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How to make USRPHC stock not be a USRPI
OK. This technical topic came from Elizabeth S.
In my last International Tax Lunch I described a strategy for avoiding FIRPTA withholding. In brief, FIRPTA withholding (IRC Section 1445(a)) only applies to foreign sellers of U.S. real estate. So if the seller is a domestic taxpayer . . . no withholding.
Assume a nonresident alien owns a single family residence in the United States – a vacation home. It’s time to sell, and you don’t want to screw around the FIRPTA withholding. Here’s what you do:
- Contribute the real estate to a domestic corporation in return for stock. This is a nonrecognition transaction under IRC Section 351 if you do some paperwork mandated by IRC Section 897.
The corporation is a “United States Real Property Holding Company.” See IRC Section 897(c)(2).
- List the real estate for sale by the domestic corporation and complete the sale.
No FIRPTA withholding is required because the seller is a domestic taxpayer, and withholding applies to foreign sellers. IRC Section 1445(a). You have a C corporation with a bucket of pre-tax cash.
- Pay Federal and State income tax on the gain recognized by the domestic corporation.
Now you have a C corporation with a bucket of after-tax cash and a bunch of earnings and profits from the sale of the real estate. And you want to get that money out of the corporation and into the hands of the foreign shareholder.
- Make a liquidating distribution of all of the cash in the domestic corporation to the shareholder. IRC Section 331(a).
A domestic shareholder is treated as selling the stock and recognizes gain equal to the liquidating distribution minus basis in the stock. But nonresident individuals do not pay tax on capital gain on corporate stock held for investment: it is neither FDAP (IRC Section 871(a)) nor ECI (IRC Section 871(b). So the liquidating distribution is received without any U.S. taxation.
- Dissolve the corporation.
How IRC Section 897(a) makes a liquidating distribution taxable
Elizabeth S. correctly noted that there’s a potential to have that liquidating distribution become a taxable event for the nonresident shareholder.
If a domestic corporation is a United States Real Property Holding Company (see IRC Section 897(c)(2)), then its stock is a United States Real Property Interest (see IRC Section 897(c)(1)).
If a foreign person disposes of a United States Real Property Interest, gain recognized on the disposition is classified as effectively connected income. IRC Section 897(a). A liquidating distribution is treated as disposition of the corporate stock by the shareholder in exchange for the money or property received in the distribution. IRC Section 331(a).
Thus, if the domestic corporation is a United States Real Property Company at the time of the liquidating distribution, then the foreign shareholder pays U.S. tax on the difference between the liquidating distribution and the shareholder’s basis in the stock.
In my little transaction, the domestic corporation is definitely a United States Real Property Company: its only asset is a vacation home in the United States. And that means that the domestic corporation’s stock is a United States Real Property Interest, and its disposition will create taxable gain for the shareholder.
Double-taxation is not something we want.
The solution—the “cleansing exception”
The solution that makes it work is called the cleansing exception. IRC Section 897(c)(1)(B) contains the three requirements. Satisfying all three requirements makes a domestic corporation’s stock NOT be a United States Real Property Interest on the first date that all three of these conditions are true (see Reg. Section 1.897-2(f)(2)):
- The domestic corporation owns no United States Real Property Interests.
- The United States Real Property Interests that the domestic corporation owned in the lookback period (shorter of actual ownership of the stock or five years) were all disposed of in taxable dispositions and gain (or loss) recognized.
- The domestic corporation isn’t a REIT or a RIC.
Only dispositions of United States Real Property Interests cause gain to be classified as effectively connected income (IRC Section 897(a)) and this is a disposition of stock of a domestic corporation that is NOT a United States Real Property Interest. Therefore, IRC Section 897(a) does not apply.
The Regulations for the cleansing exception
Reg. Section 1.897-1(c)(2)(ii) says “yeah, Code Section 897(c)(1)(B) is right” and tells you to look at Reg. Section 1.897-2(f) for implementation rules.
Reg. Section 1.897-2(f)(2) basically recites the three requirements of IRC Section 897(c)(1)(B) with a bit of embellishment. As soon as all three requirements are true, the stock becomes not a United States Real Property Interest.
But what about the paperwork?
Well, that’s all fine but you and I are tax professionals and we know there is always paperwork. It can’t be that simple, can it? Automatic reclassification of the stock to “not a United States Real Property Interest”? That’s too easy.
Reg. Section 1.897-2(g) introduces the paperwork requirements. The foreign shareholder disposing of domestic corporation stock can establish that the stock is not a United States Real Property Interest by asking the corporation to certify that fact. Reg. Section 1.897-2(g)(1)(i)(A).
(You can also ask the IRS for a determination (Reg. Section 1.897-2(g)(1)(i)(B)), but . . . I’m not a big fan of voluntary suffering.)
Paperwork failure means taxable transaction?
Then the flushleft language of Reg Section 1.897-2(g)(1)(i) throws a giant, giant bombshell. It says that if you don’t get certification in one of those two ways, then the transaction will be taxable under IRC Section 897(a). The cleansing exception won’t work.
If the foreign person does not establish by either method that the interest disposed of was not a U.S. real property interest then the interest shall be presumed to have been a U.S. real property interest the disposition of which is subject to section 897(a).
I wonder whether this is enforceable. Can the Secretary of the Treasury, by Regulation, deny a tax outcome to a taxpayer that is not conditioned on paperwork compliance?
I know the IRS can impose paperwork requirements to make sure that taxpayers are complying with the Code. But I do not think that they can, by Regulation, deny explicitly allowed tax treatment plainly stated in IRC Section 897(c)(1)(B)—for failing the paperwork requirements.
If Congress wanted to deny a tax benefit for taxpayer foot-faults, it would be built into the Code—as it is, for instance, with denying foreign tax credit in certain situations.
Find the details of the paperwork here
That aside, I encourage you to read Regs. Section 1.897-2(g) and (h) to see what the paperwork requirements are, and follow them.
I’m not going to give you the details here, because this is a newsletter, not a treatise. Maybe someday I will do a workshop on this topic and how to do one of these transactions.
Conclusion
By using the cleansing mechanism of IRC Section 897(c)(1)(B), the domestic corporation can be liquidated tax-free, without interference and tax imposed by IRC Section 897(a).