Question:
If a U.S. citizen establishes a Puerto Rican corporation (or a Puerto Rico LLC taxed as a corporation for U.S. tax purposes) and contributes capital to the entity, is the individual required to notify the IRS?
Answer:
Yes, the U.S. citizen is considered a U.S. person, and the Puerto Rican entity is classified as a foreign corporation. Therefore, the cash contribution to the Puerto Rican corporation must be reported to the IRS on Form 926.
Requirement to File Form 926
Under Code §6038B(a)(1), any U.S. person who transfers property to a foreign corporation in a Code §351 exchange (among other types of exchanges) is required to provide the IRS with specific information about the exchange. The regulations under Code §6038B mandate that this information be submitted on Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, which must be attached to and filed by the due date (including extensions) of the transferor’s income tax return for the year in which the transfer occurs.
It is not only cash transfers that must be reported on Form 926; other forms of property transferred by U.S. persons to foreign corporations in Code §351 exchanges also require reporting.
Furthermore, transfers that qualify for nonrecognition treatment under Code §§332, 354, 355, 356, and 361 must also be reported on Form 926. However, Code §351 exchanges are the most common type of transfer requiring this reporting, so the primary focus here is on those exchanges.
Puerto Rican Corporations Are Not Exempt
Certain IRS international information returns have specific rules or exceptions for bona fide residents of Puerto Rico. For instance, Puerto Rican financial assets are excluded when determining the threshold for filing Form 8938. Additionally, Form 5471 is not required for certain Puerto Rican corporations that have active businesses in Puerto Rico and primarily generate Puerto Rican-sourced income.
However, neither the statute nor the regulations provide any exceptions to the requirement for bona fide residents of Puerto Rico to file Form 926. Furthermore, Puerto Rican corporations are generally treated as foreign corporations. Under Code §7701(a)(4), the term “domestic” refers to corporations created or organized in the United States or under U.S. law. Code §7701(a)(9) defines “United States” to include only the States and the District of Columbia. Therefore, Puerto Rican corporations are typically classified as foreign, not domestic.
As a result, the regular filing requirements for Form 926 apply to bona fide residents of Puerto Rico in the same way they apply to any other U.S. person transferring property to a foreign corporation.
It is common to establish businesses in Puerto Rico as limited liability companies (LLCs). When a U.S. domestic LLC is formed without making an entity classification election, the LLC is automatically treated as a pass-through entity (a partnership if it has more than one owner, or a disregarded entity if it has a single owner). However, when a Puerto Rican LLC is formed without an entity classification election, it defaults to being classified as a corporation. A Puerto Rican LLC is an “eligible entity,” and an entity classification election can be made to treat it as a partnership or disregarded entity, depending on the number of owners. These elections are made on Form 8832, Entity Classification Election. If a Puerto Rican LLC is classified as a pass-through entity for U.S. tax purposes, it must also be treated as a pass-through entity for Puerto Rico tax purposes.
Special Rule for Transfers of Cash
A U.S. person must report a transfer of cash to a foreign corporation in a Code §351 exchange only if one of the following conditions is met: (1) immediately after the transfer, the person holds (directly, indirectly, or by attribution) at least 10% of the vote or value of the foreign corporation, or (2) the amount of cash transferred by the person (or any related person) to the foreign corporation during the 12-month period ending on the transfer date exceeds $100,000. Therefore, if only cash is transferred, the transfer amount is less than $100,000, and the transferor owns less than 10% of the foreign corporation, no Form 926 is required.
Outbound Transfers to Foreign Partnerships
Form 926 is not used to report transfers by U.S. persons to foreign partnerships. Instead, transfers to foreign partnerships are reported on Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.
Outbound Transfers by Partnerships
When a partnership transfers property to a foreign corporation in a Code §351 exchange, it is the partners of the partnership who are considered to be making the transfer to the foreign corporation. (See Treas. Reg. §§1.6038B-1(b)(1)(i) and 1.367(a)-1T(c)(3).) Therefore, if a partnership with U.S. partners forms a foreign corporation and transfers property to it, the U.S. partners are the ones required to file Form 926, not the partnership itself. Each partner is treated as transferring a proportionate share of the property. A U.S. person’s proportionate share of the partnership’s property is determined according to the partnership rules and principles under Code §§701 through 761.
Strict Requirements for Reasonable Cause Relief
It is not uncommon for taxpayers to overlook filing Form 926. However, if a taxpayer later realizes that the form was missed, it is crucial to promptly file an amended tax return that includes the missed Form 926. Timely filing of the amended return is essential if the taxpayer intends to claim reasonable cause to avoid penalties.
For example, if a taxpayer fails to file Form 926 on time and later discovers the oversight, but does not immediately file an amended return with the form and instead waits to see if they are audited by the IRS, the taxpayer would be prevented from claiming reasonable cause for the late filing once the IRS audit begins.
Penalties for Failing to File
If a taxpayer fails to file Form 926 when required, the IRS can impose a penalty equal to 10% of the fair market value of the property at the time of transfer. The penalty is capped at $100,000, unless the failure to comply was due to intentional disregard. Additionally, the statute of limitations for tax assessment (i.e., the period during which the IRS can initiate an audit and assess additional tax) is extended to three years after the required information is provided. This means that if the form is not filed, the IRS may reopen your tax return at any time in the future to conduct an examination and assess any additional tax, interest, and penalties.
Gain Recognition on Outbound Transfers of Appreciated Property
Generally, gain is recognized when a U.S. person transfers appreciated property to a foreign corporation. However, certain transfers of appreciated stock to a foreign corporation may not require immediate recognition of gain. Under the regulations, a transfer of appreciated stock of a foreign corporation to another foreign corporation in a Code §351 exchange typically requires the transferor to enter into a “gain recognition agreement” to defer gain recognition. Additionally, a transfer of appreciated stock of a domestic corporation to a foreign corporation in a Code §351 exchange generally triggers gain recognition unless at least five specific tests are met.
The exception for the active conduct of a trade or business, which previously allowed deferral of gain on outbound transfers of property, was repealed in 2017 with the enactment of the Tax Cuts and Jobs Act.
Outbound Transfers of Intangible Property
When a U.S. person transfers certain types of intangible property to a foreign corporation, different rules apply. Rather than recognizing immediate gain, the transferor is treated as having sold the property to the foreign corporation in exchange for annual deemed royalty payments throughout the property’s useful life. However, the U.S. transferor may elect to treat the transfer as a sale, bypassing the requirement to recognize deemed royalties on an annual basis.
Other Rules
There are several additional rules that may apply to a U.S. person’s transfer of property to a foreign corporation, which can overlap with one another. For example, the branch loss recapture provisions under Code §91 may apply, or gain could be recognized under the overall foreign loss rules of Code §904(f), the dual consolidated loss rules of Code §1503(d), or the anti-inversion rules of Code §7874, which may result in the foreign corporation being treated as a domestic entity. As such, it is crucial to consider all relevant outbound transfer regulations when transferring property to a foreign corporation.
Additionally, it is important to note that “deemed” transfers to a foreign corporation can occur. For instance, if (1) a U.S. person owns a foreign entity, (2) that entity is classified as a disregarded entity, and (3) an election is made to reclassify the foreign entity as a corporation, the U.S. person is considered to have contributed all the entity’s assets and liabilities to the newly classified foreign corporation in exchange for its stock.
Example – Forming a Puerto Rican LLC (Year 1)
Sarah is a bona fide resident of Puerto Rico for the entire Year 1. She had been operating as a sole proprietorship. During Year 1, Sarah establishes a Puerto Rican LLC (“PRCo”) but does not make an entity classification election, so PRCo defaults to being classified as a corporation.
During Year 1, Sarah contributes $10,000 in cash and a customer list, which she had been using in her sole proprietorship, into PRCo. Both the cash and the customer list must be disclosed on Form 926. Since the customer list is considered intangible property under Code §367(d)(4), Sarah is treated as having sold the customer list to PRCo in exchange for annual deemed royalty payments over the list’s useful life.
Assuming the customer list is valued at $200,000 and the appropriate arm’s-length royalty rate for its use is 10%, Sarah would need to report $20,000 (10% of $200,000) as deemed royalty income on her U.S. tax return. These deemed royalties would continue annually for the duration of the customer list’s useful life.
Example – Contributing Cash to a Puerto Rican LLC (Year 2)
As discussed earlier, one of the transfers that must be reported on Form 926 is when a U.S. person transfers property to a foreign corporation in a Code §351 exchange. For a transfer to qualify as a Code §351 exchange, the transfer generally involves property being exchanged for stock in the corporation, and the transferor or transferors must control at least 80% of the corporation’s stock. See Code §351(a).
A transaction where a shareholder contributes property to a corporation, but the corporation does not issue any stock in exchange for the property, is referred to as a “contribution to capital.” It could be argued that such a contribution does not qualify as a Code §351 exchange. However, both the Tax Court and the Second Circuit have ruled that the exchange requirements of Code §351 are met when a sole shareholder transfers property to a wholly-owned corporation, even if no stock or securities are issued. The issuance of new stock in this case would be considered a mere formality. Furthermore, in response to the Abegg decision, Congress enacted Code §367(c)(2), which provides:
“For purposes of this chapter, any transfer of property to a foreign corporation as a contribution to the capital of such corporation by one or more persons who, immediately after the transfer, own (within the meaning of section 318) stock possessing at least 80 percent of the total combined voting power of all classes of stock of such corporation entitled to vote shall be treated as an exchange of such property for stock of the foreign corporation equal in value to the fair market value of the property transferred.”
In Sarah’s case, she owns 100% of PRCo. Therefore, Sarah holds “stock possessing at least 80 percent” of PRCo and is treated as having received stock in PRCo in exchange for the cash contribution. Since Sarah is deemed to have received stock in PRCo in exchange for the cash, the transaction is treated as a Code §351 exchange, and Sarah is required to file Form 926 for Year 2.
Conclusion
As the IRS Campaign gets underway, taxpayers should be aware that it is being managed by the Large Business and International (LB&I) Tax Division of the IRS. Based on our experience, LB&I agents are highly experienced and knowledgeable, especially regarding the critical nature of Form 926 and other U.S. tax obligations that Act 60 companies and residents must meet.
If selected for an IRS audit, taxpayers will likely be asked to provide Form 926 early in the examination process. Failure to file this form means the IRS can continue to audit the taxpayer’s return indefinitely, as the statute of limitations does not begin until the form is filed. Additionally, considering the nature of the IRS Campaign, we expect that penalties will be assessed for those who have not filed the required form.
While it is difficult to predict whether failing to file Form 926 will lead to criminal referrals by IRS civil agents, it is certainly a possibility in cases of severe noncompliance.
Taxpayers should review their previous filings to ensure the correct forms were submitted. If there is any indication of noncompliance, they should consult a tax advisor to determine the next steps. Once an audit is initiated, it is typically too late to correct filings and avoid potential civil and criminal penalties.