Foreign Entities in the US Tax System
What you need to know
Before you go and start operating abroad or opening an offshore company as a US citizen, make sure you learn what are the different types of foreign entities according to the IRS and how they are taxed. In today’s stack we’ll take a look at the main types of foreign entities you’ll encounter (there a few more that are quite rare for you to encounter unless you’re already well-versed in these)
Controlled Foreign Corporation (CFC): What It Is and When It Makes Sense
A Controlled Foreign Corporation (CFC) is a foreign corporation where U.S. shareholders collectively own more than 50% of the total voting power or value of the corporation’s stock.
For these purposes, a U.S. shareholder is defined as any U.S. person who owns at least 10% of the foreign corporation’s stock. If your business or investment meets these thresholds, congratulations—your entity now has CFC status, and it comes with a unique set of tax rules.
CFCs are treated as separate legal and tax entities from their U.S. shareholders (in tax terms it’s “opaque”). This means that while the corporation itself may operate abroad, its activities are very much on the radar of the IRS.
CFC owners are generally required to file Form 5471, which provides detailed information about the corporation, as well as Form 8992, which calculates a tax on certain income of the CFC under the Global Intangible Low-Taxed Income (GILTI) rules. GILTI is a specific way the U.S. ensures that certain foreign profits don’t escape taxation altogether.
So, when does it make sense to operate as a CFC? If you’re running significant foreign operations that can benefit from a lower U.S. tax rate (like the GILTI inclusion), a CFC might work in your favor. You can, in some cases, get a more favorable overall tax rate. It also allows the foreign corporation to reinvest its earnings abroad without immediate U.S. tax consequences, while still providing the U.S. shareholders some control and oversight.
The downside is that the reporting and accounting for these is significantly more complex and costly, so I usually don’t recommend until you have some decent revenues.
Foreign Disregarded Entity: A Flow-Through Option
A foreign disregarded entity is a game-changer if you’re looking for simplicity in tax treatment. This classification applies when a foreign corporation elects to be treated as a flow-through entity for U.S. tax purposes, meaning it’s not considered a separate entity from its owner (in tax terms, “transparent”). Instead, all income, deductions, and credits of the foreign entity are reported directly on the U.S. taxpayer’s return.
But here’s the catch: A foreign corporation doesn’t automatically become a disregarded entity. By default, foreign corporations are treated as CFCs, so if you want to elect disregarded entity status, you’ll need to file Form 8832. Once this election is made, you’ll also file Form 8858 to report the activities of the disregarded entity.
When might this structure make sense? It’s best for U.S. taxpayers who want to simplify their tax reporting and avoid the complexity of dealing with CFC rules. This approach can work well for smaller-scale foreign operations or investments where the income is modest, and the owner doesn’t need the extra layer of legal separation that a CFC provides. However, it’s important to note that the income from a disregarded entity is taxed immediately in the U.S., so it may not be ideal for larger foreign operations that could benefit from deferring U.S. tax. You’re also exposed to potentially higher US taxes (in comparison to where the company could be incorporated as a CFC)
Foreign Branch: The Simplest Starting Point
A foreign branch is essentially an extension of a U.S. taxpayer’s operations into a foreign country, without setting up a formal legal entity abroad. If your foreign operations rise to a certain level of activity—like establishing an office, hiring employees, or generating revenue abroad—they may qualify as a foreign branch for U.S. tax purposes.
Unlike CFCs or disregarded entities, foreign branches don’t require you to form a separate legal entity. However, that doesn’t mean you can avoid tax reporting altogether. The IRS requires U.S. taxpayers with foreign branches to file Form 8858 to report the branch’s activities. All income and expenses from the branch are included on the U.S. taxpayer’s return.
When is a foreign branch the right choice? It’s often the best option for minimal foreign operations or when you’re just starting in the world international business. Setting up a formal foreign corporation might not make sense for smaller ventures, but you’ll still need to assess whether your activities meet the threshold for foreign branch reporting. As your operations grow, you can always reevaluate and transition to a CFC or disregarded entity structure if it’s more beneficial. You also need to be careful that these are more frequently audited and you may lose out on some double tax benefits depending on the country
Making the Right Choice: Factors to Consider
Deciding how to classify your foreign entity for U.S. tax purposes is about understanding your goals and the trade-offs of each option. Here’s what I tell clients to keep in mind:
The Scale of Operations: If you’re running a large, profitable foreign business, a CFC might be the best fit to take advantage of lower tax rates and reinvest earnings abroad. On the other hand, smaller operations may benefit from the simplicity of a foreign branch or disregarded entity
Tax Deferral vs. Immediate Taxation: CFCs allow for some degree of tax deferral on foreign earnings, while disregarded entities and foreign branches require you to report all income immediately. Think about whether you want to reinvest earnings abroad or bring them back to the U.S. quickly
Administrative Complexity: CFCs require significant reporting, including Forms 5471 and 8992. If you’re looking to keep things simple, a foreign disregarded entity or branch might be a better fit
Legal Separation: A CFC offers a clear legal and tax separation from its U.S. shareholders, which can be important for managing liability. In contrast, a disregarded entity is not separate from its owner, and a foreign branch isn’t even a formal legal entity
Flexibility for the Future: Your business or investment goals might change over time. For example, starting with a foreign branch might make sense initially, but as operations grow, you may want to transition to a CFC or disregarded entity to optimize your tax strategy
Last thoughts
Figure this out before expanding; you don’t want to be hit with a tax bill or ridiculous and unexpected accounting cost because you didn’t plan ahead. Now go and make a lot of money (which usually gets rid of most problems)