Foreign-Owned U.S. Real Estate: To Rent or Not to Rent

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Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
Foreign-Owned
               U.S. Real Estate:
             To Rent or Not to Rent
                          With the right structure, rent-free use of corporate-owned real property
                                 need not have any adverse U.S. income tax consequence.

                            DINA KAPUR SANNA AND STEPHEN ZIOBROWSKI, ATTORNEYS

       onresident aliens frequently       her family members be charged rent                      dent consists of only property that

N      purchase U.S. real property
       for personal use. To avoid U.S.
       estate tax, the most common
structure to hold the U.S. real prop-
erty is through a foreign corpora-
                                          for their personal use of U.S. real
                                          property when the property is
                                          owned through a foreign corpo-
                                          ration to avoid adverse U.S. tax
                                          consequences?
                                                                                                  has, or is deemed to have, a "U.S.
                                                                                                  situs" at the time of the nonresident's
                                                                                                  death, or when certain lifetime trans-
                                                                                                  fers occur that come under the
                                                                                                  "retained string provisions" of Sec-
tion organized and owned by the                                                                   tions 2035 through 2038.1 Under
nonresident. Because the property         U.S. taxation of                                        these Code sections, a decedent is
is owned by the foreign corporation       nonresident individuals                                 subject to estate tax on property
rather than the nonresident, for pur-     Nonresident individuals could                           he or she has transferred during life,
poses of U.S. estate tax the nonres-      potentially have U.S. estate tax and                    by trust, or otherwise, where the
ident is treated as owning the stock      income tax exposure.                                    decedent retained the right, either
of the foreign corporation rather                                                                 alone or in conjunction with any
than the underlying U.S. real prop-       Estate tax. For U.S. estate tax pur-                    person, to designate the persons who
erty. Stock in a foreign corporation      poses, a nonresident is a nonciti-                      would possess or enjoy the proper-
is not a U.S. situs asset, so it is not   zen who is not domiciled in the U.S.                    ty or the income therefrom or where
subject to estate tax.                    (U.S. domicile is acquired by living                    the enjoyment is subject at the date
   Although the foreign corpora-          in the U.S. with no definite present                    of his or her death to any change
tion structure addresses U.S. estate      intention of later moving from the                      exercisable by the decedent alone
tax issues, it is not without its com-    U.S.) The gross estate of a nonresi-                    or in conjunction with another
plications. The discussion below                                                                  person to alter, amend, revoke, or
begins by describing the more stan-       DINA KAPUR SANNA and STEPHEN ZIOBROWSK. are             terminate (or such power was re-
dard issues implicated by the struc-      partners with the law firm of Day Pitney LLP who reg-   linquished within three years of
ture. The balance of the article          u any advise high net worth cl'ents on cross border     death).2
                                          tax and trust planning matters. aria practices in the
addresses an issue that has not pre-                                                                 A nonresident's gross estate is
                                          New York office and Stephen practices in the Boston
viously received much attention but       office The authors wou:d Ike to thank the r colleague
                                                                                                  determined in the same manner as
plagued practitioners nonetheless:        Andrew Wogman, for his research and preparation in      the gross estate of a U.S. resident
Should the nonresident or his or          connection with parts of this article.                  or citizen, except that:
                                                                   3
                                                                   •
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
•4
     1. Property outside the U.S. is           obligations of a U.S. person or a U.S.   number of days of presence for the
        excluded.                              governmental entity, the written evi-    first preceding year is multiplied by
     2. Special rules apply to joint           dence of which is not treated as         a factor of V3, and the number of
        property where the surviving           the property itself.° There are excep-   days of presence for the second pre-
        spouse is not a U.S. citizen.          tions for portfolio debt, certain        ceding year is multiplied by a fac-
        (These rules apply to U.S.             short-term original issue discount       tor of 1/6. There are exceptions for,
        decedents with noncitizen              obligations, and bank deposits. Also,    among others, students, teachers,
        spouses as well.)                      stock of a corporation organized         foreign diplomats, and those who
     3. The deductions and credits             under U.S. law (or the law of a U.S.     can claim a closer connection to
        available to a nonresident's           state) is deemed to have a U.S. situs,   another country. In addition, a
        gross estate are limited.              regardless of where the share cer-       bilateral income tax treaty can pro-
                                               tificates are physically located.°       vide relief for dual-resident tax-
        Although a nonresident is sub-
                                               Notably, the situs rules fail to men-    payers who can claim residence in
     ject to estate tax on U.S.-situs assets
                                               tion partnership interests, nor does     the treaty country, if they satisfy
     at marginal rates of up to 40%, the
                                               any case law apply the relevant pro-     the provisions of the treaty tie-
     applicable estate tax exemption is
                                               visions to partnership interests. In     breaker.
     only $60,000, unless a bilateral
                                               the absence of authority, the fol-          A nonresident is subject to U.S.
     estate tax treaty provides other-                                                  income tax on his or her:
     wise, compared to $5 million (infla-      lowing analysis may apply.
                                                  A partnership that does not ter-      1. U.S.-source fixed or deter-
     tion adjusted to $5.34 million in                                                     minable annual or periodical
     2014) for a U.S. citizen or resident.3    minate on the death of a partner
                                               can be viewed as a separate and dis-         (FDAP) income, the tax on
        The situs rules are found in Sec-                                                  which is collected by with-
     tions 2104 and 2105, as ampli-            tinct entity from its owners or as
                                               an aggregate of their interests. Case        holding at a 30% rate (or
     fied by Treasury Regulations, but                                                      lower treaty rate) on gross
     may be modified by a bilateral            law and commentary support enti-
                                               ty theory more than aggregate the-          FDAP income.
     estate tax treaty. These situs rules                                               2. Income that is effectively con-
     provide as follows.                       ory in this context. When applying
                                               the entity theory however, there are         nected (ECI) with a U.S. trade
        With few exceptions (e.g., works                                                    or business, which is taxed at
     of art on loan and personal prop-         two possible outcomes for deter-
                                               mining situs:                                graduated rates of up to
     erty accompanying a nonresident                                                        39.6% on a net basis.13
     who dies while in the U.S.), tangi-       1. Situs is determined based on
                                                  the location where the part-             FDAP. FDAP income includes,
     ble personal property located in the
                                                  nership conducts its business.10      among other items, interest, divi-
     U.S. is a U.S.-situs asset.
                                               2. Situs is determined based on          dends, and rents from U.S. sources.14
        Real property located in the U.S.
     has a U.S. situs.4 If the real prop-         the residency of the partnership
                                                                                         1 Sections 2101-2104. Under Section 2104(b),
     erty is subject to a nonrecourse             for income tax purposes (i.e.,            any property subject to the string provisions
                                                                                            of Sect ons 2035 through 2038 is included
     mortgage, the real property is               its place of organization).”              in the gross estate of a nonresident, if it had
                                                                                            or was deemed to have a U.S. situs at the time
     included in the gross estate at its          No clear rule has emerged.                of the transfer or death.
     net equity value.5In contrast, where                                                2 Sections 2036 and 2038.

     the real property is subject to a         Income tax. For U.S. income tax           3 Section 2102(b).

                                                                                         4 Reg. 20.2104-1(a)(1).
     recourse mortgage, the real prop-         purposes, a nonresident is a nonci-       5 Reg. 20.2053-7.
     erty is included at its full value, but   tizen who does not hold a green           6 Id.

     only a pro-rated deduction for the        card or satisfy the substantial pres-     7 Reg. 20 2104-1(a)(4).

                                                                                         9 Section 2104(c); Reg. 20.2104-1(a)(7).
     mortgage is allowed, based on the         ence test.12 To satisfy the substan-      9 Section 2104(a); Reg. 20.2104-1(a)(5).
     proportion that the nonresident's         tial presence test, an individual        10 See, e.g.. Rev. Rul. 55-701, 1955-2 CB 836.

     U.S. assets bear to his or her world-     must be physically present in the        11 See, e.g., Reg. 301.7701-5, which is consis-
                                                                                            tent with the rules applied to corporations
     wide assets.6                             U.S. for 31 days in the current cal-         under Section 2104(a) and Reg. 20.2104-
        Intangible personal property, the      endar year and for a weighted total
                                                                                        12 Section 7701(b)(1)(A).
     written evidence of which is not          at least 183 days during the current     13 Sections 871(a) and (b). Nonresident alien indi-
     treated as the property itself, is        year and the two preceding calen-           viduals are not subject to the 3.8% Medicare
                                                                                           tax that may apply to the net investment income
     deemed to have a U.S. situs if it is      dar years. For this purpose, the            of U.S. taxpayers Section 1411(e)(1)
     issued by, or enforceable against, a      number of days of presence in the        14 Section 871(a)(1)(A). Exceptions exist for inter-
                                                                                           est earned on portfolio debt instruments and
     U.S. resident. 7 This includes debt       current year is counted in full, the        bank deposits. Sections 871(h) and 871(i)(3).

     FS'ATE PI ANNING                                                                                 APRIL 2014         VOL 41 / NO 4
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
•6
     FDAP income, however, generally           porate stock, if the nonresident          an agreement for the payment of
     does not include capital gains rec-       owns 5% or less of such stock).20         tax.25 A withholding certificate that
     ognized on sales or exchanges of                                                    is obtained prior to the transfer
     assets held for investment.15 Also,                                                 relieves the transferee from with-
     FDAP income does not include gain                                                   holding obligations.25
     recognized on the disposition of a                                                     A nonresident taxpayer who has
                                                Because U.S. real
     "U.S. real property interest," which,      property is a
                                                                                         FIRPTA gain must file a U.S. tax
     as discussed in detail below, is taxed     U.S.-situs asset                         return and apply the taxes with-
     as if it were ECI.15 A nonresident         for estate                               held against the tax liability shown
     taxpayer whose only income is              tax purposes,                            on the return. The lower long-term
                                                nonresidents often                       capital gains rate (currently 20%)
     FDAP income on which tax has been
                                                hold U.S. real
     withheld is not required to file a U.S.                                             is available to a nonresident indi-
                                                property through
     tax return.                                a blacker foreign                        vidual on a sale of a USRPI, if the
        EC/. A nonresident who has ECI          corporation.                             sale otherwise qualifies.
     must file a U.S. tax return and may
                                                  FIRPTA applies a look-through          U.S. taxation of corporations
     deduct expenses that are directly
                                               rule to partnerships and trusts.          The first step in determining the
     connected with the Ed. ECI is gen-        Under this look-through rule, a dis-
     erally not subject to withholding                                                   U.S. taxation of a business is to
                                               position of an interest in a USRPI        identify the form in which the enter-
     in the U.S. except where it is derived    by a partnership is treated as a dis-
     through a partnership.                                                              prise is organized.
                                               position of each partner's ratable
        Rental income from U.S. real           share of the USRPI held by the part-      Entity classification. The U.S. tax
     property can be FDAP or ECI,              nership.2i Under Treasury Regula-         classification of a business entity is
     depending on the facts. To elimi-         tions, an interest in a partnership       not always consistent with its form
     nate uncertainty, an election is          is a USRPI if 50% or more of the          of organization. Under the "check-
     available that allows a nonresident       value of the partnership's gross          the-box" rules found in Reg.
     to treat income from U.S. real prop-      assets are USRPIs and 90% or more         301.7701-3, many types of busi-
     erty as ECI.17 Despite the fact that      of the value of the gross assets of the   ness entities are permitted to elect
     ECI may be subject to a higher mar-       partnership consists of USRPIs plus       their classification for U.S. tax pur-
     ginal tax rate than FDAP, this elec-      cash or cash equivalents (but only        poses. In particular, most partner-
     tion is often favorable because it        to the extent that the gain on dis-       ships or limited liability companies
     results in tax on net income, not         position is attributable to USRPIs).      (whether U.S. or foreign) can elect
     gross income, and net rental income       FIRPTA withholding (discussed             to be taxed as corporations; other
     may be modest due to depreciation         below) may be imposed on the entire       types of foreign entities are "per
     and deductible expenses such as           proceeds of disposition of a part-        se" corporations for U.S. tax pur-
     insurance and real estate taxes.          nership interest that is a USRPI.22
        FIRPTA. Under the Foreign                 FIRPTA is enforced through             19 Sect on 871(a)(1)(A) (listing types of income
     Investment in Real Property Tax           withholding obligations imposed              other than capital gains). Despite the gener-
                                                                                            al exemption from U.S. tax for capital ga . ns
     Act (FIRPTA), gains from the dis-         on the transferee, who must gen-             that are not treated as ECI, Section 871(a)(2)
     position of a "U.S. real property         erally withhold 10% of the                   provides that net U.S.-source capital ga'ns
                                                                                            are taxable at 30% in the hands of nonresi-
     interest" are taxed as ECI to a non-      "amount realized."23 Relief from             dent aren individuals physica ly present
                                                                                            in the U.S. for 183 days or more during the
     resident.15 In general, a U.S. real       FIRPTA withholding may be avail-             tax year.
     property interest (USRPI) is (1) a        able for nonrecognition transac-          16 Section 897.

     direct interest in U.S. real proper-      tions under the Code, provided cer-       17 Section 871(d)(1).

                                                                                         16 Section 897(a).
     ty (other than an interest solely as      tain filing requirements are met.24       19 Section 897(c)(1).
     a creditor) and (2) an interest in        In other cases, withholding may be        29 Sectons 897(c)(2) and (3).

     stock of a domestic corporation           reduced or eliminated pursuant to            Sect'on 897(g).
                                                                                         22 Tem p . Reg. 1.897-7T(a). Despite the limrta-
     that is a U.S. real property holding      a withholding certificate issued             tions of the regulations, the IRS has indicat-
     company (USRPHC).19 A USRPHC              by the IRS. The IRS may issue such           ed that the applicability of the Code section
                                                                                            is not contingent on the :ssuance of regula-
     is a corporation more than 50%            a certificate where it determines            t ons. Notice 88-72, 1988-2 CB 383.
                                                                                         23 Section 1445.
     the value of which is attributable        that reduced withholding is appro-
                                                                                         24 Section 897(e), Temp Reg 1.897-6T(a)
     to U.S. real property (with an            priate, the transferor is exempt          25 Reg. 1.1445-3(a).

     exception for publicly traded cor-        from U.S. tax, or the IRS enters into     26 Id .

     ESTATF P. ANNING                                                                                  APFi    2014     VOL 41    I   NO 4
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
poses and are not eligible to elect                      ing through a disregarded entity).                      cable), because it is FDAP income.
their classification. This article pre-                  Assuming that the property pro-                         However, if no dividends are paid
sumes that the entity holding U.S.                       duces rental income and the cor-                        during the life of the U.S. corpora-
real property is taxed as a corpo-                       poration has made an election to                        tion, the 30% withholding tax can
ration in the U.S.                                       treat the rental income as Ed, the                      be avoided. If the U.S. corporation
                                                         corporation will be required to file                    is liquidated following the sale of its
General rules of corporate taxa-                         a U.S. tax return and pay tax on its                    property, the corporation can avoid
tion. In the U.S., a corporation is                      net income at rates of up to 35%.                       FIRPTA withholding tax if both:
generally a separate and distinct                        Gain on the sale of the property
taxable entity. The character of a                       will be subject to tax under FIRP-                      1. The distributing corporation
corporation's income is not "passed                      TA as Ed, and, absent an excep-                            did not hold any USRPIs at the
through" to its shareholders.27 Fur-                     tion, FIRMA withholding will                               date of distribution.
thermore:                                                apply to the sale proceeds. In addi-                    2. All of its USRPIs were dis-
                                                         tion, a 30% tax may be imposed                             posed of in transactions
• A corporation is subject to tax
                                                         on the after-tax earnings that are                         in which the full gain was
   on its net income, at tax rates
                                                         not reinvested in the U.S. business                        recognized.31
   currently ranging from 15%
   to 35%.                                               (the "branch profits tax").
                                                            Although the branch profits tax                      Corporate ownership:
• A corporation does not pay a                                                                                   benefits and downsides
   lower rate of tax on capital                          is intended to parallel the 30%
                                                         withholding tax imposed on divi-                        Because U.S. real property is a U.S.-
   gains than on ordinary income.                                                                                situs asset for estate tax purposes,
• A shareholder who receives a                           dends paid by U.S. corporations to
                                                         foreign shareholders (discussed                         nonresidents often hold U.S. real
   distribution in respect of his or
                                                         below), the branch profits tax often                    property through a blocker foreign
   her stock realizes taxable
                                                         results in a higher effective tax                       corporation. This approach has the
   income to the extent of the cor-
                                                         because the tax is imposed regard-                      advantages of low cost and sim-
   poration's current and accumu-
                                                         less of whether a dividend has been                     plicity. The downside is loss of
   lated earnings and profits.29
                                                         paid. There is, however, an excep-                      the lower capital gains tax rate on
   These amounts are treated as
                                                         tion from the branch profits tax                        a sale of property and potential for
   dividends. The portion of a dis-
                                                         when property is sold if the cor-                       a second entity-level tax (i.e., the
   tribution in excess of the cor-
                                                         poration terminates its U.S. trades                     branch profits tax).
   poration's current and accumu-
                                                         or businesses and does not reinvest                        Conduit structures, such as for-
   lated earnings and profits is                         the sales proceeds in the U.S. for at
   treated as a nontaxable return                                                                                eign partnerships or foreign non-
                                                         least three years.30                                    grantor trusts, can preserve quali-
   of stock basis. To the extent                            Alternatively, a foreign corpora-
   amounts distributed exceed the                                                                                fication for the lower capital gains
                                                         tion could set up a U.S. corporate                      rate, but those alternatives present
   corporation's current and accu-                       subsidiary, which in turn would own
   mulated earnings and profits                                                                                  their own downsides:
                                                         the U.S. real property. If the prop-
   and the shareholder's basis in                        erty produces net rental income, the                    • In the case of a foreign partner-
   his stock, the distribution is                        U.S. corporation will file a U.S. tax                     ship holding U.S. real property,
   treated as gain from the sale or                      return and pay tax at regular cor-                        the nonresident must be willing
   exchange of property (which                           porate rates. A dividend paid by the                      to accept a risk of estate tax
   may qualify as capital gain).29                       U.S. subsidiary to its foreign par-                       exposure because of the lack of
  A foreign corporation may hold                         ent will be subject to 30% with-                          clear guidance on the situs of
U.S. real property directly (includ-                     holding (or lower treaty rate, if appli-                  partnership interests.32
                                                                                                                 .:.1MMEN ■•=11..
22  This general statement has several excep-                ness activities, it must (1) cease to have any         should be subject to estate tax only if it rep-
    tions. For instance, under certa n circum-               U.S. assets, (2) not reinvest in a U.S. trade          resents an obligation enforceab e aga;nst a
    stances, corporations can make an election              or business within three years (nor can any             U.S. partnership. McCaffrey, "Tax Planning
    to be treated as corporations," which                    related corporation make such an investment),          for Foreign Ownersh:p of United States
    are generally taxed as 'pass throughs." An              (3) have no ECI for three years from the end            Homes" ACTEC Fall Meeting (October 2012).
    "S corporation" cannot, however, have a non-            of the termination year, and (4) comply with            The IRS has refused to rule on whether a part-
    resident alien shareholder.                             certain procedural requirements See gen-                nership interest is intangible property for pur-
29 Sections 301(a) and (c), and 316.                        erally Temp. Reg. 1.884-2T(a)(2)(i)                     poses of Section 2501(a)(2) (dealing w th
23 Section 301(c).                                       31 Sections 897(c)(1)(B) and 1445(e)(3).                   transfers of intangible property by a nonres-
3 ° Temp. Reg. 1.884-2T(a)(1). In order for the          32 Some practitioners have suggested that an               ident for purposes of the U S. federal gift tax).
    foreign corporation to be treated as com-                interest in a partnership that surv yes the death      Rev. Proc. 2013-7, 2013-1 IRB 233, section
    pletely terminating all of its U.S. trade or busi-      of a partner is intangible property which               4.01(28).

APRIL 2014         VOL 4 1 NO 4                                                                                            FOREIGN-OWNED REAL ESTATE
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
EXHIBIT 1
 Nonresident U.S. Real Property Holding Structures for Personal-Use Property

                                                                   U.S. Subsidiary
                                                                  (Single-Purpose
                    Directly or               Foreign             Entity) of Foreign                               Irrevocable Foreign
                  Revocable Trust           Corporation             Corporation               Partnership           Nongrantor Trust

  U.S.          Yes                    No                        No                       Maybe                    No, if not a
  estate tax                                                                                                       beneficiary and
                                                                                                                   has no "retained
                                                                                                                   strings" over trust.

  U.S.          1. 30% withholding     1. 30% withholding        1. Taxed at corpo-       1. 30 0/0 withholding    1. 30% withholding
  income tax       tax on gross           unless foreign            rate tax rates of        tax on NRA part-         tax unless trust
  of rental        basis unless NRA       corporation elects        approximately            ner's share of           elects for income
  income           elects for income      for income to be          35% and U.S.             rental income            to be taxed as
                   to be Ed, taxed        Ed, taxed at net          corporation files        unless partner           ECI on a com-
                   at net basis at        basis at corporate        return (but foreign      elects for income        pressed rate
                   individual tax         tax rates of              corporation and          to be ECI and            schedule of
                   rates of               approximately             NRA do not)              partner must file        10%-39.6% and
                   10%-39.6%              35% and foreign        2. Dividends to for-        return; NRA part-        trust files a return
                2. NRA files return       corporation files         eign corporate           ner's share of ECI       disclosing all U.S.-
                   and discloses all      return (but NRA           parent subject to        is subject to with-      source income
                   U.S.-source            does not)                 withholding tax          holding by part-      2. Distributions
                   income              2. If ECI, potential         at 30%                   nership at 35%           of ECI to NRA
                                          30% branch prof-                                2. No second-level          beneficiary are
                                          its tax on "divi-                                  tax imposed              deductible by
                                          dend equivalent                                                             trust but taxable
                                          amount" resulting                                                           to beneficiary;
                                          in effective tax                                                            both trust and
                                          rate of 54.5%                                                               beneficiary must
                                                                                                                      file returns

  U.S.          20% long-term          1. No tax on disposi-     1. Tax on disposition    20% long-term            20% long-term
  income        capital gain rate         tion of foreign           of U.S. real          capital gain rate        capital gain rate
  tax on        available and             stock                     property but          available and            available and
  disposition   FIRPTA withholding     2. Tax on disposi-           no FIRPTA             FIRPTA withholding       FIRPTA withholding
                applies                   tion of U.S. real         withholding           applies to               applies to trust
                                          property at corpo-     2. Second-level          partnership
                                          rate tax rates of         dividend with-
                                          approximately             holding tax can
                                          35% and FIR PTA           be avoided if
                                          withholding               U.S. corpora-
                                          applies                   tion liquidates
                                       3. Second-level              following sale
                                            branch profits tax
                                            can be avoided
                                            if corporation
                                            completely
                                            terminates its
                                            U.S. trades or
                                            businesses

  Basis         Yes                    No, only foreign          No, only foreign         Yes, if Section 754      No, because
  adjustment                           stock gets basis          stock gets basis         election is made         Section 1014(b) not
  at death                             step-up                   step-up                                           met

• In the case of a foreign non-                   A nonresident settlor of a for-                 dents. For example, if a nonresi-
   grantor trust holding U.S. real             eign nongrantor trust ideally should               dent wishes to use property held by
   property, because of the                    not be a beneficiary of the trust and              an irrevocable trust without pay-
   retained string provisions, the             should not use the trust property                  ment of rent, he or she may wish
   nonresident settlor must part               unless he or she pays fair market                  to make his or her spouse a bene-
   with all dominion and control               rent to the trust. Despite these                   ficiary and rely on precedent that
   over the trust to avoid U.S.                downsides, conduit structures may                  indicates that rent-free use of such
   estate tax.                                 still make sense for some nonresi-                 property contemporaneously with
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
a spouse beneficiary is not a                            the corporation based on the trans-                                                           to its foreign parent and then to the
retained interest. 33 Although the                       fer pricing rules of Section 482.34                                                           nonresident shareholder. Because
balance of this article is dedicated                     The imputed rent would be U.S.-                                                               the U.S. corporation had earnings
to the corporate holding structures,                     source income, taxable as FDAP or                                                             and profits from the business activ-
Exhibit 1 includes a chart of vari-                      ECI. However, there do not appear                                                             ities of its U.S. subsidiaries, the
ous real property holding struc-                         to be any cases, rulings, or other                                                            deemed dividend from the U.S cor-
tures, including their advantages                        guidance that take this approach.                                                             poration was subject to U.S. with-
and potential disadvantages.                             In addition, Section 482 by its terms                                                         holding tax of 30%. The Tax Court
                                                         applies to only allocations of                                                                stated that "[w]hen a shareholder
Payment of rent to corporation                           income between or among com-                                                                  or his family is permitted to use cor-
When property held through a for-                        monly controlled entities, not to                                                             porate property for personal pur-
eign corporation is used for per-                        allocations between individual                                                                poses, the fair rental value of the
sonal purposes by a nonresident                          shareholders and corporations.                                                                property is includable in his
shareholder or that individual's
                                                         Thus, Section 482 seems not be                                                                or her income as a constructive
family members, the question of
                                                         likely to apply in this situation.                                                            dividend to the extent of the cor-
imputed rent or constructive dis-
                                                            Constructive distributions. In a                                                           poration's earnings and profits ...
tribution becomes relevant.
                                                         2012 case,35 the Tax Court con-                                                               [and] ... [f]or a corporate benefit
Imputed rent. Some commentators                          sidered a situation where U.S. real                                                           to be treated as a constructive div-
have suggested that the IRS might                        property was owned by a U.S. sub-                                                             idend, the item must primarily ben-
attempt to impute rental income to                       sidiary of a foreign corporation                                                              efit the taxpayer's personal inter-
                                                         owned by a nonresident share-                                                                 ests as opposed to the business
    Gutchess Est., 46 TC 554 (1966), acq. 1967-
                                                         holder. The U.S. subsidiary was the                                                           interests of the corporation" (cita-
    1 CB 2; Rev. Rule 70-155. 1970-1 CB 189              common parent of an affiliated                                                                tions omitted).36
34 Karlin and Ruchelman, "Home Thoughts from
    Abroad: Foreign Purchases of U.S. Homes."
                                                         group of corporations filing a con-                                                              The Tax Court's holding seems
    116 Tax Notes 863 (2007).                            solidated tax return in the U.S. The                                                          to be consistent with the weight of
35 G.D. Parker, Inc., TCM 2012-327

36 Id. The personal use of corporate property
                                                         Tax Court held that the rent-free                                                             authority in this area. From a review
    also resulted in disailowance to the U.S.            use of the corporate property by                                                              of the existing law, it seems well
    corporation of tax benefits generated by the
    property, such as depreciation or the invest-        family members of the nonresident                                                             established that uncompensated use
    ment tax credit, because the corporation was         shareholder was a deemed distri-                                                              of corporate property by a share-
    not using the leased property for business
    purposes.                                            bution from the U.S. corporation                                                              holder may be treated as a con-

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APRIL 2014        VOL 41 NO 4                                                                                                                                     FOREIGN-OWNED REAL ESTATE
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
10
     structive distribution from the cor-                  the same as a dividend actually paid                   Conclusion
     poration to the shareholder. While                    to the shareholder.40                                  If a nonresident shareholder of a for-
     a few cases have characterized such                       The FSA is consistent with other                   eign corporation uses real proper-
     use as gifts from the corporation                     rulings. The IRS's position is set                     ty held by the corporation without
     to the shareholder, these cases are                   forth most succinctly in Rev. Rul.                     paying a fair market rent, the
     dated and seem to be outliers.37                      58-1.41 In that ruling, the IRS stat-                  uncompensated use of the property
        In determining the nature of the                   ed that where shareholders are                         may be treated as a constructive dis-
     constructive distribution, some                       allowed to use an apartment owned                      tribution by the corporation to the
     courts have treated the corpora-                      by a corporation for below-market                      shareholder. This may or may not
     tion's depreciation charges and                       rent, the excess of the fair market                    have adverse U.S. tax consequences.
     maintenance expenses as a con-                        rent over the amount paid by the                           Where the foreign corporation
     structive distribution, to the extent                 shareholder is treated as a distri-                    holds U.S. real property directly,
     that they exceeded the rent paid by                   bution by the corporation and is                       a constructive distribution should
     the shareholder.38 The more typi-                                                                            generally have no U.S. tax conse-
                                                           includable in the shareholder's
     cal result, however, is that the con-                                                                        quence to the foreign corporation
                                                           income, to the extent that it is a div-
     structive distribution is the differ-                                                                        or the nonresident shareholder
                                                           idend. The ruling goes on to con-
     ence between the property's fair                                                                             because neither are U.S. taxpayers,
                                                           firm that the amount constituting
     rental value and the amount paid                                                                             and the distribution is not FDAP
                                                           a dividend is that part of the con-
     by the shareholder for its use.                                                                              or Ea. In contrast, if the real prop-
        In IRS Field Service Advice, FSA                   structive distribution derived from                    erty is held indirectly, through a
     199945017, the majority share-                        the corporation's earnings and prof-                   U.S. subsidiary, as was the case in
     holder of an S corporation used a                     its.42 Although one commentator                        G.D. Parker, the constructive dis-
     corporate asset on a rent-free basis                  has suggested that rent-free use of                    tribution could be subject to a 30%
     after previously paying the corpo-                    corporate property by sharehold-                       withholding tax if the U.S. corpo-
     ration for use of the asset.38 The                    ers should always be treated as                        ration has earnings and profits.
     IRS advised that this could be treat-                 income to the shareholders,43 case                     However, if the U.S. corporation
     ed as a constructive dividend to the                  law is generally consistent in hold-                   holds no other income-producing
     majority shareholder, as he per-                      ing that shareholders must report                      property, and if the U.S. real prop-
     sonally benefited from the use of                     the value of use of the property as                    erty is not rented, then the con-
     the asset. The amount of the con-                     a constructive distribution,44 which                   structive distribution would gen-
     structive dividend was the fair                       could result in no tax liability to                    erally not be taxable because the
     rental value of the asset. This con-                  the shareholder (e.g., if the corpo-                   U.S. corporation would have no
     structive dividend would be taxed                     ration has no earnings and profits).                   current or accumulated earnings

     37 Moreover, the IRS has ind cated that corpo-            er, the entire amount would be taxable as ordi-        tors have indicated that given the subsequent
         rations generally do not make gifts. See FSA          nary income and subject to applicable employ-          case history and guidance from the IRS, these
          199945017 (re-released on 4/29/2005, with         . ment taxes and income tax withholding.                  early gift characterizations were "question-
         additional information) (see below discussion     41 1958-1 CB 173.                                          able" and examples of the courts "dabbling"
         of this guidance). Section 643(i) treats the                                                                 with the idea. See id. (stating that the courts
                                                           42 See 58th St. Plaza Theatre, Inc., 195 F.2d 724,
         uncompensated use of trust property as a                                                                     "... dabbled with the idea that where the share-
         constructive distribution, but Section 643(i)        41 AFTR 1130 (CA-2, 1952) cert. den. 344                holder did not provide any serv ces to the cor
         has no corporate counterpart.                         U.S. 820(1952) (lease to shareholder's wife);          poration, the free use of corporate property
                                                               Nicholls, North, Buse Co., 56 IC 1225 (1971)           should be considered a tax-free gift to the
     39 Riss & Company, Inc., TCM 1964-190 (find-
                                                               ("It is well established that any expenditure          shareholders ... [but the courts] eventual)/
         ing that disa .owed deductions for mainte-
                                                               made by a corporation for the personal ben-            decided that the rent-free use of corporate
         nance costs and depreciation on three resi-
                                                              efit of its stockholders, or the making avail-          property by shareholders 's properly classi-
         dential properties occupied by the
                                                              able of corporate-owned facilities to stock-            fied as a constructive dividend."); Daniel M.
         corporation's shareholder and members of
         the family were instead taxab e dstributions          holders for their personal benefit, may result         Schneider, "Characterization and Assignment
         from the corporation to its shareholder to            in the receipt of a constructive dividend.").          of Corporate and Shareholder Income," 14 N.
         the extent the disallowed deductions exceed-      43 Elkins, "Tax Consequences of Sharehold-                 III. U. L. Rev. 133 (1994) (citing the 1958 deci-
         ed rents paid), aff'd sub nom. Transport Mfg.        ers' Rent-Free Us of Corporate Property," 5             sion, but calling it "questionable").
         & Equipment Co., 434 F.2d 373, 26 AFTR2d              FIU L. Rev. 41(2009)                               45 Fillman, 355 F.2d 632 (Ct. Cl., 1966); Estate
         70-5556 (CA-8, 1970) (affirming that deduc-       44 Id. (note 14 of that article lists numerous cases       of Swan, 247 F.2d 144 (CA-2, 1957); Stran-
         tions were properly denied on one of the three        in which shareholder use of corporate prop-            gi, 417 F.3d 468 (CA-5, 2005), aff'gTCM 2003-
         properties; holdings with respect to other two       erty is found to be a constructive distribution).       145.
         properties not appealed).                            There are three cases going back to 1934,           46 It would also be helpful if the corporation Is
     39 IRS Field Service Advice Memoranda are non-            1940, and 1958 n which courts held that the            funded with cash and purchases the U.S. real
         binding, taxpayer-specif c rulings furnished         rental value was properly treated as a gift from        property, rather than the real property bemg
         by the IRS National Office issued in response        the corporation to the occupying sharehold-             contributed to the corporation. In the former
         to requests made by IRS officials in the field.      ers. As stated above. the IRS has indicated             situation, there is no transfer of a U.S. s tus
     49 The FSA also noted that if the use of the asset       that corporations generally do not make gifts.          asset that could, even in theory, result in estate
         was compensation to the majority sharehold-          See supra note 37 In addition, commenta-                tax inclusion under Section 2036.

     ESTATE PLANNING                                                                                                             APRIL 2014          VOL 41 NO 4
Foreign-Owned U.S. Real Estate: To Rent or Not to Rent
and profits. This suggests that a       a U.S. subsidiary that has no other       ration holding U.S. real property
U.S. corporation used for this pur-     income or assets), rent-free use of       will need to fund expenses associ-
pose should be a single-purpose         corporate-owned real property             ated with the property (taxes, insur-
holding entity, with no other assets,   need not have any adverse U.S.            ance, etc.). These expenses could
and should not be included in any       income tax consequence.                   be financed by capital contribu-
consolidated return with other U.S.        There may, however, be some            tions or loans by the shareholder,
corporations that could generate        risk that the IRS could argue that        or they could be financed through
earnings and profits.                   a shareholder's failure to pay rent       rental payments. If the corporation
                                        for U.S. real property held by a cor-     collects rent for the property, it can
                                        poration could be a retained inter-       claim deductions for depreciation,
                                        est in the property, resulting in         insurance, utilities, and other
                                        inclusion of the property in the tax-
 Although the                                                                     expenses that would not be
 balance of                             able estate of a deceased nonresi-
                                                                                  deductible if the property were used
 this article is                        dent shareholder. Section 2036 pro-
                                                                                  solely for personal purposes.
 dedicated to the                       vides that the gross estate includes
 corporate holding                                                                   These deductions could result
                                        the value of property transferred
 structures,                            without adequate consideration by         in a net tax loss to the corpora-
 Exhibit 1 includes                                                               tion, particularly if the nonresident
 a chart of various                     the decedent by trust or otherwise,
                                        under which he or she has retained        shareholder uses the property for
 real property
 holding structures,                    the right to designate the persons        only portions of the year (as opposed
 including their                        who will possess or enjoy the prop-       to paying a full year's rent). Those
 advantages                             erty or the income therefrom. Sec-        losses can be carried over into future
 and potential                                                                    tax years and be used against net
                                        tion 2038 provides for inclusion in
 disadvantages.
                                        the gross estate of the value of prop-    income arising in those later years,
   If the U.S. corporation had no       erty transferred by trust or other-       including gain on the sale of the
earnings and profits, a constructive    wise, where enjoyment thereof was         property. As a result, the overall U.S.
distribution would reduce the for-      subject at the date of decedent's         income tax resulting from the cor-
eign corporation's basis in the stock   death to any change through the           poration's ownership of U.S. real
of the U.S. corporation. At some        exercise of a power to alter, amend,      property could actually be lower if
point, the basis in the stock could     revoke, or terminate.                     the nonresident shareholder paid
be reduced to zero so that future          Some practitioners have raised         rent for the periods of time that he
constructive distributions would        concerns that the IRS, emboldened         or she used the property.
be gains taxable as ECI and subject     by its recent successes in litigating        Payment of rent would also
to FIRPTA withholding (because          cases involving family limited part-      avoid the risk that the IRS could
the U.S. corporation is a USRPHC).      nerships, might launch a similar          assert that the rent-free use of cor-
It could be a long time before that     attack against foreign corporations       porate property was a constructive
would happen, though, and the           holding U.S.-situs assets used for        distribution potentially subject to
property might be sold before then.     personal purposes. There are, how-
                                                                                  U.S. income tax or a retained inter-
   Moreover, if the U.S. corpora-       ever, no cases or rulings to date
                                                                                  est in the property potentially sub-
tion were liquidated following a        applying either Section 2036 or
                                        2038 to that situation. 45 There-         ject to U.S. estate tax. It would be
taxable sale of all of its U.S. real
property, there is no authority for     fore, this potential concern does not     prudent to run projections for rev-
taxing the foreign corporation on       appear at this time to justify the pay-   enue and expenses of the corpora-
the liquidating distribution, even      ment of rent, so long as the corpo-       tion before having a nonresident
if the foreign corporation's basis      ration observes corporate formali-        shareholder pay rent, but under the
in the stock of its U.S. subsidiary     ties so as not to be treated as the       right circumstances, payment of
is zero or near zero. This suggests     nonresident shareholder's alter ego.46    rent by the corporation's share-
that with the right structure (i.e.,       On the other hand, the payment         holder could be a tax efficient way
a foreign corporation holding the       of rent by the shareholder may offer      to fund the expenses of owning the
real property directly or through       a planning opportunity. A corpo-          property. •

Ar9 I 201.1   VQ3 41 ! NO 4                                                               4- 01REIGN•OWNE RUAI I5TATE
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