How Tax Reform Has Changed the Structure and Planning for Nonresident Aliens with U.S. Real Property Interests
Wolf Group International Tax Director Mishkin Santa recently interviewed International Tax Attorney David Gershel to solicit his perspectives on how the Tax Cuts and Jobs Act of 2017 (TCJA) has changed the structure and planning for nonresident aliens with U.S. real property interests.
David is an associate with the law firm of Grant, Herrmann, Schwartz & Klinger, LLP. He counsels high-net-worth individuals, multi-jurisdictional families, closely-held businesses, and fiduciaries on U.S. and international tax, wealth management, and estate and trust planning.
This article summarizes the questions and answers from the interview.
Prior to TCJA, most nonresident aliens used offshore structures to hold U.S. real property in an effort to shield them against U.S. estate tax. TCJA changed some of the rules that make this structure advantageous. Can you briefly discuss the changes and how they affect these structures? Do you have any recommendations or thoughts on how to optimize the structure for estate planning purposes under TCJA?
Offshore planning structures are still generally effective tools for mitigating U.S. estate tax for nonresident aliens. A typical pre-TCJA structure for a nonresident alien generally consisted of an offshore corporation holding a U.S. limited liability company (LLC).
Holding shares of a non-U.S. intangible (i.e., shares in the offshore corporation) generally ensures that the nonresident alien is holding a non-U.S. intangible asset that should not be subject to the U.S. gift or estate tax regime. The U.S. entity, rather than the non-U.S. corporation, should file the U.S. tax return and pay any taxes owed. This should also permit the LLC to sell the property without implicating the Foreign Investment in Real Property Tax Act (FIRPTA).
The TCJA, however, does affect such a structure in a few ways. First, the reduction of the U.S. corporate income tax rate to 21% may trigger a non-U.S. country’s controlled foreign corporation (CFC) rules.
For example, in many Latin American countries, the CFC rules are triggered if the foreign corporation is taxed at an effective tax rate of less than 75% of the home country’s tax rate for corporations. However, a few countries, such as Mexico, will include state and local corporate taxes levied on the U.S. corporation in the calculation of the effective tax rate applicable to the U.S. entity. The U.S. corporate tax rate reduction may cause complications at home, and it is advised that such individuals contact their local tax advisor to review whether there is a CFC issue in the non-U.S. jurisdiction.
The use of U.S. or non-U.S. trust structures to purchase and hold real estate has not been significantly impacted. However, changes to the U.S. CFC rules eliminated the 30-day rule, which provided that a non-U.S. corporation must have been classified as a CFC for at least 30 consecutive days in the tax year for Subpart F rules to apply to such entity.
As a result, upon the death of a non-U.S. grantor of a non-U.S. grantor trust which is, or will become, a U.S. situs trust upon the death of the grantor, or that has U.S. beneficiaries, the non-U.S. blocker corporation may immeidately become a CFC on the date of the grantor’s death. This also is an issue if the nonresident alien owns a non-U.S. corporation and the recipients of the ownership interests upon his or her death are U.S. resident alien children.
Before the TCJA, after the owner/grantor died, the trustee or executor would file a “check the box” election for the non-U.S. corporation to be treated as a disregarded entity effective no more than 29 days after the date of the grantor’s death in order to prevent the blocker from becoming a CFC for long enough (at least 30 days) to trigger current year income inclusions under the CFC Subpart F rules for the U.S. beneficiaries of the trust. As long as the blocker was either owned by the decedent or held in a trust drafted with the requisite retained powers to provide for a basis step-up, the election would result in a step-up in basis without triggering any taxable gain.
After the TCJA, the elimination of the 30-day rule means that it is no longer possible to check the box on a single non-U.S. blocker corporation with appreciated assets after the death of the nonresident grantor without generating a potential CFC Subpart F income inclusion (assuming that there are enough U.S. beneficiaries/owners to cause the blocker to be classified as a CFC after the death of the owner/grantor). However, checking the box to be effective prior to the date of death would cause the non-U.S. owner to have died holding U.S. situs assets (i.e., the U.S. real estate) through a disregarded entity, risking an estate tax inclusion and potential FIRPTA implications.
A potential solution is a two-tiered blocker structure:
- Two non-U.S. holding companies held by the trust or the nonresident directly. Each holding company would own less than 80% of the stock of the lower tier company.
- The two holding companies, in turn, would own the stock of a lower-tier non-U.S. corporation.
Upon the death of the non-U.S. grantor of the non-U.S. grantor trust, the two top-tier holding companies would check the box on the lower-tier company to be taxable as a partnership effective one day prior to the date of death. Because each company owns less than 80% of the stock of the lower tier entity, the liquidation should avoid non-recognition treatment under the Internal Revenue Code (IRC) and thus should be “taxable,” stepping up the basis of the underlying assets.
The upper-tier entities should subsequently each check the box to be treated as disregarded entities effective as of the date of death. This may cause the top-tier entities to be classified as CFCs for one day, but there should only be minimal CFC includible Subpart F income allocable to that one day.
The key to this planning technique is to reorganize current structures prior to the death of the grantor to avoid having to choose between an estate tax inclusion or CFC income inclusion if there is only a single blocker entity.
Alternatively, there is another option for a nonresident, not a citizen individual leaving assets entirely to U.S. beneficiaries through the use of non-U.S. corporation. Following the death of the decedent, the estate may domesticate the non-U.S. corporation to minimize the amount of time and income related to the corporation’s classification as a CFC.
In this scenario, the non-U.S. corporation will become a CFC following the decedent’s death as it will be owned 100% by U.S. shareholders. A domestication or “F Reorganization” may be affected by merging the CFC into a new U.S. corporation in which the CFC’s assets are transferred to the new U.S. corporation in exchange for all of the new corporation’s stock. The CFC then distributes out all of the new U.S. corporation’s stock to its shareholders in proportion to their ownership interests in the CFC.
This will be considered a mere change of identity, form, or place of organization and should not be taxable from a U.S. perspective. The U.S. shareholders of the CFC should be treated as exchanging stock in the CFC for the stock of the new U.S. corporation. Under the CFC rules, the U.S. shareholders are required to include in income as a dividend an amount equal to the earnings and profits of the CFC accumulated during the time in which the non-U.S. corporation was a CFC. However, as the U.S. shareholders should be treated as holding the stock of the CFC only for a short period from the decedent’s death until the completion of the domestication transaction, the amount of the earnings and profits attributable to this time, and taxable to the U.S. shareholders, generally should not be significant.
Clients holding U.S. real estate directly or through any structure should contact their tax advisor as soon as possible to restructure their holdings in order to mitigate their potential increased tax exposure as a result of the changes resulting from the TCJA.
A lot of nonresident aliens with LLCs in the U.S. were surprised to learn that they had a filing requirement in 2017—Form 1120 (page 1) and Form 5472. Can you briefly summarize the information that is being reported on this filing and penalties involved for failure to file? Also, what do you suggest an individual do if they were not aware of this filing requirement and have now missed the deadline to file?
Before the enactment of the new regulations, single-member foreign-owned LLCs that were disregarded for tax purposes were generally not required to file tax returns or make informational filings with the Internal Revenue Service (IRS) except to report their interests in non-U.S. financial accounts.
Unlike with U.S. partnerships and corporations, these LLCs were also generally not subject to federal record-keeping requirements or obligated to disclose their beneficial ownership to the IRS. Non-U.S. persons have commonly used LLCs for various types of activities and investments, including for the acquisition of real estate and as holding vehicles for various types of U.S. and non-U.S. investments.
The U.S. Treasury and IRS issued final regulations in December 2016 that now subject foreign-owned single-member LLCs that are disregarded for U.S. income tax purposes (i.e., LLCs that have not elected to be classified as corporations) to the informational reporting requirements established under IRC Section 6038A for 25% foreign-owned U.S. corporations. It is important to note that this is solely an informational filing and no tax is due along with the form.
The new regulations now generally require foreign-owned single-member LLCs to obtain a U.S. employer identification number (EIN) and annually file a pro forma Form 1120 corporate income tax return together with Form 5472 identifying the 100% direct and all ultimate indirect non-U.S. owners.
The first filings pursuant to the new regulations were generally due as early as April 17, 2018, covering tax years starting in 2017. The IRS will assess a penalty of $10,000 for each year the new reporting requirement is not timely filed or a filing is substantially incomplete, which constitutes a failure to file Form 5472.
The new regulations subject all foreign-owned single-member LLCs that are disregarded for U.S. tax purposes to the Form 1120 and Form 5472 informational reporting requirements for each year starting in 2017 in which an LLC has a “reportable transaction.” The definition of a reportable transaction is very broad and appears intended to include any type of activity between a direct or indirect non-U.S. owner and the LLC. Reportable transactions include:
- Capital contributions and capital reductions
- The use of LLC property (e.g., real estate) by a direct or indirect non-U.S. owner or related party
- Payments by an LLC to or for the benefit of a direct or indirect non-U.S. owner or related party
- Payments by a direct or indirect non-U.S. owner or related party for the benefit of an LLC
- Loans and/or payments of interest between an LLC and a direct or indirect non-U.S. owner or related party.
The definition of “related party” is expansive. A related party includes direct or indirect non-U.S. owners of the single-member LLC and also includes other entities and individuals under specified constructive ownership and attribution rules. For example, if the LLC were owned by a non-U.S. trust, a related party may include the trust’s settlor and beneficiaries. For an LLC owned by a non-US individual, a related party may include certain members of that individual’s family. If the LLC were owned by a non-U.S. company, a related party may include entities owned by the same parent company.
Importantly, the new regulations do not establish any de minimis thresholds. For example, even $1 contributed by a non-U.S. owner to a single-member disregarded LLC would be sufficient to trigger the new reporting requirement.
A reporting corporation’s failure to file a Form 5472, failure to maintain or cause another to maintain records, and failure to comply with the non-U.S. record maintenance requirements may be excused upon a showing that the taxpayer acted in good faith and there was reasonable cause for the failure.
To show reasonable cause for such a failure, the reporting corporation must, in a written declaration under penalty of perjury, make an affirmative showing of facts supporting reasonable cause. These may include an honest misunderstanding of fact or law that is reasonable in light of the experience and knowledge of the taxpayer.
“Reasonable cause” is not specifically defined in the IRC or accompanying Treasury Regulations. Therefore, taxpayers must look to other authorities, such as case law and the Internal Revenue Manual, when demonstrating reasonable cause and good faith.