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In IRS Proposal, an Attempt to Tackle Growing Use of LLC Loophole

May 17, 2016 | By Valentina Pasquali

A proposed reporting requirement for foreign-owned legal entities would impact a small but growing universe of companies that have likely been used to funnel illicit funds into the United States, say legal experts.

Earlier this month, White House officials disclosed draft regulations that would require so-called “disregarded” foreign-owned entities to obtain employer identification numbers, or EINs, from the IRS and disclose their addresses and the names of executors, administrators and “responsible parties,” among other information.

The entities would thereafter be obligated to inform the IRS of “reportable transactions between the entity and its foreign owner or other foreign-related parties”—data the U.S. Treasury Department would potentially share with its counterparts abroad and use domestically to assess tax liabilities.

The department, which is accepting comments on the plan through August, intends to “move swiftly to finalize these documents,” according to a spokesperson, who estimated that reporting under the plan could start in 2018.

“The IRS is trying to close a loophole that allows a non-U.S. person who is the 100-percent owner of a limited liability company in the U.S. not to report any information to the IRS unless it has U.S. income or operates a trade or business in this country,” said Scott D. Michel, an attorney with Caplin & Drysdale.

Though not all such entities are created for illicit purposes, the current lack of regulatory reporting makes it difficult for U.S. officials to identify those that are engaged in misconduct, according to Michel, who believes that the use of foreign-owned limited liability companies has “definitely been growing” in recent years.

Under the existing rules, there is little to prevent a foreign criminal from using a single-member LLC formed in Delaware, for example, and funds wired to a U.S. escrow agent to anonymously purchase real estate in the United States, he said.

“That way the LLC would only appear on the title and wouldn’t even have to open a bank account and go through the related know-your-customer checks,” Michel said.

The planned regulations could mean fines of up to $10,000 for every year that the entities failed to report the information before they are identified by the IRS, and an additional $10,000 per month after the agency has notified them of the violations.

“The IRS does have the discretion to abate the penalties if a taxpayer can establish ‘reasonable cause’ and files the delinquent forms,” said tax attorney and former IRS revenue officer Gerald Kelly. But given the current regulatory climate, U.S. officials are more likely to impose, and possibly exceed, the monetary penalties.

“If they find someone who is actively attempting to avoid the new requirements, that person is going to be a prime target for a criminal investigation by the U.S. and its foreign partners,” Kelly said.

The administration’s move comes as part of a larger effort to strengthen corporate transparency in the United States in response to revised international standards on combating money laundering and media reports alleging widespread abuses of tax havens by criminals, politicians and business leaders.

“The U.S. has been so aggressive in extracting information about American citizens from foreign governments and banks that other countries now want it to do the same with regard to their own citizens who might be hiding money in the U.S.,” said Kelly.

To identify these entities, the IRS would rely on voluntary filings by their foreign owners, tips by disgruntled associates and data-sharing agreements with the U.S. states where the LLCs were registered, according to Kelly.

But questions remain about the effectiveness of the plan, said former IRS official David Tilzer.

“There is no way that the IRS can enforce this unless it gets more resources to do so,” Tilzer said. “Given the budget constraints imposed by Congress, it is hard to imagine that happening anytime soon.”

In letter to IRS Commissioner John Koskinen published earlier this month, Chairman of the House Oversight and Governmental Reform Committee Jason Chaffetz (R-UT) characterized the agency’s request for further funding as “either an attempt to exaggerate IRS’s budget needs or a management failure in understanding the needs of your organization.”

Should the IRS finalize the rule, federal regulators could expect U.S. banks to review the disclosures filed by the foreign-owned entities they provide services for as part of their anti-money laundering programs.

“The U.S. government is likely to impute a bad motive to financial institutions who don’t comply, even if they do so for entirely benign reasons,” said Kelly. “They don’t want to be found failing to take reasonable action to ensure that due diligence is done to comply with this regulation.”

Valentina Pasquali
Reporter – Washington D.C.
Mobile: +1-202-315-8308
Association of Certified Anti-Money Laundering Specialists (ACAMS)

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