Example of the Tax Dabble Trap | Rochester MN International Tax Lawyer
Some years ago a Client (he was not a client at that time) inherited a Foreign Corporation. It was a mid-sized Foreign Corporation, and he was not the only owner there, but a partial owner, a minority owner.
In a Foreign country, the classification of ‘Entity’ may not be exactly in line with the US Tax Classification. So to figure out whether this is a Corporation or a Partnership, you really have to look into how this company operates and what the law says (in) how it operates.
He came to a Business Lawyer and actually there was an Accountant involved in this case as well. (We’ll talk about the next trap after that and why the Accountant may not have been the best choice there). An Accountant was involved there but the chief role was played by the Business Lawyer. The Business Lawyer was involved some years before in another Transaction. In that transaction, he was advised by the Accountant that the Form 5471 had to be filed and about the penalties associated with the form.
He told the Client, “We don’t know what kind of Entity this is and I know about this Form 5471 and based on what the Accountant told me, I don’t think your Entity is actually a Corporation; I think it’s a Partnership. You are a minority owner; that means that Form 8865 doesn’t apply and you don’t have the 5471 form requirement. That will be an easier way to get rid of the IRS Penalties associated with Form 5471.”
What he forgot about… well, two things is – one little detail about income. If it’s a Partnership, it’s a Pass Through Entity. That means that this Client was in Income Tax Non-Compliance since the time he inherited the Company. For this Client, that would mean that he was underreporting about 90% of his income in each year.
The second issue, is obviously the one I have already mentioned. You have to look at what the law says, what the Local Law says. How did the Company operate before? You cannot just randomly say: this a Foreign Partnership and this is a Foreign Corporation just because some of the details are here or some of the details are not here.
In the end, we were able to go back. It was a Corporation, not a Partnership so we were able to file a 5471 Voluntary Disclosure and were able to end that issue without any penalties. But if the IRS had audited his tax returns and discovered that he underreported his income by 90%, tremendous penalties would have ensued.
