Foreign-Owned US Subsidiary: Cash or Accrual, Books and Payroll

Should a foreign-owned US subsidiary use cash or accrual accounting?

A US subsidiary taxed as a C corporation may use the cash method for tax only if it is a small business taxpayer: average annual gross receipts of $32,000,000 or less for the three prior tax years, and not a tax shelter (Form 1120 instructions; Rev. Proc. 2025-32). A subsidiary in existence under three years uses the years it has, with any predecessor's, and receipts for a year shorter than 12 months are annualized (section 448(c)(3)). Otherwise it uses accrual, which counts income and expenses when earned or owed, not when cash moves. Farming businesses and qualified personal service corporations follow separate rules, covered in cash or accrual for a small business.

A corporation that is not a small business taxpayer must also use accrual for purchases and sales of inventory (Form 1120 instructions). And the return follows the books: taxable income is figured under the method the books regularly use, and that method must clearly reflect income. A subsidiary whose books are on accrual generally files on accrual; keeping accrual books under a cash return is a records question covered in accrual books and a cash-basis tax return.

A case is not simple when:

• The parent wants monthly numbers in its own format, and payroll, tax and filings land in a country its team does not run from. Method, standard, who keeps the ledger and payroll, and the filing calendar are decisions to settle before the first close, because changing the method later generally needs IRS consent (Form 1120 instructions).
• The parent's group is large. Businesses treated as one employer under sections 52 and 414 count as one person for the receipts test (section 448(c)(2)). For corporations that is a controlled group, defined in section 1563(a) with a more-than-half ownership test in place of the usual four-fifths (section 52(a)). Whether the parent and its other subsidiaries count, and how a foreign parent's receipts outside the US are treated, depends on ownership facts and the aggregation rules: get the group's facts before relying on cash.
• It holds inventory, or the parent, a lender or an investor expects accrual statements.
• The parent charges fees or interest. An accrual-method corporation counts accrued amounts on Form 5472 (Form 5472 instructions), and a deduction for some unpaid amounts owed to a foreign related person, such as interest, waits until payment. The timing rule is under how the books tie to the return, below.
• It starts on cash and later wants accrual, or outgrows the receipts test. A corporation that fails the test must change to accrual, effective for the year it fails (Publication 538). Any overall method change needs IRS consent, usually Form 3115 filed during the year of change, and may bring a section 481(a) adjustment (Form 1120 instructions).

Gather before the first close: formation papers and the EIN letter, a list of what the parent will charge and fund, the funding wires, the parent group's gross receipts for three years, the payroll provider, state registrations, and the parent's group chart of accounts, close calendar and the format it wants each month.

Does the US return require US GAAP or the parent's accounting standard?

Neither. Form 1120 asks for the accounting method the books use and does not name a standard. The Schedule L balance sheet should agree with the books, and Schedule M-1 reconciles income per books to income per return (Form 1120 instructions). The parent's reporting still reaches the return in four places:

• Schedule M-3. A subsidiary with total assets of $10,000,000 or more files Schedule M-3 instead of M-1; a smaller one may choose it (Form 1120 instructions). Below $50,000,000, or if filing by choice, it may complete Part I and Schedule M-1 instead of Parts II and III. Part I uses the subsidiary's own statements, not a controlling parent's, and records the standard used: US GAAP, IFRS, statutory, tax-basis or other. A subsidiary with no statements of its own, included in a foreign parent's, answers No and starts from its books and records (Schedule M-3 instructions).
• Statements prepared for others. A Schedule M-3 filer may use a tax-basis income statement only if no other kind was prepared for any purpose, and statements prepared for management, creditors, shareholders or regulators count (Schedule M-3 instructions). A monthly package prepared for the parent, its shareholder, can end that option.
• Schedule UTP. A subsidiary with assets of $10,000,000 or more, whose operations appear in audited statements issued by it or a related party, may have to report certain tax positions. A related party includes an entity whose consolidated audited statements, under US GAAP, IFRS or another country's standard, also include the subsidiary (Schedule UTP instructions), so the parent's audit can matter.
• Revenue timing. For an accrual-method taxpayer with an applicable financial statement, income is generally taxed no later than when it is booked as revenue in that statement, and a group's statement counts if it reports the taxpayer's results (section 451(b)). Which statements qualify depends on their standard and use: for example, certified GAAP statements used for credit or reporting to owners, or IFRS statements filed with a foreign securities regulator.

Which accounting standard should the subsidiary's books use if the parent reports in IFRS or local rules?

The return does not choose, so choose by who will read the statements. Schedule M-3 does rank standards, but only as a tiebreaker: with no Form 10-K and two or more non-tax-basis income statements, certified ones first, US GAAP ranks first, then IFRS, then the other standards the instructions list (Schedule M-3 instructions).

To keep two standards from becoming two sets of books, with net income per books tying to the return:

1. Keep one dollar accrual ledger as the book of record.
2. Map each US account to a line in the parent's group chart and produce the parent's package as a report from that ledger, with a written bridge for every difference.
3. If a lender, investor or auditor will read statements, ask in writing which standard and periods they want before the first close. See audited financials for investors and financial statements for a bank loan.

Which currency do the books use, and how are dealings with the parent converted?

Generally US dollars. For federal tax, a US-resident corporation uses the dollar as its functional currency whatever currency its books are kept in. A qualifying foreign branch with its own books can have a different one (section 985(b); 26 CFR 1.985-1(b); IRS: foreign currency).

Translate each item into dollars at the rate prevailing when the subsidiary receives, pays or accrues it. If more than one rate exists, use the one that most properly reflects income (IRS: foreign currency). Keep the original amount, the rate and its source on every line that touches the parent.

Form 5472 states all amounts in dollars and needs a schedule of the rates used (Form 5472 instructions). Exchange gains and losses on balances held in another currency are in foreign currency accounts in US books.

Which tax year-end should the subsidiary pick, and does it follow the parent?

No general rule makes the subsidiary follow the parent's year. A corporation that is not a personal service corporation may use a calendar year or a fiscal year, and a new corporation adopts its year by filing its first return. Filing an EIN application, an extension or estimated tax does not adopt one (Form 1120 instructions; Publication 538).

• Books follow the year. A fiscal-year corporation must keep its books and report income on that period consistently (Publication 538).
• The first return may be short. A corporation organized mid-year files for the period it existed (Publication 538).
• Changing later needs consent. A corporation generally must get IRS consent on Form 1128. For automatic approval it is due by the due date, including extensions, of the return for the short period that makes the change (Form 1120 instructions; Form 1128 instructions).
• A year different from the parent's is workable. Schedule M-3 has a line that reconciles an income-statement period to the tax year (Schedule M-3 instructions).

Decide before the first return, with the parent's close calendar and the US due dates below side by side. Other year-end questions are in fiscal year or calendar year.

How do I keep parent charges, loans and share capital apart in the chart of accounts?

Give the parent its own accounts in three groups that never mix: equity, loans, and trade charges. Form 5472 reports loans by balance and trade dealings by category, and the subsidiary must keep records that support each figure (Form 5472 instructions; Form 5472). Line numbers below are from the December 2023 revision of the form; check the current one.

Tag every line with the related party's name, the date, the currency and the rate. A separate Form 5472 is filed for each related party the subsidiary had a reportable transaction with, and related parties include the parent's other companies (Form 5472 instructions).

Which charges are reportable and which need withholding is in US subsidiary of a foreign company. Funding with shares or a loan is in putting money into your US corporation from abroad. The full tagging routine is in bookkeeping for a foreign-owned US company.

Who can keep the books, and where must the records be kept?

Any of the options below can keep them. The subsidiary must keep ordinary tax records. Unless an exception below applies, it must also keep, or cause another person to keep, permanent books sufficient to establish the correctness of its return, including records of dealings with related parties (26 CFR 1.6038A-3(a)). The records may be held by the subsidiary, a foreign related party such as the parent, or a third party, if the location rule is met (1.6038A-3(b)(2)).

The special record rules do not apply to a subsidiary with less than $10,000,000 of US gross receipts (related reporting corporations count together) or one under the low-value safe harbor (1.6038A-1(h) and (i); thresholds in bookkeeping for a foreign-owned US company). Ordinary tax records and Form 5472 still apply. Otherwise required records must be kept in the US, unless the subsidiary keeps them abroad and either delivers requested records to the IRS within 60 days of the request, or moves them to the US in that time with an index and a US custodian. For material profit and loss statements the rules require to be created, the period is 120 days, unless otherwise specified. Translations of specific documents are due within 30 days of a request (1.6038A-3(f) and (b)(3)).

Failing to keep the required records carries the same $25,000 penalty as failing to file Form 5472 (Form 5472 instructions). Retention periods are in bookkeeping for a foreign-owned US company.

Who runs payroll, and what must exist before the first paycheck?

The subsidiary is the employer and generally stays liable for its payroll taxes, whoever runs payroll; a certified professional employer organization is the exception, below. An employer that outsources payroll duties generally remains responsible for them, including the taxes (Publication 15). A responsible person who willfully does not pay over withheld tax can owe 100% of the unpaid trust fund tax personally (section 6672). Officers, directors, shareholders and others who control which bills are paid can qualify, and the IRS generally has 3 years from the later of the return's filing or the next April 15 to assess it (IRS: trust fund recovery penalty; IRM 5.19.14). See trust fund recovery penalty.

Before the first paycheck:

1. An EIN for the subsidiary, used on every payroll return and deposit (Publication 15).
2. For each employee: a completed Form I-9 verifying identity and work authorization, a name and Social Security number (an ITIN does not replace it), and a signed Form W-4 effective with the first wage payment (IRS: hiring employees). A worker still waiting for an SSN appears on Form W-2 as "Applied For" (zeros if e-filed). With no W-4, withhold as Single or Married filing separately, no entries in Steps 2 to 4 (Publication 15).
3. State accounts: most employers pay both federal and state unemployment tax, and every new employee must be reported to the state new hire registry (Publication 15). State registrations depend on the state.
4. Electronic deposits: federal payroll tax deposits must be made by electronic funds transfer (IRS: employment tax due dates).

For the first employee in detail, see setting up payroll. For staff sent from abroad, see sending employees from abroad to the US.

Which annual filings does a foreign-owned US subsidiary have (Form 1120, Form 5472, payroll)?

At least these, each in the subsidiary's own name (Form 1120 instructions; Form 5472 instructions):

Payments of fees, interest or royalties to the parent may add Forms 1042 and 1042-S, and a US-source payment such as interest or a royalty may require the subsidiary to withhold 30% unless a valid Form W-8BEN-E supports a treaty rate or exemption. The subsidiary is personally liable for tax it should have withheld (Publication 515). See US subsidiary of a foreign company.

How do the books tie to the tax return each year?

The return is built from the closed books, in this order:

1. Close and agree balances. Close on the tax year-end, reconcile bank and payroll accounts, and agree each parent balance with the parent's own records.
2. Move income and deductions to Form 1120. Schedule L shows the balance sheet per books and should agree with them (Form 1120 instructions).
3. Reconcile books to return. Schedule M-1, or the required parts of M-3 for a larger subsidiary, bridges income per books to income per return. Items the tax rules time differently belong here, such as a charge accrued to the parent but unpaid at year-end. For an amount owed to a foreign related person, the statute directs regulations that match the deduction to when that person reports the income (section 267(a)(3)). Under the regulation, a deduction for an unpaid amount such as interest or US-source rent or royalties generally waits until payment. Foreign-source amounts other than interest, such as fees for services done abroad, generally fall outside the rule unless they are effectively connected income, and a tax treaty can change the result (26 CFR 1.267(a)-3). Which applies depends on each charge's type and source.
4. Build Form 5472 from the parent accounts. Use dollar amounts, the rate schedule and accrued amounts when the books are accrual (Form 5472 instructions).

A subsidiary with total receipts and total assets under $250,000 may skip Schedules L, M-1 and M-2 if it answers Yes to Schedule K, question 13. A subsidiary whose books cannot be agreed to the parent's records, or whose first months were never recorded, needs that fixed before a return rests on them: see rebuilding books for missed foreign-owner filings.

Example

All figures and choices are illustrative. Amounts are in US dollars unless stated.

A German parent forms a Delaware subsidiary

A German parent forms a Delaware subsidiary on August 15. It expects $2,000,000 of revenue in its first full year and will employ eight people. Its own receipts are far below the cash limit, but the parent's other companies may count in the test, so the books are kept on accrual from day one, in dollars. A payroll provider runs payroll under the subsidiary's EIN, as a reporting agent with Form 8655 on file. The calendar year is adopted, so the first return covers August 15 to December 31 and is due the next April 15. The parent's euro-format package is a monthly report from the dollar ledger.

A Japanese parent lends money

A Japanese parent wires ¥30,000,000 as a loan. On the wire date ¥150 equals $1, so the subsidiary books a $200,000 loan from the parent, with the yen amount and the rate on the entry. If the terms support a loan, it is kept apart from share capital. The beginning and ending balance feeds Form 5472, and repayments are kept apart from dividends. A repayment in yen at a different rate raises a foreign-currency gain or loss question.

An Indian parent bills for services

An Indian parent bills the subsidiary $400,000 for the year: $300,000 of engineering services and $100,000 of recharged costs. The ledger has one parent sub-account for each, with each invoice's date, currency and rate. At year-end $50,000 of the services bill is unpaid. Assume the recharges are amounts taken into account in the subsidiary's taxable income (line 35). On accrual, Form 5472 then counts all $400,000, paid or not. Deductibility is a separate test. If the engineers worked in India, the fee is foreign-source and the unpaid $50,000 is generally outside the timing rule for amounts owed to a related foreign person. If they worked in the US, the fee is generally US-source and the deduction waits for payment, unless the income is effectively connected with the parent's US business. A treaty can change the US-source result.

Different for you?

• The subsidiary is formed, the parent wants monthly numbers in its own format, and payroll, tax and filings land in a country you do not run from: the method, the standard, who keeps the ledger and payroll, and the calendar of US filings are decisions to settle before the first close, since changing the method later generally takes Form 3115. Get bookkeeping help.
• You have not yet chosen between a subsidiary, a branch or an LLC, or how to fund it: see a foreign company entering the US. The EIN, US address, registered agent and bank account for a company run from abroad are in US business address and bank account.
• The subsidiary pays the parent fees, interest or royalties: withholding, W-8 forms and pricing are in US subsidiary of a foreign company, with cross-border tax help.
• The US company is a single-member LLC, or one person abroad owns the corporation with no parent company: see bookkeeping for a foreign-owned US company.
• You need Form 1120 and Form 5472 prepared from the books: what a preparer asks for is in what your preparer needs for a foreign-owned corporation; get corporate tax help.
• Books are months behind, live only in the parent's ledger, or a Form 5472 was missed: see rebuilding books for missed foreign-owner filings and missed Form 5472 and penalty relief, and get bookkeeping help.
• An investor, lender or auditor wants statements in a set standard: see audited financials for investors.
• You want the general cash or accrual rules for a smaller business: see cash or accrual for a small business.