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
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
•
•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
•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
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
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
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
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
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 I5TATEYou can also read
