In the course of helping a variety of investors and small business entrepreneurs to prepare required returns for their foreign corporations, foreign partnerships or foreign trusts, I have observed that the complexity of the information that is required on these returns is much greater than for comparable domestic returns.  In most of the assignments I have taken on, it has been necessary for me to devote a substantial amount of time to construct or to reconstruct the financial information in the form of an income statement and a balance sheet. In many cases, the preparation of the forms is a small part of the total time required.

Balance Sheet Requirements

Taxpayers who are accustomed to filing individual tax returns are not required to prepare a balance sheet as part of the information required for the Form 1040, even for an unincorporated business.  The same is true for small partnerships,  small corporation returns and small trust returns.  By contrast, all of the forms required for the same entities based outside the U.S. require a balance sheet. As the term implies, a balance sheet is designed to balance the total assets with the total liabilities and owner's equity. Because the owner's equity includes the accumulated profits, the balance sheet must tie in to the income statement.

What is not obvious to most taxpayers is that most of the various items on either the balance sheet or the income statement must be supported by a list of the components of that item. For example, the number used for any income or expense item will need to be equal to the sum of the various sources of income received or accrued during the year. Likewise, the numbers on the balance sheet for various assets or debts need to be supported by a detailed list of each type of asset or debt.

Taxpayers who are not accustomed to preparing financial statements that include an income statement and a balance sheet often have difficulty understanding why it takes so much time to prepare their returns for various foreign entities. But there are often additional reasons that add to the time and cost of preparing these returns.

GAAP vs. Cash Accounting

Most individual taxpayers are accustomed to using the cash method of accounting for income, expenses and related balance sheet accounts -- albeit with some modification for inventory, equipment and certain liability accounts. With the cash method, income and expenses are measured by the amount actually received as income or the amounts actually paid for expenses.

However, Generally Accepted Accounting Principles (GAAP) that are used in the preparation of financial statements for large entities involves the use of an accrual method of computing income, expenses, assets and liabilities. Accrual accounting recognizes income when it is earned and expenses when they are incurred -- regardless of when they are are received or paid.  The returns for most of the U.S. owners of foreign entities requires the use of GAAP for some of the key schedules and exhibits, even if a modified version of the cash method is used in the rest of the return. Actually, it is less confusing and less time consuming to use GAAP for the entire return if it must be used for portions of the return.

In any event, the accounting methods that must be used in the preparation of most foreign entity returns are the same methods that are required for large publicly held entities in the U.S.  It is more complicated, it is more difficult and it is more time consuming.

In some cases where the books are kept in terms of a foreign currency of a major country, the records may be kept on the basis of a different set of rules, which are sometimes referred to as Foreign GAAP. Those records must then be adjusted to reflect what would be reflected with U.S. GAAP.

U.S. Dollar Values vs. Foreign Currency Values

I have had the pleasure of preparing returns for some clients who were involved in buying and selling a variety of foreign investments based on different foreign currencies. The U.S. tax laws basically require that these transactions be converted into U.S. dollars from the foreign currency at the time of any purchase or sale. An exchange of funds from one foreign currency account to another is treated by the IRS as the same as a sale from the first currency and a purchase of the second currency. Where the entity is engaged in frequent trading, the time and cost of the currency conversions can be substantial.

Businesses that operate in foreign countries often find it is necessary to use the foreign currency in their day to day accounting. However, the values at the end of any accounting period must be converted into U.S. dollars. And, a currency conversion must take place at the time of a variety of transactions between the foreign business and any U.S. owners.

U.S. Source Income vs. Foreign Source Income

When a U.S. company or person owns a foreign corporation or other entity, the tax treatment is different for transactions in the U.S and for business transactions outside the U.S. When a foreign corporation engages in business in the U.S. or purchases investments in the U.S. that income is subject to tax the same as if the corporation were located in the U.S.  With extensive qualifications and restrictions, the profits of a foreign corporation that are derived from a trade or business outside the U.S. may be tax deferred until the profits are received as a dividend or from the sale of shares of the foreign entity.

Consequently, it is critical that the foreign entity keep track of its U.S. source income separately from its foreign source income.

Details of Transactions with Related Persons or Entities

The form 5471 for controlled foreign corporations includes a schedule (M) that requires the disclosure of Transactions Between Controlled Foreign Corporation and Shareholders or Other Related Persons.  The Form 8865 for Controlled Foreign Partnerships includes a similar schedule (N).

This schedule asks for the dollar value of of virtually any type of transaction between the corporation and any shareholder, any U.S. entity controlled by any shareholder and any other foreign corporation controlled by the U.S. shareholder.  If the accounting records don't keep track of these transactions during the year, it will be necessary for someone to review all of the transactions for the tax year to locate such items.

Minimum Record Keeping Requirements

In addition to my work as tax accountant, I'm the President of a very tiny family owned publishing business that publishes and markets some of the reports and books that I have written.  As the active operator of a small publishing company, I find it to be a disruption and inconvenience to take time to keep track of various transactions purely for the purpose of complying with various tax filing obligations. Like most small business owners, I don't need elaborate financial statements to know the current condition of my business.  But I do what is required.

A great many of my clients who have formed foreign trusts, corporations, partnerships or other entities apparently like to believe that since their entity is outside the U.S., they no longer have to put up with the insane and intrusive record keeping requirements of the IRS.  That may partly be true for those who have given up their U.S. citizenship and moved (permanently) to a foreign country.  But those who choose to retain their status as a U.S. citizen (or green card holder)  remain subject to the demands of the IRS.

The minimum records that must be kept by a foreign entity is a detailed check register for each foreign account or investment, showing enough information to make the adjustments described above. With this minimum amount of record keeping, a trained accountant should be able to construct an income statements and balance sheet for the tax year and to isolate those transactions that must be reported on various schedules or exhibits of the foreign entity returns.

Those who would like to avoid the expense of having to pay an accountant to do that work will need to acquire the same understanding of how to prepare financial statements from partial records.  However, that is not likely to be an effective use of the time of an investor or entrepreneur.

Vern Jacobs
http://www.vernonjacobs.com