By Cynthia

Introduction

It is common for nonresident aliens (NRAs) to invest in real estate in the United States. However, when they wish to gift this property to their children who reside in the U.S., they can face up to 40% in gift tax and estate tax. Here is a structured approach to mitigate these taxes.

Gift Tax Issues

Direct Gifts of Real Property:

1. Gifts of U.S. real estate by an NRA are subject to U.S. gift tax (IRC §2501(a)(1)).
2. The annual exclusion amount applies, but the exemption limits for NRAs are significantly lower compared to U.S. citizens and residents.

Gifts of Stock in a Foreign Corporation:

1. Stocks of a foreign corporation are considered intangible property.
2. Gifts of intangible property by an NRA are not subject to U.S. gift tax (IRC §2501(a)(2); Treas. Reg. §25.2511-3).
3. This includes gifting stock of a foreign corporation that holds U.S. real estate indirectly.

Estate Tax Issues

Direct Ownership:

1. S. real estate directly owned by an NRA is considered U.S. situs property and is subject to U.S. estate tax upon the NRA’s death (IRC §2103).
2. The estate tax rate can be up to 40% on the value of the property exceeding the $60,000 exemption for NRAs.

Indirect Ownership via a Foreign Corporation:

1. Stock in a foreign corporation is not considered U.S. situs property and is not subject to U.S. estate tax upon the NRA’s death (IRC §2105(d)).
2. This provides a potential tax planning advantage as the foreign corporation structure can avoid U.S. estate tax on U.S. real estate.

Structuring Through a Foreign Corporation

A potential solution to mitigate gift and estate tax issues is for an NRA to hold U.S. real estate through a foreign corporation. Here’s how this structure works:

Structure Overview

Foreign Corporation (ForCo):

1. The NRA owns 100% of ForCo.
2. ForCo owns 100% of a U.S. corporation (USCo).

U.S. Corporation (USCo):

1. USCo owns the U.S. real estate directly.
2. This structure separates the direct ownership of the U.S. real estate from the NRA.

1. Income Tax Perspective

Foreign Corporation Holding U.S. Corporation (U.S. Real Property):

Income from U.S. Real Property:

• Example:Suppose a U.S. corporation (USCo) owns a commercial building in California. The rental income generated from leasing the building is $500,000 annually.
  • The USCo must report and pay federal income tax on this rental income (IRC §11).
  • Assuming a corporate tax rate of 21%, the federal tax liability on this income would be $105,000.

Dividends:

• Example:If USCo distributes $100,000 as dividends to its parent foreign corporation (ForCo), a 30% withholding tax applies (IRC §881).
  • Therefore, USCo must withhold $30,000 and remit it to the IRS, leaving $70,000 for ForCo, unless a tax treaty reduces this rate.

Branch Profits Tax:

• Example:If ForCo directly owns the U.S. real property and operates it as a branch, it earns $500,000 in rental income. After paying the federal income tax of $105,000, the net income is $395,000.
  • The branch profits tax (30%) applies to the $395,000, resulting in an additional tax of $118,500 (IRC §884).

IRS Regulations and Rulings:

• Reg. §1.882-5 guides the calculation of ECI for foreign corporations.

2. Gift Tax Perspective

Gifting the Foreign Corporation’s Stock:

Intangible Property:

• Example:An NRA owns 100% of ForCo, which holds 100% of USCo, which owns U.S. real property. The NRA decides to gift the stock of ForCo to a U.S. resident daughter.
  • Since ForCo’s stock is considered intangible property, this gift is not subject to U.S. gift tax (IRC §2501(a)(2); Treas. Reg. §25.2511-3).

3. Estate Tax Perspective

Estate Tax on U.S. Situs Property:

NRA directly own the U.S. Corporation:

• Example:Upon the death of the NRA, who directly owns USCo’s stock, the value of USCo’s stock (which indirectly owns the U.S. real property) is included in the NRA’s estate for U.S. estate tax purposes (IRC §2104(a), IRC §2103).

Foreign Corporation Holding U.S. Corporation:

• Example:If the NRA owns ForCo, which owns USCo, and USCo holds the U.S. real property, upon the NRA’s death, the stock in ForCo is not considered U.S. situs property and is not subject to U.S. estate tax (IRC §2501(a)(2), Treas. Reg. §25.2511-3).

Ownership of Stock in a Foreign Corporation:

• If the NRA owns stock in a foreign corporation (ForCo), which in turn owns a U.S. corporation (USCo) holding U.S. real property, the stock in ForCo is not considered U.S. situs property and is not subject to U.S. estate tax (IRC §2105(d), Treas. Reg. §20.2105-1(f)).

IRS Regulations and Rulings:

• Reg. §20.2104-1(a)(4) confirms inclusion of U.S. corporation stock in a nonresident decedent’s estate.
• Reg. §20.2105-1(f) excludes foreign corporation stock from the gross estate.

Disadvantages of This Structure

While this structure offers tax planning benefits, it also has notable disadvantages:

Income Tax Disadvantages:

Double Taxation: Profits from USCo are subject to U.S. federal income tax, and dividends to ForCo are subject to a 30% withholding tax, unless reduced by treaty (IRC §881).

Example: $100,000 in dividends from USCo to ForCo results in a $30,000 withholding tax, unless treaty-reduced.

Branch Profits Tax: If ForCo directly owns U.S. real property and operates it as a branch, it may be subject to a 30% branch profits tax (IRC §884).

Example: $395,000 net income from U.S. property faces an additional $118,500 branch profits tax.

Compliance and Reporting Requirements:

• Example:Managing multiple jurisdictions increases compliance costs. Both USCo and ForCo need to file annual tax returns, maintain transfer pricing documentation, and possibly comply with FATCA reporting.

Gift Tax Disadvantages:

• Potential Legislative Changes:Future legislative changes could make gifts of foreign corporation stock by an NRA subject to U.S. gift tax (IRC §2501(a)(2)).
• Perception of Abuse:This structure might draw IRS scrutiny, leading to audits and increased compliance costs.

Estate Tax Disadvantages:

Complex Valuation Issues: Valuing ForCo, which holds USCo and U.S. real property, can be complex and lead to disputes with tax authorities.

Example: Significant appreciation in U.S. property complicates valuation.

Step-Up in Basis Issues: Upon the NRA’s death, the basis of U.S. real property does not get a step-up to fair market value if held indirectly through a foreign corporation. This can result in significant capital gains tax upon sale.

Example: Property with an original basis of $1,000,000 and a current value of $5,000,000 could face substantial capital gains tax.

Increased Administrative Costs: Maintaining a multi-layered corporate structure involves legal, accounting, and administrative costs.

Example: Annual costs for legal and accounting services to maintain compliance.

Conclusion

This structure minimizes U.S. gift and estate tax exposure but comes with disadvantages like potential double taxation, compliance complexity, and significant administrative costs. Careful evaluation and consultation with tax and legal professionals are crucial to ensure alignment with the NRA’s overall tax planning strategy.

References:

• IRC §881, §884, §2501(a)(2), §2104(a), §2105(d)
• Reg. §1.882-5, §20.2104-1(a)(4), §20.2105-1(f)
• Rul. 69-187, Rev. Rul. 80-330, Rev. Rul. 87-61, Rev. Rul. 92-105