Non-U.S. individuals making direct investments in the United States face a bewildering U.S. tax regime. Generally, there is no perfect structure for holding such investments; each one has benefits and drawbacks. Adding to the uncertainty is a surprising lack of authority regarding certain U.S. tax rules for interests in partnerships and limited liability companies. This article provides an overview of the relevant law and several "case studies". Of course, each potential investment will present its own facts and circumstances, and there is no substitute for individual advice from a capable tax adviser. Readers should recognise that some planning techniques and related tax rules and exceptions are beyond the scope of this article. Non-U.S. taxes, particularly those of the country in which the individual is resident, must be considered as well.
Direct investment means equity investment in U.S. real estate or in a U.S. business other than through publicly traded securities. For example, a non-U.S. person may wish to buy residential property in Florida. Another may be interested in investing in a genetic engineering start-up company created by an old friend from university. In each case, there will be many structuring options.
As discussed below, the U.S. federal income tax laws applicable to non-U.S. persons have developed independently of the applicable federal estate and gift tax laws. This discontinuity begins with the definition of who is a foreign person. For income tax purposes, an individual who is not a U.S. citizen is considered a U.S. resident (taxable on worldwide income) if he or she is a lawful permanent resident (i.e., possesses a "green card") or satisfies the "substantial presence" test, which looks to the number of days the individual is physically present in the United States. For estate and gift tax purposes an individual who is not a U.S. citizen is a resident (subject to tax on transfer of worldwide assets) if (and only if) he or she is a domiciliary of the United States. For purposes of this article, we assume the individual investor is neither a citizen nor a resident of the United States under either of these tax regimes.
BASIC U.S. FEDERAL TAX RULES
A. Income Tax
1. U.S. Trade or Business in General
Non-U.S. individuals are generally subject to regular U.S. federal income tax on business income considered derived from U.S. sources. (In the case of an individual who is a tax resident of a treaty country, U.S. taxation is often limited to income attributable to a "permanent establishment" in the United States. For purposes of this discussion, we generally assume the existence of a permanent establishment.) Such an individual engaged in a U.S. business is required to file an annual U.S. federal income tax return on Form 1040NR, as well as other federal and state tax filings (including quarterly estimated taxes). The maximum federal income tax rate is currently 39.6%, but is 20% for gains from capital assets held for more than a year. In high-tax states like New York and California state income tax rates, which are independent of federal taxes, can exceed 8%.
If a business is conducted as a sole proprietorship, i.e., without the interposition of any legal entity, then the owner will report the U.S. income directly on Schedule C to Form 1040NR. Under U.S. income tax rules, gain on the sale of a business conducted in this form would generally also be considered income "effectively connected" with a U.S. trade or business, and therefore taxable, albeit often at long-term capital gains rates. The tax laws of the individual's home country may provide for foreign tax credits which could mitigate the cost of the U.S. taxes.
A partnership is a "flow-through" entity under U.S. tax law. Therefore, if the U.S. business is conducted in partnership form, the foreign partner's "allocable share" of profits—whether from operations or on disposition of the business by the partnership— would similarly be subject to income or capital gains tax, and the partnership must withhold such taxes. This is true whether or not the partnership is organised in the United States and regardless of the existence of intermediate holding companies classified as partnerships.
However, should the foreign partner sell his partnership interest, whether to another partner, to the partnership or to a third party, the law is less clear. It is the position of the Internal Revenue Service that any gain recognised on such a sale is subject to U.S. tax to the extent the gain is attributable to assets of the partnership that are used in a U.S. trade or business. However, this position, reflected in a 1991 IRS revenue ruling, has never been tested in court, and there are reasonable arguments that may be made against it. The IRS is currently considering amending its own regulations to buttress its position.
If a corporation is utilised to conduct the U.S. business, the income taxation generally depends upon whether the corporation is organised in the United States and therefore domestic, or outside the United States and therefore foreign. If domestic, the corporation will be liable for federal corporate income tax (at rates up to 35%) and will file a Form 1120. Dividends paid out of current or retained profits to a foreign shareholder will be subject to U.S. withholding tax (at a rate of 30%, unless reduced by an applicable treaty). However, gain realised by a non-U.S. shareholder on sale of stock of the corporation, or on liquidation of the corporation following a sale of its assets, will not be subject to U.S. tax, except as discussed below in respect of real estate holding companies.
If a foreign (non-U.S.) corporation is directly engaged in a U.S. trade or business (without the interposition of a U.S. subsidiary), then it will be subject to corporate income tax on its U.S. source business income, and will file Form 1120F. It will also be subject to a 30% (or lower treaty rate) "branch profits tax" intended to mimic the withholding tax applicable to dividends paid by a domestic subsidiary to its foreign parent. Because the regular withholding tax regime is in some respects preferable to the branch profits tax, one often sees a two-tier structure: a foreign corporation owning a domestic (e.g., Delaware) corporation. Both U.S. and non-U.S. corporations engaged in business in the United States may be subject to state and local taxes, in addition to federal taxes, in jurisdictions where they have a physical business presence.
Two developments in approximately the last 20 years have greatly expanded taxpayers' flexibility in structuring businesses. The first was the introduction and gradual acceptance of the limited liability company (or LLC) as an alternative to a corporation or partnership. The second was the adoption by the IRS of the "check-the-box" regulations allowing taxpayers to elect to classify most business entities (including an LLC) either as a corporation or as a flow-through entity for all federal tax purposes. Thus, an LLC is classified in one of three ways for U.S. federal tax purposes, generally at the election of the entity and its owners. It may be classified as a corporation, as a partnership or (if it is owned by just one person) as a "disregarded entity". In its "disregarded" form, an LLC can be useful in limiting an owner's legal liability (to the assets held in the LLC) while preserving "flow-through" income tax treatment. A limited partnership can also be used to limit an investor's liability while providing flow-through tax treatment, but because an LP must have a general partner, an investment structure involving an LP may be more complicated than one involving an LLC.
While LLCs and LPs are treated almost identically under U.S. tax law, they may be regarded differently under the tax law of an investor's residence country. In particular, creditability of a non- U.S. investor's allocable share of the U.S. taxes may be problematic in the case of an LLC. Countries that regard LLCs as corporations generally do not attribute to their owners the taxes paid by LLCs. Therefore, some non-U.S. investors will be eligible for foreign tax credits if they invest through a limited partnership, but not if they make the same investment through an LLC.
2. U.S. Real Property
The rules regarding the taxation of income from U.S. real property differ from the foregoing in some crucial respects.
Income from direct investment in U.S. real estate is generally taxable, and the United States will not enter into a treaty that exempts such income from tax. Under the "Foreign Investment in Real Property Tax Act" (FIRPTA), which was enacted in 1980 in response to fears that foreigners were acquiring too much U.S. real estate, non-U.S. investors are always taxable on the sale of U.S. real estate. This is true whether the real estate is held directly or through one or more flow-through entities. Also, a non-U.S. partner is taxable on the gain from a sale of a partnership interest to the extent the gain is attributable to U.S. real estate. (This clear rule stands in contrast to the uncertainty described above with respect to partnerships engaged in other lines of U.S. business activities.)
FIRPTA also goes further than the regular income tax rules discussed above, insofar as it treats gain on the sale of shares of a U.S. corporation (but not a non-U.S. corporation), the principal asset of which is U.S. real estate, as "effectively connected" income subject to U.S. taxation.
Even if a real estate investment is entirely "passive", a non-U.S. investor will generally benefit from an election to treat the investment as a trade or business, taxable on the basis of net income. Otherwise, the gross rental income will be subject to 30% withholding tax.
B. Estate and Gift Tax
An individual who is neither a citizen nor a domiciliary of the United States is subject to U.S. federal gift tax only on transfers of real estate or tangible personal property with a situs in the United States. Such a person is subject to estate tax, however, on tangible and intangible property owned at death and having a situs in the United States. Thus, although the estate and gift taxes are in most respects integrated, a non-U.S. person holding U.S. situs intangible assets can escape U.S. transfer taxes by making a lifetime gift (including a properly constructed gift in trust), but will be subject to potentially substantial estate taxes should she hold the same assets at death. This difference leads to many of the complexities in planning for direct investments in the United States. The difficulty is compounded by a lack of authority on what is and what is not intangible property (e.g., the IRS will not rule that a partnership interest is intangible property) and how situs should be determined. The current federal gift and estate tax rate is 40%. If a non-U.S. individual is subject to estate tax in her own country, any U.S. estate tax may be creditable against the residence country estate tax liability.
Regardless of whether an individual is subject to U.S. estate tax, the income tax basis of any property he owns at the time of his death is adjusted for U.S. income tax purposes to its fair market value on that date. If appropriate elections are made, the basis of property held through a flow-through entity (but not a corporation) will similarly be adjusted.
Real property and tangible personal property are situated in the United States if they are physically located in the United States. (Many states also have their own estate taxes, which typically apply at least to real estate and tangible personal property within the state that is owned by non-residents.) But how is the situs of intangible property determined? The federal tax regulations provide that the following intangible property is (with certain exceptions not relevant here) considered to have a U.S. situs:
- Shares of stock issued by a domestic corporation, irrespective of the location of the certificates.
- A debt obligation, including a bank deposit, the primary
obligor of which is:
- a U.S. person (as defined in section 7701(a)(30) of the Internal Revenue Code); or
- the United States, a state or any political subdivision thereof, the District of Columbia, or any agency or instrumentality of any such government.
- Intangible personal property the written evidence of which is not treated as being the property itself, if it is issued by or enforceable against a resident of the United States or a domestic corporation or governmental unit.
The regulations go on to state that intangible property within these three general categories that does not satisfy these conditions is considered non-U.S. situs. Thus, for example, stock issued by a non-U.S. corporation has a non-U.S. situs, irrespective of the location of the certificates. It is the third category of assets that has given rise to the most difficulty of interpretation.
There are no regulations dealing specifically with equity interests in partnerships or LLCs. Moreover, the regulations discussed above pre-date the advent of the "check-the-box" entity classification regime, so it is not clear how such taxpayer elections affect the application of the situs rules. Presumably an interest in an LLC that is classified as a corporation for federal tax purposes should have its situs determined as a corporation. An LLC that is "disregarded" for federal tax purposes should probably be disregarded for purposes of determining estate and gift tax situs, although one recent judicial decision suggests otherwise. But what about an LLC that is classified as a partnership? And what about a foreign corporation that has elected to be treated as a partnership for U.S. federal tax purposes? Most importantly, what about partnerships themselves? Is some sort of analogy to the stated regulations required? Is an entirely different rule to be applied? The answers are not known.
The IRS has struggled to apply the situs rules to partnership interests, and has failed to articulate a clear, consistent theory. Its most authoritative attempt is a 1955 revenue ruling. In that ruling, the IRS held that (for purposes of the then applicable U.S.-U.K. estate tax treaty) a partnership interest should be considered to have a situs in the United States if it is engaged in a business in the United States. The ruling rejected several other approaches, such as one based upon the partner's domicile and one based upon the location of the partnership's assets. Because this old ruling is unpersuasive on the merits and does not directly interpret the applicable Treasury Regulation, it may not represent the correct interpretation of the law. Moreover, it is unclear whether the same situs rule should be applied to an LLC that is treated as a partnership for U.S. federal tax purposes. One could argue that an LLC is more like a corporation, from a property law perspective (i.e., a juridical entity independent of its members), and therefore the place of organisation should control, even if it is treated as a partnership for income tax purposes. The same should be true in the case of a foreign corporation that has elected to be treated as a partnership; the fact that it is treated as a partnership for all federal tax purposes does not necessarily mean that one should apply the situs rules as if it were actually a partnership. These uncertainties create both risk and potential opportunity.
The taxable gift or estate is based on the value of the property net of associated debt. If a non-U.S. person owns all the shares of a U.S. corporation, the value of the shares is naturally net of any debt at the corporate level. A similar rule applies to partnership and LLC interests. In the case of directly owned real estate, a mortgage will reduce the value dollar-for-dollar only if the mortgage is non-recourse to the non-resident owner. In many states, home mortgages are "recourse" as a matter of law. If the loan is made to an LLC, however, it should not be considered recourse to the non-resident LLC owner (unless he or she guarantees it), even if the LLC is "disregarded". A loan from a person or entity related to the equity owner is sometimes considered but should be approached with caution.
While a lifetime transfer in trust of an interest in a partnership (or LLC treated as a partnership) through which the U.S. business is held may be made free of gift tax as an intangible asset (notwithstanding the no-ruling policy of the IRS), the non-U.S. transferor should be aware that retained controls by the transferor over the trust assets or use of the trust property by the transferor may result in inclusion of the trust property in the transferor's estate for U.S. tax purposes. Also, if the transferor's creditors can reach the trust property, this may also result in U.S. estate tax inclusion. In such cases, the interest may become taxable, if the situs is considered to be in the U.S.
1. A New York Condominium
Gotham Properties is developing a high-rise condominium building in midtown Manhattan with views of Central Park. Apartments in the building, known as the "Aerie", are expected to sell for as much as $8,000 per square foot. Several non-U.S. individuals have decided to purchase apartments in the building.
Wei is an unmarried, 37-year-old resident of Hong Kong. He believes that prices of high-end New York City real estate will continue to rise. He intends to buy an apartment in the Aerie as an investment. Wei plans to sell the apartment within five years, renting it out in the interim. At prevailing rents, he expects to earn a small profit from renting the apartment, but he is more focused on the expected gain upon its sale. To protect himself from liability and for purposes of confidentiality, Wei plans to hold the apartment through a newly formed business entity.
The idea of using a U.S. corporation is rejected, principally because of the high rate of federal, state and city income tax that would be imposed not only on operating income but especially on the gain on sale. A non-U.S. corporation suffers from the same high tax burden on both operating income and sale of the apartment. A foreign corporation does offer two potential benefits. One is the tempting prospect of entirely avoiding U.S. income taxes on the gain on sale, if Wei sells the stock of the foreign corporation. However, most buyers will be reluctant to purchase the apartment in this form without a significant discount in the price. In addition to any unknown liabilities that the corporation might have, there is a latent income tax that will eventually be payable when the corporation disposes of the apartment. Use of a foreign corporation would also enable Wei to avoid estate tax should he die while owning the apartment. However, he is a young man and plans to sell the apartment within five years. Wei therefore rejects the idea of corporate ownership.
U.S. income taxes on sale, which are Wei's principal concern, will be significantly reduced if he invests through one or more flow-through entities—whether U.S. or foreign, and whether disregarded or treated as a partnership. Wei should elect to be taxed on a net basis in order to take advantage of allowable deductions. Upon sale, the gain will be subject to tax at only 20% on the federal level, plus New York State (but not City) income tax.
A single-member disregarded entity is appealing because it would allow Wei to report his U.S. income on a single federal tax return. A domestic U.S. LLC would generally be less expensive to maintain and less complicated than a foreign entity. If Wei is able to secure financing that is non-recourse to him, the debt will reduce the amount includible in his U.S. estate, in the event of his early death. Note that Wei will have to file a tax return that discloses his identity to the IRS, but if he does the paperwork carefully, public records will reveal only the name of the LLC.
Margaret is an 80-year-old Belgian citizen and resident. Imogen, her only child, lives in the United States and has a green card entitling her to permanent residence. Imogen is married, with children, and lives in New York, where she is a specialist in sub- Saharan African Art for Christie's. Margaret does not like Imogen's husband, but loves Imogen's children. Margaret is considering buying an apartment in the Aerie. Imogen can live there with her family, and there is a guest room for Margaret when she visits. Margaret intends to leave the apartment to her daughter.
Margaret asks her U.S. lawyer how she should structure the purchase. The lawyer explains that only by owning the apartment through an offshore corporation can Margaret be confident that it will not be included in her U.S. estate. A corporation is a reasonable choice because the condo will not generate rental income. However, it would be far from ideal for Imogen, as a U.S. tax resident, to inherit ownership of the apartment through a non-U.S. corporation. Also, outright ownership by Imogen would give her husband certain rights in the apartment under New York law, in the event of Imogen's death. The lawyer suggests that it would be preferable for Margaret to form a trust under U.S. law, for the benefit of Imogen, and have the trust purchase the apartment. The trust must be structured so that its assets will not be considered part of Margaret's estate under U.S. estate tax principles. That means the trustee must be independent. Whether Margaret can be a discretionary beneficiary of the trust will depend upon the law of the jurisdiction in which the trust is established. Regular use of the apartment by Margaret could also raise U.S. estate tax issues. As a non-resident, Margaret would not be subject to U.S. gift tax when she establishes the trust so long as the trust is funded with cash from a non-U.S. account. The trust can be drafted so that Imogen's husband has no rights in it or in the apartment. The lawyer notes that there may be significant Belgian tax issues relating to this plan. After consulting her Belgian tax adviser, Margaret goes ahead with the plan.
2. An Oregon Vineyard
The Courtois family have been making great wine in Burgundy for generations. Unfortunately, what was once a reasonably large estate has been split up over the years so that Jean, who is 55 years old, tends only three hectares. Jean has two children, Andre and Beatrice, who are 29 and 25 respectively. Not wishing to further divide the plot, the family have agreed that Andre will remain in Burgundy, but Beatrice will cultivate her garden in Oregon, in the United States. It so happens that Beatrice has already married an American she met while studying at the University of California.
With her father's financial backing, Beatrice will purchase a vineyard and make wine under the family label. Beatrice will own 1/3 of the enterprise and Jean will own 2/3. Jean intends to eventually split his 2/3 interest between his two children. He does not anticipate a sale of the company ever—or any time soon— because the Courtois have always been in for the long-term.
Beatrice wishes to hold her interest through an entity that will give her limited liability but provide for one level of taxation (as well as allow her to claim losses should they arise). Her accountant proposes a limited liability company or a limited partnership. Jean's primary goal is to minimise his overall taxes on income earned in the United States. But he also wishes to avoid U.S. estate and gift taxes. What should Jean do?
A flow-through entity such as an LLC or limited partnership makes sense for income tax purposes, because it avoids the second level of taxation as a result of U.S. dividend withholding tax or the branch profits tax. On the other hand the federal tax rate applicable to ordinary business income of individuals is slightly higher than the rate applicable to corporations. For French tax reasons, Jean decides he prefers a limited partnership to an LLC or a corporation.
So the business will be held in a limited partnership organised in the State of Delaware and qualified to do business in the State of Oregon. Because a limited partnership must have a general partner, Beatrice will own a limited liability company that will serve as the general partner.
Notwithstanding the IRS's no-ruling policy, Jean should be able to make gifts of the limited partnership interests to his children without U.S. gift tax. However, if he dies owning the partnership interests, there is a significant risk that their value would be includible in his U.S. gross estate. Jean may be able to reduce this risk by holding the limited partnership interest through a non-U.S. entity, such as a Cayman Islands exempted limited partnership. As discussed above, the law is not clear on the situs of such an interest. However, Jean's executors may be able to make a retroactive "check-the-box" election, to treat the partnership as a corporation as of the date of his death. In that case, estate tax may well be avoided, but any unrealised appreciation in the Oregon real estate would be taxable as capital gain.
Interestingly, the U.S.-France Estate and Gift Tax Treaty would permit the U.S. to tax interests in entities that are not taxable under current U.S. law. It provides at Article 5 that real property may be taxed by the country in which it is situated. Under the 2004 Protocol (amendment), real property includes "shares, participations and other rights in a company or legal person the assets of which consist, directly or through one or more other companies or legal entities, at least 50% of real property...". This could be enough to allow the United States to tax the value of the partnership interest held by Jean at his death. Furthermore, Article 6 permits the taxation of "assets used in or held for use in the conduct of the business of a permanent establishment" by the country in which the permanent establishment is located. Also (as revised by the Protocol) it goes on to state: "If an individual is a member of a partnership or other similar pass-through entity which is engaged in industrial or commercial activity through a fixed place of business, he shall be deemed to have been so engaged to the extent of his interest therein." These two rules suggest that the treaty drafters were tracking closely the U.S. income tax rules. But, as discussed above, the estate tax situs rules in the U.S. Internal Revenue Code have little relation to the income tax rules. The treaty merely allows (or limits) what the United States may tax in the case of French residents; it is not self-executing. If the transfer of the limited partnership interest (or the interests in the Cayman partnership) by will or by gift is not taxable under the Code and regulations, the treaty does not make it taxable.
Originally published in The International Comparative Legal Guide to: Private Client 2014 by Global Legal Group Ltd, London.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.