PERSONAL USE OF CORPORATE PROPERTY IN A USRPI HOLDING COMPANY STRUCTURE

To insulate the ultimate individual owners from U.S. estate taxes, nonresident aliens often hold U.S. real property in a U.S. corporation, which corporation is owned by a foreign corporation. The foreign corporation is owned by the ultimate nonresident alien owners (either directly or through intermediate non-U.S. entities).

If the real property is a residential unit that will be personally used by the individuals involved (or other family members or friends), the payment of rent for the personal use should be considered. A recent Tax Court case illustrates the results that can arise when there is no rental payment.

The case advises us:

1. Holding the property in a corporation does not automatically create deductions for residence expenses and depreciation. Trade or business activity is needed for deductions to be allowed under Code §162. The Tax Court denied the corporate deductions for these items since there was no trade or business activity.
2. However, some “incidental” personal use will not void otherwise applicable trade or business expenses (“In  general, where the acquisition and maintenance of property such as a yacht or a residence are primarily associated with profit-motivated purposes and personal use can be said to be distinctly secondary and incidental, a deduction for maintenance expenses and depreciation will be permitted. Int’l Artists, Ltd. v. Commissioner, 55 T.C. 94, 104 (1970)”). However, in the case at issue the personal use was primary, not incidental.
3. Personal use of the property without rent will constitute a deemed distribution from the U.S. corporation to its foreign parent corporation, with additional deemed distributions through the entire ownership chain on down to the individual stockholders.
4. The amount of the deemed distribution is the fair rental value of the personal use.
5. Such distributions will be taxed as dividends to the extent of earnings and profits of the paying entities. Absent an income tax treaty applying, such dividends from the U.S. corporation to the foreign parent corporation will be subject to 30% withholding if a “dividend” (i.e., to the extent of E&P). The case was remanded to determine the earnings and profits of the U.S. corporations.
6. A question that was not addressed was whether there were any “deemed rent payments” that could give rise to constructive earnings and profits. This would create E&P that could be used to create taxable dividends. Absent such constructive E&P, presumably there would not be much, if any, E&P in the U.S. real property holding corporations.
7. Even if there is no E&P, the deemed distributions will be treated as either return of capital or capital gains under Code §301. This could alter future computations of capital gain on sale or liquidation and/or eventually create current capital gain from deemed rent once the aggregate deemed distributions exhaust the tax basis in the shares of the company.
8. The inclusion of rental income on the tax return of the U.S. corporation (which occurred here at the suggestion of the clients), absent an actual rent payment, does not avoid these issues.

Note that similar principles can apply to real property owned by LLC’s and dividends (albeit without the application of U.S. withholding taxes on E&P distributions under the corporate income tax rules).

Thanks to Carlos Somoza of Kaufman, Rossin & Co., P.A. for sending me a copy of this case.

G.D. Parker, Inc. v. Comm., TC Memo 2012-327

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PARTIAL WIN FOR GOLFER IN TREATY CASE

A recent Tax Court case addressed some interesting athlete and treaty issues. The Court ended up siding with the golfer on some, but not all, of the golfer's positions.

Sergio Garcia is a professional golfer. In the tax years at issue, he was a party to an endorsement agreement with TaylorMade Golf Co. Garcia was obligated to use certain TaylorMade products, both on and off the golf course (the "personal services" income). TaylorMade also had the right to use Garcia's name and image in advertising and other promotions (the "royalties" income). The distinction between personal services income and royalties income was important because under the applicable Switzerland - U.S. income tax treaty, royalties income is taxable only in Switzerland. Personal services income could be taxed by the U.S. as to personal services performed in the U.S.

ALLOCATION OF PAYMENTS BETWEEN ROYALTIES INCOME AND PERSONAL SERVICES INCOME. The endorsement agreement allocated 85% of the TaylorMade payments to Garcia as royalties income, and the rest as personal services income. The IRS claimed, at least initially, that all of the payments were for personal services. 

The Tax Court rejected that the contract allocation was binding based on a claim that the parties were adverse to each other in making this allocation. The Court did not believe that TaylorMade was adverse to Garcia simply because it did not want to suffer the bad publicity of the IRS disputing its tax allocation.

The Tax Court determined that 65% of the income was royalty income, thus reducing Garcia's claimed percentage but still allowing him a major allocation to royalties. This was a factual analysis, but the Court borrowed from other cases (including Goosen v. Commissioner) that dealt with similar contracts. The case is instructive for others as to the factors the Court will review in testing such allocations.

WHAT PORTION OF PAYMENT QUALIFIES AS A ROYALTY? The key test employed was what portion of the payments were "for the right to use a person's name and likeness...because the person has an ownership interest in the right."

SUPREMACY OF ROYALTIES ARTICLE OVER ARTISTES AND SPORTSMAN'S ARTICLE OF TREATY. The royalties article of the treaty gives exclusive taxing jurisdiction of royalties to Switzerland  - “Royalties derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State.”  To be able to tax the royalties payment, the IRS argued that as an athlete, the Artistes and Sportsmen article overrides the royalties article and applied to Garcia, thus allowing the U.S. to tax those payments  - "income derived by a resident of a Contracting State as an entertainer, such as a theatre, motion picture, radio, or television artiste, or a musician, or as a sportsman, from his personal activities as such exercised in the other Contracting State may be taxed in that other State.” 

In resolving disputes between the articles, the Treasury Technical Explanation provides that "the controlling factor will be whether the income in question is predominantly attributable to the performance itself or other activities or property rights.”  Applying this test, the Court found that:

we believe that even though petitioner's golf play and personal services performed in the United States has some connection to his U.S. image rights, income from the sale of such image rights is not predominantly attributable to his performance in the United States. Rather, the image rights are a separate intangible that generated royalties (as defined by article 12(2)) for petitioner when TaylorMade paid him for their use. 

Thus, the Court concluded the royalties article prevailed and that the U.S. had no jurisdiction over the royalty portion of the payments.

SERGIO GARCIA V. COMM., 140 TC No. 6 (3/14/2013)

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APPLICABLE FEDERAL RATES–APRIL 2013

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NRA GAIN ON SALE OF PARTNERSHIP INTEREST TREATED AS CREATING EFFECTIVELY CONNECTED INCOME

Nonresidents are generally not subject to U.S. income taxes on their capital gains if present in the U.S. for less than 183 days in the tax year. Code Section 741 treats the gain from the sale or exchange of a partnership interest as capital gain (subject to some limited exceptions). Therefore, if a nonresident who has been in the U.S. for less than 183 days sells a U.S. partnership interest, then it appears that any resulting gain is capital gain, which is not subject to U.S. income tax.

A recent Legal Advice Issued by Field Attorney advises that such gains will be subject to U.S. income tax if the partnership was engaged in a U.S. trade or business. The LAFA strings together several Code provisions to support this conclusion, but such provisions do not fully resolve the issue (contrary to the IRS’ position).

Code Section 875(1) states that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.” This provision thus supports the conclusion that the NRA partner of a partnership that is engaged in U.S. trade or business is himself deemed engaged in a U.S. trade or business. However, the partnership interest of the partner is not directly used in the business. Therefore, Code Section 875(1) without more should not convert the gain on sale of a partnership interest into effectively connected income (ECI) that is taxable to the NRA.

Code Section 864(c)(2) looks like it may support such gain as ECI when it provides that ECI includes (A) the income, gain, or loss is derived from assets used in or held for use in the conduct of such trade or business, or (B) the activities of such trade or business were a material factor in the realization of the income, gain, or loss. But the face of the statute again does not provide direct support to ECI since under (A) the partnership interest itself is not used in the trade or business, and it is unclear how under (B) the partnership trade or business activities become a material factor in the sale of the partnership interest.

The foregoing nontaxation arguments have force when the partnership is viewed as an entity. However, we all know that the IRS at times will treat a partnership as an aggregate of its assets and treat its partners as owning such assets. It is by applying an aggregate theory that the IRS counsel concludes that the sale of the partnership interest generates ECI for the selling NRA partner. However, given the express entity methodology used in Code Section 741, a strong argument against the use of the aggregate theory here exists.
                              
The IRS is not without support in this area. Rev.Rul. 91-32 supports the use of the aggregate theory in this context, and the IRS counsel cites to it.

There have been proposals to codify Rev.Rul. 91-32 in recent years. However, the very existence of such codification attempts raises the question of the correctness and authority of the Revenue Ruling until the Code is changed.

Notwithstanding this IRS analysis and Rev.Rul. 91-32, there are those that still consider this an unresolved issue, at least until some court weighs in on the issue.

Note that if the gain is not subject to tax, Code Section 754 may operate on the sale to step up the basis of the partnership assets, thus reducing future gains on sales of assets by the partnership allocable to the sold partnership interest.

Legal Advice Issued by Field Attorney 20123903F

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MERE RECORDING OF DEED DOES NOT COMMENCE FOUR YEAR STATUTE OF LIMITATIONS ON FRAUDULENT CONVEYANCE [FLORIDA]

Under fraudulent conveyance law, a creditor of a debtor can reach property of the debtor that the debtor transferred to third parties if the transfer is a fraudulent conveyance. However, Fla.Stats. §726.110(1) provides that an action to reach such transferred property must be commenced within 4 years of the transfer, or if later, within 1 year after the transfer was or could reasonably have been discovered. Thus, if the transfer occurred more than 4 years ago, a creditor cannot sue if the property owner can show that the transfer “was or could reasonably have been discovered” within the preceding 1 year period. If the transfer was not discovered and could not reasonably have been discovered, then the statute of limitations does not expire – hiding the transfer will not yield a reward to the transferor or the transferee. 

In a Florida case, the subject property was Florida real estate. A transfer was made by the debtor, and a deed was recorded in the public records. The current owner of the real estate claimed that the recording of the deed put the creditor on notice and since both the 4 year period and the 1 year period had expired since recording, a fraudulent conveyance claim against the current owner was time barred. More particularly, the issue was whether the recording of a deed constitutes such notice that a creditor “could reasonably have discovered” the transfer for purposes of the above rules. 

The trial court dismissed the fraudulent claim as time-barred. However, the 1st District Court of Appeals reversed and held that the mere recordation of the deed was not enough notice to start the 1 year rule of the statute as being a transfer that is reasonably discoverable. The DCA noted that recording statutes are there to put third persons who have a reason to examine the records on notice of a transfer – such as subsequent purchasers or would-be lienors. Authorities in other jurisdictions typically (but not unanimously) distinguish between subsequent purchasers and creditors alleging fraudulent transfers int his context. 

The DCA ultimately determined that: 

It is not reasonable to require a defrauded creditor to monitor the land records in all 67 couties or, indeed, outside the state, as well, as a routine practice.

Desak v. Vanlandingham, 37 Fla.L.Weekly D2354 (1st DCA)

CO-GUARANTORS LIMIT AMOUNT AT RISK

Code §465 limits deductions for taxpayers in business and investment activities to the amount the taxpayer has "at risk" in the venture. Amounts of owners that are contributed to capital are generally at risk. Also at risk are amounts that are borrowed by the venture, and for which the taxpayer is personally liable for repayment or has pledged property as security for repayment.

However, Code §465(b)(4) provides that the taxpayer is NOT at risk for amounts for which the taxpayer is ‘protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements." A recent Chief Counsel Advice explores this limit in context of an LLC owner that guarantees debt of an LLC.

The first issue raised in the CCA was whether the guarantor's rights of indemnification against the LLC borrower protected the guarantor against loss under Code §465(h)(4). That is, under state law, a guarantor who has to pay is entitled to be indemnified for the payment made against the original borrowing party. Here, the Chief Counsel's  office recognized that this indemnification right was meaningless since if the LLC did not pay the debt it would be because it had no assets to do so. Therefore, notwithstanding the indemnification right, the guarantor was the 'payer of last resort in the worst-case scenario' since it could not recoup its loss from payment on the guaranty from the LLC obligor.

The second issue was a little different. Here, the guarantor had other co-guarantors. If the lender came after the guarantor and collected the full amount from the guarantor, the guarantor would have rights of contribution from its co-guarantors. Therefore, applying the worst-case scenario, the guarantor would not be on the hook for 100% of the loan amount. Therefore, the guarantor's at risk amount, for purposes of taking deductions, is limited to the amount that the guarantor could not collect from its co-guarantors.

Chief Counsel Advice 201308028

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ADDING ACCRUED INTEREST TO PRINCIPAL BALANCE DOES NOT GENERATE A DEDUCTION

Cash basis taxpayers may deduct “qualified residence interest” when paid. Qualified resident interest is generally interest on a loan taken out to purchase a qualified residence, or to refinance it within certain dollar limits.

In a recent Tax Court case, a taxpayer accrued interest on his home mortgage. Per an adjustment clause under the mortgage a portion of the interest was paid, and a portion was added to the principal of the mortgage. The taxpayer deducted all of the accrued mortgage interest, including the portion that was not paid but was added to the mortgage. The IRS contested the deduction for the capitalized portion of the interest.

The Tax Court ruled for the IRS. Other precedent provides that the delivery of a promissory note to satisfy an interest obligation is not payment of the interest obligation. The reasoning for such a rule is that the note may never be paid, and if it is not paid, the taxpayer has not parted with anything (other than his or her promise to pay). Unable to distinguish that situation from adding interest to the principal amount of a mortgage, the Court held the capitalized interest amount was not deductible.

Philip C. Smoker, TC Memo 2013-56

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WHEN IS A NOTICE ADDRESSED TO A PERSON OUTSIDE OF THE UNITED STATES?

Seems like a simple question, but is it? Is a notice addressed to a person outside of the U.S. if at the time of mailing the person is physically in the U.S., even though they reside outside of the U.S.? What about if it was mailed to a U.S. address? What if it was mailed to a U.S. address and the taxpayer was in the U.S. when it was delivered? More than one tax case has struggled with these questions, including one recently decided by the Tax Court. In the recent case, the Tax Court itself could not even agree on the answers, with some judges filing dissenting opinions to the majority decision.

A taxpayer who received a Notice of Deficiency has 90 days from the date the IRS mails it to file a petition in Tax Court to contest the asserted tax. Otherwise, the taxpayer will need to pay the tax first, and then sue for a refund in federal District Court or the Claims Court. However, Code §2613(a) provides a 150 period in certain circumstances:

Within 90 days, or 150 days if the notice is addressed to a person outside the United States, after the notice of deficiency authorized in section 6212 is mailed (not counting Saturday, Sunday, or a legal holiday in the District of Columbia as the last day), the taxpayer may file a petition with the Tax Court for a redetermination of the deficiency. (emphasis added)

So in the recent case, the taxpayer formerly resided in the U.S., but took up residency in Canada. She still had a San Francisco home and post office box, and the IRS mailed the notice to her U.S. post office box. Coincidentally, the taxpayer was in the U.S. when the notice was mailed, and was still there when it was delivered to her P.O. box, but she did not pick it up. She went back to Canada and the notice was eventually forwarded to her in Canada. She filed a petition in Tax Court, but more than 90 days after the date of mailing and less than 150 days after the mailing date.

There were lots of ways the Tax Court could have ruled her petition untimely – she was in the U.S. when it was mailed, and when it was delivered, and it was mailed to a U.S. address. Nonetheless, the Court ruled in favor of the taxpayer and allowed her petition. The Court noted that “the crucial criterion to be gleaned from the decided cases is whether the `person' is physically located outside the United States so that the notice of deficiency mailed to its United States address will be delayed in reaching it in a foreign country *** and thereby hamper its ability to adequately respond by filing a petition to litigate its case in this Court.” Thus, the Court held:

“She was a Canadian resident (i.e., when the notice was mailed and delivered); was not at the address to which the notice was delivered; and received the notice, in Canada, 127 days after the notice's mailing date. Although petitioner was in San Francisco when the notice was mailed and delivered, her status as a person “outside of the United States” is largely a function of her residency and is not vitiated by her brief presence in the United States.”

Note that the opinion never lets us know whether the taxpayer was a U.S. citizen, or a resident for income tax purposes (by reason of the # of days present in the U.S. or green card status). That is because the 150 rule can be used by U.S. taxpayers and not just nonresidents, if they are physically outside of the U.S.

Deborah L. Smith v. Commissioner, 140 T.C. No. 3 (2013)

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