Entries Tagged 'Inbound (investments in the US)' ↓

In response to an email I just got from Denis Carrade, here’s another resource.

Denis, you remember we talked in the class yesterday about the interesting situation of having a corporation, and the corporation’s assets are being used by the shareholder for personal purposes.  I can hear the brain klaxons firing up now, just thinking about that.

I mentioned that I had remembered some Tax Court case somewhere involving an alien ownership of a house inside a corporation and how the Tax Court judge casually addressed this situation while breezing by on the way to resolving another issue.

After some brainstorming on Lexis, I found the case.  It is Bigio v. Commissioner and my memory was correct.  The comment by the judge is not on the issue of the case.  The issue the judge was addressing was the “Resident?  Yes or no?” one.

If you look at Footnote 2, I have highlighted the relevant sentence.  The taxpayer owned a property inside a Panamanian corporation and the judge cavalierly marches past it to attribute beneficial ownership to the taxpayer.  The language is mushy, the implications tenuous, etc.

But this is the only case I can think of off the top of my head involving a nonresident alien and a house inside a corporation.

Using the appropriate lolcatz eyerolling, I’d say this is Dicta! in a Footnote!  Translation to English — this case doesn’t answer any questions for us.

For all of the people who were in my “Foreign Investment in U.S. Real Estate” class yesterday in San Francisco (I taught a 1-day course sponsored by the California Society of CPAs Education Foundation), here is one of the things I promised to deliver.

Tax Court Opinion

The Estate of Fung attached (warning: PDF) are from the United States Tax Court, and the affirming opinion from the Ninth Circuit Court of Appeals.

The problem, with easy math

The idea here is to describe the pickle facing heirs of a nonresident alien who has the bad judgment to die while owning U.S. real estate.

Let’s say the nonresident owns real estate and there’s a mortgage on the property.  Let’s make up some numbers.  The property is worth $5,000,000, and the mortgage is $4,000,000.  The nonresident dies.  What’s the estate tax?

Example 1:  nonrecourse debt

If the mortgage is truly nonrecourse (meaning the lender can ONLY go after the property in the event of a default, and can never go after the borrower personally), then the estate tax is calculated on the nonresident’s equity in the property, $1,000,000.

For the sake of our example, let’s say the applicable estate tax rate is 40%.  The heirs sell the property, pay off the mortgage, give Uncle Sam $400,000 ($1,000,000 equity times 40% tax rate = $400,000 estate tax), and go home with $600,000.

Example 2:  recourse debt

If the mortgage is recourse (meaning the lender has the option of going after the borrower for personal liability on the debt in the event of a default), then the estate tax is calculated on $5,000,000 — the gross value of the real estate, without deducting the mortgage.

The heir sell the property.  Pay off the mortgage ($4,000,000).  They have $1,000,000 of cash left over.  Now they tote up the estate tax on a $5,000,000 asset at 40% = $2,000,000.  Note the conundrum:  the mortgage plus the estate tax liability adds up to a bigger number than the cash on hand.  The heirs get nothing.

My God!  Is there no mercy?

Seems insane, doesn’t it?  Well, in fact there is a way to get that mortgage to help reduce the estate tax.

On the nonresident dead guy’s estate tax return (Form 706NA) (warning:  PDF) the executor will report the nonresident dead guy’s worldwide balance sheet.  (!)  Then there is some higher math involved.  The details of the higher math are unimportant for our purposes–we’re just talking concepts here.  But if you’re looking for specifics, look at the instructions for Schedule B of Form 706NA.

The idea is that since the nonresident dead guy only has U.S. estate tax on his U.S. assets, you have to do a pro-rata allocation of debt based on a fraction that looks like U.S. assets (numerator) divided by worldwide assets (denominator).

The answer is usually pretty grim.  Usually your nonresident dead guy has LOTS of assets outside the United States, and only a little bit in the United States.  This means that when you pro-rate that $4,000,000 mortgage, it’s not going to end up being all that big of a deduction from the gross estate in order to arrive at the taxable estate.

Which means that the tax savings for going through this exercise are likely to be relatively small.

And the heirs aren’t going to want to tell the U.S. government all about nonresident dead guy’s worldwide assets.  Maybe they don’t want to spend the money for accounting and legal fees to do this.  Maybe they’re just not interested in doing all of the necessary work.  But more likely it is because of a healthy desire for privacy.

Action plan

If you have a situation like this (nonresident owner of U.S. real estate, and mortgage on the real estate) first look at the loan documents very carefully, and come to a professional conclusion as to whether it is a recourse mortgage or a nonrecourse mortgage.

If you have a recourse mortgage, do a quickie spreadsheet to calculate out the value of reporting worldwide income in order to use the mortgage to reduce the size of the taxable estate.  Tell your (alive) nonresident alien investor or the (dead) nonresident alien investor’s heirs that number.  Let them tell you whether they’re willing to report worldwide assets on Form 706NA.

I’m guessing the answer is “Not!”

Thanks

Thanks to all of you who came to the course.  Please keep in touch.  Subscribe to the RSS feed here so you’ll get updates of stuff we talked about.

International tax planning can get fearsomely complex.

You have at least two (usually more) countries interested in extracting some tax revenue from you, and their laws are usually only barely consistent. It’s a bit like three dimensional chess, except that the rules change from time to time. (And no one in our law firm is anything like Spock in any way whatsoever. Just for the record.)

It’s also a bit of fun. For some people, anyway. There’s a little bit of the “Ooooh, shiny” when we talk about setting up holding companies in small palm-fronded island nations.

I am a tax lawyer. My job in life is to deflect the discussion away from tax. My job is to push companies to think about the business, THEN think about tax. Cart. Horse. Etc.

For privately held companies doing business worldwide (we help these people), talk to the shareholders–the people who started the company. Sooner or later they will dispose of their shares. There’s an exit strategy that every company owner has in his/her head.

• They get bought out by a third party.
• They give/sell the company to their kids.
• They get divorced and the ex gets a piece of the company.
• They die.

Yeah, the other exit strategy is to go public. But that’s a transformer strategy (transforming stock in a private company into stock in a public company). When it’s all done, the shareholder still has an exit strategy for the shares he/she owns. Going public isn’t a disposition strategy.

The disposition strategy that no one is willing to talk about is death. I talk to entrepeneurs who tell me they plan to run their companies foreverrrrrr. FAIL.

Here’s the simplistic way of approaching things for corporate income tax planning:

• First, think about the business and how it can maximize its profits from running the business. Where do you need people? Where do you need to control inventory, run quality control, provide customer service, build your widgets?
• Then, remember that profit is profit. Worldwide. Do your tax engineering for the lowest average income tax cost on company profits. Worldwide. Numerator = taxes paid everywhere, denominator = net profit before taxes. Your metric is to drive that number down slowly, year after year, if you can.

After that, work on the estate tax side of the equation. Why after? Because the company is worth some multiple of its profits. If you focus on the business planning, then the income tax planning, you should be increasing your worldwide pre-tax and after-tax corporate income, thereby increasing the value of the company. You build wealth by building wealth, not by shaving taxes.

One thing at a time. Business planning first because it creates higher pre-tax profit. Income tax planning second because it creates higher after-tax profit. Then and only then, estate and gift tax planning to make sure Mr. Congress doesn’t share too much of your wealth.

This post was triggered because I never really thought about why I do what I do until I saw a recent post, completely unrelated to tax law.

Dave McClure, in talking about web businesses, says in “not safe for virgin ears” language that the problem isn’t exotic “issue du jour” stuff.  The major problem people face is “I forgot my password.”

Same thing with tax planning.  That’s not the most important thing for a business.  The most important thing is “I need to make a profit.”  That’s boring and repetitive and in front of you every day.  It’s much more fun to talk about the Cayman Islands.

Nope.  Let’s deal with the “Duh!” stuff first.

Senator Carl Levin (D-Mich) introduced the Incorporation Transparency and Law Enforcement Assistance Act on May 1, 2008. This law (God help us all if it ever becomes law) would force States to determine the “beneficial owners” (the really-truly owners, not fakey-fakey owners) of corporations and LLCs.

Professor Bainbridge has commented on this. He’s way smarter than I’ll ever be. Go there for the reasoned analysis. Come back here for the rant.

<rant>

CURE IN SEARCH OF A DISEASE

This is a cure in search of a disease.

Senator Levin says this law will protect the United States from U.S. corporations being misused to commit terrorism, money laundering, tax evasion, or other misconduct.

I’d like to know how to do this, please. In my world everything is potentially visible to the government all the time.

If you have a reason to know who owns a corporation, you can get that information. No problems.

• Corporation owes you money? You’re suing the corporation, right? There’s this little thing called discovery.
• You’re the IRS? Don’t get me started. They already have plenty of clubs to beat this information out of you.
• You’re law enforcement? Don’t get me started.

What if you’re going to do a business transaction with a corporation? You think maybe there’s a skanky person who “really” owns the corporation.

Simple answer, easily solved without a Nanny State: you ask for the information, you get a personal guarantee from the people behind the corporation, or you don’t do the deal. See, all you need to be is an adult.

Yes, people are going to lie. They will lie you, to the IRS, to the FBI, to your mom. This proposed law won’t change anything. If someone is going to lie about a foreign bank account under threat of $250,000 fine or 5 years in prison (Form TD F 90-22.1), (warning: PDF) do you think Senator Levin’s new law is going to make the difference and scare them straight?

THE REAL BENEFIT OF THIS LAW?

So I guess I don’t see the added benefit to the government for collecting this data in terms of law enforcement. Well, except for the fact that the government slowly beats more data points out of us, randomly, so that some day in a fit of fiscal pointillism the government will see everything and will be able to tax everything.

I don’t think that’s Senator Levin’s motive.

Maybe he believes the bogeyman argument. “Look! Over there! Behind that tree! A terrorist!” I doubt he is that gullible.

So why is it proposed law on the table? Hmmm. Maybe because it is politically expedient during an election cycle?

NEW MINIMUM QUALIFICATION REQUIREMENT FOR SENATORS?

I propose a new entry requirement before someone is permitted to run for the Senate.

Before you run for election, you should have to own and operate a business for two years. If the business succeeds, you get to sleep in a warm, dry place every night and feed your kids. If the business fails, well, I’m so sorry.

The exercise of dealing with employment taxes and making sure that employees get their paychecks on time — that alone — just might be the sanity pill that we need.

</rant>

Sorry this post isn’t nuanced.

Calm down. It only applies to a small group of people (who, incidentally, are our customers). Probably not you. Who? Nonresidents have high U.S.-source long term capital gains.

The AMT rules can create alternative minimum taxable income greater than the actual capital gain. Translated into English: Imagine making $100 of capital gain in real money and having the IRS say your tax should be calculated as if you made $110.

Let’s just say that the people who wrote the Internal Revenue Code didn’t bother to synchronize the Alternative Minimum Tax rules with the rest of the Code. The explicit tax rate applicable to nonresidents is cheerfully ignored for AMT purposes.

Let’s also say that this is yet another instance the Lazy Penalty applies. Interpretation: don’t blindly using an income tax return preparation program without understanding–REALLY understanding–what is happening.

Congratulations to David Nguyen for looking at this, thinking “Hey, this ain’t right!” and figuring it out. He even went to the effort of spending quality time on the phone with the Internal Revenue Service.

Download this file for the program materials from my January, 2004 speech entitled “Taxation of Income Not Effectively Connected With a U.S. Trade or Business: Sections 871 and 881.”

In plain English, this is all about passive investments made by nonresidents of the U.S.