By Anthony Diosdi
In the individual foreign investor setting, inbound tax planning often requires a balancing of U.S. income tax considerations and U.S. federal gift and estate tax considerations. While U.S. federal income tax rates on the taxable income of an individual foreign investor are the same as those applicable to a U.S. citizen or resident, the federal estate and gift tax as applied to individual foreign investors can and often results in a dramatically higher burden on a taxable U.S. estate or donative transfer of a foreign investor than for a U.S. citizen or domiciliary. As a result, for many individual foreign investors, the most important U.S. tax consideration is the U.S. federal estate and gift taxation.
The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $11,700,000.
For U.S. citizens and residents that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the tax. The article will discuss estate and gift tax planning opportunities available to foreigners who own real property in the United States.
Owning the Real Property Directly
The simplest planning estate and gift tax planning option available to a foreign investor is to own U.S. real property directly and sell the property before he or she dies. The problem is this type of planning depends on one’s ability to predict his or her own death. Although directly holding U.S. is risky, there are planning options available to individual investors that could reduce or eliminate the estate and gift tax. First, in certain cases, a foreign investor may utilize a Estate Tax Treaty to to reduce or eliminate the U.S. estate tax (The United States has entered into a relatively small number of tax treaties that address the estate tax). Second, a foreign investor may use of nonrecourse financing to reduce his or her exposure to the estate tax. A foreign investor may potentially reduce his or her exposure to the estate and gift tax through nonrecourse financing (A nonrecourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable). Property that a nonresident decedent owns at death is subject to the U.S. estate tax, its value enters into the computation of the value of the decedent’s gross estate. Deductions are authorized by statute against the “taxable estate” for creditors’ claims. Properly structured, nonrecourse financing may be fully deductible from the taxable estate of a foreign investor.
Holding U.S. Property Through a Foreign Corporation
Historically, foreign investors have made their direct investments in U.S. property principally through corporate ownership structures. Frequently, a foreign corporation was used as either the direct investment owner or as a holding company for a U.S. subsidiary (which, in turn, owned the direct U.S. real property). Individual foreign investors have frequently preferred use of corporate structures to avoid the U.S. estate and gift tax. While holding U.S. property through a foreign corporation will typically enable the foreign investor to avoid the U.S. estate and gift tax, there are significant U.S. income tax consequences associated with investing in the U.S. real estate through a foreign corporation. We will discuss these consequences in more detail below.
One of the benefits of having a foreign corporation acquire U.S. real estate, rather than having an individual directly own shares of a U.S. company, is the avoidance of U.S. estate tax. This is because of estate and gift tax purposes, the U.S. estate and gift tax is assessed only on U.S. situs assets. Stock of a U.S. corporation is U.S. situs and stock of a foreign corporation is foreign situs, regardless of place of management or location of stock certificates. Since a foreign corporation has foreign situs for purposes of the estate and gift tax, transferring U.S. real property to a foreign corporation enables the foreign investor to avoid exposure to the U.S. estate and gift tax.
For income tax purposes, corporate structures not longer has the benefit of preferential long-term capital gains tax treatment on the sale of the property. Although the 21% percent corporate tax rate is similar to the 20% capital gains rate, there is a great deal of uncertainty about the future of the U.S. tax system and corporate tax rates. The cost of losing the preferential capital gains rates is made worse by the branch profits tax. The branch profits tax specifically treats the deemed repatriation of already taxed profits from the United States by a foreign corporation as an occasion to impose a second tax under Section 884. Internal Revenue Code Section 884 describes this second tax as the “dividend equivalent amount” of the “effectively connected earnings and profits” with certain adjustments. This second tax is known as the “branch profits tax.” The branch profits tax is intended to be the functional equivalent of earnings distributed as dividends by a subsidiary either out of current earnings not invested in subsidiary assets or out of accumulated earnings withdrawn from such investment. The branch profits tax imposes a tax equal to 30% of a foreign corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions.
The use of foreign corporate structures to hold U.S. real estate may also tax disadvantages for U.S. heirs. Although a a foreign structures avoid U.S. estate and gift taxes, at the death of the foreign investor, U.S. beneficiaries may inherit “cursed” shares in a foreign corporation. Depending on the number of shares inherited, the foreign corporate shares could be taxed as either a Controlled Foreign Corporation (“CFC”) or a Passive Foreign Investment Company (“PFIC”). There are significant U.S. tax disadvantages to inheriting stocks classified as CFC or PFIC.
Holding U.S. Real Property through a Domestic Corporation
Given the disadvantages of playing U.S. real property in a foreign corporation, foreign investors may elect to utilize a domestic corporation to hold U.S. real property. From an income tax point of view, a domestic corporation will be subject to federal income tax on any future capital gain at up to 21 percent. On the sale of the real property, any distribution of the proceeds other than in liquidation of the corporation will be dividend to the extent of the corporation’s E&P and therefore subject to tax at a flat rate of 30 percent or a lower treaty rate. Any amounts distributed from a domestic corporation would likely be subject to withholdings under the Foreign Investment in Real Property Tax Act (“FIRPTA”) and/or Fixed, Determinable, Annual, Periodical Income (“FDAP”) provisions of the Internal Revenue Code.
For gift tax purposes, a foreign investor may make gifts of domestic corporate shares without being subject to U.S. gift tax. The consequence of the death of the foreign owner depends on the structure of the ownership of the domestic corporation. If the foreign corporation is owned directly by the foreign owner, the taxable estate will include the shares, and the estate will be subject to estate tax on those shares upon the owner’s death. This is because stock in the domestic corporation has a U.S. situs for estate tax purposes. In certain limited cases, domestic stock can be exempt through an estate tax treaty.
If the domestic corporation is owned by a trust, the consequences will depend on whether any of Section 2036 (transfers with retained life estate), 2038 (revocable transfers), and 2041 (powers of appointment) apply to the foreign decedent. If so, the value of the stock in the domestic corporation will be includable in the estate of the foreign owner; otherwise, there will be no estate tax, except in unusual circumstances, possibly when the foreign corporation is treated as an alter ego during the foreign investor’s lifetime. See Home Thoughts From Abroad: When Foreigners Purchase U.S. Homes, Taxnotes Federal, August 17, 2020, p. 1165.
Holding Real Property through a Partnership
Although not often considered by foreign investors, the use of a traditional partnership (regardless of whether it is domestic or foreign, general or limited) has the very significant advantage of enabling the individual foreign investor to obtain the benefits of avoiding entity level tax (at the federal level) on all of the U.S. trade or business income being generated. In addition to this federal U.S. income tax benefit, the partnership also provides a vehicle for making U.S. tax-exempt gifts of the partnership’s underlying U.S. real estate through transfers of the partnership interest itself. See IRC Section 2501(a)(2). Finally, foreign investors may be able to avoid the estate tax by holding real property through a partnership. As discussed in greater detail below, the extent to which the U.S. estate tax rules apply to partnerships held by foreign investors are not totally free from doubt.
As noted above, there may be some risk that the Internal Revenue Service (“IRS”) will assert that a traditional partnership should be classified as “U.S. situs property” (and, thus, subject to the U.S. estate tax on the foreign investor) when the partnership is engaged in a U.S. trade or business. This is the conclusion one may seemingly extract from an analysis of Treasury Regulation Section 20.2104-1(a), which provides what appears to be, in broad conceptual terms, a list of assets that may constitute “property within the United States.” Under that regulation, both real property and tangible property located in the United States are U.S. situs, as are shares in U.S. corporations, debts issued by U.S. persons, and U.S. government bodies.
In the case of decedents dying before November 14, 1966, there was a rule that “the written evidence of intangible personal property which is treated as being the property itself, This was known as the “physical presence test,” and it applied to an even broader spectrum of intangible assets when it was first adopted by the Regulations. At the time, the physical presence test also applied to shares of non-U.S. corporations. In November of 1966, with the enactment of Foreign Investor’s Tax Act, the “physical presence tax” was abandoned and replaced by situs rules that turn on where the underlying entity is organized, regardless of whether it engaged in a U.S. trade or business and where the physical certificates are held.
When the original “physical presence test” was adopted by the regulations, dicta in some otherwise authoritative cases suggested that the physical presence test for the situs of intangibles might also be met if the foreign entity was engaged in a U.S. trade or business. For example, in Farmers’ Loan & Trust Co. v. Minnesota, 280 U.S. 204 (1930), the U.S. Supreme Court recognized the principle that choses in action may acquire a situs for taxation other than at the domicile of their owner if they have become integral parts of some local business. Similarly, in Sanchez v. Bowers, 70 F2d 715 (2d Cir. 1934), after already finding that the “sociedad de ganancials” (a juridical entity under the then applicable Cuban law) was deemed liquidated upon the death of Sanchez (such that the underlying securities which the sociedad de gananciales had maintained in new York were U.S. situs under the physical presence test). The Supreme Court went on to say:
“It may be that a foreign corporation by its activities can also so subject itself to the power of Congress as to ‘present’ as obligor, for the purpose of taxing the devolutions of its shares or debts, just as it may make itself ‘present’ for personal judgment. In that event the question here would be how continuously and substantially Sanchez carried on the ‘business’ of the ‘sociedad de ganancials’ in New York. If his [the sociedad de gananciales] activities were enough, his individual estate could be made liable for the devolution of some part of his dividend in liquidation, which is all we are holding it for anyway.”
Sanchez v. Bowers appears to articulate the concept that a business presence of a foreign entity might be sufficient to cause the entity interests in the foreign entity to be deemed physically present in the United States under the physical presence test for determining situs of intangibles. Neither Farmers’ Loan & Trust Co v. Minnesota nor Sanchez v. Bowers come to the conclusion that a business presence of a foreign entity is sufficient to cause its equity interests to be deemed “present” in the jurisdiction where it is engaged in a trade or business for U.S. estate tax purposes. Neither case provides for a stand-alone rule that a U.S. trade or business of a foreign entity causes its equity interests to have a U.S. situs. However, given the seemingly significant sweep of the above two decisions, an introduction of a “U.S. trade or business” test for determining physical presence in a catch-all rule might seem reasonable.
Since 1966, we have ended up with the principal situs rules providing: 1) that real and tangible personal property are sitused based on where physically located and 2) that stocks and bonds are situated based on the place of incorporation of their issuer or obligor, with no consideration of where such entities are engaged in trades or businesses oe where the physical certificates of such corporate entities are held. Thus, if the catch-all intangible situs rule today is intended to be simply analogous to the principal entity situs rule that turns on the place of incorporation of the issuer or obligor, then it would be a logical extension of the principal corporate intangible situs rule and one might accept that such a rule’s application to a partnership interest should be that: a) if the partnership is formed in the United States, then its interests will have a U.S. situs, whereas; (b) if the partnership is organized outside the United States, then its interest are non-U.S. situs. On the other hand, if the continuing reference to a “resident” of the United states is intended to import a “U.S. trade or business test” in the case of partnerships, then it would appear to be a wholly unreasonable interpretation and an arbitrary and capricious adoption of a rule that lacks both statutory and judicial precedents, especially following the effective repeal of any remaining use of the “physical presence test” by the Foreign Investors Tax Act of 1966. See The U.S. Tax Effects of Choice of Entities For Foreign Investment In U.S. Real Estate And Businesses And The Taxation of Dispositions of U.S. Partnership Interests, Baker & McKenzie, Miami, Robert F. Hudson, Jr. 2015.
If the current catchall rule of Treasury Regulation Section 20.20104-1(a)(4) is intended to be simply analogous to the principal rule that the situs of corporate stock and bond interests turn on the place of incorporation of the issuer or obligor, then the analogous rule would provide that if the partnership is formed in the United States, its equity and debt interests are non-U.S. situs. As a result, it would be most prudent for the partnership to be formed outside the United States if you wish to achieve non-U.S. situs treatment for its equity and debt interest. Furthermore, it is generally thought to be prudent to ensure that the foreign partnership is regarded (under local, foreign law) as an entity separate from its partners and that the death of the partner in question does not terminate the partnership.
Ownership of U.S. Property Through a Trust
Finally, a foreign investor my hold U.S. property in an irrevocable trust. The trust can be domestic of foreign. An irrevocable trust is potentially an attractive vehicle for newly acquired residential property. This type of planning will depend following the foreign grantor trust rules of Internal Revenue Code Sections 671 through 679. Trusts are taxed at rates applicable to individuals and there is a preferential rate of 20 percent now applicable to long term capital gains.Trusts are taxed at rates applicable to individuals, albeit with essentially no progression through the brackets, and are therefore entitled to the preferential rate of 20 percent now applicable to long-term capital gains.
Properly structured, a foreign irrevocable trust will avoid the U.S. estate and gift tax. However, as with foreign corporate entities, a tax trap lucks for trust distributions to U.S. beneficiaries.
U.S. beneficiaries may be subject to a special tax on distributions from a foreign trust known as DNI which could rexlassify capital gains into ordinary income. In addition, accumulation distributions from a foreign trust could be subject to Section 668(a) interest surcharge at the floating underpayment penalty interest rates (compounded daily) of Section 6621.
Conclusion
Foreign investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate and business investments, as do their U.S. counterparts, although their objective is complicated by the very fact they are not U.S. persons. Foreign investors have a number options when investing in the U.S. real estate market. As in many areas of international tax planning, one size does not fit all. A careful analysis must be done by a qualified tax attorney to determine the best estate and gift planning for each individual foreign investor.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.