No audit is necessary! The tax law allows the IRS to automatically assessed that tax on the gross income and disallow all expenses when a Form 1120F is not filed or is filed late.
Applying for an IRS ruling on your international tax planning will save you taxes in the long run.
U.S. international tax law disallows all business expenses when a Form 1040NR or Form 1120F is filed late or has not been filled.
Here is an IRS explanation. The legal advice is in blue below:
Third Party Communication: * * *
Date of Communication: Month DD, YYYY
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Sent: Friday, March 27, 2015 10:12:01 AM
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Subject: FW: IRC 882(c)(2) and TEFRA (POSTS-143012-14)
The section 882 limitations on deductions is not a partnership items because it is not something the partnership must determine under Subtitle A. I.R.C. 6231(a)(3) and 703.
Instead, the limitation is a partner-level affected item similar to partner limitations on partnership deductions under the at risk (sec. 465), passive loss (sec. 469) and outside basis limitations (sec. 704(d) rules. See Treas. Reg. 301.6231(a)(5)-1(a) through -1(d).
Consequently, the deductions should be disallowed through an affected item notice of deficiency issued under section 6230(a)(2)(A)(i).
Under Roberts v. Commissioner, 94 T.C. 853, 860 (1990), we do not have to open and close a TEFRA partnership proceeding before issuing such affected item notice of deficiency. But for the purposes of the affected item notice, we will be bound by the amounts reflected on the partnership return, before application of the partner-level limitations on those amounts.
Example of the tax trap for the foreign investor in LLC or partnership
A foreign investor uses a foreign corporation to be a ten percent member in a U.S. LLC. Domestic LLC’s are classified as a partnership. The partnership has income of $10,000,000 and expenses of $8,000,000. The foreign corporation share of the $2,000,000 of net income is $200,000. However, foreign corporation is late in filing its form 1120F.
Section 882 denies a tax deduction of all of the expenses when a return (form 1120F) is filed late or is not filed. Thus, the IRS can assess tax on $1,000,000 (ten percent of the income of $10,000,000). Under section 882, the foreign investor is denied a tax deduction for all of the expenses incurred by the partnership.
This is the case despite that LLC timely filing its partnership return. Usually, the IRS would have to audit the partnership. However, the legal advice explains that the IRS can merely assess the foreign corporation.
U.S. Estate Taxation of the Foreign Investor using a Foreign Corporation
The shareholder of the foreign corporation will owe U.S. estate taxes. The U.S. has an estate tax and not an inheritance tax. U.S. estate tax law ignores the corporation. Here is why on this link.