsource them.

    We are here to help. HBK offers cost-effective solutions to address these challenges. We have IT professionals across numerous disciplines, from specialists in privacy regulations to technicians who facilitate infrastructure changes. Get access to the specific skill sets and resources you need when you need them. For more information or to schedule an appointment, call (724) 934-5300; or email me at MSchiavone@hbkcpa.com.

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    GRC: Just Another Acronym?

    Date October 8, 2019
    Article Authors

    Governance, Risk Management and Compliance (GRC) is a methodology that provides organizations with an integrated approach to cyber security maintenance. It is most efficient when executed in its entirety as a three-pronged but single initiative though they are often considered separately.

    • Governance is the process ensuring effective and efficient use of Information Technology (IT) to enable an organization to achieve its fundamental goals.
    • Risk Management is the process of identifying, assessing and managing risk as a way to help achieve an organization’s objectives and based on its tolerance for threats — in short, clearly establishing the company’s risk acceptance or risk avoidance.
    • Compliance involves adhering to accepted practices, rules and regulations within a business at an industry or governmental level –or both.

    One should take a holistic approach to GRC, as with any control or protocol it establishes to mitigate a risk. That is, the cost to implement the control should be less than the cost of actual exposure to the risk being mitigated. This approach is expanded by GRC when an individual or business considers costs associated with non-compliance — namely, fines or penalties.

    The culmination of Governance, Risk Management and Compliance occurs when IT policies help convert the desired behaviors of team members into a formal, successful cyber security plan.

    HBK Risk Advisory Services can help you design and develop your own GRC program to protect your business. Contact Bill Heaven at 330-758-8613; or via email at wheaven@hbkcpa.com. As always, HBK is here to answer your questions and discuss your concerns.

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    Doing Business with Microsoft? Privacy Protection is Key

    Date September 9, 2019
    Article Authors
    HBK CPAs & Consultants

    Microsoft executives take security and privacy initiatives seriously. Not just their own, but those of their vendors, as well.

    Microsoft is committed to Vendor Risk Management (VRM). Suppliers and business partners are often required to undergo varying levels of attestation to their information security initiatives, including SOC 2 or Microsoft’s Supplier Security and Privacy Assurance (SSPA).

    Microsoft has established data protection requirements (DPRs) for suppliers who process Microsoft personal or confidential data. More often than not, suppliers must undergo annual attestation as to their ability to meet the requirements defined in Microsoft’s DPR.

    “Process” in Microsoft’s DPR refers to any operation or set of operations performed on any Microsoft personal data or confidential data—and whether or not operations are by automated means. Processes include collection, recording, organization, structuring, storage, adaptation or alteration, retrieval, consultation, use, disclosure by transmission or dissemination, and alignment or combination, restriction, and erasure or destruction.

    SSPA is a Microsoft program that involves not only making sure that suppliers understand these requirements but ensuring their compliance. The program combines Microsoft Procurement, Corporate External and Legal Affairs, and Corporate Security to make certain that suppliers follow privacy and security principles when processing Microsoft personal data or Microsoft confidential data. It covers all global suppliers processing Microsoft personal or confidential data.

    Suppliers considered high risk are required to provide independent verification of DPR compliance. Such companies are asked to select an independent auditor affiliated with the American Institute of CPAs (AICPA) or the International Association of Privacy Professionals to assess DPR compliance; that auditor is responsible for providing an unqualified letter of attestation to the Microsoft SSPA.

    At HBK, our affiliation with the AICPA is merely one aspect of our capabilities. Our auditors have years of experience performing attestation engagements, including extensive SOC 2 work. We have intimate knowledge of security and privacy best practices and hold these critical credentials: Certified Information Systems Security Professional (CISSP) and Certified Information Systems Auditor (CISA).

    Most importantly, we are experienced in navigating businesses through Microsoft’s SSPA and compliance with the company’s Data Protection Requirements.

    We can help you if Microsoft is on your business horizon and you want to maximize the value of these efforts–or if you’re preparing for a security audit. Call us at 724.934.5300 or email me at MSchiavone@hbkcpa.comand let’s get started.

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    Reminder about Requirements for Foreign-Owned U.S. Disregarded Entities

    Date March 30, 2018
    Article Authors
    HBK CPAs & Consultants

    The Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) issued final regulations on December 13, 2016 for the Internal Revenue Code (“IRC”) Sections 6038A and 7701. These regulations take effect for tax years beginning after January 1, 2017 and make way for additional filing requirements for domestic disregarded entities (DREs) that are wholly owned by foreign persons.

    Under the new rules, foreign-owned Disregarded Entities (DREs) are required to file Form 5472, Information Return of a 25 percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. For many foreign-owned DREs, this new requirement has added implications. In order to file Form 5472, these entities are now required to obtain an Employer Identification Number (EIN) if they have not yet established one. When applying for an EIN, the foreign-owned DRE must identify the owner or name of a responsible party. If the foreign owner or responsible party does not have a Social Security Number (SSN) or an Individual Taxpayer Identification Number (ITIN) potential complications can arise.

    Another nuance under these regulations is a requirement for foreign-owned DREs to maintain books and records that would allow them to accurately file Form 5472 and follow US tax treatment with respect to reportable transactions. Reportable transactions under these regulations include sales, assignments, leases, licenses, loans, advances or any other transfer that constitutes a right to use property or money in addition to the performance of any services for the benefit of or on behalf of another taxpayer. In addition, contributions and distributions are also considered reportable transactions under IRC 6038A.

    To facilitate compliance with the additional requirements of Section 6038A and the required reporting under Form 5472, a foreign-owned DRE that has a U.S. filing requirement is required to have the same taxable year as the foreign owner; and similarly, if the foreign owner has no U.S. filing requirement, the taxable year of the entity is the calendar year unless otherwise indicated.

    The penalties for failure to file are steep. Not filing Form 5472 could cost a taxpayer $10,000. This penalty can also be assessed for failure to maintain proper records. In fact, filing a substantially incomplete Form 5472 would constitute a failure to file Form 5472 and the $10,000 penalty can be assessed. However, there is no guidance provided by the IRS or any other regulatory agency as to what constitutes filing a substantially incomplete Form 5472. Criminal penalties may also apply for failure to submit information or for filing false or fraudulent information. Lastly, foreign-owned DREs cannot electronically file Form 5472.

    If you have any questions regarding the new filing requirements, please reach out to a member of the Tax Advisory Group (TAG) at HBK.

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