Under Subpart F of the Internal Revenue Code, U.S. shareholders of a controlled foreign corporation ("CFC") must include the CFC's "subpart F income" on their U.S. income tax returns. I.R.C. § 951. For a foreign corporation to be classified as a CFC for tax purposes, it must be controlled by U.S. shareholders. Significantly, the terms "control" and "U.S. shareholder" are specifically defined legal terms. In this respect, "control" means more than 50% of the vote and value of the corporation and a "U.S. shareholder" means a shareholder who holds 10% or more of the total voting power. Thus, a foreign corporation is considered a CFC if 10% shareholders collectively own more than 50% of the corporation.
But how is "U.S. shareholder" status determined when a U.S. partnership owns a foreign corporation? For instance, consider the scenario where a U.S. general partnership owns 100% of a foreign corporation that generates subpart F income. Assume that none of the individual partners hold a greater than 5% partnership interest. Since none of the individual partners hold a greater than 5% partnership interest, none of them can constructively be considered "U.S. shareholders" by application of upward entity attribution (because 10% ownership is required). Therefore, the foreign corporation cannot be considered a CFC, and none of the individual partners will be required to recognize subpart F income, right? Wrong. A U.S. partnership is considered a "U.S. person" for tax purposes. I.R.C. § 7701(a)(30). Moreover, nothing in Subpart F or the regulations thereunder indicates that a domestic partnership cannot be a "U.S. shareholder" for Subpart F purposes. Consequently, the U.S. partnership would be considered to be a U.S. shareholder because it satisfies the 10% or more ownership test. Moreover, since the U.S. partnership owns more than 50% of the foreign corporation, the foreign corporation would be considered a CFC. As a result, the partnership will have Subpart F income, and because a partnership is a pass-through entity, this Subpart F income will pass-through to the individual partners, notwithstanding the fact that none of them are "U.S. shareholders" within the definition of that term.
Takeaway: Partners of a U.S. partnership with an interest in a foreign corporation may have Subpart F income to report.