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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.

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