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:
- 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.
- 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.
- 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.
- The amount of the deemed distribution is the fair rental value of the personal use.
- 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.
- 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.
- 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.
- 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 2012-327Follow @RubinOnTax Tweet