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Sunday, January 28, 2018

The U.S. Will Now Bar Tax Delinquents from Travelling Abroad

I wrote back in 2015 here about new legislation that gave power to the Secretary of State to deny, revoke or limit the passport of persons with delinquent taxes. Code §7345 provides that the Commissioner of the IRS will provide notice to the Secretary of the Treasury, who will then transmit that notice to the Secretary of State, in regard to a taxpayer’s delinquent tax debt. Generally, it applies to delinquent tax debt over $50,000 (adjusted for inflation), for which a notice of lien has been filed or a levy has been made. Upon receipt of a Code §7345 certification, §32101(e) of the 2015 FAST Act provides that the State Department will generally deny an application for issuance or renewal of a passport from such individual, and may revoke or limit a passport previously issued to such individual.

In Notice 2018-01, the Treasury Department announced that the IRS and the State Department will begin implementing these provisions in January, 2018. The Notice provides information about the implementation of the rules.

The National Taxpayer Advocate in its annual report to Congress noted the right to travel internationally is a fundamental right of citizenship. Many civil libertarians would assert that the right to travel is more than this - it is a natural right of individuals that is not bestowed by governments, and should be restricted only for security purposes (including immigration and criminal enforcement). Restricting a fundamental and natural human right for the enforcement of civil debt obligations is a new chapter in U.S. tax law, and one that can be expected to give rise to constitutional challenges.

Notice 2018-01, Revocation, Limitation or Denial of Passport in Case of Certain Tax Delinquencies

Sunday, January 21, 2018

Applicable Federal Rates – February 2018



Monday, January 15, 2018

Obscure Provision of New Tax Act Complicates Testamentary Tax Planning for Nonresidents with U.S. Beneficiaries

Nonresidents with a significant portfolio of U.S. stocks typically use a non-U.S. corporation to hold their portfolio. This is because U.S. stocks are generally subject to U.S. estate taxes at the death of their owner, and absent treaty relief a nonresident owner can only exempt $60,000 in assets from U.S. estate taxes. Since stock of a non-U.S. corporation is not a U.S. situs asset for estate tax purposes, assets held in the corporation, such as U.S. stocks, avoid U.S. estate taxation.

If the nonresident owner has U.S. individual heirs who will succeed to the stocks, the transfer of the shares of stock of the foreign corporation at death can create unpleasant tax consequences for the new U.S. shareholders. If they will own a majority of the shares, in most circumstances the foreign corporation will become a controlled foreign corporation (CFC) for U.S. income tax purposes. This will result in the 10% or more U.S. shareholders becoming taxable on the investment income of the company, including capital gains, on a flow-through basis and at ordinary income rates by reason of such income being characterized as foreign personal holding company income (FPHCI). The U.S. shareholders will also suffer some level of double taxation as to U.S. withholding taxes imposed on the foreign corporation (e.g., on its U.S. source income and dividends), and on any non-U.S. withholding and other taxes - no full U.S. tax credit arises and the individual shareholders only receive in effect a deduction for such taxes. Municipal bond interest also becomes taxable to the U.S. shareholders under the CFC rules.

Until now, these problems were easily resolved by liquidating the foreign corporation within 30 days of the death of the foreign stockholder. If the U.S. shareholders received a stepped-up basis in their shares (which is usually the case, subject to some questions when there is an intervening trust), the liquidation generally would have no adverse U.S. income tax consequences to them. This is because the foreign corporation would not become a CFC if the U.S. shareholders did not own it for 30 days. This could be accomplished either by an actual liquidation within the first 30 days after the death of the stockholder, or a check-the-box election (if the company was eligible) with an effective date within that period. Since a check-the-box election can be retroactive up to 75 days, this effectively provided a 105 day window to take care of things.

The problem today is that the new Act repeals the 30 day window, thus resulting in CFC status immediately as of death of the stockholder. Thus, a liquidation or check-the-box election effective within the first 30 days is taxed as a CFC liquidation, which is not nearly as painless as a non-CFC liquidation. Note that making a check-the-box election with an effective date PRIOR to death of the shareholder may resolve the liquidation problem, but will likely void the estate tax insulation of the foreign corporate ownership of the securities.

What's the problem with liquidating the CFC? Under Code §336, the CFC is treated as having sold its assets on liquidation for their value. If the stocks are appreciated in value, and assuming this results in overall net gain, that gain is treated as FPHCI which flows through to the U.S. shareholders and is taxable to them as ordinary income. The U.S. shareholders do get a basis step-up under Code §961 for this income, and they also likely received a basis step-up at death of the stockholder - this will typically result in a capital loss to the U.S. shareholders equal to the FPHCI they realized on the liquidation. Since the capital loss cannot offset the ordinary income treatment of the FPHCI (beyond $3,000), the loss is of not much help as to the FPHCI, resulting in the burdensome taxation of the passed-through ordinary income.

Thus, the removal of the 30 day exempt period in the new Act makes things difficult for nonresidents with U.S. heirs and their planners who sought to avoid the negative CFC implications of the foreign holding company structure.

The problem is not insurmountable - there are ways to deal with it.

One way is via churning. This involves regular and periodic sale and repurchase of the appreciated stock by the foreign corporation during the lifetime of the nonresident stockholder. Such sales and repurchases will increase the income tax basis of the stocks on a regular basis. In most circumstances any gain from such sales is not subject to U.S. income tax absent the involvement of real property holding companies. It does require some diligence to keep current on the churning, however. Further, if the U.S. stock is not publicly traded, then the sale and repurchase can be more difficult. The step transaction doctrine and attempts by the IRS to disregard the churning are always an issue. Note that this is not a "new" technique - many practitioners in the past have been leery of their clients taking immediate action upon death of the stockholder within the 30 day/105 day windows discussed above, so churning was recommended to avoid the need for such immediate action.

An alternative method to deal with the issue would be to domesticate the foreign corporation post-death, make a Subchapter S election to avoid double tax on the appreciation, and wait out the 5 year built-in gains period. This is a possible approach, but clients may be uncomfortable with having to hold the stock for the five year period.

Another approach involves having the foreign holding company owned in turn by two foreign corporation holding companies, with the nonresident owner being the shareholder of those companies. A check-the-box election is made after death, retroactive to prior to death, for the foreign subsidiary holding the U.S. stock. On the deemed predeath liquidation, a deemed sale occurs of the U.S. stock, but since it occurred prior to death there is no CFC or FPHCI flowing through to U.S. shareholders - but a basis step-up still occurs by reason of the liquidation. The two intermediate holding companies then liquidate after death - while they are CFC's, there is no gain on the U.S. stocks they received from the liquidating subsidiary and thus no FPHCI (except perhaps on appreciation occurring after the deemed liquidation date of the subsidiary foreign corporation). This still requires diligent action near the time of death, and issues of tax relevancy of the check-the-box election may apply.

Of course, there are alternate methods of planning for the U.S. securities, such as the use of an irrevocable trust to own the U.S. stocks, dual partnership structures, and tiered foreign corporate structures that can do a post-death check-the-box election retroactive to predeath to enter into a dual partnership structure.

Non-U.S. situs appreciated assets held through a foreign corporation can result in similar problems for the U.S. heirs. However, if those are segregated into their own foreign corporation, a pre-death effective check-the-box election can be conducted to eliminate the taxable gain. This can be done for the non-U.S. situs assets since they will not be subject to U.S. estate taxes even if deemed owned by the nonresident shareholder directly at the time of death.

These problems and resolutions may also apply to other U.S. situs assets other than stock of U.S. corporations. However, U.S. real property interests (including stock of U.S. real property holding companies) are more problematic given that capital gains from disposition are nonetheless subject to U.S. income tax under Code §897.

Giving Credit it Where it is Due Department: As to the dual corporate holding structure described above, to Seth Entin's presentation at the recent Florida Bar International Tax Conference.

Sunday, January 07, 2018

The Stealthy Tax Increase in the Tax Cuts and Jobs Act of 2017

Ever since the Reagan Administrative, tax brackets have been indexed for inflation. This avoids bracket creep when taxpayers move into a higher tax bracket because inflation pushes up their income. The thinking is that inflation increases are not real increases in earnings, so the rate tables should be indexed to avoid tax increases arising solely from inflation. This seems like less of an issue today with relatively tame inflation rates, but remember that inflation went into the teens in some years in the1970’s making bracket creep a big issue.

The new Act changes rate indexing and other Code indexing from the former Consumer Price Index (CPI) to a new creation known as “chained CPI.” Chained CPI is an adjustment to CPI that reduces the inflation rate by attempting to factor in human behavior that when prices rise, some consumers will look for less expensive substitute products, so that the overall inflation is lower than it would first appear when measured by actual spending.

So was chained CPI brought in due to a desire by Congress to more accurately measure inflation? Doubtful. By reducing the inflation rate for tax purposes to what may be less than the actual rate, bracket creep will now increase faster for taxpayers. This will increase taxes, and is thus a hidden revenue raiser. The differences between the two rates are not that significant, but will add up over time. See this table for how the cumulative spread increases over time:

[source: BloombergPolitics]

I have seen estimates that the effective tax increase next year will be $800 million, and is estimated to be $31.5 billion by 2027. Bracket creep tends to burden lower income taxpayers more than higher income taxpayers, because the brackets are smaller and thus will trigger more increases on the low end - further, for taxpayers already at the highest rate there is no higher bracket to creep into.

The wealthy will still be impacted as the unified credit exemption from transfer taxes is now coming under chained CPI adjustments. This means slower increases in such exemptions and thus more potential transfer taxes.

It is interesting that chained CPI was brought in by the Republicans and in a tax cut bill. I assume it was included to help the budget numbers work.

Note that Pres. Obama tried to bring chained CPI to social security increases during his administration which would have the effect of reducing social security payouts, but was beat down by Democrats. Don’t be surprised if we see that before Congress again in the near future.