This is another episode in the FIRPTA Series. We are looking at the tax complications – and there are many – for nonresidents who simply buy a house in the United States for personal use.
Imputed income from personal use of corporate-owned property
This episode starts the discussion about income tax. And I’m going to start with highlighting a problem with corporate structures: imputed income.
Start with this typical statement from Brock v. Commissioner, T. C. Memo. 1982-335 :
It is well settled that a shareholder’s use of corporate property can result in a constructive dividend to him measured by the fair market rental value of the property.
There are so, so many cases that say the same thing. This is not controversial.
If you look at the court opinions that involve personal use of corporate assets, you see two common outcomes for taxpayers:
- Constructive distributions equal to the fair market rental value of the real estate used.
- Denial of tax deductions for the corporation.
I’m just going to talk about the problem of constructive distributions from a corporation to a shareholder. (And yes, the courts have no problem in creating constructive distributions where a subsidiary’s real estate is used by the parent company’s shareholder.)
This is a “fragile” structure
I’m going to use the normal type of structure that we all know and love: a foreign corporation owns 100% of the stock of a U.S. corporation, and the U.S. corporation owns the house.
This type of structure is fragile, in the way that word is used in Nassim Taleb’s book, Antifragile. Something is fragile when it is:
- Sensitivity to variability: It is negatively affected by randomness and uncertainty. (The only possible outcome of a future tax law change or IRS enforcement practice is, as someone once described it to me, “worser and worser.”)
- Lack of robustness: It lacks the ability to withstand or recover from shocks. (Once you are locked into a C corporation structure, you’re locked in. Restructuring incurs heavy tax costs.)
- Negative asymmetry: You have more to lose than gain when exposed to unexpected events. (Self-evident, and just remember Section 965 when you think long-standing tax principles and IRS enforcement practices are forever.)
If something is fragile and has a large downside compared to its upside, the only sane thing to do is avoid it.
Book recommendation: buy and read Antifragile.
How a constructive distribution works
When a corporation makes a distribution to a shareholder – including a make-pretend distribution cooked up in an audit or imposed by the Tax Court – we look to IRC §301(c) to figure out the impact on the shareholder.
First, it’s a dividend
Section 301(c)(1) says that a distribution is a dividend to the extent of the distributing corporation’s earnings and profits. So the first risk is dividend income, taxable at 30%. IRC §881(a).
That’s bad.
But a domestic subsidiary owning a personal use home that is never rented will have no earnings and profits. So the constructive distribution cannot be a dividend and will not create a tax liability for the recipient shareholder.
That’s good.
Then it’s return of capital
Next we go down to Section 301(c)(2). If a distribution is not a dividend, then it is a return of capital and reduces the shareholder’s basis in the domestic subsidiary stock.
That’s bad.
But the typical method for dealing with a domestic corporation is to sell the real estate, pay the corporate income tax due on the sale, then dissolve the corporation and pay all funds upstream in a liquidating distribution to the foreign shareholder.
And Section 331(b) says that you don’t use the Section 301(c) to characterize the liquidating distribution as a dividend, return of capital, or capital gain. Instead, you look at Section 331(a) which says the liquidating distribution is like the sale of stock.
And capital gain on sale of stock is not taxed to nonresidents or foreign corporations. The liquidating distribution is neither FDAP (taxed under Section 881(a)) nor effectively-connected income (taxed under Section 882).
Therefore it doesn’t matter at all whether the foreign shareholder’s basis in the domestic subsidiary stock is a penny or a million dollars. Capital gain is tax-free.
Therefore, characterizing the constructive distribution as a reduction in basis cannot hurt the foreign shareholder.
That’s good.
Finally, it is capital gain
If the cumulative distributions exceed the foreign shareholder’s basis in the domestic subsidiary’s stock, then the constructive distributions will be treated as a return of capital by Section 301(c)(3).
This triggers capital gain treatment, and as noted above, U.S. source capital gain is not subject to tax for a foreign corporation or nonresident individual.
That’s good.
Except! The domestic corporation owns U.S. real estate, so it is a U.S. real property holding company, and the capital gain will be subject to tax because of FIRPTA – Section 897(a).
That’s bad.
What about imputed income for the corporation?
Now the flip side of this puzzle. If the shareholder uses a corporate asset, does the corporation have imputed income, which creates earnings and profits, which in turn makes the constructive distribution become a dividend?
We have two models in the Code to look at. These give us clues about what will happen in the future, if the IRS gets serious about rent-free use of corporate-owned real estate.
Section 7874 says, in a below-market loan in a family context, we pretend the lender-parent (for instance) made a gift to the borrower-child, who, we pretend, immediately paid interest to the lender, which is included in the lender’s income. This suggests one way the government could go: “make pretend” turtles all the way down, conjuring up income at every step of the analysis.
Section 643(i) says when a U.S. beneficiary uses property owned by a foreign trust and doesn’t pay fair value, there is a deemed trust distribution to the beneficiary. Unlike the below-market rules (and just like this constructive distribution problem I describe above) there is no explicit statutory rule that says the foreign trust is deemed to have make-pretend rental income from the beneficiary.
In the corporate structure holding a personal use asset, I can see the government following either model. All they have to do is persuade Congress to add something to the Internal Revenue Code.
What’s the solution?
Again I emphasize: practical experience (knock on wood) says this will probably not blow up on your face. At least it hasn’t yet, in my world. Recite with me “past performance is no guarantee blah blah blah.” All of this may change tomorrow.
I don’t want you to get smart. You and I are not smart enough to predict what the IRS or Tax Court will be thinking a decade from now. You and I are not smart enough to know what Congress will do to the Internal Revenue Code.
I want you to avoid catastrophic tax risk. There are three ways to do this:
- Do not use a corporate holding structure. You can’t have a constructive dividend if there is no corporation.
- Pay rent. Have the shareholder pay rent for using the house. Listen. They’re going to be pouring money into the structure constantly for property tax and other carrying costs. Do it with rent. This is a math exercise, an Excel model, which I suppose I should run a workshop on someday.
- Get lucky. This is the default choice. 🙂
My bias is to not use a corporate structure. Use a trust instead. Failing that, pay rent. Failing that, be lucky.