The Why, the Who and the How of the New Reporting Requirements for Foreign-Owned Domestic Disregarded Entities

The so-called ‘check-the-box’ entity classification regulations (§§ 301.7701-1 through 301.7701-3) will cause a classification of a single owner business entity as a “disregarded entity” for federal tax purposes unless that entity elects to be treated as a corporation. This is a common scenario in regard to single member domestic limited liability companies (LLCs), whereby in absence of a timely made entity classification election, the LLC becomes disregarded as separate from its owner and henceforth reports its items of income and expense on Schedule C (an integral part of a personal tax return). Note that a nonresident who reports his or her effectively connected income and expenses from business or practiced profession on Form 1040NR would also use Schedule C to give a detailed report in that regard.

The recent regulations (T.D. 9796) – implemented as of January 1, 2017 – introduce a profound change for one class of disregarded entities.

Why the new regulations?

The U.S. Treasury has long viewed the opportunity for foreign nationals to form U.S. based single member LLCs, while not electing the corporate status for tax purposes, as a fertile ground for shell games. In the more recent years, the Treasury has become far more keen to enter into additional, bilateral Tax Information Exchange Agreements (TIEAs) – the last notable effort in that field being evidenced by the December 2016 agreement with Argentina – and, as a consequence, has become more attuned to the needs of its counterparts.  At the same time, many a sovereign player and some international organizations have not hesitated to put a lantern on the weaknesses of the U.S. financial and tax system when it comes to making it more difficult for non-U.S. persons to evade taxes in their home jurisdictions.

Considering that a disregarded entity that does not have U.S. based employees or Form 1099 filing requirements (reporting of payments rendered to an independent contractor) is typically not required to obtain an Employee Identification Number (EIN), the visibility on the LLC’s asset holding activities is substantially reduced. The asset holding activities of such LLCs, in their substance, more often than not, may be indistinguishable from the asset holding activities of their respective owners.  With an eye toward reciprocity, the Treasury constructed the new regulations primarily in order to enhance its ability to harvest information that would be useful to treaty and/or TIEA counterparts.

Who will be affected?

Any foreign person that owns, directly or indirectly, a domestic disregarded entity in its entirety.  The indirect ownership encompasses ownership via other disregarded entity, as well as ownership via a grantor trust. The definition of a foreign person extends to any foreign corporation, company, partnership or association, as well as to any foreign estate or trust described in §7701(a)(31).

How will the regulations affect this particular class of entities?

In essence, the new regulations throw the foreign-owned disregarded entities into the existing realm of reporting for foreign corporations engaged in U.S. trade or business and domestic corporations with at least 25% foreign ownership interest. This area is governed by §§6038C and 6038A of the U.S. tax code. For the limited purpose of complying with section 6038A of the code and the derived therefrom regulations, a foreign-owned disregarded entity will be treated as a domestic corporation. In practical terms this policy shift will mean the following:

  • Foreign-owned disregarded entities will be required to obtain an EIN. The very process of obtaining an EIN will give the IRS a glimpse of what is at the core of that entity’s activities.
  • Foreign-owned disregarded entities will be obligated to file, on annual basis, Form 5472 and therein report on a whole host of transactions with foreign related parties. The reportable transactions, whether monetary or for other consideration, include but are not limited to: sales, purchases, commissions (paid and received), rents, royalties, cost sharing payments and receipts, and – more crucially – all contributions, distributions, and amounts loaned or borrowed.  The term related party for the purpose of Form 5472 reporting includes all thirteen categories under §267(b), which among other classes of relationship covers spouses and most types of relationship by blood, as well as certain controlled partnerships, as stipulated under §707(b)(1). Lastly, the relationship may be established by operation of §482, which relates to allocation of income and expenses among taxpayers – a somewhat more esoteric concept and perhaps a less likely way to be pulled into the new reporting requirements.
  • Foreign-owned disregarded entities will have to adhere to the record keeping requirements of §6001. That will certainly benefit a foreign government’s efforts when seeking information in the U.S. via letters rogatory or other recognized protocol.

Barring one’s ability to show a reasonable cause, noncompliance can be castigated rather harshly by the IRS. This is also the case here. The theme of penalties and the remedies leading to their [potential] abatement may provide enough fodder for a separate article.

IMPORTANT DISCLOSURES

The presented here information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change.  Moreover, the information is presented here for educational purposes and is not specific to any individual’s personal circumstances.  As such, this information should not be used for the purpose of avoiding penalties that may be imposed by law.  A determination as to how your specific circumstances may relate to the presented material should be made by means of a consultation with your tax adviser.

Cezary Tchorznicki, CPA does not provide legal or investment advice. 

Co-investing (with Foreign Persons) in the U.S. Real Estate – When Implementing Your Business Strategy Hits a Snag.

You are a U.S. citizen living abroad and decide to invest in the U.S. real estate. You find a cohort of three business partners that are willing to embark with you on this venture and, upon taking into consideration that two of them are foreign persons, you select a “C” corporation as the legal form of the operation. Are you potentially setting yourself (and your partners) up for an unpleasant surprise?

Flow-through entities (FTEs), especially the “S” corporation, have been long considered the preferred structure for running a closely held business. The allure of FTEs lays mainly in the single-layer tax arrangement and the relative ease of liquidation. However, nonresident aliens are ineligible for “S” corporation stock ownership. Indeed, in the community property states a mere act of marrying a nonresident alien by an “S” corporation shareholder will trigger the termination of the “S” corporation status. As a consequence, you give the “C” corporation another look. After all, since 2012, the highest individual tax rate exceeds the highest U.S. corporate tax rate and the political winds indicate that this gap may soon widen. Naturally, you remain leery of the “C” corporation double taxation stigma.

Your foreign investors can partake, directly or indirectly, in an ownership of a “C” corporation and, depending on the treatment of dividend income in their respective countries, may find the arrangement sufficiently palatable in the context of income taxation.

However, lurking around the corner are potentially detrimental outcomes for you, your U.S. partner, as well as the two foreign investors.

Let us begin with you and your U.S. co-investor. The formed corporation (we’ll call it generically QYQ World Properties) buys and then rents out commercial buildings across the United States; whenever the situation dictates it, properties are also sold, either at gain or loss. Within the forest called the Internal Revenue Code (IRC) there is an obscure, primeval subdivision. In that primeval thicket of the IRC reside the code sections that govern a dreadful mechanism known as the Personal Holding Company Tax. IRC section 543 defines the income that is subject to that tax; rental income is a personal holding company income. An entity that derives 60% or more of its income from sources listed in section 543 is a Personal Holding Company (PHC).

OK, you say (already suspecting the worst). How is this exactly affecting my business?

Well, in addition to the corporate income tax and the personal income tax that the shareholders will have to pay on their salaries and received dividends, QYQ World will be liable for a 20% tax on the undistributed portion of its retained earnings. Think of it as an annual tax on your corporation’s “savings” account. Accordingly, if QYQ was to accumulate its profits as part of an overall expansion plan but failed to quickly find strategic opportunities, the shareholders may be penalized for their growth oriented ambitions [thus the “primeval” in my intro to this topic].

What are the remedies?   One could say: “diversify,” engage in another line of business that is not covered by IRC 543 and then, ensure that the profits from that activity exceed 40% of the total. However, considering that you had lured your co-investors with the promise of the relatively low risk and steady returns of the commercial real estate, it may be difficult to sell them on investing in ice cream parlors. Yet a key word was mentioned that couldn’t be ignored: “profits”. The 60%+ test is based on gross profit (precisely speaking, on the adjusted ordinary gross income), not on the gross receipts. The starting point for computation of the PHC income is line 28 of Form 1120 (U.S. corporate tax return). Therefore, one begins with a post-depreciation amount (note that some excess depreciation is added back to PHC income). In real estate, depreciation can be quite a significant factor in reducing the profit. Consequently, the other, non-section 543 line of business, may not have to generate nearly 40% of QYQ’s cash flow in order to account for more than 40% of the company’s net profit.

In order to be classified as a PHC , at least one half of the entity’s stock must be owned by 5 or fewer shareholders. In “our” scenario, an invite to two additional investors would nullify the PHC tax dilemma. That may prove an easier task than the development of a secondary business model and, by extension, the forging of an additional business strategy. The existing shareholders, however, must be prudent about the ways in which they plan to amplify the ownership pool. For instance, gifting shares to relatives may trigger the attribution rules and the IRS would likely [successfully] challenge the bona fide character of a new ownership structure. Moreover, the downside of this approach is the dilution of ownership and with it, a watering down of control. Down the road, for a minority shareholder, that may also mean a diminished valuation of his or her ownership interest.

What should the foreign stakeholders be aware of?

The PHC tax would equally affect them as the earnings available for distribution would be reduced. The consequences of having the so-called “effectively connected income” from QYQ’s U.S. activities would not be much different than if the income from the U.S. business activities was earned in some other way. However, a nonresident alien engaging in U.S. real estate investments may be potentially exposed to some acutely unfavorable – and certainly unintended by that investor – consequences in the realm of gift and estate tax. Per 26 CFR 20.2104-1(a), all U.S. situated, tangible property (real estate included) of a nonresident alien is included in that nonresident alien’s gross estate.  An exception is made for a certain class of artwork (IRC 2105(c) and CFR 20.2105-1(b)). Furthermore, barring a paltry exemption under 26 CFR 20.6018-1(b), there is no corresponding lifetime exclusion for federal gift and estate tax that would be normally afforded to U.S. persons [in order not to complicate things to the nth degree, we’ll assume that “our” foreign investors are not married to U.S. citizens]. In sum, in case of a foreign shareholder’s passing, and depending on the overall asset mix, up to 40% of his or her U.S. based wealth would be wiped out.

What ownership structure would accord a nonresident alien shareholder a better succession (wealth transfer) option?

After all, in “our” scenario, the foreign investors own the real estate indirectly via a U.S. corporation. Isn’t that a sufficient protection? Sorry to disappoint, but according to IRC § 2104(a) and 26 CFR (that stands for Code of Federal Regulations) 20.2104-1(a)(5), shares issued by a U.S. corporation have a U.S. situs, i.e. their physical location is deemed to be in the U.S. Therefore, at nonresident alien shareholder’s death, the shares would be included in his or her gross estate.

That leaves us a roundabout way. Your foreign co-investors could set up a foreign corporation (or two corporations), which in turn would be allocated shares of stock of QYQ World Properties. Per CFR 20.2105-1(f), the situs of the shares issued by a foreign corporation and owned by a nonresident alien is not in the U.S. In order to withstand the IRS scrutiny, the foreign corporation must be a bona fide ongoing concern formed under the laws of a given country, not a sham or illusory corporation. A caution must be exercised in applying the term corporation as some forms of ownership that are quite common in other countries do not meet the criteria of being a corporation under U.S. tax laws. For instance, a stiftung – a legal form quite commonly adopted in Switzerland and Liechtenstein – has been ruled to be a revocable trust and not a corporation (Estate of Oei Tjong Swan , 1957).

You could ask: “What would prevent my foreign associates, upon forming that objective specific corporation in their country, to invest via that corporation in the U.S. real estate market without me partaking?”

That is a legitimate question. Apart from giving up on reaping the fruits of your vast experience – it is you that knows the lay of the land – acting on their own, your foreign colleagues (it now seems appropriate to downgrade the level of relationship) could be served another venomous pill of the IRC: the branch profit tax. In the crudest terms: a corporation pays a tax on its income, then deducts the amount of that tax from the income figure and pays another tax (the branch profit tax) on what is left for distribution to the parent company. Ouch! Yes, colloquially speaking, this is a form of double taxation and it impacts only the foreign corporations operating directly in the U.S.  A handful of countries secured a treaty exemption from the branch profit tax. Another question worth asking is this: “Could these guys set up a U.S. corporation of their own which would be wholly owned by their foreign corporation and use that as a vehicle to funnel the profits to the foreign corporation, thus avoiding the branch profit tax?” Yes, they could. However, other business reasons would be probably compelling enough to work with U.S. citizens and/or permanent residents.

So we have breached a few gates and seemingly arrived to a solution to the estate tax and branch profit tax worries. We are, however, still left to grapple with the looming PHC tax threat.

Even with the “S” corporation option off the table, there are some alternatives to the “C” corporation structure. For one, there is the limited liability company (LLC) that technically has no shareholders but is owned by members. The LLC is a common form of ownership but has a much shorter legal history than partnerships and corporations. Much of the recent litigation stemmed from valuation and transfer of ownership disputes. LLC membership leads to self-employment tax liability issues. Furthermore, a merger of a LLC with a corporation may present unique tax problems. Perhaps it is not a perfect vehicle. Nonetheless, a LLC with at least 2 members may be treated as a U.S. partnership for income tax purposes and that in itself defeats the PHC tax bogeyman. You need to be aware, however, of the rather arcane tax withholding requirements on the income allocated to the nonresident alien partners. This may place a significant administrative and cash flow burden on your LLC.

Could one improve on that option?

Depending on the totality of circumstances, yes. For example, you and your U.S. associate could form QYQ World and make the “S” election. Subsequently, QYQ World could enter into a partnership with QYQ World Bis (a U.S. corporation owned wholly by a foreign corporation set up by your foreign associates). Note that partnering up directly with the foreign corporation would bring back the specter of the branch profit tax. The state law determines whether a corporation can enter into a partnership with another entity. For example, the Delaware Revised Uniform Partnership Act defines partnership as “an association of 2 or more persons” and then, gives us the following definition: “Person” means a natural person, partnership (whether general or limited), limited liability company, trust (including a common law trust, business trust, statutory trust, voting trust or any other form of trust), estate, association (including any group, organization, co-tenancy, plan, board, council or committee), corporation, government (including a country, state, county or any other governmental subdivision, agency or instrumentality), custodian, nominee or any other individual or entity (or series thereof) in its own or any representative capacity, in each case, whether domestic or foreign.1 [the bold letters are mine]. Your “S” corporation structure would alleviate the PHC tax malady, at least in case of the two U.S. actors.

In the initial planning stages, it would be important to understand the letter and the spirit of the income tax conventions between the U.S. and the respective countries from which hail your foreign co-investors. Whenever applicable, that understanding should extend to the modifying aspects of the tax treaties that had been signed but not yet ratified (as I write this, several are awaiting the ratification of the U.S. Senate). Also important would be to make a determination whether the foreign investor’s home country signed an estate tax treaty with the United States – a vast majority of countries have not entered into one (some do not have an estate tax). It is noteworthy that the pre-1966 category of estate tax treaties centers on the situs of the property approach. Beneficial might also be delving into the provisions of the Foreign Investment in the Real Property Tax Act (FIRPTA) of 1980 and thus acquiring a better understand of the tax implications of disposal of real estate interest by nonresident aliens. Lastly, but of equal importance would be the understanding of the relevant state laws.

Once you craft your preliminary plans and have a general idea about the expected, geographic locus of your administrative and management activities, you should strongly consider seeking a qualified advice (legal and accounting) and thus ensure that you will make an optimal choice of entity (or set of entities) and that your plan can be implemented the way you and your partners envisioned it.

This stuff may not be rocket science, but it can get confusing at times. Before you make a substantial financial commitment, what you want to hear is what the Liverpool Football Club fans sing before games (a borrowing from a Broadway musical): “You’ll Never Walk Alone”.

1§15-101(16) of the Act.

IMPORTANT DISCLOSURES

The presented here information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change.  Moreover, the information is presented here for educational purposes and is not specific to any individual’s personal circumstances.  As such, this information should not be used for the purpose of avoiding penalties that may be imposed by law.  A determination as to how your specific circumstances may relate to the presented material should be made by means of a consultation with your tax adviser.

Cezary Tchorznicki, CPA does not provide legal or investment advice.