The trend in Chinese offshore investment in the U.S. has been increasing each year. In 2012 the level of investment was $6.5 billion. Much of this investment is in U.S. real estate where great buying opportunities still exist.
The registered foreign retirement plan is an ideal asset protection vehicle for Chinese investors that make investments that generate effectively connected income in a U.S. trade or business (ECI). These investments generally include direct investment in U.S. residential and commercial real estate as well as investments in funds structured as partnerships and limited liability companies.
Tax Planning Considerations in the Purchase of a U.S. Residence.
A. Federal Estate Tax Treatment The federal estate tax is imposed on the estate of every non-domiciliary decedent under IRC Sec 2101 based upon the value of gross estate situated in the United States at the time of death.
The exemption threshold is very low – $60,000. Property is not ordinarily included in estate for estate tax purposes unless the decendent owns the requisite property at death. Real property physically located in the U.S. and owned outright has a U.S. Situs as does U.S. stock owned by a non-resident at the time of death.
Property that is considered U.S. Situs property for estate tax purposes may be purchased directly by a foreign corporation as its parent or ultimate beneficial owner and be treated as having a foreign Situs for U.S. federal estate tax purposes. The entity must be classified as a corporation and corporate formalities must be observed and the corporation should be the real owner of the property in substance.
B. How Ugly Can it Get when Selling Real Estate?
It is a cold, grey, wet, unpleasant Friday afternoon in New York when banks will close for business in 15 minutes. A U.S. real estate sale, by an alien seller, is about to close when, suddenly, the buyer’s attorney announce, “We must withhold and remit to The Treasury, 30% of the purchase price, because of the Foreign Account Tax Compliance Act.” The reason is because the alien seller is not able to verify that he has no U.S. Person connection or U.S. Person beneficiary. FATCA requires that both the buyer and seller in capital transfers must submit a W-8BEN-E signed by a person authorized under a FATCA Identification Number registration.
The alien seller says, “What! FATCA is only an enforcement act to verify that U.S. Persons with any foreign accounts report those accounts for tax. It is not aimed at me!?” He argues, that this transaction is not foreign as it is going down within the USA and the only thing that is foreign is he, the Seller. The attorney replied, “But the IRS needs verification that there is not a USA person associated with you, behind you or a beneficiary of you.”
- The seller says, “But I don’t have any U.S. Person connections or beneficiary”
- The attorney says, “Unless you have a FATCA registration, you ain’t gonna see your money. Ever again.”
- The seller says, “Deal Off.”
The revelation that the ownership of the U.S. homestead is improperly structured is likely to result during an audit and will be a big surprise. The initial estate tax bracket under the progressive rate structure is 26 percent. Absent an arms-length lease between the corporation and the non-resident alien, a deemed dividend will be assessed based upon a fair market rental of the property.
The U.S. corporation is the withholding agent and is personally liable for the withholding on the dividend deemed payable to the foreign corporation that owns the shares of the U.S. corporation. Based upon the personal use of the residence, no deductions (absent business use) the corporation will be unable to deduct any expenses or depreciation. The withholding tax rate on the deemed dividend is 30 percent absent a lower rate under a tax treaty.
Juan Valdez, a resident and citizen of Colombia, purchased a three bedroom condo on Brickell Key in Miami for $750,000 in January 2010. Based on rentals within the same condominium, a fair market rental is $4,500 per month or $54,000. The condo is owned within a Florida LLC that is treated as a corporation. The LLC is wholly owned by a Cayman corporation, which is owned by Juan. Juan’s children have lived in the property on a full time basis since the purchase while they attend the University of Miami. Juan and his wife have lived in the property while in the U.S., which is approximately half of the year.
The IRS audits Juan’s returns for the following tax years – 2010-2013. They determine that he should have declared income based upon the value of the deemed dividend of $54,000 each year. The withholding liability amount is $16,200 per year in 2010-2013, four years. An estimate of the taxes, interest and penalties for the four years is $60,080.
C. Federal Tax and Compliance Requirements of Electing to be Taxed as a Corporation LLCs are entities created by state statute. A single member LLC is treated as a disregarded entity for tax purposes absent an election to be treated as a corporation through the filing of Form 8832. A domestic LLC with two members is treated as a partnership for tax purposes unless it files Form 8832 and elects to be treated as a corporation. A single member LLC is treated as a sole proprietorship absent an election to be treated as a corporation.
An election must be filed within 75 days of the formation of the company. Alternatively, the IRS allows Form 8832 to be filed within the first 75 days of the fiscal year, which is the calendar tax year for our foreign buyer. Rev. Proc. 2009-41 permits business entities to file a classification election with an effective date retroactive up to 3 years and 75 days prior to the date that the request is filed. Normally an entity may not change its corporate status within a 60-month period unless there is a change of ownership of more than fifty percent.
The 60-month rule does not apply to a LLC that was a newly formed entity that made its initial election upon formation. Most entities formed by non-resident aliens should be able to fall under this rule in regard to make an election for the LLC to be treated as a corporation for federal tax purposes. As previously stated in the discussion of federal estate taxes, the corporate election is critical to avoid U.S. federal estate taxation. The LLC will require a tax identification number and file a Form 1120 each year.
D. Taxation of U.S. Real Estate Investments for Chinese Investors. IRC Sec 871(d) gives a non-resident alien the right to treat U.S. real estate investment as effectively connected income (ECI) with respect to a trade or business in the United States. Without this election, real estate income and gains would be subject to the 30 percent withholding tax under IRC Sec 871(a) without the benefit of any tax deductions. IRC Sec 882(d) provides a similar deduction for foreign corporations with investments in U.S. real estate.
When a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be ECI. This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year. Taxes are withheld at a 35 percent rate. The foreign taxpayer is taxed according to the graduated rate structure. State taxation would also apply when applicable.
FIRPTA introduced a federal withholding tax system which requires the buyer of the real property to deduct and withhold ten-percent of the gross sales price and remit to the federal government within twenty days of the sale. The application of FIRPTA provides a few exceptions for the withholding requirement. One exception applies to the sale of a principal residence and the amount of gain not exceeding $300,000. Another key exception applies with respect to publicly traded stock owning U.S. real estate with the selling shareholder owning less than five percent of the outstanding shares for the five year period preceding the sale.
Also, an exception under FIRPTA applies if the transferor provides 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 U.S. tax treaty.
Hong Lee is a wealthy Chinese industrialist. The Lee family office maintains an investment office in San Francisco that focuses on U.S. investment opportunities. The family office is looking to make significant investments in multi-family and residential housing. The family uses a real estate investment advisor, Acme Investments, an independent investment specialist, in multi-family housing to manage the investments. Acme will have discretionary authority over all investment decisions.
Solution is by means of a specific IRC 402(b)ORSO regulated, IRS acknowledged and Foreign Account Tax Compliance Act (FATCA) registered retirement Plan.