Fiscal year corporations and section 965

Today’s post is a followup to the (last post), about a US citizen who owns shares of a fiscal year foreign corporation that is subject to the new deemed repatriation rule of section 965. Here is the setup:

I am a US citizen reporting on a calendar year. I have a foreign corporation with a fiscal year ending June 30. When am I subject to the repatriation tax? What is the rate of tax?

In the last post, I wrote that this corporation may be subject to section 898, which forces certain CFCs to conform to its shareholder(s) tax year. For example, if a US citizen is the sole shareholder of a foreign corporation, then the foreign corporation is forced to use the calendar year, even if it keeps account on a fiscal year. In this situation, the US citizen has income under section 965 in 2017 instead of 2018.

Exemption in proposed regulation

Several responses to the newsletter points to a proposed regulation that provides an exception to the conformity rule:

A specified foreign corporation is not required to conform its taxable year to the required year so long as its United States shareholders do not have any amount includible in gross income pursuant to section 951(a) and do not receive any actual or deemed distributions attributable to amounts described in section 553 with respect to that corporation. Prop. Treas. Reg. §1.898-1(c)(1).

What this exemption says is that if no US shareholder of a foreign corporation has ever included income from the foreign corporation as a result of subpart F rules or foreign personal holding company rules, then the foreign corporation does not need to conform to the US shareholder(s) tax year.

Under this proposed regulation, and assuming the foreign corporation never had subpart F income and never was a foreign personal holding company, the foreign corporation would have a tax year equal to its fiscal accounting period. This means the US citizen has income under section 965 in calendar year 2018, not 2017.

Can I rely on the proposed regulation?

Probably.

A proposed regulation is a substantial authority construing a statute. Usually you can rely on its being correct and avoid negligence and substantial understatement penalties. Reg. §1.6662-4(d)(3)(iii). The exception, of course, is if there is stronger authority indicating that the proposed regulation is not correct (for example, the Code, a temporary regulation, or a final regulation).

Section 898(c)(1) says this:

The required year is–

(A) the majority U.S. shareholder year, or

(B) if there is no majority U.S. shareholder year, the taxable year prescribed under regulations.

The statutory language here is quite clear: If there is a majority US shareholder year, then that is the tax year. If there is not one, then follow the regulations. By the text of the statute, the IRS lacks regulatory authority to prescribe a tax year when there is a majority US shareholder year.

But remember the normal rules for the tax year under section 441(b)

For purposes of this subtitle, the term “taxable year” means–

(1) the taxpayer’s annual accounting period, if it is a calendar year or fiscal year;

The statutory language here is quite clear as well: If the taxpayer has a fiscal year accounting period, then the accounting period is the tax year.

It is normal for an administrative agency’s regulations to resolve conflicting statutory commands. So our readers probably are correct, and my last post was not: We can rely on the proposed regulation and use the fiscal year, leading to deemed repatriation in 2018.

The corporation switches to a calendar year after the deemed repatriation

What happens if a section 898 corporation uses a fiscal year for several years, then a US shareholder has inclusion of income? The proposed regulation tells us the solution:

Once any United States shareholder of that specified foreign corporation has any amount includible in gross income pursuant to section 951(a) or receives any actual or deemed distributions attributable to amounts described in section 553 with respect to that corporation, then the specified foreign corporation must comply with section 898 and §§1.898-3 and 1.898-4 beginning with its first taxable year subsequent to the taxable year to which that shareholder’s income is attributable. Prop. Reg. §1.898-1(c)(1).

In our hypothetical, the first year in which subpart F inclusion under section 951(a) happens is the fiscal year ending 2018-06-30, because section 965’s deemed repatriation works by increasing subpart F income. IRC §§965(a), 951(a).

For the first subsequent taxable year, the foreign corporation must conform to its majority US shareholder year. This means it will have a short tax year from 2018-07-01 to 2018-12-31, then use the calendar year starting 2019.

The IRS can change the rules with another proposed regulation, but at least for now, we would expect a switch to the calendar year.

Disclaimer: This article is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

The post Section 965 and Fiscal Year Foreign Corporations, Part II appeared first on HodgenLaw PC – International Tax.

How expatriation works is something we talk about with clients all the time, and it’s worth devoting a little blog space to a general description of the basic mechanics every once in a while.

Imagine we are now boarding an airplane and zooming up to 30,000 feet. Let’s see how the expatriation process works from 6 miles up.

But first… Some warnings

From this far up, we can see the mountains and oceans and rivers, but not the cars or trees or houses or people.

Because we are taking a very high-level view, we must ignore the details, the nuances, and all the little things that make this topic so complicated.

If we were using art metaphors, we would be sketching on a napkin, not painting the Sistine Chapel.

It would be in very poor judgment to make your life choices based on an email newsletter or a blog post you found on the internet, especially one that is claiming at the beginning to ignore all the important stuff. Talk to a professional about the specifics of your situation and get advice that is designed for you before you expatriate.

What do we mean when we talk about expatriation?

Typically when people talk about “expats” or “expatriates” they are talking about citizens of one country who live in another country. Most expats in this meaning of the word keep their citizenship from the first country and simply live abroad, possibly returning back to their home country at some point or moving elsewhere on the planet.

When we CPAs and tax lawyers talk about expatriation, we mean people who are US citizens or green card holders and who terminate their citizenship or green card. For green card holders, there is a test for the amount of time you have the green card that must be satisfied for you to be an “expatriate” under the meaning of the term we are using here.¹

Two tasks to expatriate

When you want to expatriate, there are two things that you must do. You must convince the State Department or USCIS that you are no longer a citizen or green card holder, and you must convince the IRS that you are no longer a US taxpayer.

Logging out of the citizenship or green card system

The first (and easiest) part is to terminate your citizenship or green card.

Citizens must convince the State Department that they are no longer citizens. This requires paying a fee of around $2,500, filing some papers (look at DS-4079, DS-4080, and DS-4081), and having an in-person interview or two at a US embassy or consulate.

Green card holders must convince USCIS that they are no longer green card holders. This involves putting the original green card and Form I-407 in the mail, or delivering those items by hand.

Logging out of the tax system

Step two is to convince the IRS that you are no longer a part of the US tax system. That is the hard part.

The IRS sorts all expatriates into two categories: “Rich”, and “not rich”.

“Rich” expatriates have to pay an exit tax. They also have to file a tax return that ranges in difficulty from fairly complicated to extremely complex.

“Not rich” expatriates do not have to pay exit tax, but they do still have to file some extra paperwork.

Rich = paperwork + tax. Not rich = just paperwork.

Financial tests for whether you are “rich”

Whether you are rich or not for exit tax purposes is unfortunately not a matter of how you see yourself.

The IRS has two tests to determine whether you are rich. Satisfy either one of them, or both, and you have to pay exit tax.

One is the net worth test. Look at your personal net worth (assets minus liabilities) and if the number is $2 million or more, you are “rich” and you will be paying exit tax.

The other is the net tax liability test. Here is how to do a rough back-of-an-envelope calculation: Look at your tax returns for the past five years. Write down the number on the line that says “total tax” for all five years. Add those up, then divide by five. If the result is more than about $160,000 (this number changes every year with inflation), you are “rich” and you will be paying exit tax.

Exit tax calculation for someone who is “rich”

For a rich person who turns in their passport, there is a “mark-to-market” event. Pretend you will sell all your worldwide assets at their market values the day you expatriate. The first approximately $700,000 of gain (another number that changes with inflation each year) is tax-free. The rest is subject to tax at normal rates.

There are special rules for some assets, like pensions and trusts. But the general rule is that you will pretend you sold everything you own on the planet and pay real cash money tax on the gains.

Exit tax paperwork

The tax return you file for the year you terminate your citizenship or green card will be more complicated than the return you usually file. It gets filed according to the normal filing deadlines, so if you expatriate in 2018, you will file the return in 2019.

The tax return is typically a “dual-status” return: Part of the year you are taxed as a citizen or resident, and part of the year (after you expatriate) you are taxed as a nonresident. You also file (along with your tax return) Form 8854, to report to the IRS that you expatriated, and to give them information about yourself, your assets, and your income.

Prior five years must be clean

Regardless of whether you are “rich” or not, it is imperative to make sure the tax returns for the five years before expatriation are squeaky-clean and all your tax is paid.

There are consequences to not doing this: If you are “not rich” according to the tests I described above, you could be treated as if you are anyway. If you are already paying exit tax because you are “rich”, not having the prior five years filed correctly could mean audits and other lengthy, unpleasant conversations with the IRS.

An abundance of caution is the right amount to have

There are a lot of things to consider when you expatriate, and this very short newsletter simply can’t cover most of them. Remember that we are in an airplane at 30,000 feet looking down on the expatriation landscape. We can see the major contours, but none of the detail.

Make sure you understand all the details that pertain to your situation before you decide to terminate your citizenship or green card, or you could end up in a very uncomfortable position.

Some shameless promotion

We do lots of expatriation work.

We help clients make well-informed decisions: How to expatriate, how long it takes, what the estimated tax hit (if any) will be, and what planning can be done to reduce or eliminate taxes or paperwork.

If you hire us, we can take you through the planning stages to the filing of your final US tax return. We find that the “get out of the citizenship or green card” part is straightforward but the tax stuff is not. We do the pre-expatriation tax planning. We help get the prior five years of tax returns squeaky-clean. We do the exit year returns for you and the following year of tax returns as well because there are usually some lingering things to report in that year; it is rare that someone gets their financial affairs arranged so that their US taxes are completely wrapped up by the time they leave.

The post How Expatriation Works: Just The Basics appeared first on HodgenLaw PC – International Tax.

Proving the Obvious

In a quick email exchange I had with Susan Brown Otto (hi Susan) we touched on a topic that deserves attention. The topic is not terribly difficult, but its existence points to a meta problem.

Susan’s question/comment was about the non-requirement of withholding that is required when nonresidents own U.S. rental real estate . . . sometimes. It’s counterintuitive, because the IRS loves withholding.

So often in tax law there is an answer that you know, intuitively, but you can’t put your finger on exactly why the answer is true. This is dangerous territory for tax advisors. I have done this: blurt out an answer only to find out my memory was faulty. Ooops.

There is great value in systematically proving the obvious.

Let’s do that right now.

Withholding Requirements on Rent

A nonresident alien owns U.S. real estate. Tenants pay rent. How is that rent taxed? Do the tenants have a requirement to withhold tax on rental payments made?

Your brain leaps to the immediate answers:

• Default: the nonresident alien landlord pays 30% tax on gross rent received (no deductions for expenses), and the tenant must withhold 30% of rent payments and remit the withheld amount to the IRS. Give the tenant Form W-8BEN.
• Smarter: the nonresident alien landlord pays tax on net rental income (rent collected minus deductible expenses) at graduated tax rates, with no tax withholding required. Give the tenant Form W-8ECI.

Default: 30% Tax on Gross Rental Income; Withholding Required

The default treatment of that rental income is straightforward (if unpleasant): the nonresident alien landlord pays a tax of 30% of gross rent received.¹

The Internal Revenue Code makes sure that the nonresident alien pays that tax by adding a withholding requirement:

• the tenant² paying rent must withhold 30% of the rent payment for taxes, and
• send the withheld tax to the IRS.³

A practical caution: sometimes tenants have “net” leases, where they pay property tax and other costs for the property. The tenant’s payment of these expenses is rental income received by the nonresident alien landlord, and withholding should be done on those payments as well.

The tenant (as a withholding agent) has personal liability for any withholding screwups.

So the intelligent tenant will demand a Form W-9 from the landlord. A Form W-9 will show that the landlord is a domestic taxpayer; no withholding is required.

If the landlord does not deliver Form W-9 (because he is a nonresident alien), then the intelligent tenant will ask for Form W-8BEN. This will prove that the landlord is a nonresident alien and the 30% tax will be withheld.

The withholding rules are vastly more fiddlier⁴ than my description. If you want to see anal-retentive thinking in action, read Section 1441 and the accompanying Regulations. Someone with a very systematic brain wrote that stuff.

Smarter: Graduated Tax Rates on Net Income

If the nonresident alien owner of U.S. real estate is “engaged in business” in the United States, then the rental income is taxed differently. Net income is taxed (rental income minus deductible expenses) at the normal graduated rates that apply to U.S. residents and citizens.⁵

Interesting point: no withholding is required.⁶

A nonresident alien owner of U.S. rental real estate is treated as “engaged in business” by the IRS in one of two ways:

• Prove it. The nonresident proves to the satisfaction of the IRS that the real estate activities look like a business, not like a passive investment.
• Paper it. The nonresident files a piece of paper (the “net election)⁷ on a tax return filed with the IRS. Just do it.⁸

On the tenant’s side, again, the paperwork received from the nonresident landlord is critical.

Tax withholding is not required if the nonresident landlord gives the tenant Form W-8ECI.

This is a superior solution for both sides: the nonresident alien owner of U.S. rental real estate pays less tax on rental income, and the tenant avoids the complexity and brain damage that comes with tax withholding.

Summary

My email from Susan centered mostly on the paperwork side of things: what to do after the nonresident alien real estate owner made the net election. So here’s the basic set of rules:

• Form W-8BEN = 30% tax withheld by the tenant.
• Form W-8ECI = no tax withheld by the tenant.

One final warning. The withholding rules are riddled with lacunae and treachery, so be wary. Get someone to help you (if you are the tenant). The “right” paperwork in your files will eliminate your risk of making a costly withholding mistake.

See you in a couple of weeks.

Phil.

The post Withholding when Nonresidents Own U.S. Rental Real Estate appeared first on HodgenLaw PC – International Tax.

How a green card holder might avoid section 965 and GILTI with a treaty election

Today’s post is a (sort of) followup to Phil’s Friday Edition post on 2018-03-16.

Here is the 1 paragraph summary to Phil’s post: In the 1990s, the IRS adopted regulation section 301.7701(b)-7, stating that if a US resident elects income tax treaty benefits for a nonresident, then he calculates tax as a nonresident, but he remains a US resident for all other purposes of the Code. In 2008, Congress changed the Code to say that if a green card holder elects income tax treaty benefits for a nonresident, then he ceases to be a US resident.

Phil’s conclusion was that the Code controls: The green card holder who elects treaty benefits is a nonresident alien for all purposes of the Code. In that post, Phil discussed whether the treaty election affects Form 5472 filing requirements. Today, let us look at this question in a context that is somewhat more financially impactful.

Our hypothetical

Let us look at this hypothetical situation (which is not all that hypothetical):

A husband, wife, and their child are Chinese nationals from mainland China.

They family were admitted to the US on a EB-5 visa and became green card holders. The wife and child moved to California for the child’s high school and university education. The husband remained in China to run the family business after getting his green card. He makes occasional visits to the US on the green card but generally lives in China.

The husband and wife did not enter into any marital agreements. The couple started a company in 2000 in mainland China, of which each owned 50% of the shares. The company does business in China has accumulated significant profits which were not distributed or deemed distributed under US tax law before and after the couple became green card holders.

All family held their green cards at the end of 2017.

Let us assume that if the husband were to determine his residence under the China-US income tax treaty, then the treaty would assign his residence to China. There are some procedural issues with the China-US treaty that this post will not discuss. For now, let us assume that were he to make the treaty election, he would be able to do so successfully and survive an IRS challenge.

Deemed repatriation under section 965 and GILTI

In December of 2017, Congress passed laws that changed the US taxation of foreign income significantly.

One of these changes is the new section 965. There are many nuances to section 965, but the general idea is that “United States shareholders” of “deferred foreign income corporations” have income equal to the “accumulated post-1986 deferred foreign income” of the corporation. For most, the extra income is for 2017, though some shareholders of fiscal year corporations have the extra income in 2018.

Another change is GILTI. GILTI is under section 951A. It shares similar concepts as section 965: Each “United States shareholder” of any “controlled foreign corporation” must include his share of the CFC’s GILTI in his income annually. GILTI starts applying in 2018.

I put several terms in quotation marks, because they are defined terms under the Code. For example, if you are not a “United States shareholder” under the Code, then you do not have deemed income under section 965 or GILTI.

Deferred foreign income corporation

United States shareholders of deferred foreign income corporations have deemed income under section 965.

A deferred foreign income corporation is a “specified foreign corporation” which has accumulated post-1986 deferred foreign income. IRC §965(d)(1). We assumed that there is accumulated post-1986 deferred foreign income for this company, though it is good to check for each company. IRC §965(d).

That leaves us with the question of whether it is a specified foreign corporation.

A specified foreign corporation includes any “controlled foreign corporation” and “any foreign corporation with respect to which one or more domestic corporation is a United States shareholder”. IRC §965(e)(1). In our example, the Chinese company does not have any direct shareholders that are US corporations, and there are no US corporations that are related to the Chinese company. This means we need only worry about whether it is a controlled foreign corporation (CFC).

Controlled foreign corporation

In our scenario, section 965 and GILTI only create tax issues if the Chinese company is a “controlled foreign corporation” (CFC). This is what CFC means (IRC §957(a)):

For purposes of this title, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of–

(1) the total combined voting power of all classes of stock of such corporation entitled to vote, or

(2) the total value of the stock of such corporation,

is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.

Again, we see the term “United States shareholder”. If United States shareholders together own more than 50% of the shares of a foreign corporation, then it is a CFC. We will need to see what this term means to determine the tax results.

United States shareholder

A “United States shareholder” of a foreign corporation is

[A] United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. IRC §951(b).

The husband owns 50% of the shares, and the wife owns 50% of the shares. Both satisfy the percentage ownership. The only question is whether they are “United States persons”.

A United States person has the same meaning as the general definition under section 7701(a)(30). IRC §957(c). This means US citizens, US residents, domestic partnerships, domestic corporations, domestic estates, and domestic trusts. IRC §7701(a)(30). The individuals in our hypothetical are not US citizens, partnerships, corporations, estates, or trusts, but they might be US residents.

Who are US residents?

US residents include lawful permanent residents, aliens who satisfy a substantial presence test (counting days in the US over a 3 year period), and aliens who make a first year election. IRC §7701(b)(1)(A).

Our hypothetical deals with green card holders. We will focus on the lawful permanent resident test, otherwise known as the green card test.

The wife, who lives in the US and makes no treaty elections, clearly is a US resident. She is a US shareholder of the Chinese company.

But what about the husband? Referring back to Phil’s post: Under the 1990s regulations, the husband is a US resident who calculates his tax as a nonresident alien, but he remains a resident for any other purpose of the Code. He remains a US shareholder of the Chinese company. Under the 2008 Code, he is a nonresident alien, so he is not a US shareholder of the Chinese company.

Let us look at the tax implications of these contradictory conclusions.

The 2 tax implications

Suppose the regulation is right: The husband is a US resident who merely calculates his taxes as a nornesident alien.

This means he is a United States shareholder. This means the Chinese company is 100% owned by US shareholders. It is a CFC. This means the wife must take into account her share of the company post-1986 deferred foreign income at the end of 2017. Then, she must take into account half the company’s GILTI each year starting in 2018.

Now, suppose we go by the text of the Code: The husband is a nonresident alien.

This means he is not a United States shareholder. This means there is only 1 United States shareholder: the wife. A nonresident alien’s shares are not attributed to a US citizen or resident under family attribution rules. IRC §958(b)(1). This means United States shareholders own only 50% of the company. This means the company is not a CFC. The wife does not need to take into account any income under section 965 or GILTI.

Pretty significant difference, no?

Before the tax law changes, the most common approach I have seen to the question of “is the green card holder who makes the treaty election a resident for all purposes other than calculating his tax liability” is: “Better safe than sorry. Assume that the husband remains a US resident”. Under the old rules, this meant higher professional fees for filing information returns, but it did not create additional taxes. The penalties for failure to file information forms often were higher than the professional fees

Now, with potentially a lot more taxes on the line, perhaps it is a good idea to take a closer look at the other position.

Be careful about community property

Mainland China and California both are community of acquisitions jurisdictions. This means property acquired after marriage automatically is owned 50-50 between the spouses, regardless of who is the nominal owner.

When community property is the default rule of a jurisdiction, US income respects community property rules. Poe vs Seaborn, 282 US 101 (1930). This means the same problem potentially applies even if the husband were the 100% owner (by title) of the shares.

Only for green card holders

The treaty election issue is for green card holders only. It does not apply to substantial presence residents who make the treaty election, because nowhere in the Code does it say that a substantial presence resident who makes a treaty election ceases to be treated as a US resident. If the husband were a US resident under the substantial presence test, then even with the treaty election, he would remain a United States shareholder.

The post How a Green Card Holder Might Avoid Section 965 and GILTI appeared first on HodgenLaw PC – International Tax.

We often mention that covered expatriates, who are subject to a deemed sale of all their worldwide assets (with a few exceptions), are permitted to exclude the first $700,000 or so of gains that arise from the deemed sale.

For someone hiring us to prepare their tax return, that is typically all they really want to know – “my exit tax is lower because I get to exclude some of this pretend income”.

It is rare that we talk about how to apply the gain exclusion, because that is the behind-the-scenes work that we do for our clients when preparing their tax returns.

Today’s topic will cover just that: How the gain exclusion is applied to all the assets you are pretending you sold.

What “covered expatriate” means

An expatriate is either a citizen who terminates his citizenship, or a green card holder who has had the green card for a long enough time ¹ and terminates the green card.

A covered expatriate is an expatriate who meets any one of three financial tests:²

1. Net tax liability test – If your average net US tax liability for the five years before expatriation is more than approximately $160,000 (indexed annually for inflation), you are a covered expatriate.
2. Net worth test – If your personal net worth is $2,000,000 or greater when you expatriate, you are a covered expatriate.
3. Certification test – If you cannot certify under penalties of perjury that your tax returns for the 5 years before expatriation are correct, complete, and all your tax is paid, you are a covered expatriate.

I will not talk about how to apply these tests in this publication; that is a topic (or series of topics) for another time. It is sufficient to know that if you are expatriating and you meet any one of these tests, you will be a covered expatriate.

Covered expatriates pretend they sold all their stuff

A special rule applies to covered expatriates:³

All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value.

This is where you have to play pretend. You still have all your stuff, but for your tax return, you must pretend you sold all your stuff. You pay tax on the pretend gains and can deduct losses according to the normal rules. The tax you pay on the pretend sale of all your assets is known as the exit tax.

There are a few assets that are exceptions to this rule. You do not have to pretend you sold them; other rules apply to these assets instead. The assets not subject to the pretend sale are deferred compensation items, specified tax deferred accounts, and interests in nongrantor trusts.⁴

I will not discuss what those terms mean or what special rules apply to them here. I will focus instead on assets that are subject to the deemed sale.

Gain exclusion for deemed sale assets

It is generally bad to be a covered expatriate, because you must pay tax as if you sold all your assets without receiving the cash you would get had you actually sold your assets. There is also the issue of having to pay US tax on the sale of your foreign assets, but without the benefit of a foreign tax credit to help offset the US tax.

To lessen this burden, you can apply an exclusion to reduce the gains on which you have to pay tax.⁵

The gain exclusion was $600,000 when the law was first enacted. That amount is indexed for inflation, so it increases each year. If you expatriate in 2018, you are allowed to exclude the first $713,000 of gains from the pretend sale of your worldwide assets.

Note that the exclusion does not apply to gains that arise from regular transfers or sales – it applies only to the assets that you have to pretend you sold because you are a covered expatriate. You can use it to reduce your exit tax, but not your regular income tax.

How to apply the exclusion

The Internal Revenue Code does not explain how to apply the gain exclusion against your deemed sale gains. The rules for this are instead found in Notice 2009-85.

The instructions are quite explicit:⁶

Specifically, the exclusion amount must first be allocated pro-rata to each item of built-in gain property (“gain asset”) by multiplying the exclusion amount by the ratio of the built-in gain with respect to each gain asset over the total built-in gain of all gain assets. The exclusion amount allocated to each gain asset may not exceed the amount of that asset’s built-in gain. If the total section 877A(a) gain of all the gain assets is less than the exclusion amount, then the exclusion
amount that can be allocated to the gain assets will be limited to the total section 877A(a) gain.

From this blurb, you can extract a set of instructions. (There are also some really helpful examples in Notice 2009-85 that demonstrate how this works.)

1. Separate assets with built-in gains from assets with built-in losses

The exclusion is applied to “gain assets” only – assets that, if you sold them, would generate gains rather than losses.

This means your first step is to make a list of all your deemed sale assets, their fair market values as of the day before your expatriation date, and their bases as of that same date. Hint: If you have a bunch of stocks that you hold in a single brokerage account, you must do this separately for each stock – you cannot consider the account a single asset.

Compute gain or loss by subtracting basis from fair market value for each asset. If the result is a positive number, it is a gain. Negative, loss.

Next, create two separate groups: assets with built-in gains, and assets with built-in losses.

The assets with built-in losses we will set aside until a later step. It is the assets with built-in gains that we are now concerned with.

2. Allocate the exclusion pro rata to all the gain assets.

Now that you know what the gain assets are, you must allocate the exclusion to all the assets.

To do this, you start by computing a ratio for each asset: the ratio of the gain for that asset over the total built-in gains of all gain assets. It is pretty easy to do this in Excel using formulas, once you have all the gain amounts computed.

Lastly, you multiply the ratio you calculated by the total exclusion amount for the year. That will give you the amount of the exclusion allocable to the gain for that asset.

3. Be mindful of limitations

If your total built-in gains for deemed sale assets are less than the total gain exclusion amount, you will not have to pay exit tax on your gains because they will be fully excluded.

Remember, however, that the exclusion you can take is limited to the amount of the built-in gains you have on deemed sale assets. In other words, you do not get to take a loss for the exclusion that is in excess of your total gains from the deemed sale, and you do not get to apply the exclusion to real dispositions or transfers that you may need to report for that tax year.

4. Report the gains and the exclusion on your tax return

Your last step is to report the gains and the exclusion you allocated to them on your tax return. Notice 2009-85 has instructions for this, too:⁷

After allocating the appropriate amount of the exclusion amount among the gain assets, the covered expatriate must report gains and losses on the appropriate Schedules and Forms depending upon the character of each asset. Losses may be taken into account only to the extent permitted by the Code, except that the wash sale rules of section 1091 do not apply.

You report the gains according to the character of each asset. For assets that would normally get reported on Schedule D and Form 8949, you report the deemed sale on Schedule D and Form 8949, use the adjustment column to show the exclusion, and the net gain flows to your Form 1040. For passive foreign investment companies, use Form 8621 to report the gains. For business assets, use Form 4797.

These instructions also tell you what to do with the losses that you had set aside in Step 1 above: those also get recognized according to the normal rules, with the exception that the wash sale rules do not apply.

A simple example, using three assets

Let us take a quick look at how the allocation of the gain exclusion would work, using an example.

Pretend that you are expatriating in 2018, and you have exactly three assets subject to the exit tax. Two of them have $500,000 each of built-in gain. One has $500,000 of built-in loss. All are capital assets that get reported on Schedule D.

The gain exclusion for 2018 is $713,000.

First separate out the gain assets from the loss assets. Your total gains are $1,000,000.

You then compute the ratio of the gain for each asset over the total gain. In our example each asset will have the ratio of .5, because the gain is $500,000 divided by total gains of $1,000,000.

Next, multiply the ratio for each asset by the total exclusion amount. $713,000 x .5 = $356,500. That is the amount of the gain exclusion allocated to each gain asset.

Now, you know the amount of gain that you have after applying the exclusion: ($500,000 – $356,500) x 2 = $287,000.

You end up with $287,000 of total capital gains. Remember you also had $500,000 of capital losses. The result is a net capital loss of $213,000 from the deemed sale. If these are the only dispositions of capital assets that you report on your tax return, you will have to carry some losses forward to future years.

An observation

If you have high built-in gains in your assets, you will not end up with such a nice tax result. More often than not, the tax returns I prepare for covered expatriates show net taxable gains and exit tax to pay.

But this example is interesting, in that it demonstrates that the gain exclusion is applied in a favorable way: rather than applying the exclusion after deemed sale gains and losses are netted, the exclusion is first applied to gains only, and then post-exclusion gains and losses are separately reported. If you are dealing with a pool of only capital assets, that means you net post-exclusion gains against losses.

The post How to Apply the Gain Exclusion for Covered Expatriates appeared first on HodgenLaw PC – International Tax.

Hello from Singapore by way of Jakarta, and welcome to the Friday Edition. It’s all alt-country¹ and international tax here, folks.

Go fire up Ribbon of Highway by Christy Hays on Ye Olde YouTube (or here on Spotify) then sit back and give this a read.

Build Your Holding Structure Before You Sign a Purchase Contract

For our literary purposes, you are a nonresident and noncitizen of the United States. You sign a contract to buy U.S. real estate, then think of tax planning and come to see me.

You decide on some kind of holding structure to own the real estate. Let us arbitrarily assume that your U.S. real estate purchase will be owned by a corporation, and you will be the sole shareholder of that corporation.²

Problem! The contract says you are the buyer, but you want your holding structure to be the owner. So you ask the seller whether you can assign the purchase contract to your new corporation.

The seller does not care — as long as the purchase price is paid, the identity of the buyer is of no concern to the seller. So the seller agrees, and the purchase contract is assigned. Now the buyer is the corporation, not you. You are off the hook for the purchase.

You put enough money in the corporation’s bank account to buy the property, and that’s exactly what happens. Now your corporation is the proud owner of U.S. real estate.

All is well, right?

Not quite.

It’s a Bad Thing

When a nonresident has a “disposition” of a “U.S. Real Property Interest”, that is a taxable event, and tax withholding is required.

A contract to acquire U.S. real estate is a “U.S. Real Property Interest”.³

Therefore, when you assigned the purchase contract to your new corporation, you had a “disposition” of a “U.S. Real Property Interest”.

Yes, I know. What you did is no different from reaching into your left pants pocket, pulling out your car keys, and putting the keys in your right pants pocket. It’s a total non-event in the real world.

Result of the Bad Thing

Yet in the tax world, it is a real event, with real consequences:

• You must file a U.S. income tax return to report the fact that you signed a purchase contract then assigned the contract to the corporation that you own.
• Your corporation must withhold tax (in real cash money) and pay it to the IRS. You will get a refund later (many, many months later).

The IRS Knows About This

The IRS knows about this, and published a little warning to real estate professionals about it. Fact Sheet 2005-16 says:

The IRS has become aware of instances in which foreign persons have acquired options or entered into contracts to purchase U.S. real property interests and sold the options or assigned the contracts before such instruments are exercised or executed and title to the underlying property is taken. Buyers of the options or contracts are failing to withhold and remit to the IRS the required 10 percent [now 15%]⁴ from the proceeds of the sale.

Why File a Tax Return?

Why must you file a U.S. income tax return? You did not make any capital gain, and you in fact collected no money when you assigned the purchase contract from yourself to your corporation.

You Are Engaged in Trade or Business

Section 897(a) tells us to treat a nonresident as engaged in trade or business in the United States when there is a disposition of U.S. real estate:

. . . [G]ain or loss of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest shall be taken into account . . . as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business.⁵

By assigning the purchase contract (a “disposition”) you are treated as being “engaged in trade or business in the United States”. That is a term of art, and it means something.

Return Filing Requirement

Nonresidents who are engaged in trade or business in the United States must file income tax returns — even if they make no money:

[A] nonresident alien individual who is engaged in a trade or business in the United States at any time during the taxable year is required to file a return on Form 1040NR even though (a) he has no income which is effectively connected with the conduct of a trade or business in the United States, (b) he has no income from sources within the United States, or (c) his income is exempt from income tax by reason of an income tax convention or any section of the Code.⁶

Tax Withholding Requirement

Your corporation is the “buyer” in the transaction. Tax law talks of the parties as “transferor” and “transferee”, if you want to think of it that way.

When someone acquired U.S. real estate from a nonresident, tax must be withheld — by the buyer (or “transferee”) and paid to the U.S. government. The amount of tax to be withheld is 15% of the “amount realized” by the nonresident who is transferring the purchase contract to the holding structure:

Except as otherwise provided in this section, in the case of any disposition of a United States real property interest (as defined in section 897(c)) by a foreign person, the transferee shall be required to deduct and withhold a tax equal to 15 percent of the amount realized on the disposition.⁷

This means that your corporation must figure out what the “amount realized” is, and send 15% of that amount to the Internal Revenue Service.

Example: Assign the Contract to a Corporation

Let’s put some numbers to your purchase, and see how it works.

You sign a contract to buy U.S. real property for $1,000,000. You gives a deposit of $100,000 when signing the contract, with the remaining purchase price of $900,000 to be paid on the closing date.

You then create a corporation.

You assign your right to purchase the real estate (meaning you assign the contract) to the new corporation, and the seller agrees.

After the assignment, the corporation is new buyer in the real estate transaction.

The corporation now sits in the following position:

• It has a binding contractual right to buy the real estate for $1,000,000; and
• It has a binding contractual obligation to pay the seller $1,000,000; and
• It owns your $100,000 cash deposit that you paid the seller when signing the purchase contract.

What is your “amount realized” for the purpose of computing the tax that the new corporation must withhold and pay over to the IRS?

Amount Realized

The “amount realized” is what you get in return for what you transferred away. Here is how the government defines “amount realized”:

The amount realized by the transferor for the transfer of a U.S. real property interest is the sum of:

(i) The cash paid, or to be paid.

(ii) The fair market value of other property transferred, or to be transferred, and

(iii) The outstanding amount of any liability assumed by the transferee or to which the U.S. real property interest is subject immediately before and after the transfer.⁸

Cash [Reg. §1.1445-1(g)(5)(i)]

In my example, you receive no cash back from your corporation in return for assigning the purchase contract (and ownership of the $100,000 cash deposit).

Amount realized: zero.

Other Property [Reg. §1.1445-1(g)(5)(ii)]

When you assign the purchase contract to your new corporation, you are transferring ownership of the $100,000 cash deposit.

This is a capital contribution, for which you receive corporate stock in return. That is “other property”.

The value of that stock is the value of the property transferred to the corporation:

Relief from Liability [Reg. §1.1445-1(g)(5)(iii)]

In addition to the cash deposit, you transferred a second asset to the corporation: the right to buy a $1,000,000 piece of real estate.

This right, however, comes with an obligation to pay $1,000,000 to the seller of the real estate, so the value of the contractual asset is zero.

But the effect of this transfer (the corporation is the buyer and must pay the purchase price, and you are off the hook for paying the puchase price) is that the corporation has assumed a liability of $1,000,000 that used to be yours.

You have an “amount realized” of $1,000,000. But since the seller already has $100,000 of cash as the deposit, the “amount realized” by you is $900,000:

Total Amount Realized

The total amount realized — when the nonresident assigns the purchase contract to the corporation that will purchase and own the U.S. real estate — is $1,000,000.

Since the nonresident has an “amount realized” of $1,000,000, we have two results:

• The nonresident (who signed a purchase contract and then assigned it to the holding structure he created) must file a U.S. income tax return; and
• The holding structure (a corporation in my example) must withhold $150,000 (15% of the $1,000,000 “amount realized”) and pay this in cash to the IRS.

How Do You Make Bad Things Go Away?

How do you make bad things go away? Here are some ways to handle this problem:

Start Over

• Cancel the purchase contract,
• the seller returns the deposit to you,
• The corporation signs a new purchase contract with the seller,
• The corporation makes the deposit and pays the purchase price.

This requires cooperation from the seller. It is the safest method. When you cancel the purchase price, you have not made a disposition of a U.S. Real Property Interest. This means that the whole cascade of tax problems (tax returns for you, withholding for the corporation) will not occur.

Do the Withholding, File a Tax Return

• Assign the purchase contract to the corporation,
• The corporation withholds 15% of the amount realized,
• You file a tax return and claim a refund of the purchase price.

Really? Who does this?

• Answer: people who have a lot of cash liquidity and can affort to put 15% of the purchase price into the U.S. Treasury for several months while waiting for a tax refund.
• Answer: transactions where a hyper-aware third party exists. Real estate brokers, title companies, escrow companies, and other professionals can be treated as “withholding agents” and therefore personally on the hook for the withholding tax. They may insist on withholding in order to protect themselves.

Don’t Do the Withholding, File a Tax Return

• Assign the purchase contract to your corporation,
• DON’T do the tax withholding,
• File a tax return to report the assignment of the contract and zero tax liability.

Then the holding structure (as withholding agent) is on the hook for interest only⁹ on the amount of the tax withholding that should have been done–but wasn’t. Maybe the IRS will catch this, maybe they will not.

No Withholding, No Tax Return

• Ignore the whole problem and hope it doesn’t blow up in your face.

This works well if you do not have real estate professionals in the transaction (title companies, escrow companies, real estate agents) who could potentially be “withholding agents” and thereby be on the hook for the tax withholding that should have been done but was not.

Real World?

In the real world, people ignore the whole problem and it never blows up in anyone’s face. It’s a no harm, no foul situation. I’m not saying that’s the right thing to do. I’m just saying that is what happens.

Which means that now is the perfect time for a disclaimer.

Nothing here is legal advice. Go hire someone to give you good advice. My frank opinion is that the “start over” strategy is best, but you can’t always rely on cooperation from the seller.

The post Build Your Holding Structure Before You Sign a Purchase Contract appeared first on HodgenLaw PC – International Tax.

How to make the first section 965 installment payment

Today’s post is for individuals living abroad who file their tax returns on June 15 and who have deemed repatriation income from their foreign corporations under section 965.

Background: deemed repatriation under section 965

A quick introduction to section 965: In December of 2017, Congress passed laws that changed the US taxation of foreign income significantly. One of these laws is section 965.

There are many nuances to section 965, but here is the short version that covers what we need today: If you are a US citizen, green card holder, or other resident, or you are a US entity; and you own at least 10% of a foreign corporation, you might have a lot of income from the deemed repatriation of your share of the foreign corporations’ accumulated profits since 1986.

For example, suppose you are a US citizen, you are the sole shareholder of a foreign corporation, and the foreign corporation has $10,000,000 of accumulated profits since 1986. You would have deemed income of $10,000,000 under section 965.

Installment plan for the 965 tax

There are some provisions to mitigate the impact of the deemed repatriation. One of these is the participation exemption. Another one is the installment plan. The installment plan is the topic of today’s post.

A person subject to section 965 can elect to pay the tax in 8 installments: 8% in each of the first 5 years, 15% in the 6th year, 20% in the 7th year, and 25% in the last year. IRC §965(h)(1). And the timely payment of an installment does not incur interest. H. Rpt. 115-466, 115th Cong., 611.

Given how back loaded the installment plan is, and using it does not trigger interest, it is generally a good idea to use the installment plan.

How do you make the installment election?

You make it by attaching the right statement to your tax return. This is question 7 of the IRS’s section 965 FAQ.

Because the due date of the return is a few months away (with extension), this post will skip the details of how to make the election.

How do you make the first installment payment?

This is question 10 of the IRS’s section 965 FAQ.

EFTPS users

If you normally make payments using EFTPS, you can wire the first installment payment instead. There is no penalty for using wire instead of EFTPS for the first installment.

The installment payment must be made separately from any other payment. The wire must carry a 5 digit tax type code of 09650 in addition to the normal information you need to include with a wire payment.

Check users

Those who normally pay by check should send the check with a payment voucher, e.g. 1040-V.

The installment payment must be made separately from any other payment, i.e. using a separate voucher and with a separate check. You must write “2017 965 tax” on the front of the payment in addition to the normal information you need to include with a voucher payment.

What if you just made a big payment with the normal tax payment?

This is question 13 of the IRS’s section 965 FAQ.

For your estimated tax payments, the IRS first applies the payment to your tax liability determined without regard to section 965. Then it applies any remaining apply to your section 965 tax liability, including the first installment.

If you overpaid your estimated quarterly taxes or did not separate out the first installment from your normal payment, the overpayment will be applied to your first installment.

It is a good idea to follow the IRS procedure and make it easier for the IRS to process the payments, but if you already paid the taxes together, some of it should be credited to the first installment.

When is the first installment due?

“The first installment shall be paid on the due date (determined without regard to any extension of time for filing the return) for the return of tax for the taxable year…” IRC §965(h)(2).

For those who live in the US, the first installment was due April 17th, 2018.

For those who live outside the US, the IRS extended the first installment due date to June 15th, 2018. Notice 2018-26, §3.05(e).

What if you do not pay on time?

“If there is an addition to tax for failure to timely pay any installment required under this subsection […] then the unpaid portion of all remaining installments shall be due on the date of such event…” IRC §965(h).

What the Code tells us is that if you do not pay an installment on time, and the late payment results in “an addition to tax”, then the entire balance of section 965 is due as of the date the installment payment was due.

For example, suppose your section 965 tax is $1,000,000. The first installment is $80,000, and it is due June 15. You pay nothing on June 15, but you pay the $80,000 with your tax return on October 15. The IRS assesses an “addition to tax” because of the late payment. Then the entire $1,000,000 becomes due retroactively as of June 15.

To trigger this acceleration, there must be an “addition to tax” for failure to timely pay the installment. For example, a timely payment of an installment does not incur interest. H. Rpt. 115-466, 115th Cong., 611. Presumably a late payment of an installment incurs interest like any other underpayment of tax. Is that interest an “addition to tax” that triggers acceleration?

Section 965 offers no definition of “addition to tax”, so we have to make inferences.

Chapter 68 of the Internal Revenue Code (sections 6651 to 6751) is labeled “additions to the tax, additional amounts, and assessable penalties”. Subchapter A of chapter 68 (sections 6651 to 6665) is labeled “additions to the tax and additional amounts”. If you look in these sections, you will see familiar penalties such as the failure to file penalty, the failure to pay penalty, negligence penalty, etc.

By contrast, interest is in chapter 67 (sections 6601 to 6631), which is labeled “interest”. This suggests that interest is not an “addition to tax”.

Based on the chapter labeling, my guess is that if the late payment or underpayment results in a penalty, then the entire payment is accelerated, because the penalty is an “addition to tax”. If the late payment or underpayment merely results in interest, then you merely owe interest, because the interest is not an “addition to tax”.

What if calculation of the tax is not available by June 15?

Our plan is to overestimate and ask the client to make a first installment payment that is an overestimate, to minimize the possibility that there would be an “addition to tax” that accelerates the entire tax under section 965.

For example, paying 12% instead of 8% in the first year is better than having to pay 100% in the first year because of an underpayment penalty.

If you are really short on cash, you can try to make just enough payment to avoid penalties. But keep in mind that we are not sure what exactly is an “addition to tax” that triggers acceleration of the entire tax due.

What happens to overpayment of the installment?

This is question 14 of the IRS’s section 965 FAQ.

If you overpay the first installment (or any installment), the IRS keeps the extra money and applies it to subsequent installments. You cannot get a refund of overpayment of an installment.

By contrast, if you overpay the entire tax liability, you can get a refund like normal.

The post Paying the First Installment of the 965 Tax appeared first on HodgenLaw PC – International Tax.

Filing deadline for expatriates is approaching

We are just a few short days away from a very important date. If you expatriated during 2017, chances are you need to file your tax return and Form 8854 by June 15, 2018. You also need to make full payment of any tax due by that date.

If you need more time to get the tax return ready, you can file for an extension to December 15. However, the payment due date remains June 15, 2018.

Today’s topic will be limited to a description of the filing and payment deadlines for expatriates and how to get an extension to file your tax return.

Nonresident aliens must file by June 15

Your tax return filing status for the year is based on your status as of December 31. For tax year 2017, you look at your status as of December 31, 2017 to determine your filing status.

If you expatriated during 2017, you were a nonresident alien on December 31, 2017. Nonresident aliens must file their tax returns by June 15 in the following tax year.¹ Form 8854 gets filed with your tax return. That means you must file your tax return and Form 8854 by June 15, 2018.

Exception: you had wages on which US tax was withheld

Unfortunately, for some expatriates the deadline for filing your tax return has already passed. If you earned US wages that are subject to withholding in the year of your expatriation, you would have had to file your tax return and Form 8854 by April 15.²

This is not an unheard-of situation for expatriates. We have seen it many times, in fact – most often with green card holders who terminate their US employment, return to their home country, and turn in their green cards, all within the same calendar year.

If this is your situation, it is too late to file an extension for your 2017 tax return. You will have to file your return late.

You may face a monetary penalty for filing Form 8854 late, or for any other information returns that should have been filed along with your return, and you may be converted from a non-covered expatriate to a covered expatriate. Today’s topic does not cover those things, but you should be aware that they are possible consequences of filing your expatriation return late. You may want to seek help from a professional if this is your situation.

Extension to December 15 available

A nonresident alien who had no wages subject to US withholding can file for a 6-month extension from June 15.

A timely and properly-filed extension extends the filing deadline for a nonresident alien to December 15, 2018. Just like filers with an April 15 deadline can get an automatic 6-month extension to October 15, filers with a June 15 deadline can get an automatic 6-month extension to December 15:³

An individual who is required to file an individual income tax return will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the individual files an application under this section in accordance with paragraph (b) of this section.

The method for getting the automatic 6-month extension is spelled out in Treasury Regulations Section 1.6081-5(b). In plain English: File Form 4868.

To get the extension, you must file Form 4868 by June 15, 2018 and check the box at the bottom where it says “Check here if you file Form 1040NR or 1040NR-EZ and didn’t receive wages as an employee subject to US tax withholding”. If you do not file Form 4868 on time, then you are not allowed the extension and your tax return will be considered late.

Payment deadline remains June 15 if you file an extension

Now that we know when expatriates have to file their tax returns and how to get an extension, let us look at when their payment of tax is due.

Generally, tax is due on the due date for filing your tax return:⁴

Except as otherwise provided in this subchapter, when a return of tax is required under this title or regulations, the person required to make such return shall, without assessment or notice and demand from the Secretary, pay such tax to the internal revenue officer with whom the return is filed, and shall pay such tax at the time and place fixed for filing the return (determined without regard to any extension of time for filing the return).

As is common in the Internal Revenue Code, we have to check for exceptions before we can rely on what it says. “Except as otherwise provided in this subchapter” are the words that send us in search of exceptions. “This subchapter” refers to Title 26, Subtitle F, Chapter 62, Subchapter A of the United States Code. (Title 26 of the United States Code is colloquially referred to as the “Internal Revenue Code” and it is where Federal tax law lives). Subchapter A includes Sections 6151 through 6159. We have checked; there is no exception lurking in Sections 6151 through 6159 of the Internal Revenue Code that would apply to our nonresident who expatriated in 2017 and is filing an extension by June 15, 2018.

A nonresident alien who files Form 1040NR must pay any tax due (including exit tax) by June 15. Getting an extension to file your return does not give you an extension of time to pay tax.⁵

Different payment deadline for nonresidents with income tax withholding from wages

The payment deadline of June 15 is for nonresidents who did not have US income tax withholding from wages.

Those taxpayers with US income tax withholding from wages should have made their payments by April 15, their deadline for filing a return or extension.

Thanks and disclaimers

Thanks for reading, and please keep in mind that you have not received legal advice from the author just because you found an article on a website. Seek professional help if you need it.

The post Tax Return Filing Deadline for Expatriates appeared first on HodgenLaw PC – International Tax.

I received an email from a practitioner this morning and figured it’s worth a blog post.  

Reader C in Sydney asked me:

Hi Phil,

Would a MFJ couple (US citizen and NRA Spouse) using Sec 6013(g) Election qualify for Unlimited Spousal transfer from decedent US Citizen?  Inquiring minds would like to know

Election to be a U.S. taxpayer

Nonresidents who are married to U.S. persons (citizens or residents for income tax purposes) can choose to be fully subject to U.S. income tax laws.  Ordinarily, a sane person would attempt to avoid this status, if possible.  

But sometimes we do the math and it actually saves tax overall to do so.  Sometimes this result is driven by differing tax rates that apply to married couples compared to a married person filing a separate tax return.  Other times, tax savings are driven by a glitch in the foreign tax credit matrix.  

The election

The law allowing a nonresident to make this election is found in Internal Revenue Code Section 6013.  Look at Regs. §1.6013-6 for the details of who can do it, when, and how.

“U.S. taxpayer” for limited purposes only

Making the election does not make the nonresident individual a U.S. taxpayer for all purposes.  Instead, the nonresident spouse is a resident of the United States for the purposes of:

• Income tax; and
• Withholding tax imposed on wages paid by a U.S. employer.

I have never seen the second item be a factor.  When I have worked on projects like this, the nonresident spouse—if he or she works and earns wages—is employed outside the United States and the U.S. rules for withholding tax on wages will simply not apply.

Specifically, IRC § 6013(g)(1) says:

A nonresident alien individual with respect to whom this subsection is in effect for the taxable year shall be treated as a resident of the United States—

(A) for purposes of chapter 1 for all of such taxable year, and

(B) for purposes of chapter 24 (relating to wage withholding) for payments of wages made during such taxable year.

Not estate and gift taxes

Look what is missing:  estate and gift tax.  

These are big, problematic taxes. The nonresident’s election to become a U.S. taxpayer for income tax purposes does not affect his or her status as a U.S. taxpayer (or not) with exposure to the U.S. estate and gift taxes.

The meaning of life

A nonresident married to a U.S. person can therefore make the election to be taxed as a U.S. resident for income tax purposes while retaining all of flexibility for creative planning to minimize or eliminate U.S. estate or gift tax.  

The nonresident spouse’s assets are not at risk of being taxed by the U.S.  This means that the optimum U.S. tax strategy (not necessarily life strategy, however) is to have the nonresident spouse own all assets in excess of the unified credit amount.  This ignores, of course, any estate or gift tax laws in the country where the couple lives.

The post Resident for income tax purposes but not gift tax purposes appeared first on HodgenLaw PC – International Tax.

Let’s look at the taxation of income earned by spouses living in community property jurisdictions. When a U.S. person is married to a nonresident alien, the tax rules are different.

The normal rules: two U.S. taxpayers

The normal rules are described in IRS Publication 555.¹ Where spouses are subject to community property rules and they file separately, community income is split equally between the two spouses. The community property jurisdiction might be California. Or it might be any one of a number of countries outside the United States.

Different rules for a nonresident alien spouse

When one of the spouses is a nonresident alien, the rules are different.

A U.S. person married to a nonresident alien may not, except for a few situations, file a joint return.² Head of household status is denied to a nonresident alien.³ This means that a nonresident alien may only claim single or married filing separate status.

Earned income

For a couple filing separately with community income under the local laws, how will they split the income so it is properly reported by the nonresident alien spouse and the U.S. taxpayer spouse?

Earned income is allocated entirely to the earning spouse. ⁴

Earned income defined

Earned income is defined by a cross-reference to the foreign earned income exclusion rules. Section 879(a)(1) defines earned income as follows:

Earned income (within the meaning of section 911(d)(2)), other than trade or business income and a partner’s distributive share of partnership income, shall be treated as the income of the spouse who rendered the personal services[.]

Section 911(d)(2)(A) defines earned income as follows:

The term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.⁵

Earned income rules applied

We have a simple rule: allocate earned income to the spouse who earns it, regardless of the local community property rules. This can cause unexpected results. Consider this example, where a U.S. citizen is subject to U.S. income tax on income that is not (under local law) hers.

Example

A U.S. citizen lives abroad and is married to a nonresident alien. They live in a community property jurisdiction so that earned income is treated as equally owned by both spouses.

The U.S. citizen spouse is the sole wage earner in the family. Under local law, the U.S. citizen spouse is deemed to own half of the earned income, and the nonresident alien spouse is deemed to own the other half.

Section 879(a)(1) says the wages are allocated for U.S. income tax purposes to the U.S. citizen spouse. The U.S. citizen will file claiming married filing separate status, and will report 100% of earned income as taxable, even though under local laws 50% of the earned income belongs to the nonresident alien spouse.

One wonders about this.⁶ Under the local laws of the country where the U.S. citizen spouse lives, only half of the income is hers. Yet the U.S. government taxes her on 100% of the income.

It is equally possible for Section 879 to define earned income as nontaxable to a U.S. citizen even though under local law 50% of it is hers.

Example

A U.S. citizen lives abroad and is married to a nonresident alien. They live in a community property jurisdiction so that earned income is treated as equally owned by both spouses.

The nonresident alien spouse is the sole wage earner in the family. Under local law, the U.S. citizen spouse is deemed to own half of the earned income, and the nonresident alien spouse is deemed to own the other half.

Section 879(a)(1) says the wages are allocated for U.S. income tax purposes to the nonresident alien spouse. The U.S. citizen spouse will file claiming married filing separate status, and will report no earned income, even though under local laws 50% of the earned income belongs to the U.S. citizen spouse.

Earned income: write the rules yourself

Under the laws of many countries, it is possible to trump community property rules by agreement between the spouses. U.S. citizens married to nonresident aliens should do this. By doing so, they can take themselves out of Section 879 entirely and allocate income in a tax-efficient way.

Section 879 only forces an allocation of community income.⁷ A spousal agreement can make the earned income be treated for local law purposes as separate property of one of the spouses. If the nonresident alien spouse is treated as the sole owner of the income under local law, then Section 879 will not re-allocate half of the income.

Example

A U.S. citizen is married to a nonresident alien. The nonresident alien is the sole wage-earner in the family. Under local community property law, each spouse is deemed to own half of the income.

However, under local community property law the spouses can agree between themselves as to the characterization of the earned income as community or separate income. They make a valid agreement under local law to treat the earned income as the separate property income of the nonresident alien.

The U.S. citizen spouse files a U.S. income tax return, using the married filing separate status. No earned income is reportable on that income tax return because it is not community income.

Trade or business income

Section 879 merely points to a different part of the Code so you can figure out how to allocate community income between a U.S. citizen spouse and a nonresident alien spouse when you are dealing with “trade or business income” and a partner’s distributive share of partnership income:

Trade or business income . . . shall be treated as provided in section 1402(a)(5).⁸

The rule is simple: community income derived from a trade or business is allocated to the spouse who did the work:

[T]he gross income and deductions attributable to such trade or business shall be treated as the gross income and deductions of the spouse carrying on such trade or business or, if such trade or business is jointly operated, treated as the gross income and deductions of each spouse on the basis of their respective distributive share of the gross income and deductions[.]⁹

Trade or business income means income in which both personal services and capital are material income producing factors.¹⁰ Thus, a sole proprietorship that is a service business will allocate its income as earned income under Section 879 rather than trade or business income.

The fact that a spouse has management and control attributed to him or her by community property laws does not give that spouse a share of the income. Only by actively working in the business does the spouse receive an allocated share of the income:

The term “management and control” means management and control in fact, not the management and control imputed to the husband under the community property laws of a State, foreign country or possession of the United States. For example, a wife who operates a pharmacy without any appreciable collaboration on the part of a husband is considered as having substantially all of the management and control of the business despite the provisions of any community property laws of a State, foreign country, or possession of the United States, vesting in the husband the right of management and control of community property.¹¹

The allocation rules for trade or business income thus trump the community property rules of the relevant jurisdiction.

Example

A U.S. citizen is married to a nonresident alien. The nonresident alien is engaged in a trade or business. Under the local community property laws, the U.S. citizen is deemed to have a 50% interest in the income generated from the trade or business. Nevertheless, for U.S. income tax purposes the U.S. citizen does not include any of the income from the business on her U.S. income tax return.

Distributive share of partnership income

Community property rules do not matter when allocating the distributive share of partnership income between spouses where one is a nonresident alien. The spouse who is the partner will take the entire amount of community income from the partnership into his or her income for U.S. tax purposes:

If any portion of a spouse’s distributive share of the income of a partnership, of which the spouse is a member, is community income for the taxable year, all of that distributive share shall be treated as the income of that spouse and shall not be taken into account in determining the income of the other spouse. If both spouses are members of the same partnership, the distributive share of the income of each spouse which is community income shall be treated as the income of that spouse. A spouse’s distributive share of the income of a partnership that is community income shall be determined as provided in section 704 and the regulations thereunder.¹²

If spousal agreements are possible under the laws of the local jurisdiction, use them to convert the character of the income from community to separate property. Section 879 only controls the allocation of community income from a partnership to one spouse or another. It does not control the allocation of separate property. This may be the only possible way to avoid an over-allocation of income to the U.S. tax system.

Income from separate property

Income from separate property is allocated to the spouse in one of two ways. If the local community property rules say that separate property generates separate income, then Section 879 cannot throw a trump card. Section 879 only forces reallocation of community income. The separate income belongs to the spouse who owns the separate property.

If the local community property rules say that separate property generates community income, that income will nevertheless be allocated—for U.S. income tax purposes—to the spouse owning the separate property: ¹³

Any community income for the taxable year . . . which is derived from the separate property of one of the spouses shall be treated as the income of that spouse. The determination of what property is separate property for this purpose shall be made in accordance with the laws of the State, foreign country, or possession of the United States in which, in accordance with paragraph (a)(1) of this section, the recipient of the income is domiciled or, in the case of income from real property, in which the real property is located.¹⁴

This rule does not apply to earned income, income derived from a trade or business, or partnership income.¹⁵

Everything else

For all other types of community income, Section 879 instructs us to follow the allocation rules under local law.¹⁶

Election to be U.S. resident taxpayer

Recall that a U.S. citizen with a nonresident alien spouse cannot use the married filing jointly filing status.¹⁷ However, the nonresident alien can make an election to be treated as a U.S. person for the purposes of income taxation. There are two separate rules, one for nonresidents in their first year of residency who are married to U.S. citizens or residents,¹⁸ and one for nonresident aliens married to U.S. citizens or residents.¹⁹

If either of these elections has been made, the Section 879 rules governing allocation of community property will not apply. This makes sense, because the basic premise of Section 879(a) is to provide rules to allocate community income between U.S. taxpayers and nonresident aliens. Making the election to treat a nonresident alien as a U.S. taxpayer eliminates the need for these rules.

Thanks and Disclaimer

I am a lawyer but not your lawyer, and this is not legal advice. I would recommend that you seek professional help but that implies a need for psychiatry. Maybe that is appropriate – tax law has been proven to cause insanity.

The post Community Property for Americans Married to Nonresidents appeared first on HodgenLaw PC – International Tax.

Today’s topic: Do covered expatriates get to use their suspended passive activity losses?

Let us imagine that you are planning to expatriate in 2018, and that you will be a covered expatriate. You have a number of rental properties in the United States. Those rental properties have accumulated a substantial amount of passive activity losses (PALs) during the time that you have owned them. Because you are a covered expatriate, you will need to pretend you sold all those properties at fair market value on the day before your expatriation and report the gains or losses on your tax return as if you really sold the properties.

Today’s topic covers what happens to the suspended PALs you have accumulated in the rental properties: Do they get released when you pretend you sold the properties (and thereby reduce your exit tax), or do they remain suspended because you did not really sell the properties?

The short answer: You will be allowed to utilize those losses in the year of the deemed sale to help offset your taxable income. If you want to know why, keep reading.

A “deemed sale” is like a regular sale for tax purposes

According to Internal Revenue Code section 877A, “All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value”.¹

In our fact pattern, we assume you are a covered expatriate, so you will have to treat all your property “as sold” at fair market value on the day before your expatriation date. Notice 2009-85 refers to the requirement to treat all property as sold as a “deemed sale”.²

There is nothing in the Code or Notice 2009-85 that defines deemed sale. A deemed “sale” under section 877A should therefore be considered the same as a “sale or exchange” under section 1001.

What to do with deemed sale gains and losses in general

Gains and losses from a deemed sale are recognized as follows:³

(A) notwithstanding any other provision of this title, any gain arising from such sale shall be taken into account for the taxable year of the sale, and

(B) any loss arising from such sale shall be taken into account for the taxable year of the sale to the extent otherwise provided by this title, except that section 1091 shall not apply to any such loss.

Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain or loss taken into account under the preceding sentence, determined without regard to paragraph (3).

The rules assume a “sale” occurs, and overrides other provisions of the Code. The rules say when to recognize the gains or losses from that “sale” – the taxable year of the sale.

Section 877A(a)(2)(A) prevents nonrecognition rules from applying and overrides any rules causing gain recognition to occur at a time other than the day before expatriation date.

Section 877A(a)(2)(B) permits the operation of all loss allowance rules, with the exception that it allows you to recognize losses that arise from the deemed sale that would otherwise be disallowed because of the wash sale rules.

PALs arising from the deemed sale are losses you can deduct

Under the normal passive activity rules, if a passive asset is disposed of entirely (by sale or other disposition) during a taxable year, then any loss left over (after some calculations) “shall be treated as a loss which is not from a passive activity”.⁴

In other words, suspended losses that remain after an asset is sold are treated as ordinary losses that are deducted from ordinary income in the same year as the asset sale.

The deemed sale of your passive assets will be, for purposes here, a disposition of your “entire interest” in the passive activities.⁵ Recall that section 877A states that “all property of a covered expatriate shall be treated as sold” (emphasis added).⁶ This should be equivalent to a “sale or exchange” for purposes of the code generally.

Unless there are explicit exceptions under the passive activity loss rules or under section 877A that apply to you, your suspended passive activity losses should be deductible on the tax return that reports the deemed sale of your passive assets.

We have found no such exceptions. To the contrary: Section 877A(a)(2)(B) explicitly allows all losses that arise from the deemed sale, including wash sale losses that would otherwise be disallowed under section 1091. Since section 877A allows the loss and because the deemed sale is a loss-releasing complete disposition for section 469 purposes, the passive activity losses will be allowed.

Possible exceptions to suspended PAL rule: No problems here

The Code for covered expatriates (and expatriates in general) is silent when it comes to suspended passive activity losses. Likewise, there is no mention of suspended passive activity losses in Notice 2009-85. Those resources make up the entirety of the guidance we have from the IRS for covered expatriates.

If any exceptions apply to you, then, they would be found under the normal passive activity rules. The only possible exception there relates to dispositions involving related parties.⁷

Under the deemed sale rules, you are effectively selling the passive assets to yourself at fair market value. When the deemed sale takes place, you still own the assets but your new basis in the assets becomes the fair market value as of the day of the deemed sale.⁸ For tax purposes, a sale from you to yourself has taken place.

You are not considered to be a related party to yourself, however, because you are not defined as a member of your own family under section 267(c)(4): You are not your own brother, sister, spouse, ancestor, or decedent. None of the other definitions of a related party apply either. You should be able to deduct your suspended passive activity losses.

Those losses will be deducted from ordinary income on your expatriation year income tax returns.

Disclaimer

The usual disclaimer applies: This is not legal advice, so don’t use it to make big decisions. Hire someone and get good, focused advice.

The post Do Covered Expatriates Get to Use Their Suspended Passive Activity Losses? appeared first on HodgenLaw PC – International Tax.

I received an email from Scott, a good friend who, well, does taxes in Mexico.

He had a question about an American couple in Mexico who are setting up a S de RL (Sociedad de Responsabilidad Limitada), which is similar to a U.S. LLC. One of the features of this type of entity is that it must have two owners. H and W. How convenient.

Mexico has community property laws for married couples, and Scott tells me that this S de RL is a community property asset of H and W.

Will this entity (S de RL) be treated as a corporation, partnership, or disregarded entity for U.S. tax purposes? And if the married couple wishes to change the U.S. tax classification to something else, what are their options?

The way a foreign country treats foreign business entities is its own business. When American taxpayers own foreign business entities, the IRS is keenly interested in what that entity is, and how to apply U.S. tax law to its operations.

We need to classify a foreign business entity for U.S. tax purposes. Here is the quick summary of how it works:

Not a Trust or Per Se Corporation

The first thing to do is deal with a couple of arbitrary knockout punches. Do these rules force a particular classification for the entity?

• Trust: No. Make sure the foreign entity is not a trust (using U.S. tax law definitions).¹ If it’s a trust, the rest of this discussion does not apply–you have a trust.
• Per Se Corporation: No. Make sure that U.S. tax rules do not force the foreign business entity to be classified as a corporation for U.S. tax purposes.² If this particular type of entity is on the list for “corporation only” treatment, that’s the end of the discussion. Jargon alert: this is called a per se corporation because lawyers love Latin.

For a Sociedad de Responsabilidad Limitada, the answer is “no” to both: it is not a trust, and it is not on the list of Mexican business entities that are automatically and always treated as corporations for U.S. tax purposes.

Initial Classification For Eligible Entity

If you get this far, you have a “foreign eligible entity”.³ U.S. tax law tells you how the entity is classified if you do nothing, and it tells you what alternate classifications are available for you to choose from.

The initial classification of the entity is determined by figuring out–under local law–whether all of the owners have limited liability, or whether at least one owner has unlimited liability.⁴

• Multiple Owners, One Has Personal Liability. If at least one of the owners has unlimited liability, the foreign entity will be treated as a partnership by the U.S. tax system.⁵
• No Owner Has Personal Liability. If all of the owners (could be one owner or many) have limited liability, the U.S. tax system will treat this foreign entity as an “association” taxable as a corporation.⁶
• Single Owner has Personal Liability. If the entity has one owner who has personal liability for the entity’s debts, then the entity is disregarded for U.S. tax purposes.⁷ (Many countries have formal entities for sole proprietorships; that’s what this rule is all about).

For the Sociedad de Responsabilidad Limitada, it has two owners and both have limited liability. Therefore, the initial classification for this entity is “association taxable as a corporation” for U.S. tax purposes.

Change of Classification Rules

A foreign eligible entity can elect to change its classification from the initial classification to something different for U.S. tax purposes. Since a Sociedad de Responsabilidad Limitada is not a per se corporation, it is a foreign eligible entity, and the owners can make this election.

These are your choices, straight from Form 8832, Part I, Line 6:

• Foreign eligible entity electing to be classified as an association taxable as a corporation.
• A foreign eligible entity electing to be classified as a partnership.
• A foreign eligible entity with a single owner electing to be disregarded as a separate entity.

For a S de RL (with two owners) the choices are “corporation” or “partnership”. H and W (seemingly!) cannot choose to have the S de RL disregarded as a separate entity, because it has two–not one–owner.

Foreshadowing the Denouement . . .

Except . . . let’s talk about the application of community property law to entity classification.

Hint: we can treat husband and wife as one person, and choose disregarded entity status for the S de RL.

Community Property: Choose Partnership or Disregarded Entity

The IRS will let a married couple who own a foreign eligible entity (like a Mexican S de RL) as community property choose disregarded entity status or partnership status.

Behold the majesty of Rev. Proc. 2002-69.⁸ Here is how it works.

First, you need a “qualified entity”,⁹ which means:

1. The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States;
2. No person other than one or both spouses would be considered an owner for federal tax purposes; and
3. The business entity is not treated as a corporation under T. Regs. § 301.7701-2.

All three of these are true for a Mexican S de RL. Note particularly that “wholly owned by a husband and wife as community property” can mean:

• Ownership by one spouse alone, but the company is a community property asset so the other spouse has a 50% ownership interest even though he/she is not named as an owner; or
• Ownership by both spouses (as is the case with the Mexican S de RL we are discussing).

After that, it’s pretty easy:

• If the married couple “treats” the entity as a disregarded entity, then the IRS will respect that treatment.¹⁰
• If the married couple “treats” the entity as a partnership and “file the appropriate partnership tax returns”, then the IRS will respect the treatment of the entity as a partnership.¹¹

No Form 8832 Required (It Seems)

It appears that you do not even need to file Form 8832 in this situation. All you do is start reporting income on Schedule C (for disregarded entity status) or file a Form 1065 (if you want partnership classification).

To see this in action, ponder the wisdom of CCA 200852001.¹² This is a purely domestic situation, but the principles apply equally to a foreign eligible entity.

Husband and Wife formed a domestic corporation, and were both equal shareholders. They never did any of the State-required paperwork, so in short order the State dissolved the corporation. Husband and Wife nevertheless kept on truckin’ doing business in the name of the corporation.¹³

The IRS audited them. Things got bad, things got worse (YouTube), and they end up in Tax Court.

The couple then files a Form 1040 reporting all of the business income on Schedule C–functionally treating the business entity as a disregarded entity.

The Chief Counsel’s office said that they satisfied the requirements of Rev. Proc. 2002-69. All the couple had to do–in order to force the result of “disregarded entity”–was to file a tax return. And that was the end of the Tax Court case.

Harry Callahan, Intrepid Revenue Agent

For the husband and wife who own the Mexican S de RL, a strict reading of Rev. Proc. 2002-69 would seem to tell us that they need not file Form 8832. They just need to start filing their tax returns the way they want the results to occur:

• Disregarded entity. If they want the S de RL to be treated as a disregarded entity, report its income and expense on Form 1040, Schedule C, and file Form 8858 to tell the IRS that they have a foreign disregarded entity.
• Partnership. If they want the S de RL to be treated as a partnership for U.S. tax purposes, file Form 8865 (U.S. partners in foreign partnerships) and report the income on Form 1040, Schedule E.

But . . . that conclusion seems so . . . incomplete.

Imagine your future self, under audit by IRS Revenue Agent Harry Callahan (YouTube). You earnestly press your case for the application of Rev. Proc. 2002-69. Revenue Agent Callahan squints at you, smirks ever so slightly, and says:

Uh uh. I know what you’re thinking. “Did I make an effective change of classification election or not?” Well to tell you the truth in all this excitement of this audit I kinda lost track myself. But being this is a multiple year failure to file Form 5471 penalty on top of a bunch of other penalties I can pull out of my pocket, which could bankrupt you, you’ve gotta ask yourself one question: “Do I feel lucky?” Well, do ya, punk?

Just File Form 8832

It strikes me that filing Form 8832 is a pretty good idea. And I have a Private Letter Ruling to back up my hunch.

PLR 201151010¹⁴ involved a husband and wife with a foreign eligible entity. They forgot to make the entity classification election for their foreign entity, but always treated the entity as a disregarded entity (reporting income on Schedule C).

In due course, the sun rises in the East, and the taxpayers asked for the Commissioner’s consent to make a late entity election. Permission granted. You have 120 days to file Form 8832.

From that, I take note: for whatever reason, the taxpayers felt it appropriate to wear a belt and suspenders. Technically they had satisfied the requirements of Rev. Proc. 2002-69 — and were entitled to treat their foreign entity as a disregarded entity for U.S. tax purposes.

But they felt compelled to file Form 8832, just to be really sure. No talking back to Dirty Harry for them.

Same for me. I would file Form 8832 to elect the specific tax treatment desired for the S de RL. I wouldn’t trust fate and the whims of bureaucracy.

Disclaimer

Shhh. Don’t tell anyone, but between you and me . . . this isn’t legal advice to you and I’m not your lawyer. This is just something I did on a Tuesday night because it amused me (and helped Scott). Go hire someone to figure out the answers to your tax questions. Penny wise, pound foolish, etc.

The post Form 8832, Community Property, and Foreign Business Entities appeared first on HodgenLaw PC – International Tax.

Of the three tests that an expatriate must meet to be non-covered, the certification test is the most difficult to understand. It is also the only test to which there are no exceptions – fail this test, and you are a covered expatriate.

Today’s topic will be limited to a general discussion of what it means to pass this test.

Expatriation and the three tests

Expatriation occurs when a US citizen or “long-term resident” terminates his or her citizenship or permanent residence. ¹

If the expatriate meets certain thresholds for net worth and the amount of tax they have been paying over the last five years, he or she will be what is known as a covered expatriate. Covered expatriates must pretend they sold all their worldwide assets at the time of expatriation and pay tax on the gains, so it is generally bad to be covered.

The thresholds for net worth and tax paid are known as the net worth test and the net tax liability test. Most new clients who approach us are already at least somewhat familiar with these and pre-qualify themselves as either covered or non-covered expatriates based on these two tests.

There is a third test that is more difficult to know if you have passed: the certification test.

No way out of exit tax if you fail the certification test

The two financial tests – whether your net worth and net tax liability exceed certain thresholds – can be avoided if you meet certain criteria. If you are under age 18 ½ when you expatriate (and meet certain residency requirements), or if you were born a dual citizen (and meet certain residency requirements), you will be a non-covered expatriate even if you exceed the thresholds.

But there is no exception to the certification test. Anyone who fails this, even if they meet exceptions to the other tests, will be a covered expatriate and will be subject to the exit tax.

Certification test basics

The certification test asks you to certify under penalty of perjury that you have complied with all your tax obligations for the past five years before expatriation.

On the face of it, this seems quite simple: have you been filing your tax returns? If the answer is yes, you would probably assume that you have met the certification test unless you know of things that you have omitted from your returns.

But this can get rather tricky. Most people who are expatriating have at least some aspect of their financial lives that is cross-border; perhaps it is a US citizen who moved overseas and started a business, or someone who moved to the US to live and work and had a green card while here.

It is when you get into the world of cross-border tax that things start to get a little more complicated, a little less predictable, and a little more difficult to get right.

Specific requirements

To pass the certification test, an expatriate must be able to certify that they have met all the requirements of Title 26. Title 26 is where the Internal Revenue Code is found. To meet all the requirements of Title 26, someone would have to report all their income correctly, file all necessary information returns, and pay all tax, penalties, and interest due. This includes other types of tax, as well – gift tax and employment tax – so make sure those are taken care of in addition to your income tax.

The easy stuff

Most of the things you need to check on the certification test will be relatively easy. Here are some questions to ask yourself when looking at your US tax returns (this is by no means an exhaustive list – not even close).

• Did you report your foreign accounts on Form 8938?
• Did you report your foreign salary income and take the foreign earned income exclusion correctly?
• Did you file Form 8621 to report your foreign mutual funds?
• Did you report all your cryptocurrency transactions, and did you report accounts on foreign cryptocurrency exchanges as required?
• Did you report your ownership interest in foreign businesses?
• Did you report inheritances or gifts you received from foreign persons?

The hard stuff

Some of the things you need to check will be more difficult, and you will likely need the expertise of a professional to help with these. Here are some questions to think about (again this is quite far from an exhaustive list).

• Did you set up or contribute to a foreign trust?
• Are you a beneficiary of a trust?
• Do you have a foreign pension or retirement plan? If so, how did you report it on your US tax return? Does it qualify as a pension under a tax treaty, or does it qualify for some other tax treatment under the US tax system?
• Does your nonresident spouse have a foreign business, and did you ever report anything related to that business under the attribution rules?

Most of what I am pointing to here are items that an ordinary person who doesn’t have years of experience preparing US tax returns to report foreign assets and income would have no reason to know about.

It is these types of items that tend to be problematic in the certification test review.

How to know if you’ve passed

There are a couple safeguards you can use to decide with a reasonable degree of certainty whether you have passed the certification test. Please note these safeguards only work if you have hired a professional to prepare your tax returns.

1. Did you tell your tax preparer about every tiny detail of your financial life?
2. Does your tax preparer have experience and expertise in preparing tax returns for individuals with cross-border stuff?

If your answer to both questions is a very resounding “yes” with no doubts whatsoever, then you can probably reasonably assume that you have passed the certification test. If you have any doubts at all, I highly recommend checking with a professional before expatriating.

Some words of caution

As always, thanks for reading, and keep in mind that the several items I mentioned in this post are just a tiny, tiny fragment of the potential ways you can mess up your tax returns and fail the certification test. Don’t use this as your checklist. Don’t rely on this to make sure you are safe. Hire a professional to provide advice specific to your situation.

The post Certification Test Basics appeared first on HodgenLaw PC – International Tax.

Nonresidents often show up and sign contracts to buy U.S. real estate in their own names. Then, before the sale is complete, they set up a holding structure. They transfer the purchase contract to the holding structure, and the purchase is complete.

Hey presto.

As I wrote a few weeks ago, transferring a purchase contract from a nonresident individual to a holding structure is a “disposition” of U.S. real estate. The result?

• Paperwork. Until proven otherwise, the nonresident individual must file a U.S. tax return to report the “disposition” of a “U.S. real property interest”, even though self-evidently there is no capital gain.
• Withholding. When a nonresident disposes of U.S. real estate, the buyer must withhold 15% of the purchase price for tax, and send it to the IRS. That’s terrible. You don’t want to be sending real money to the tax authorities when nothing has really changed.

This time I am going to tell you why one restructuring technique avoids all of this. There is no tax return paperwork required. There is no tax withholding required.

The Steps

This is what we want to do:

• The nonresident signs a contract to buy U.S. real estate.
• The nonresident creates a U.S. limited liability company.
• The nonresident, with the agreement of the seller (or by a right reserved in the contract), assigns the right to buy the real estate to the limited liability company.
• The limited liability company buys the real estate.

We like pretty pictures:

The Holding Structure

This is one of the simplest structures that a nonresident can use to own U.S. real estate. The nonresident owns a domestic limited liability company. The limited liability company owns the U.S. real estate.

This is not a spectacularly good holding structure, but it is useful.

• The limited liability company gives some risk protection.
• It is a little easier for the nonresident to get banking in the United States.
• If the nonresident dies, there will be U.S. estate tax imposed on the value of the U.S. real estate.
• Capital gain will be taxed (almost) like a resident would be taxed. (The nonresident actually pays slightly less tax on capital gain than a U.S. resident taxpayer).
• The U.S. probate courts will control the transfer of the asset to the nonresident investors heirs — if the nonresident commits a monumental error in judgment and dies while owning this real estate. This is a time and expense burden for the heirs.

Enhancing the Holding Structure #1

You don’t want your family to have the expense and delay of waiting for the U.S. courts to administer a will and transfer the real estate to your heirs if you die.

To control that risk, I usually add a simple revocable trust into the structure.

This makes no difference for tax purposes. It merely controls inheritance. It is an order of magnitude cheaper and faster to transfer property to heirs this way.

Enhancing the Holding Structure #2

If you die while owning U.S. real estate, you do not want your family to lose 40% of the value of the U.S. real estate investment you made. That is what the estate tax will do.

To mitigate the pain of the estate tax, I like the investor to buy term life insurance.

Now, if you die, there will be cash to pay the estate tax. Assuming you are young enough and healthy enough, this is an extremely cost-effective way of dealing with the estate tax risk.

Step One in the Process

OK. So you know where we are going with this super simple holding structure. Let’s talk about the first step in getting there: assigning the purchase contract to the limited liability company. We can add all the other stuff after the purchase is complete.

Disposition

The key to understanding this is understanding the idea of a “disposition”. If a nonresident individual has a disposition of a U.S. real property interest, then the tax return filing requirements and the tax withholding requirements are imposed.¹

A contract to buy U.S. real estate is a U.S. real property interest.²

We don’t want a “disposition”. No disposition = no tax. The government’s attempt at defining “disposition” is embarrassingly tautological:

For purposes of sections 897, 1445, and 6039C, the term “disposition” means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.³

For the rest of us, think of it this way. You start the day as the owner of something. You end the day and it isn’t yours anymore. It doesn’t matter how that happened: gift or sale. It isn’t yours.

That’s a disposition.

Not a Disposition

At first glance, when the nonresident transfers the purchase contract (a U.S. real property interest, remember?) to a limited liability company, it sure looks like a disposition. A human owned the contract rights at the beginning of the day, and at the end of the day a limited liability company owned the contract rights.

But it’s not a disposition.

Here’s why.

A U.S. limited liability company that is owned by one person is ignored for U.S. tax purposes. It is a disregarded entity.⁴ The individual owner of the limited liability company is treated as the owner of the limited liability company’s assets.

For Federal tax purposes, a disregarded entity owned by an individual is treated as a sole proprietorship.⁵ That means that the assets are treated as belonging to the owner, and all of the income is taxed directly to the owner.

In practical terms, transferring an asset to your own limited liability company is a nonevent for tax purposes. It is equivalent to reaching into your left pants pocket, pulling out your car keys, and putting them in your right pants pocket.

Nothing changes. You are still the owner of the asset.

And since you are still the owner of the asset — in the eyes of the U.S. tax system — there can be no disposition.

Withholding Rules Give Us a Clue

The withholding rules give us a clue.

The withholding rules (“buyer withholds 15% of the purchase price when buying from a nonresident”) have an exception: if the seller certifies that he/she/it is a domestic taxpayer, then no withholding is required.

What if the seller is a single member limited liability company? A “disregarded entity”, in other words.

The IRS tells you (the buyer) to ignore the limited liability company. The transferor (the person making the disposition of real estate upon which withholding might or might not be required) is not the limited liability company. It is the owner of the limited liability company:

A disregarded entity may not certify that it is the transferor of a U.S. real property interest, as the disregarded entity is not the transferor for U.S. tax purposes, including sections 897 and 1445. Rather, the owner of the disregarded entity is treated as the transferor of property and must provide a certificate of non-foreign status to avoid withholding under section 1445. A disregarded entity for these purposes means an entity that is disregarded as an entity separate from its owner under § 301.7701-3 of this chapter. . . . .⁶

If the rule is good enough for when the limited liability company is selling property, then the rule should also be good enough for when the limited liability is acquiring property. Ignore the limited liability company.

Paperwork and Withholding

Because there is no “disposition”, there is no capital gain event to report when the nonresident transfers the contract to a limited liability company. No U.S. income tax returns are required for the nonresident.

Similarly, because there is no disposition there will be no tax withholding requirement. No need to send 15% to the Internal Revenue Service.

Subsequent Steps

This is a bit long already. The next step is to add a revocable trust to the holding structure.

I won’t deal with this step here. However, note well that this trust should be a “grantor” trust. If so, then the nonresident (who is the settlor and beneficiary of this trust) is treated as the owner of the trust’s assets for tax purposes.

You can see where this is going: the nonresident is treated as owning everything that the trust owns, which is a limited liability company. The trust is treated as owning everything that the limited liability company owns. Therefore, the nonresident is treated as owning the limited liability company’s assets.

Again, a disregarded entity, and again the transfer is a nonevent for U.S. tax purposes.

Other Structures

There are many other structures that nonresidents use to own U.S. real estate. There may well be a way for a nonresident to assign a contract to one of these other holding structures with trivial tax consequences. Maybe there is tax paperwork, but withholding tax can be avoided.

The temptation is always to skip over the fiddly bits. Assigning a contract from yourself to a holding structure entity (limited liability company, trust, partnership, or corporation) seems as though it should be a non-event — and it SHOULD be.

But deal with the paperwork anyway. Your future self will thank you. Don’t create potential wreckage in your future.

Not Advice, Not Nothing

This is not legal advice. I am not your lawyer. Insert your favorite battery-operated lawyer disclaimer here.

The post Assign a Purchase Contract to an LLC and Why It Works appeared first on HodgenLaw PC – International Tax.

The impact of treaty elections on long-term resident status and expatriation

Over the course of two days last week, I received three questions about the interaction of treaty elections, long-term resident status, and expatriation.

It seems there exists some confusion about what happens when a lawful permanent resident makes a treaty election to be taxed as a resident of another country: Does it cause you to expatriate? Does it prevent you from becoming an expatriate?

I am not surprised this confusion exists. Depending on when the treaty election is made, it could either cause you to expatriate or prevent you from becoming an expatriate.

Today I will explore what it means to be an expatriate, what it means to be a long-term resident, and how you can use treaty elections to toggle either of those statuses.

Expatriation – who can do it, and how

There are two groups of people who can become expatriates:¹

• US citizens, and
• Long-term residents.

US citizens become expatriates when they terminate their US citizenship or the US government takes it away.

Long-term residents become expatriates when they terminate their lawful permanent resident status, or when the US government terminates it (but interestingly, not when their green cards expire).

Definitions – citizen and long-term resident

You typically know if you are a US citizen. You were either born in the US or naturalized.

It is less easy to know if you are a long-term resident. There are two factors that must both be satisfied for you to be a long-term resident:²

• Lawful permanent resident (green card) status, plus
• Having that status “in” at least 8 of the last 15 years.

The use of the word “in” rather than “for” indicates that if you have a green card “in” any given calendar year, even for just one day in that year, that year counts as a full year toward the 8-year test.

Once you become a long-term resident, terminating your permanent residency results in expatriation.³ If you never become a long-term resident, terminating your permanent residency is a non-event for expatriation purposes.

It is important for green card holders to carefully track their status with respect to the long-term resident test so that they know whether terminating their permanent residency will result in expatriation.

How to apply the long-term resident test

Look at the last 15 calendar years, including the current year. Right now it is 2018. That means the 15-year period to look at is 2004-2018.

If you were a lawful permanent resident in any 8 of those 15 years, you are a long-term resident.

Don’t count treaty election years

You may not need to count all of your permanent resident years toward the long-term resident test.

For any year that you have made a treaty election to be taxed as a nonresident of the US, you can omit that year from your count:⁴

[For purposes of the long-term resident test,] an individual shall not be treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country for the taxable year under the provisions of a tax treaty between the United States and the foreign country and does not waive the benefits of such treaty applicable to residents of the foreign country.

For example, let’s say you got your green card in 2009. You filed resident returns for 2009-2013, which is 5 years. In 2014-2016, you had a tax home in a treaty country and made a valid treaty election to be taxed as a resident of that other country (and as a nonresident of the US).

Before you file your 2017 return, you have 5 years toward the 8-year long-term resident test, and 3 years that do not count toward that test because you made a treaty election to be taxed as a resident of another country for those years.

If you are eligible to make the treaty election again on your 2017 tax return, you could do so. If you make the treaty election, your long-term resident count will still be at 5 years; if you do not, it will increase to 6 years.

In neither case will you be a long-term resident after filing your 2017 return.

Don’t accidentally expatriate yourself by treaty election

The treaty election functions to prevent years from being counted toward the long-term resident test as long as you have not yet met that test. But once you qualify as a long-term resident, the treaty election works quite differently.

Let us use the same example as before, but we will change the facts slightly. Let’s say you got your green card in 2009 and filed your US return as a resident each year 2009-2016.

Before you file your 2017 return, you have 8 years toward the 8-year long-term resident test. You are a long-term resident.

If you make a treaty election to be taxed as a resident of another country (and as a nonresident of the US) on your 2017 return, that will be an act of expatriation.

Making the treaty election serves as an act of terminating lawful permanent residency:⁵

An individual shall cease to be treated as a lawful permanent resident of the United States if such individual commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, does not waive the benefits of such treaty applicable to residents of the foreign country, and notifies the Secretary of the commencement of such treatment.

Recall that termination of lawful permanent residency, once you have met the 8-year long-term resident test, is an act of expatriation:⁶

The term “expatriate” means, in the case of a long-term resident of the United States, the date on which the individual ceases to be a lawful permanent resident of the United States (within the meaning of section 7701(b)(6)).

Summary

The impact of making a treaty election to be taxed as a resident of another country (and as a nonresident of the US) depends entirely on whether you have already met the 8-year count for the long-term resident test at the time that you are making the treaty election.

If you make the treaty election BEFORE you have 8 years of the last 15 as a lawful permanent resident (excluding treaty election years), the treaty election will serve to prevent the year for which you make the election from counting toward the long-term resident test.

If you make the treaty election AFTER you have 8 years of the last 15 as a lawful permanent resident (excluding treaty election years), you are a long-term resident and the treaty election will serve as an act of expatriation.

Be careful and make sure you know which category you are in before you make the treaty election.

The post Treaty Elections, Long-Term Resident Status, and Expatriation appeared first on HodgenLaw PC – International Tax.

This week we are talking about dual-status returns. An email reader sent us this question, asking what his income tax return should look like in the year of expatriation:

I file 1040 covering income up to the date of renunciation. Do I have to file 1040NR from the date of renunciation to the end of the year if I don’t have any US source income at all for either before or after renouncing?

The expatriation year income tax return is a little more complicated than that. It is slightly difficult to figure out whether you need to file Form 1040NR or Form 1040 as your tax return. Once you have figured that out, then you figure out what income to report on the return, and what income you do not have to report.

In the year of expatriation, you must file a tax return with the IRS. There are three possibilities for what you are filing:

• Form 1040 treating yourself as a resident for the full year;
• Form 1040NR treating yourself as a nonresident for the full year; or
• Form 1040NR treating yourself as a part-year resident and a part-year nonresident (this one is the “dual-status return”).

If you are filing Form 1040NR as a nonresident for the full year, you only report income from US sources. Income from foreign sources is generally not taxed by the US.

If you are filing Form 1040NR as a part-year resident and a part-year nonresident, it is a little more complicated – for part of the year you will report income from all sources worldwide, and for part of the year you will report income from US sources only.

Let’s look at the details.

Your tax year

Human individuals file tax returns using a calendar year, or January 1 through December 31. There are a few rare exceptions to this rule, but we will ignore those.

When the IRS looks at your tax return for the year you renounce your US citizenship (or give up your green card) they will be expecting to see a return that covers the entire calendar year.

It might seem counterintuitive: Your filing requirements should end on the date that you renounce. But that is incorrect. All humans must use a full 12-month tax year, which almost always must be a calendar year (January 1 through December 31). The only humans who can use a short year (January 1 through a date earlier than December 31) are dead people; their tax years end on the date of death.

Your tax return

To figure out what tax return you must file, look at yourself on December 31 – the last day of the tax year. What are you on that date? Because you are no longer a citizen or green card holder, you are an “alien” for income tax purposes.

Resident aliens, if they have a tax return filing requirement, must file Form 1040 and pay tax on their worldwide income.

Nonresident aliens, if they have a tax return filing requirement, must file Form 1040NR.

The general rules

You will need to figure out if you are a “resident alien” or a “nonresident alien” of the US for income tax purposes on December 31 of the year you expatriate.

You are a resident alien (and file Form 1040) if you spent too many days in the US in the three-year period ending with the year of renunciation. This is known as the substantial presence test.

It might be possible for you to be a resident alien and make a treaty election to be taxed as a nonresident of the US. This is a complicated subject that I will not be discussing here, but you should be aware it is possible.

You are a nonresident alien (and file Form 1040NR) if you did not spend enough days in the US to satisfy the substantial presence test.

Special rules for expatriation year

Even if you meet the substantial presence test in the year of expatriation, you might still be a nonresident on December 31 of that year.

For citizens who renounce, you get to use your date of renunciation as your first day of nonresident alien status.

For green card holders who terminate their green cards, you can use what is known as an “earlier termination date” if you meet the criteria given in IRS Publication 519.

Not splitting the tax year

If you file Form 1040NR because you make a treaty election to be taxed as a resident of another country, you will be taxed as a nonresident for the entire year, and you will report your income from US sources only.

You will still be required to file all the information returns you would normally need to file – FBAR, Form 8938, Form 5471, etc.

Splitting the tax year

If you file Form 1040NR and you either do not meet the substantial presence test or you qualify for an “earlier termination date”, then you are what the IRS calls a dual-status taxpayer.

You will file a dual-status return.

For the part of the year that you are a citizen or green card holder, you report your income from all sources worldwide on your US tax return. This is from January 1 through the day before your renunciation date.

For the part of the year that you are considered a nonresident, you report your income from US sources only on your US tax return. This is from your renunciation date through December 31.

You will still be required to file all the information returns you would normally need to file – FBAR, Form 8938, Form 5471, etc.

IRS Publication 519 has some further guidance on how the dual-status return works.

Answering the question

Now we can answer the reader’s question.

He had no income from US sources. All of his income was from sources outside the US. Here is what he needs to report:

From January 1 through the day before renunciation, all income received by the taxpayer is taxable by the US. It is irrelevant whether it is foreign or US source – the IRS has this power based on the fact that the taxpayer is either a US citizen or green card holder.

From the date of renunciation through the end of the year, only US source income received by the taxpayer is taxable by the US. Since our reader had no US source income at all, he will be showing $0 of US source income for this time period on his tax return.

Usual disclaimer

Do not rely on this communication as advice to you, because it is not advice to you. You should get help from a professional if you need to make decisions.

The post Dual-Status: Expatriation Year Tax Returns when US Income is Zero appeared first on HodgenLaw PC – International Tax.

If you are an American living abroad and sweating the October 15, 2018 tax filing deadline for your 2017 income tax returns, there is a possible piece of relief. You may be able to qualify for a further extension of time for filing your tax return — to December 15, 2018.

Summary

For American taxpayers living abroad, if you want to get a filing deadline of December 15, 2018 for your 2017 Form 1040, do this:

• On or before June 15, 2018, file Form 4868.
• On or before June 15, 2018, pay whatever tax you have to pay for 2017, along with that Form 4868 you are filing.
• On or before October 15, 2018, write a letter and mail it to the IRS using the procedures I describe below.
• File your 2017 Form 1040 on or before December 15, 2018 with all of the stuff attached to it that I describe below. On a side note, December 15 falls on a Saturday this year so the deadline is technically on Monday, December 17, but I’ll continue referencing December 15. I also recommend aiming for Friday, December 14 to be safe.

Basic filing deadline: April 17, 2018

Everyone’s 2017 income tax return has a filing deadline of April 17, 2018. Internal Revenue Code Section 6072(a) says:

In the case of returns under section 6012, 6013, 6017, or 6031 (relating to income tax under subtitle A), returns made on the basis of the calendar year shall be filed on or before the 15th day of April following the close of the calendar year and returns made on the basis of a fiscal year shall be filed on or before the 15th day of the fourth month following the close of the fiscal year, except as otherwise provided in the following subsections of this section.

Human taxpayers–no matter where they live–are required to file income tax returns by the requirements of Internal Revenue Code Section 6012. That means the default filing deadline for human taxpayers filing income tax returns will always be April 15. It was April 17 this year because April 15 was a Sunday and April 16 was Emancipation Day, a holiday in Washington, D.C. (Well, I guess technically April 18 with the IRS systems fiasco).

Americans living abroad: automatic extension to June 15, 2018

Americans living abroad (this means your normal home is outside the USA) have an automatic extension to file their income tax returns. They get an extra two months, hardwired into the Treasury Regulations. No work is needed, and no paperwork is required, per Treasury Regulations Section 1.6081-5(a)(5):

An extension of time for filing returns of income and for paying any tax shown on the return is hereby granted to and including the fifteenth day of the sixth month following the close of the taxable year in the case of . . . United States citizens or residents whose tax homes and abodes, in a real and substantial sense, are outside the United States and Puerto Rico[.]

The sixth month after the closing of the tax year (December 31, 2017) is June. The fifteenth day of June is your deadline. You get this extension automatically if your tax home is outside the United States or Puerto Rico. Note that this automatic extension only applies to people who have their “tax home” outside the United States and Puerto Rico, or to military personnel posted outside the United States and Puerto Rico. If you are abroad temporarily (on vacation or for work), you do not get the automatic extension. The way you get this extension is simple. If you are filing your 2017 Form 1040 on or before June 15, 2018, all you need to do is write “Taxpayer Abroad” at the top of Page 1 of Form 1040 when you file it. The Instructions to Form 1040 give you this piece of information. If you do not believe the Instructions are trustworthy (and they sometimes are not), look at Treasury Regulations Section 1.6081-5(b)(1), which says:

In order to qualify for the extension under this section— (1) A statement must be attached to the return showing that the person for whom the return is made is a person described in paragraph (a) of this section[.]

You are claiming, because your true home is outside the United States and Puerto Rico, that you qualify for the automatic extension provided in Treasury Regulations Section 1.6081-5(a)(5). In this case, I would be pretty comfortable following the Instructions. Just write the magic words “Taxpayer Abroad” at the top of Form 1040, page 1. This, apparently, is all the IRS wants in order for you to assert that you are the kind of person who should qualify for the automatic extension. A paranoid person might write the words “Taxpayer Abroad” in big block letters using a red Sharpie.  This isn’t mandatory, but you do not get bonus points for being subtle.

Payment deadline for Americans abroad: June 15, 2018

Getting an extension of time to file a tax return is not the same as getting an extension of time to pay the tax due. Ordinarily, your tax return is due on April 15 (April 17, 2018 this year), and the IRS expects you to send in a check on or before April 17, 2018 to settle up any tax due for 2017. But Americans abroad not only get an automatic two month extension of time to file their 2017 income tax returns, they get a two month extension of time to pay their 2017 income tax liabilities. Again, look at Treasury Regulations Section 1.6081-5(a):

(a) An extension of time for filing returns of income and for paying any tax shown on the return is hereby granted to and including the fifteenth day of the sixth month following the close of the taxable year in the case of—

Interest starts accruing from April 17, 2018 for any unpaid tax no matter what however.

Extending the filing deadline from June 15, 2018 to October 15, 2018

Every human taxpayer, whether living in the USA or abroad, can use Form 4868 to get an extension of time to file tax returns. The extension is good for six months from the default filing deadline of April 15 — not the June 15 deadline that applies to Americans abroad. That puts the filing deadline at October 15, 2018 for everyone—Americans abroad and at home. You get this extension to October 15, 2018 by filing Form 4868 before the filing deadline that applies to you. For an American living in the USA, the April 17, 2018 deadline applies and Form 4868 must be filed before April 17, 2018. Otherwise you’re too late in applying for an extension. For an American living abroad, your automatically extended filing deadline is June 15, 2018. You have to get your Form 4868 filed before June 15, 2018. But filing on or before June 15, 2018 doesn’t get you (the American living abroad) an extra six months. It only gets you four months of extension. From the instructions to Form 4868:

If, on the regular due date of your return, you’re out of the country and a U.S. citizen or resident, you’re allowed 2 extra months to file your return and pay any amount due without requesting an extension. Interest will still be charged, however, on payments made after the regular due date, without regard to the extension. For a calendar year return, this is June 15, 2018. File this form and be sure to check the box on line 8 if you need an additional 4 months to file your return.

The two month extension (to June 15) that applies to Americans abroad runs concurrently with the automatic six-month extension (to October 15) that applies to everyone. Because the IRS has been known to claim in Tax Court that its own Instructions are wrong, we again look to the Inspired Holy Writ.  Treasury Regulations Section 1.6084-1(a) says:

An individual who is required to file an individual income tax return will be allowed an automatic 6-month extension of time to file the return after the date prescribed for filing the return if the individual files an application under this section in accordance with paragraph (b) of this section. In the case of an individual described in §1.6081-5(a)(5) or (6), the automatic 6-month extension will run concurrently with the extension of time to file granted pursuant to §1.6081-5.

An American living abroad is an “individual described in §1.6081-5(a)(5)” who gets the automatic six-month extension. So an American living abroad has two filing extensions running concurrently. Both start with the default filing deadline of April 15. One of them runs for two months and doesn’t require any paperwork. The other one runs for six months, and requires paperwork: Form 4868.

Extending the filing deadline from October 15, 2018 to December 15, 2018

All of that was the unnecessary excess information I promised. But good stuff, right? You have a great topic to bring up at cocktail conversations. Now you understand how you arrived at October 15, 2018, with a valid extension of time. You, the American abroad, filed a Form 4868 on or before June 15, 2018, and you paid up your 2017 tax liability at the same time. To get yourself an extra two months of time (December 15, 2018) to file your 2017 income tax return, you have to write a paper letter. Yes, we are off the fairway and into the rough. There are no tax forms for what we need to do next. First, let’s look at the law so you can see what it requires. Treasury Regulations Section 1.6081-1 is where you look in the Holy Tax Scriptures for the answer. Section 1.6081-1(a) gives the IRS the authority — in its discretion – to grant you an additional extension of time. Section 1.6081-1(b) tells you how to do it, and what to put in the letter. For your late-night reading pleasure, here is the entire Section:

1.6081-1(a) In General.

The Commissioner is authorized to grant a reasonable extension of time for filing any return, declaration, statement, or other document which relates to any tax imposed by subtitle A of the Code and which is required under the provisions of subtitle A or F of the Code or the regulations thereunder. However, other than in the case of taxpayers who are abroad, such extensions of time shall not be granted for more than 6 months, and the extension of time for filing the return of a DISC (as defined in section 992(a)), as specified in section 6072(b), shall not be granted. Except in the case of an extension of time pursuant to Section 1.6081-5, an extension of time for filing an income tax return shall not operate to extend the time for the payment of the tax unless specified to the contrary in the extension. For rules relating to extensions of time for paying tax, see Section 1.6161-1.

1.6081-1(b) Application For Extension Of Time—

1.6081-1(b)(1) In General.

Under other sections in this chapter, certain taxpayers may request an automatic extension of time to file certain returns. Except in undue hardship cases, no extension of time to file a return will be allowed under this section until an automatic extension of time to file the return has been allowed under the applicable section. No extension of time to file a return will be granted under this section for a period of time greater than that provided for by automatic extension. A taxpayer desiring an extension of the time for filing a return, statement, or other document shall submit an application for extension on or before the due date of such return, statement, or other document. If a form exists for the application for an extension, the taxpayer should use the form; however, taxpayers may apply for an extension in a letter that includes the information required by this paragraph. Except as provided in § 301.6091-1(b) of this chapter (relating to hand-carried documents), the taxpayer should make the application for extension to the Internal Revenue Service office where such return, statement, or other document is required to be filed. Except for requests for automatic extensions of time to file certain returns provided for elsewhere in this chapter, the application must be in writing, signed by the taxpayer or his duly authorized agent, and must clearly set forth—

1.6081-1(b)(1)(i)

The particular tax return, information return, statement, or other document, including the taxable year or period thereof, for which the taxpayer requests an extension; and

1.6081-1(b)(1)(ii)

An explanation of the reasons for requesting the extension to aid the internal revenue officer in determining whether to grant the request.

1.6081-1(b)(2) Taxpayer Unable To Sign.

In any case in which a taxpayer is unable, by reason of illness, absence, or other good cause, to sign a request for an extension, any person standing in close personal or business relationship to the taxpayer may sign the request on his behalf, and shall be considered as a duly authorized agent for this purpose, provided the request sets forth the reasons for a signature other than the taxpayer’s and the relationship existing between the taxpayer and the signer.

1.6081-1(c) Effective/Applicability Dates.

This section applies to requests for extension of time filed after July 1, 2008.

Let’s write a letter to the IRS

Now it is time to write a letter to the Internal Revenue Service. The key ingredients for this letter are:

• the specific tax return that you’re attempting to get an extension for; and
• the reason you need the extension.

Why a letter? The Treasury Regulations say so. The IRS told you to write a letter (because a form does not exist), and they’ve told you to provide the information required by “this paragraph.”

The tax return

Treasury Regulations Section 1.6081-1(b)(1)(i) asks you to tell the IRS what you need the extension for. They want to know:

The particular tax return, information return, statement, or other document, including the taxable year or period thereof, for which the taxpayer requests an extension[.]

Your letter should say:

“I request an extension to file Form 1040 for the 2017 tax year until December 15, 2018.”

The reason

Treasury Regulations Section 1.6081-1(b)(1)(ii) asks you for a reason. Why should the IRS grant you an extension of time from October 15, 2018 until December 15, 2018? The reasons you need an extension are usually along the lines of:

“I need more time to gather income and expense information necessary to accurately prepare my 2017 income tax returns. I live outside the United States and this takes additional time to accomplish due to communication and mailing delays.”

If there is a specific thing that is slowing you down, it is good to mention that as well. “I need information from MegaGiantJuggernaut Bank to compute my income on Form 8621 for foreign mutual funds I own” might be something useful to add.  If of course it is true. Or pick anything that applies to you, and add it to your letter. There is no magic language to use. Just be sure that your letter does NOT sound like “I sat around and played Procrastination Roulette and OMG it’s October already? Yikes!” Make your letter sound like you were a diligent little taxpayer and the successful completion of your appointed task is being prevented by people and events outside your control. The extra two months will give you the time to surmount those external forces.

Mailing address

You send the letter to the IRS Service Center where you ordinarily file your income tax returns. See Treasury Regulations Section 1.6081-1(b), which says, in relevant part:

Except as provided in §301.6091-1(b) of this chapter (relating to hand-carried documents), the taxpayer should make the application for extension to the Internal Revenue Service office where such return, statement, or other document is required to be filed.

For an American abroad, this is:

Department of the Treasury
Internal Revenue Service Center
Austin, TX 73301-0215

How to send it

Me? I would use a private delivery service: FedEx, DHL, etc. I have gone through the fights with the government about proof of mailing of tax returns when something was dropped in the mail in a postal service outside the United States and was that tax return filed timely or not according to the IRS. It’s worth the extra money to emphatically prove that something arrived at the IRS office. The way you prove that is through the power of capitalism. Use a private company like UPS, DHL, or FedEx that gets a signature and proof that your envelope arrived at the IRS. The IRS specifically permits you to use a Private Delivery Service. The three approved companies are DHL, FedEx, and UPS. If you use such a service, you will need to send the envelope to a street address. The IRS has a web page that gives you the street address for IRS Service Centers. If you are sending your extension request to Austin, Texas, the street address to use is:

Internal Revenue Submission Processing Center
3651 S IH35
Austin TX 78741

When?

Do not wait until October 15, 2018 to send that letter from a foreign country. SEND IT NOW. Everyone thinks “If I have it postmarked on that date I have filed my IRS stuff on that date.” Ain’t necessarily so, Bucky. “Postmarked by the loving Postal Service in [INSERT COUNTRY] on October 15, 2018″ does not mean, necessarily, that the IRS will treat you as having timely filed your request for an extension of time on or before October 15, 2018.

You won’t hear from the IRS

If you send in a letter requesting an extension of time to December 15, 2018 to file your 2017 income tax return, you won’t hear from the IRS. No file-stamped copy, no nuthin’. Just silence.

Filing your tax return

Your 2017 tax return will be filed before December 15, 2018. Attach these things to your tax return:

• A copy of your letter (festooned with copies of all of the various proofs of mailing that you can muster) to your tax return when you file.
• A copy of the Form 4868 that you filed on or before June 15, 2018.

Also write “Taxpayer Abroad” on the top of Form 1040, Page 1.  Red sharpie!  It can’t hurt.

Merry Christmas

Congratulations. By the time you finish with your 2017 income tax returns, it will December 15, 2018. It’s almost 2019, and time for you to start thinking about your 2018 income tax returns.

Disclaimer

Other forms have different filing deadlines.  So do not assume this procedure works for every form you have to file with the IRS.  A quick example off the top of my head:  Form 3520-A if you have a foreign trust.  The deadline for that is March 15.  This blog post just applies to Form 1040.

The post File an Income Tax Return Extension to December 15, 2018 appeared first on HodgenLaw PC – International Tax.

Today’s topic: A quick overview of the exit tax

The term “exit tax” is not used or defined in the Code or regulations anywhere. It is a shorthand to describe the federal law that requires some citizens and green card holders who are leaving the US tax system to pay US tax, one last time, on their worldwide assets.

The defining feature of the exit tax is that all assets are treated as if they are sold on the day before citizenship or resident status is terminated. If there are any profits from the pretend sale, you pay tax on those profits. This is the “mark-to-market” feature of the exit tax.

There are some assets – certain types of retirement accounts, trust interests – that also are subject to income tax acceleration.

The general idea is that, when you expatriate, the US gets to tax you on items that may be out of its reach after your expatriation. You get a step-up in basis for the items subject to the mark-to-market sale, so if you have any assets that remain within the reach of the US tax system, the appreciation of the assets is not taxed again when you sell them.

Why does the exit tax exist?

The theory behind the exit tax is fairly simple: Without the infrastructure created by governments, individuals would not be able to obtain wealth. When you exit a nation’s tax system, that nation wants to be able to collect tax for the wealth you have accumulated using its infrastructure.

The United States is not the only country that has an exit tax. There are other countries that impose similar rules. But the United States is unique in that it ties the exit tax to immigration status.

A Canadian who moves abroad can be taxed as a nonresident while remaining a Canadian citizen, for example. An American citizen who wishes to be taxed as a US nonresident must relinquish US citizenship in order to do so.

The reason for this distinction – taxation tied to a change in nationality or immigration status – is that the US is unique in the way that it taxes individual humans. While you may have heard quite a bit in the news over the last year or so about the US adopting a “territorial” tax system, that is only true for corporations. Individuals must still operate within what is called a “citizenship-based” or “worldwide” tax system: If you are a US citizen, you are taxed on worldwide income and assets.

Every other country follows a “residence-based” tax system for individuals: If you are a resident, you are taxed in that country. If you are a nonresident, you are not taxed in that country.

This is why Canada (residence-based) allows its citizens to live abroad and be taxed as nonresidents, while it is impossible for the US (citizenship-based) to do so. The US has tied nationality to taxation.

Another way to say this is that if you want to remove the US tax system from your life, there is only one way to do it: You must cease to be a US citizen or resident (for income tax purposes).

Who should care about the exit tax?

The exit tax applies to only two categories of people:

• US citizens, and
• “Long-term residents” – these are US permanent residents, or “green card holders”, who have had that status for a certain amount of time.

If you are not in one of those categories, then the exit tax will not apply to you and you do not need to read further.

What must happen for the exit tax to apply

You are not subject to the exit tax rules simply because you are a US citizen or long-term resident. There are two more critical requirements:

1. An event occurs that terminates your citizenship or long-term resident status, and
2. You “fail” certain financial and/or paperwork tests.

Let us look at both of those requirements.

Status change to trigger expatriation

If you are a US citizen or long-term resident and retain that status indefinitely, no exit tax will apply to you because no “exit” from the US tax system has taken place. A critical requirement for the exit tax to apply is that an event must occur that terminates your citizenship or long-term resident status.

It is this equation – status as US citizen or long-term resident, plus an event that terminates that status – that makes you what is called an expatriate.¹ Only expatriates have to worry about the exit tax.

The formula looks like this:

Starting status + status-changing event = expatriate.

Starting status

There are only two categories of people to whom the exit tax can potentially apply:

• All US citizens, and
• Some US green card holders.

People who are residents of the US under a different type of visa have no risk of being subject to the exit tax when they become nonresidents.

A US citizen who relinquishes US citizenship will always be an expatriate.²

A green card holder who terminates his green card will be an expatriate only if he is a “long-term resident”.³ This requires the person to have held the green card for a sufficiently long period of time under a count-the-years test.

But “a sufficiently long period of time” is not as simple as just counting the years. If the green card holder elected to be taxed as a resident of another country under a tax treaty for any entire tax year, that year will not count toward the count-the-years test. This subject will be the focus of a separate edition later in the year.

Status-changing event

A citizen or long-term resident becomes an expatriate if his personal status changes from either citizen to nonresident alien or from green card holder (and specifically long-term resident) to nonresident alien.

A green card holder also becomes an expatriate if, once he has become a long-term resident, he makes a treaty election to be taxed as a nonresident of the US for income tax purposes.

On or after June 17, 2008

The US law on expatriation changed in the middle of 2008. All discussions that take place here will be in reference to people who expatriate on or after June 17, 2008. In other words, we are only talking about the rules as they exist right now.

A different set of rules applies to people who expatriated before that date.⁴ If you expatriated before June 17, 2008, what I talk about here does not apply to you.

Analysis: Does the exit tax apply to you?

All people who expatriate have to file some extra paperwork when they expatriate. Some also have to pay exit tax. Here is how you see whether the exit tax applies to you.

Are you an expatriate?

First, determine whether you are an “expatriate”. If you were a US citizen or long-term resident, and then terminated that status, you are an expatriate.

If you are not an expatriate, then the exit tax does not apply to you. If you are an expatriate, proceed to the next step to see whether you need to pay exit tax.

Are you a covered expatriate?

Next, you need to know whether you are a “covered” expatriate to see if you have to pay exit tax. Covered expatriates are subject to exit tax. Non-covered expatriates are not subject to exit tax.

There are three tests to check for covered expatriate status. If you satisfy (or fail, depending on your point of view) any one of these three tests, then you are a covered expatriate:

1. You are “too rich” because your net worth was $2 million or more when you expatriated, or
2. You are “too rich” because your average US tax bill for the five years before expatriation was above a certain threshold (indexed for inflation each year), or
3. You didn’t file your tax returns correctly or pay all your tax for the five years before expatriation.

Consequences of being a covered expatriate (hint: exit tax)

If you are a covered expatriate, then you have to file the same tax return paperwork as regular, non-covered expatriates.

In addition, you are also subject to the exit tax. You will have to pretend that you sold all your worldwide assets on the day before your expatriation. You will pay US tax on the gains from the pretend sale.

You also have to pretend that you received distributions in full from your IRAs and most foreign pension plans. Some other types of retirement assets and trust interests trigger immediate taxation, as well.

The impact of expatriation does not end with you. US persons to whom you make gifts or leave an inheritance also must pay tax on what they receive from you.

Where to find the law

The exit tax law is found in Internal Revenue Code section 877A. The only other significant communication from the IRS on how the exit tax works is found in IRS Notice 2009-85, Guidance for Expatriates Under Section 877A.

Some definitions from section 877 (the section that contains the old, outdated expatriation rules) still apply.

There are no regulations to accompany either section 877 or 877A.

Section 2801 of the Internal Revenue Code contains the rules that impose tax on the recipients of gifts or inheritances from covered expatriates. Proposed Regulations have been published and will likely become Final Regulations at some point.

Special tax forms

There are three special forms you should be aware of as an expatriate. One of them does not exist yet:

1. Form 8854 must be completed by all expatriates, covered or non-covered.
2. Form 708 (not yet published) is what a US person files to report the receipt of a gift or inheritance from a covered expatriate.
3. Form W-8CE is one of the W-8 series forms, used to tell a withholding agent that a recipient of a payment is a covered expatriate.

I have heard, but cannot verify, that it is possible we will see a Form 708 and Final Regulations for gifts and inheritances from covered expatriates soon.

A note about grammar

When people to speak to each other in normal conversation, the word “expat” is used to describe someone living outside his home country. Expat is, of course, short for expatriate.

The Internal Revenue Code has taken that word and given it a specific meaning for US tax law: a citizen or long-term resident who ceases to be a citizen or long-term resident.⁵ This is different from how people normally use “expatriate”.

The word can also be used as a verb, although it is never used that way in the Internal Revenue Code. When I say it as a verb, I use “to expatriate” to mean the act of terminating one’s citizenship or long-term resident status.

This usage of the term “expatriate” generally has been and will continue be consistent throughout all of our articles – as both a noun, using the tax law meaning of the term (and not the common usage), and a verb, to mean the action you take to become an expatriate.

See you next month

Thanks for reading. Next month, I will talk about how US citizens expatriate, including a somewhat detailed discussion of precisely when a citizen who terminates her citizenship becomes an expatriate.

As always, please don’t try to get your tax advice from a blog post. It probably won’t work out well for you. Hire someone to help you if you want advice that is relevant to your situation.

Debra

The post Exit Tax Book Chapter 1: A Quick Overview of the Exit Tax appeared first on HodgenLaw PC – International Tax.

What’s an American Minimultinational?

What do I mean by American minimultinational?

Multinational

A multinational business operates in multiple countries, exposed to multiple tax-hungry governments. Apple. General Motors. Exxon.

A minimultinational is a multinational business, but smaller.

• Do you have 100 people in a cubicle farm working on your international tax stuff? You’re a multinational.
• Is that thought ludicrous bordering on insane? You’re a minimultinational.

American

An American minimultinational is one that is owned by a U.S. citizen or resident.

Merely by having a U.S. citizen or green card holder as an owner, a business that operates 100% outside the United States is a multinational business. It is exposed to the tax system of the country where it operates (because it’s based and operating in that country), and it is exposed to the U.S. tax system because of the citizenship/resident status of its owner.

• The company might be based in the United States and do business abroad.
• Or it might be entirely based abroad — with no customers or business activities in the United States. These are the companies that interest me most.

In summary

• American because the company is based in the USA and does business abroad, or because a 100% foreign business is owned by an American citizen or resident.
• Minimultinational because the company is bigger than a lemonade stand and smaller than General Motors.

Who?

The series is for American entrepreneurs living abroad, running normal businesses. Specifically, you have a business that looks approximately like this:

• You’re an American citizen or green card holder. You own a business.
• It’s a normal, everyday business. Could be a tech operation, could be a janitorial service.
• It’s profitable. Let’s arbitrarily use a threshold of $1 million/year profit.¹
• You probably don’t have a CFO, or if you do, your CFO doesn’t have the time or training to devote to U.S. tax planning.

Complexity

More to the point, you are squeezed by complexity from all sides.

I know that life because I live that life.

This series is intended to give you, the American entrepreneur, just enough information to make good decisions on how to remove (tax) complexity from your life.

Why a problem exists

The United States asks its citizens and residents to pay U.S. tax on their worldwide income.²

The request extends to the businesses that American taxpayers own. Thanks to a dramatic change in U.S. tax law, it is likely that most of an American minimultinational’s net profit will be taxable in the United States every year.

In a nutshell:

• Your personal income is taxable in the United States, no matter where you live and where you earn it; and
• Your company’s net profit is (probably) taxable in the United States, even if you have no business operations in the United States at all.

If you live and do business in a country with an income tax, your home country probably wants to tax your personal income and your business profits as well.

This creates complexity.³

The upcoming episodes

Here’s where we’re going with the series. Remember that I reserve the right to change things as I go. And I will definitely take input from you, dear reader, about places to go and dead ends to avoid.

01. Overview of the series

• Tax concepts overview. What are the features of U.S. tax law that make running an American minimultinational so brutal?
• Structures overview. Why choosing a business structure correctly makes such a big difference in outcomes.
• Introduce the default structure we will look at: a U.S. citizen lives abroad, owns 100% of a foreign corporation that is engaged in business in the country of residence.
• Give a preview of the coming attractions.

02. Why business profit is (mostly) taxable

• The types of business profit you (as an owner) will be taxed on, even if your business doesn’t distribute a dime of cash to you.
• With a minimum of jargon, explain how the tax rules these types of business profit work.⁴

03. Cash distributions

• Your foreign corporation had business profits that you paid U.S. tax on. Then it paid you a dividend. Do you pay tax again? Maybe! Let’s look at the impact of choosing the right business structure.

04. Good corporations, bad corporations

• The U.S. tax system sees good foreign corporations and bad foreign corporations: Controlled Foreign Corporations and Passive Foreign Investment Companies.⁵
• I attempt to explain it all ELI5-style. You will decide whether I succeed.

05. An overview of structure choices

• An overview of the different structures you can choose for your American minimultinational.
• What are the criteria you use to judge whether one structure is better than another? Less tax, sure. But what else?

06. Just use a U.S. corporation

• A discussion of how a U.S. citizen living/working abroad uses a U.S. corporation to run a minimultinational.

07. Direct ownership of a foreign corporation

• The classic default situation for a U.S. citizen entrepreneur living abroad. You form a corporation in your home country because that’s how people do business.
• What are the U.S. tax consequences?

08. Direct ownership plus Section 962

• The classic default situation for a U.S. citizen entrepreneur living abroad. You form a corporation in your home country because that’s how people do business.
• But you don’t like the U.S. tax consequences. Here’s a special election that might/might not help.

09. Sole proprietorship or disregarded entity

• What if you get rid of the corporation? It’s a dreadful source of tax complexity and potential penalties. Just do business as you–a sole proprietor.
• Or if you need a business entity, make a special tax election to make your foreign company invisible (mostly) for U.S. tax purposes.

10. Parent/subsidiary

• This is probably the new default “best idea” for American minimultinationals: a U.S. holding corporation that owns your foreign corporation. How does it work? What are its benefits? What are its drawbacks?

11. Dual-resident corporation

• You know about people who hold two passports, right? Dual citizens. Well, you can do the same thing with corporations. A company can simultaneously be a domestic limited company for U.K. tax purposes and a domestic corporation for U.S. tax purposes. Cool, no? We will look at this strategy and see if it saves tax, reduces paperwork, and mixes fine cocktails for happy hour.

12. Conclusion and “Into Action”

• Wherein we wrap up loose ends and explore concrete “next action” steps that the American entrepreneur can take.
• Plus I will try to hardwire a cliff-hanger into the plot to get you to return for Season 2.

The post American Minimultinationals: An Introduction appeared first on HodgenLaw PC – International Tax.

American minimultinationals are small (for various definitions of “small”) business enterprises subjected to the U.S. tax system.

There are many ways that a minimultinational becomes exposed to the U.S. tax system. Doing business in the United States is an obvious way. If you have an office or employees in the United States, some portion of your business profits will be taxed.

I focus here on businesses that operate mostly or entirely outside the United States but are owned by U.S. citizens or residents. This factor alone–ownership by a U.S. person–means that the business profits will be exposed to U.S. income tax, even if the business never operates in the United States.

In this chapter I give a brief overview of the reasons–technical and practical–why tax planning is so brutal for minimultinationals.

Then, I introduce you to my “Buckets and Pipes” theory¹ of tax planning. Plumbers make sure that water flows where it is supposed to go, without leaks. Tax lawyers create plumbing systems so money can flow from one place to another.

I conclude with a global view of all of the types of business structures there are. Or, at least, I list every genus that I can think of, because species variations within a genus are infinite.

Why Tax Planning is Brutal for American Minimultinationals

In brief, because tax law is borderline insane, you’re dealing with multiple countries’ worth of insanity. Megacorps can buy their way around the problem, but you can’t.

Let’s explore, shall we?

Many Crocodiles in the River

The first (and obvious) reason that minimultinationals face problems with tax planning is because there are multiple countries who assert the right to tax business profits.

Most countries have a residence-based system of taxation: if you live here, or if you do business here, we will tax your income. Our American minimultinational owner living and doing business in France would probably (in the eyes of the French tax collectors) look like a resident and be asked to pay French income tax personally, and business profits would be taxable in France as well.

The United States asserts the right to tax its citizens and residents (green card holders, for our purposes) on all of their income, no matter where those citizens or residents happen to be on the planet. So our American minimultinational owner in France pulls a salary from the business? The United States expects to see some U.S. income tax paid on that salary, barring some workaround that might prevent tax–and there are workarounds.

Congressional Fiction and Your Money or Your Life

Income tax on our American minimultinational owner’s salary is not what we care about. We care about the business profits.

The minimultinational is an active business enterprise with operations and customers entirely outside the United States. Wherever it is operating, this same “taxation based on residence” concept will apply to the minimultinational. “Resident” corporations are defined in a host of ways by different countries’ tax laws. But with certainty: if a business is operating in a country (employees, offices, customers, etc.), it will be a resident under almost all definitions, and its business profits taxed there.

The United States also asserts the right to tax the business profits of that business enterprise–even if the business activities never touch the United States. In Chapter 2, I will give you the gory technical details. But for our purposes it is sufficient to say that almost all business profits of an American-owned minimultinational will be taxable in the United States.

How does the United States assert the right to, for instance, tax the business profits of a French corporation doing business entirely in France?

Quite simply, it doesn’t. The French government wouldn’t put up with that claim for a minute. Instead, the U.S. government relies on its right to tax U.S. citizens and residents.

If you are a U.S. citizen and you own all of the shares of a French corporation, U.S. tax law creates a fiction:

“Let’s pretend that all of the profit earned by your French corporation is somehow magically distributed to you, the U.S. citizen human, even if no money was in fact ever distributed to you. Guess what! You personally have taxable income and must pay U.S. income tax on that.”

Now the U.S. citizen human–our American owner of a minimultinational–is faced with a classic “Your money or your life” situation. U.S. tax law, via a self-created fiction, forces the American to either pay U.S. tax on the French corporation’s profit, or go to jail for tax evasion.

Downside Risk

The United States has created a system where–to use my patented “buckets and pipes” metaphor–we pretend that profits flow smoothly from a foreign corporation to a U.S. citizen’s personal income tax return, where those foreign profits are taxed.

Legislative fiction begets complexity. Or, to quote noted international tax scholar Walter Scott:²

Oh, what a tangled web we weave
When first we practise to deceive!

Now that we have introduced a fiction, we need more fiction, workarounds, and exceptions to solve the problems that our original fiction created.

And this creates risk for the minimultinational. The rules are baroque, and over any considerable period of time Congress makes them worse—never better. You are quite likely to get it all wrong.

And getting it wrong does not just cost more tax. Getting it wrong will cost more penalties. There are a host of penalties in tax law generally, because we are a Nation of Puritans who believe in Punishing the Iniquitous.

As a general proposition in international tax matters, the rule of thumb is simple:

Accidentally missing a piece of paper that the government wants you to give them is a $10,000 penalty, minimum.

I remember well the first project like this that I worked on as a Young Tax Lawyer^TM. A small ($10M per year) company had three even smaller subsidiaries in three different European countries. They didn’t know about Form 5471, so had never filed it. An audit occurred. The Revenue Agent discovers the problem. Three missing Form 5471s times three tax years (“Lemme tell you how nice I’m being to you”) equals $90,000 of penalties. Hilarity ensued.

Imagine getting a gratuitous invoice from the IRS for $90,000, with the implicit “Your money or your life” threat behind it. A minimultinational cannot stand too many cash flow hits.

Talent

Tax law is complicated enough. The international tax rules are an overlay on top of the regular tax laws. So if you have a corporation, you look at Subchapter C of the Internal Revenue Code plus Subchapter N (the international stuff). If you have a partnership, it’s Subchapter K plus Subchapter N. And I’m not counting the gratuitous misfiled and hidden little gems littered about the Internal Revenue Code that you need to remember.

Finding people who are good at this stuff is hard. Very hard. They tend to be overworked. And expensive. Accounting requirements, legal fees, and tax return preparation costs balloon disastrously when an American business goes international.

You Can’t Solve This Problem With Money

Bluntly put, a minimultinational cannot buy its way out of the tax problem—even with a total willingness to pay whatever tax is owed. (And I highly recommend that you file tax returns on time and pay the tax on time. Live free.)

Google can “lobby” politicians. You, dear minimultinational owner, will never see enough money in your lifetime to turn the head of a Federal politician.

Google can pay for cubicle farms of people to analyze and manage its tax affairs. You can’t.

So you’re going to have to be smart. Sometimes you need the Regular Army. Sometimes you need ninjas. Google has armies. You need a ninja or two to fight this battle.

Structure Overview

It’s all Buckets and Pipes.

Humans, when you look at it, are simply self-propelled filtration devices designed to ingest coffee and then . . . well, you get the idea.

Businesses are the same. What is a business but a method for moving money from one place (a customer’s wallet) to another place (an entrepreneur’s wallet)? This is an honorable and valuable human activity. Flowing the other way–from the entrepreneur to the customer–is the creation of value in the eyes and heart of the customer. The customer is demonstrably better off in the transaction. That is why the customer willingly exchanges money for a product or service.

So if we look at businesses as a flow of money (in one direction) and value (in the other direction), it’s easy to see where tax planning fits in.

Tax planning is the creation of financial plumbing to move money from a customer to the entrepreneur with minimum leakage.

There are two types of leaks. One is tax. The other is the transaction cost of creating and maintaining the financial plumbing system: accounting, tax returns, penalties, clever tax lawyers like me, and adjusting the plumbing system to random new tax laws created by non-Skin in the Game³ politicians.

Create your business structure to minimize leaks and make it adaptable to whatever our friends in Washington DC choose to do. Well, as adaptable as possible.

The Received Wisdom in international tax planning for many decades until December 2017, was deferral. Set up a foreign corporation, do business through that corporation, and avoid various landmines hidden in the Internal Revenue Code.

If you did that, that foreign corporation’s business profits would not be immediately taxable in the United States. The business profits would only be taxed in the United States when, for instance, the foreign corporation paid a real dividend to its U.S. shareholders.

In December 2017, Congress took all of the puzzle pieces, put them back in the box, shook the box, and dumped out the pieces and said “start over”. American entrepreneurs abroad with decades of business operations and retained earnings suddenly faced an enormous tax bill. “Come to Jesus” indeed. I saw people who faced retirement ruin because of this. Apple and Google bought the right kind of law for their purposes. The minimultinationals of the world were simply collateral damage. (I’m talking about Section 965, if you want to ask the internet about this specific tax law).

Your financial strategy should not rely on Congress for success. They don’t care about you.⁴

The Universe of Choices

It’s easy to catch a fish. Just drain the lake and pick up the fish you want.

Similarly, it’s easy to pick the right business structure. Just list the entire universe of possibilities and cross off the ones that don’t work.

Here are all of the types of business structures that I can think of. Over the course of this series we will talk about all of them. We will be looking at how efficient they are–as financial plumbing.

For our purposes, assume that we have a single-owner minimultinational. Here are the structure choices:

That’s the bait to keep you subscribed. I will talk about each of these structures in upcoming episodes.

Next Time

Why U.S. tax law is so pernicious: a simple explanation of Subpart F income and GILTI. I am going to acquaint you with the way the U.S. system works so you know what you’re dealing with.

And I’m going to live dangerously. I will limit myself to two pieces of tax jargon (“Subpart F” and “GILTI”) and attempt to limit myself to words with one or two syllables. Let’s see how that works!

1. Patented, trademarked, copyrighted worldwide, protected by barbed wire, starving hyenas, a moat filled with crocodiles, and your grandmother’s disapproving gaze. 
2. Walter Scott, Marmion, Canto VI, stanza XVII. 
3. Skin in the Game: Hidden Asymmetries in Daily Life, by Nassim Nicholas Taleb 
4. YouTube. Don’t click on this link if potty-mouth words offend you. Places like this and bands like this (and specifically this band) occupied most of my free time in law school. I’m better now, thank you very much. 

The post Minimultinationals Chapter 01: Overview of the Series appeared first on HodgenLaw PC – International Tax.