The Reporting and Tax Implications of Accepting Foreign Funding for Your Business

March 24, 2020 Published by

When it comes to raising money to grow their business an increasing number of Bay Area entrepreneurs are considering bringing in foreign stakeholders to help meet their funding needs. Foreign investors can be a great source of ready cash, but before accepting their help businesses need to recognize that doing so usually means additional reporting requirements and increased government oversight.

In recent years, the U.S. government has increased its oversight of foreign financial transactions as part of its efforts to combat international money laundering and the use of foreign accounts to avoid U.S taxes. As a general rule, complying with the necessary rules and reporting obligations that accompanied that increased oversight is not difficult, but failing to do so can lead to steep penalties.

Foreign Investment Will Affect Your Tax Treatment

Perhaps the biggest impact that bringing in a foreign investor will have on your company’s operations will be if you have chosen to operate it as an S corporation. A company that has a non-resident alien shareholder will no longer qualify as an S corporation. That means your corporation will be treated as a C corporation for federal tax purposes and taxed at the company level.

One option for addressing this issue would be for the business to restructure as a limited liability company (LLC). The LLC structure allows the business to remain a pass-through entity for federal tax purposes. However, tax treaties between the United States and the home country of the foreign investor may have an impact on how the business or investor are taxed.

Check with the Office of Foreign Assets Control

The Office of Foreign Assets Control (OFAC)  is the financial intelligence and enforcement arm of the U.S. Treasury that enforces trade sanctions intended to further U.S. foreign policy and national security objectives. Most often these are terrorists or drug traffickers.

The OFAC does not maintain a current list of those countries with which U.S. residents are barred from doing business, but it does keep a list of active sanctions programs that are targeted at specific countries.

Additionally, the OFAC maintains a sanctions search tool that allows anyone to see if an individual is on the Specially Designated Nationals and Blocked Persons List. The list contains about 6,300 names of individuals who are connected to various sanctions targets. U.S. persons are prohibited from dealing with any individual on the list and all of that individual’s assets are blocked.

The fines and penalties for violating OFAC regulations regarding designated nationals can be in the millions of dollars.

U.S. Securities Regulations

Any transaction a business conducts with a foreign investor must comply with U.S. securities regulations. Many early-stage companies avoid registering with the SEC prior to offering securities to investors by taking advantage of Rule 506 exemptions that allow for securities sales to accredited investors, providing certain requirements are met.

While it is possible for foreign investors to become accredited, it is often easier for the company to issue securities to those investors under Regulation S. That regulation allows for securities to be offered outside of the U.S.  without being subject to registration requirements, if certain requirements are met and no efforts are made to market the securities in the U.S.

If a business is careful to comply with the rules it is possible to offer securities to both accredited investors under Rule 506 and foreign investors under Regulation S. However, it is usually more cost-effective to offer securities under one or the other.

Annual Reports of Foreign Direct Investment

U.S. companies are required to file annual reports of their foreign direct investments with the Bureau of Economic Analysis (BEA) under certain circumstances. Those circumstances include a foreign entity acquiring ownership or control of at least 10% of a company’s voting securities when the cost of acquiring those securities exceed $3 million. Should both circumstances be met, the company is required to file a report with the BEA.

If a foreign entity acquires at least 10% of a company’s voting securities while spending less than $3 million it may claim an exemption to the reporting requirement.

A persistent failure to comply with the BEA’s filing requirements may result in civil or criminal penalties.

Using Foreign Gift or Inheritance as Funding

If you are lucky enough to have a well-to-do family member who is willing to gift you funding for your business, or you have inherited funds you plan to use to fund it, U.S. federal tax law is actually fairly generous. U.S. residents who receive foreign gifts or inheritances are not required to pay either the federal gift or inheritance tax.

However, if you receive more than $100,000 from a non-resident alien or a foreign estate the IRS will require you to report the gift using Form 3520. Gifts from foreign corporations and foreign partnerships, or individuals related to them, are also subject to the reporting requirement if they exceeded $16,076 for 2018 (the amount is adjusted annually for inflation). No tax will be imposed as a result of filing the form, but failing to file will result in penalties of up to 25% of the gift.

Despite foreign gifts or inheritances not being subject to tax in the U.S., they are often subject to tax in country where the donor or decedent lived. That will not be a consideration for the U.S. resident receiving the gift or inheritance, but it is a factor that should be considered by the donor or decedent’s estate.

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This post was written by Sean Allaband

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