FIRPTA Structure Series #3: Avoid Structures With Uncertain Estate Tax Risk

The “Real Estate Holding Structure” Series

This is the third episode of the real estate holding structure series. In this series I walk you through the thought process of a non-resident who wants to buy a home in the United States for personal or family use–not for rental.

  • Episode 1 – Thirteen single-level holding structures exist for possible use. (We’ll deal with multi-level holding structures later. Three are eliminated: forbidden, logically impossible, or wildly impractical.
  • Episode 2 – Of the ten remaining single-level holding structures, we eliminate three because they are guaranteed to result in estate tax if the real estate owner dies.
  • This episode – Of the remaining seven holding structures, four have uncertain estate tax results. Some are more uncertain than others. Eliminate them: “maybe” means “no.”

You don’t have to be smart–just avoid being dumb

You need not – and should not – be a tax law scholar. An apt Charlie Munger quote:

It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

The nonresident investor’s decision, when buying the real estate, is “Do I choose a holding structure that creates an optional estate tax risk? Or do I use an ownership method for which the estate tax protection is certain?”

The “not stupid” choice is to avoid uncertainty.

Where is a foreign partnership interest located?

A nonresident-noncitizen is a partner in a foreign partnership. The partnership owns U.S. real estate. The nonresident-noncitizen dies. What is in the decedent’s gross estate?

The property interest owned by the decedent is an ownership interest in a partnership. That’s clearly an “interest” in “property” (specifically, intangible personal property).

But where is that partnership interest “situated”? 

There is no answer from the people that matter – the Internal Revenue Service. 

From people who don’t matter (tax practitioners, law professors, etc.) we have Theories. Fountains of “should.”

Here are some theories about the situs of a foreign partnership interest. There are good and less good arguments for each of these.

“Trade or business”

One theory is where the foreign partnership conducts its “trade or business.” Well, what about a foreign partnership that holds a personal use asset – like a house. It isn’t conducting a trade or business . . . or is it?

“Domicile of the partner”

The classic rule of law is that intangible personal property is deemed to be located at the domicile of the owner. 

If a partner lives in Burkina Faso, then a partnership interest owned by that partner is located in Burkina Faso. It doesn’t matter where the partnership’s assets are located, or where the partnership does business, or under which governing law the partnership was formed.

“Location of the partnership assets”

Maybe the partnership interest is situated in the place where the partnership owns assets. This is a sort of hidden invocation of the aggregate theory of partnership taxation, isn’t it? 

What happens if the foreign partnership owns U.S. real estate and real estate in Burkina Faso? Presumably there is some pro-rata allocation of the value of the partnership interest to “situated in the United States” and “situated outside the United States.”

“Governing law”

Corporate stock is located in the jurisdiction where the corporation is organized. Maybe the same rule could apply to partnerships? We don’t know.

Reject the foreign partnership holding structure idea.

Domestic partnership interests

If anything, a partnership interest in a domestic partnership is far riskier than using a foreign partnership. Everything except “domicile of the partner” tilts in favor of inclusion of the partnership interest in the gross estate of a deceased nonresident-noncitizen.

I see only a small amount of metaphysical uncertainty about inclusion in the gross estate. This is not a winner.

Foreign disregarded entity – does “disregarded” mean “disregarded”?

A nonresident owns 100% of a foreign disregarded entity and the foreign disregarded entity owns U.S. real estate. The nonresident-noncitizen dies. What’s in the decedent’s gross estate?

Disregarded means disregarded

The check-the-box regulations give us the blessing of business entities that are disregarded for U.S. tax purposes. Those business entities can be domestic (i.e., limited liability companies formed in the 50 United States and the District of Columbia) or foreign (business entities formed outside the United States that are eligible to make the check-the-box election).

The Regulations say that the entity is “disregarded as separate from its owner” and that you should look at the structure as if it is a sole proprietorship. Reg. §301.7701-2(a) says (emphasis added):

A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.

If you believe the Regulations, then when the owner of the entity dies, we treat the individual as the owner of the assets inside the disregarded entity. 

Disregarded means disregarded.

Disregarded doesn’t really mean disregarded

But the Tax Court takes a different view. Disregarded does not mean disregarded in all cases.

The Tax Court in Suzanne Pierre v. Commissioner held that “disregarded” does not mean disregarded for ALL tax purposes. For gift tax (and by extension estate tax) purposes, first you determine what the donor (decedent) owns by reference to state law, and then determine the U.S. tax consequences based on the nature of that property interest. 

In Suzanne Pierre v. Commissioner, the taxpayer owned 100% of the membership interests of an LLC that held cash and securities. She gave membership interests to her children and claimed a valuation discount. 

The government argued “disregarded means disregarded” and that this was a gift of a pro rata share of the LLC’s assets to her children. The Tax Court said that no, this was a gift of a property interest separate from the LLC’s assets: the membership interest. Since it was a gift of a minority interest, the Tax Court allowed a valuation discount for the gift of a membership interest compared to the value of the underlying assets.

Disregarded means disregarded for income tax purposes, but not for estate and gift tax purposes.

If the Suzanne Pierre v. Commissioner logic is extended to estate tax, then we would ask “What did the decedent own when he died?” and the answer would be “ownership of stock of a corporation organized under the laws of a country outside the United States, which happens to be classified as a foreign disregarded entity for U.S. tax purposes.” 

Typically a foreign disregarded entity is a corporation or limited company under local law, with stock certificates, a Board of Directors, and everything. It looks and smells like a corporation. 

Thus, the IRC §2104 situs rules would seem to suggest you look at the place of organization, because we use local laws to determine property rights, then Federal tax law to determine how that property right is taxed.

This seems fabulous! Hold U.S. real property in a Bahamas corporation, make a check-the-box election, and you’re done. You can die and not get taxed on the value of the real estate (because the real estate itself is not included in your gross estate) or on the value of the stock of the Bahamas corporation (despite the check-the-box election) because the stock of that corporation is deemed to be located in The Bahamas – not in the United States.

Clearly, I have drawn a cartoon version of the argument. Tax law is subtle and the government has multiple vectors of attack. A retained interest attack might be one of them: is this structure, for instance, one in which the decedent has a power to revoke, creating a retained interest under IRC §2038?

But again. If this is right, why doesn’t everyone do it? Where are the customers’ yachts? If this idea works, why don’t we see everyone doing it? We don’t have to be clever–it is enough to avoid being dumb.

Maybe I have been living under a rock. Maybe all of you know some secrets that I don’t know. Maybe everyone IS doing it. All I know is that (a) I don’t know the answer; and (b) my clients, when presented with safety vs. danger, invariably choose safety.

Domestic disregarded entity

A nonresident-noncitizen owns 100% of the membership interest of a domestic limited liability company that is classified as a disregarded entity. The LLC owns U.S. real property. The nonresident-noncitizen dies.

What happens? Inclusion in the gross estate of the decedent. But why? It’s a “damned if you do, damned if you don’t” situation. Or to be specific, does “disregarded” mean “disregarded”?

If “disregarded” means “disregarded” (this is the IRS’s position), then there is an asset includible in the decedent’s gross estate. A disregarded entity, if owned by an individual, is treated like a sole proprietorship. Regs. §301.7701-2(a). In a sole proprietorship, assets are owned directly by the individual. 

Therefore, if a nonresident-noncitizen owns U.S. real estate through a domestic disregarded entity (i.e., a domestic limited liability company), the real estate is treated as if it is owned by the individual directly. 

If “disregarded” does NOT mean “disregarded” (this is the Tax Court’s position), then the nonresident is not treated as owning the assets in the LLC for gift (and estate) tax purposes. But the decedent owns the membership interest of a domestic limited liability company. That’s a domestic asset using the same logic as the IRC §2104(a) “corporate stock is located where the corporation was formed” rule.

Suzanne Pierre v. Commissioner, 133 T.C. 24 (2009) says that for gift tax purposes (and, according to the opinion, estate tax rules too) the asset owned by the individual at the moment of a gift (or the moment of death) is the membership interest in the LLC.

Where is the membership interest of the LLC “located” for purposes of the situs rules? There is no definitive answer to this question – that I know of. But if anything, the risk of estate tax inclusion for domestic disregarded entities is higher than for foreign disregarded entities.

Conclusion: don’t be dumb

The first rule of life is to not die. You risk death by embracing catastrophic choices. 

Why place bets if you might lose? Eliminate these four holding structures from contention.

estate tax results