Tag Archives: British Virgin Islands company

IRS Rescues Non-Resident Alien Owning U.S. Real Estate and Residences

International tax planning and strategy

Applying for an IRS ruling on your international tax planning will save you taxes in the long run.

The British Virgin Island (BVI) corporation is used by many non-residents aliens  (NRA) to own real estate and their personal residences in the U.S.

When the property is sold, an excessive tax is paid.   Instead of being taxed at 15% to 20%, the corporate income tax rate is 35%.  After paying the corporate income tax, a foreign corporation also pays the branch profits tax.  This tax is 30% of the net income.

Removing  the real estate from the corporation caused a “double taxation”.    A corporate (domestic or foreign) distribution of  property is taxed as if the corporation sold the property.  Second, when the shareholder receives the property, he or she is taxed as if they have received a dividend.

Estate Tax for the Non-Resident Alien owning U.S. property with a Foreign Corporation.

About 15 years ago, the IRS won estate tax cases using section 2036.  This law puts assets of a foreign corporation in the alien’s taxable estate if he can enjoy the corporate property or  the corporate income.    Since the estate tax exemption for the non-resident alien is $60,000 or less, a large estate tax is due.

Because of the foreign corporation owns the real estate,  the corporate income taxes described in the first paragraph can apply either in whole or in part.

The IRS has come up with a method to solve the income tax problems.   The method is called a “dual resident corporation.”

A dual resident corporation has two corporate charters.  One charter is issued by a foreign government.  The other charter is issued by a State.  For example, a BVI corporation owns a home.   The corporate files for a charter to be a Delaware corporation.  The corporation now has two corporate charters.

The IRS allows such a corporation (if owned by Americans and residents) to elect the be taxed under Subchapter S.  Thus, any gain on the sale of the property is taxed by the individual shareholders at the 15% or 20%  long-term capital gain rate.

The foreign corporation branch profits tax does not apply because the corporation has two corporate charters (one of which is American).

Once Caveat:  A foreign corporation converted to a Subchapter S corporation has to wait 7 years to sell its appreciated property to avoid the double taxation discussed in the first paragraph.

However, the double taxation applies only to the amount of appreciation of the real estate (also known as “built-in gain”) at the time of converting to an S-corporation.   For example, the BVI corporation purchased a home for $100,000.  A few years later it becomes an S-corporation.  At that time the home is worth $200,000.  A few years later, the home is sold for $400,000.

The gain of $300,000 is a long-term capital gain.  An additional tax is charged on the gain of $100,000 ($200,000 minus the cost of $100,000).

One of the hidden savings of the dual resident corporation is the low cost of a domestic tax return.  A foreign corporation owning U.S. real estate must file a complicated Form 1120F.  The cost of preparing a Form 1120F is three to four times the cost of a domestic corporation tax return.    In additionally, a foreign corporation has special reporting because of a tax law known is the Foreign Investor Real Property Tax Act (FIRPTA).

International Tax Strategy for the Foreign Offshore Corporation Distribution of Appreciated Property to a U.S. Shareholder

Sometimes a foreign or domestic corporation will distribute property, rather than cash, to its shareholders.

The distribution of appreciated property will cause the corporation to realize and recognize gain equal to the difference between the adjusted basis of the property (also known as its tax cost) and its fair market value.   It can also cause the U.S. shareholder to recognize taxable income.

Here is what happens: 

The corporation is treated as if it sold the property at the time of the distribution[1].

This gain increases earnings and profits of both foreign corporations and domestic corporations[2].   When a corporation makes a distribution, the shareholder has dividend income if the corporation has earnings and profits. When a foreign corporation is involved, it goes from bad to worse.   Not only is the Federal tax rate up to 44%, but the punitive passive foreign investment company law may also apply. The longer the foreign corporation was owned the greater the amount due.

For example, Bob owns a British Virgin Islands corporation that owns other foreign corporations.  This is also known as a  holding company.  The cost of all the shares of the other foreign corporations was $10,000.  Now, those shares are worth $100,000.  

The BVI holding company distributes all of the shares of the other foreign corporation to Bob.   Section 311 of the U.S. tax code, treats the distribution as a sale to Bob.  The BVI holding company has $90,000 of tax accounting gain.  Under the U.S. tax law, this gain is taxable to Bob as ordinary income.

What if Bob had the BVI holding company make an election to be treated like a U.S. LLC (this is known as the “check the box” election)?

The result is the same. U.S. tax law treats that election as a liquidation of the BVI holding company followed by a distribution of its assets to the shareholder.

By the way, Congress purposely wrote this law to be unfair by not including the corresponding provision that permits a corporation to recognize the loss on the distribution of property.

This is important: The gain is based on the value of the asset distributed and not the value of the property received by the shareholder. 

The court case of Pope & Talbot v. Commissioner demonstrates this tax trap.[3]  The corporation distributed appreciated property to a limited partnership, which in turn distributed limited partnership interests to the company’s shareholders.

The corporation argued that, in calculating the gain recognized, the IRS should have determined the fair market value of the distributed property by aggregating the market value of the limited partnership interests the shareholders received instead of calculating the fair market value of the distributed property.

The Ninth Circuit affirmed the Tax Court and held that the fair market value is not determined by the property interest received by each shareholder.    Accordingly, the minority ownership discount can’t be used to reduce the taxable income.

Code Section 311’s disallowance of the recognition of a loss in non-liquidating distributions is a dangerous tax trap.   For example, an offshore company has two assets.  Both are worth $1,000.  One asset costs $100 and the other $1,900. The corporate distributes both assets.   The loss of $900 can’t offset the gain of $900. 

Thus, the corporation and/or its U.S. shareholder have $900 taxable income.

Footnotes

[1] Code Section 311(b) for non-liquidating distributions and Code Section 336 for liquidating distributions.

[2] Code Section 312(b)(1).

[3] 162 F.3d 1236 (9th Cir. 1999)