What Is a Controlled Foreign Corporation?

Definition & Examples of a Controlled Foreign Corporation

Business travelers arriving at hotel reception desk.
•••

alvarez / Getty Images 

A controlled foreign corporation (CFC) is a foreign corporation in which more than 50% of the stock is owned by U.S. shareholders.

Learn more about controlled foreign corporations and what they can mean for your taxes.

What Is a Controlled Foreign Corporation?

A controlled foreign corporation is a U.S. corporation that operates overseas with U.S. shareholders who have 50% or more of the control of that corporation.

A foreign corporation is generally any corporation that is incorporated to do business in a state or country other than its original state.

CFC rules are designed to reduce tax evasion and the abuse of tax shelters as well as figure out what portion of foreign income should be taxed in the U.S.

Other countries have their own CFC laws as well, including the United Kingdom, Germany, Spain, the Netherlands, China, and Columbia.

How Does a Controlled Foreign Corporation Work?

The IRS considers only non-U.S. companies and only companies that are taxed as corporations (including LLC's that elect to be taxed as a corporation) when deciding whether a company is a CFC.

Typically, corporate shareholders pay taxes on the income of the corporation only when they take dividends. If they take dividends on U.S. domestic corporations, these dividends must be reported each year, using Form 1099-DIV

But if these shareholders take dividends or other income from foreign corporations, they may think they don't have to report that income or pay taxes on it. That's where the controlled foreign corporation comes in: as a way to tax U.S. business owners on their income from foreign corporations.

Shareholders

If you are a U.S. shareholder, director, or officer of one of these corporations, you must report your income from the foreign corporation and pay tax on that income.

The IRS defines a foreign corporation as being controlled if "the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders."

The IRS defines a U.S. shareholder of a foreign corporation as someone who "owns directly, indirectly, or constructively 10% or more of the total combined voting power of stock entitled to vote or 10% or more of the total value of all classes of stock entitled to vote in a foreign corporation."

In other words, a foreign corporation is categorized by the amount of stock owned by U.S. shareholders. If more than 50% of the stock is owned by U.S. shareholders, the corporation is considered a controlled foreign corporation.

Reporting

Shareholders who have a controlling interest in a foreign corporation must report their share of income from the CFC and their share of earnings and profits of the CFC that are invested in U.S. property. This property includes investments, tangible property (assets), and stock in the foreign corporation.

The corporation must file an annual report on IRS Form 5471, "Information Return of U.S. Persons With Respect to Certain Foreign Corporations." This form is completed and attached to the corporation's income tax return.

Form 5471 is filed by the company for a tax year, and it requires information on:

  • U.S. citizens who are officers, shareholders, and directors
  • A listing of all U.S. shareholders and the stock they hold
  • The corporation's classes of stock and shares outstanding
  • The corporation's balance sheet and income statement for the tax year

In addition to the 5471 information return filed by the corporation, a separate report is needed for each U.S. shareholder, officer, or director who meets the 50% criterion above. This report lists the person's income from the foreign corporation in dividends and other income and investments. This individual report, called a summary of shareholder's income from foreign corporation, is given to the person, who must include the income on their tax return. 

The income received by the individuals and the tax on that income is separate from the corporate income tax the company pays.

You will likely need an experienced tax preparer who is knowledgeable about foreign corporations and taxes to prepare this form.

The summary report described above for the individuals listed on Form 5471 is included on the person's individual income tax return. The section of the return where the information is included depends on the type of income. For example, if the income is dividends, the income might be included on Schedule B, "Interest and Ordinary Dividends."

Also, how the income is taxed depends on the type of income. Dividend income, for example, is taxed depending on the type of dividend and the length of time it is held. 

Details on where your CFC income is included on your income tax return is available on in the instructions for Form 5471.

The CFC status is complicated, and knowing whether you must report your income as a shareholder in a CFC is tricky. Talk with your tax professional if you think you might need to report income from your foreign earnings and pay tax on that income.

Key Takeaways

  • A controlled foreign corporation is one that operates outside the U.S. with 50% or more U.S. shareholders.
  • U.S. shareholders, directors, or officers of a controlled foreign corporation must report their income from that corporation and pay tax on it.
  • To report this income, use Form 5471 (to be attached to the corporation's income tax return) with a separate report required for each shareholder who meets the 50% criterion.

Article Sources

  1. Internal Revenue Service. "Instructions for Form 5471 (02/2020)." Accessed Nov. 23, 2020.

  2. The Tax Foundation. "How Controlled Foreign Corporation Rules Look Around the World: United States of America." Accessed Nov. 23, 2020.

  3. The Tax Foundation. "CFC Rules Around the World." Accessed Nov. 23, 2020.

  4. Internal Revenue Service. "Certain Taxpayers Related to Foreign Corporations Must File Form 5471." Accessed Nov. 23, 2020.

  5. Internal Revenue Service. "4.61.7 Controlled Foreign Corporations." Accessed Nov. 23, 2020.

  6. Internal Revenue Service. "Form 5471: Information Return of U.S. Persons With Respect to Certain Foreign Corporations." Accessed Nov. 23, 2020.