Estate Tax Traps: What Non-Residents Need to Know Before Engaging in US Share Transfers
By Fiorella Belardi, Director, Tax & Business Services
The US real estate in many US states has proven to be a very attractive investment for non-US individual investors. Many investors are reluctant to hold US real property in their name and are often advised to establish a US corporation to own the property. Using a US corporation as a vehicle to own US real property may provide investors with a measure of anonymity as well as legal protection. In addition, The Tax Cuts and Jobs Act (“TCJA”) enacted in 2017 lowered the corporate federal income tax rate from 35% to a flat 21%, making US corporations a more attractive vehicle to own real estate investments.
A significant issue foreign individuals should consider when investing in US real estate is the potential imposition of US estate tax. The US estate tax is imposed on foreign decedents that own the US “situs” assets on the date of death. The US situs assets include tangible property located in the US. The US situs assets also include shares of a US corporation. The US estate tax can be imposed at a maximum rate of 40% on the value of the US assets after applying an exclusion of $60K. Depending on the value of the US asset, the US estate tax liabilities may be significant. For example, assume an investor owns a US corporation with assets valued at $2M, the investor funded through capital contributions to the corporation. The estate tax base, in this case, would be $1.94M ($2M – $60K), and the US estate tax of approx. $776K would be imposed.
Foreign investors are often advised to transfer their ownership interest in their US Corporation to a non-US holding entity to eliminate the US estate tax exposure. As a result, the investor will no longer be a direct owner of the US entity and will instead own shares of a non-US entity, which would not be considered a US situs asset.
Before engaging in transfers of this nature, foreign taxpayers should consider two significant US tax implications, as these provisions may deliver some unexpected tax consequences. Specifically, foreign taxpayers should consider the following:
- Whether the transfer is considered a taxable event under The Foreign Investment in the Real Property Tax Act (“FIRPTA”) provisions; and
- Whether the US “Inversion” Rules will apply.
Under the FIRPTA provisions, any transfer by a non-resident alien of shares of a US corporation may be subject to US tax if the corporation predominantly owns US real estate. This can be problematic because a share-for-share transfer can generate a cash tax liability even though the transfer is not a cash sale.
The US tax rules allow a transferor to avoid recognizing a taxable gain for certain “non-recognition” transfers to ameliorate this problem. A non-recognition transfer is any transfer that, under US tax principles, would be considered a tax-free transaction and include the following types of transfers:
- The transfer of a US corporation’s shares to a foreign corporation in a share for share transfer provided that the transferor owns 80% or more of the vote and value of the foreign corporation after the transfer, or that 80% or more of the US Corporation’s shares are acquired by such foreign corporation in the transaction.
- The transfer of a US corporation’s shares to a foreign partnership in exchange for an interest in such partnership.
Taxpayers engaging in non-recognition transfers must provide a written notice that no recognition of any gain or loss on the transfer is required because of a non-recognition provision in the Internal Revenue Code or a provision in a US tax treaty.
A copy of the notice must be filed with the Internal Revenue Service by the 20th day after the date of transfer. The notice should be in the form of a statement that describes the transaction, provides the names of the parties involved in the transfer, and explains the provisions of US tax law that allows the transfer to be made free of US tax. This non-recognition statement essentially puts the Internal Revenue Service on notice that a transaction has occurred for which no gain or loss is required to be recognized.
Taxpayers engaging in non-recognition transfers must respect the notice requirements to avoid required withholding taxes on such transfers for which the IRS may impose penalties.
In addition to navigating the FIRPTA rules described above, non-US taxpayers also need to be aware of the Inversion provisions when transferring shares of US corporations to non-US corporations. Under the inversion rules, transfers of a US corporation’s ownership to a foreign corporation may result in the foreign corporation being treated as a US corporation for all purposes of US tax law if the same owner (or owners) of the US corporation own 80% or more of the foreign corporation’s shares after the transfer.
The US inversion rules discourage US corporations from re-incorporating outside the US or transferring its operating assets outside the US to avoid paying US tax. These rules are extraordinarily complex and contain many nuances and exceptions. A complete analysis of the application of the inversion rules is beyond this article’s scope.
However, Taxpayers are often surprised to learn that seemingly innocuous share transfers to minimize US estate tax exposure may qualify as inversions. These “accidental inversions” would render the transfer of a US Corporation to a foreign corporation meaningless because the foreign corporation would continue to be treated as a US corporation for US tax purposes, even if the entity is incorporated outside the US. This would mean that the transferor would be treated as owning a US situs asset and continue to be exposed to US estate tax, even though they own shares of a non-US entity.
The FIRTPA and inversion provisions are expansive and complex. However, taxpayers must consider these provisions when engaging in share transfer transactions, even if such transfers are being made within commonly controlled entities and are being done for estate planning purposes. The failure to consider these rules may result in unexpected and often unwanted surprises. Taxpayers should discuss these issues with qualified tax professionals before engaging in entity reorganizations or share transfers.