August 2, 2020 – New York, United States
Accepting Accipitor: Foreign Corporations, Imputed Rental Income, and the IRS
English poet Ted Hughes is quoted with the saying that…” Nothing is free. Everything has to be paid for. For every profit in one thing, payment in some other thing”. This might as well have been the IRS mantra as it seems to be a code the agency swears by. If there is a means by which they can intervene and apportion for themselves a percentage of a transaction, rest assured they will. A recent case handed down in Tax Court affirms the notion that an individual is obligated in his/her rental payments for the use of a property owned by a closely held corporation. In this instance, the closely held corporation is a British Virgin Islands company named Accipitor Trading Ltd, incorporated in 1994.
Before delving into the facts, one needs to understand a Lichtenstein tax structure called a Stiftung. This is a legal entity under Liechtenstein law that is formed by filing a foundation charter or by operation of terms incorporated into a will. Generally recognized and treated as a trust by the IRS, the foundation is established to provide benefits to the members of a designated family, charity, or religious foundation. Pursuant to regulation, the IRS believes that the primary purpose of the Stiftung is for the conservation of assets and property and not for the active carrying on of business. However, the Liechtenstein structure will be treated as a business entity under US tax law if it was established for business purposes.
Accipitor is a Stiftung and owned real estate in California. The individuals residing at the property had a verbal understanding as far as the lease that had been in effect for twenty years. During those twenty years, Acciptor had not filed any US tax returns. As is frequently the case, in the absence of tax filings, the IRS will presuppose the filings by completing substituted tax returns. Accipitor, pursuant to the substitute tax filings, was in default of the taxes due on $4.4 million in gross rental income for the years 1998 to 2017. Their tax bill came out to nearly $2 million, which also included penalties. In their defense, Accipitor argued in Tax Court that the fair rental value imputed by the IRS on the California real estate was in fact much lower than the Service’s determination.
Accipitor is not a precedent case. The IRS has broached this issue in other circumstances. The case arose in 2012, in GD Parker Inc., when a foreign corporate owner and his family made personal use of the corporation’s owned property titled in the name of its US subsidiary. Since no rent had been paid to the US subsidiary, the rent-free use was treated as a constructive dividend from the subsidiary to the foreign parent, which ultimately would be taxed to the owner. As seen, the Service examines these multiple tiered structures when residential real estate is involved. This is because the structure’s essence violates the legal purpose of a holding structure resulting in an unlawful avoidance of a tax obligation. Foreign corporations are also utilized for the purpose of avoiding estate taxes and are referred to in the industry as blockers. In establishing a blocker, one must be careful to engage the “blocker” as a legitimate corporation with a lawfully intended purpose. Otherwise, it will fail IRS scrutiny and be treated as an actual estate tax shelter.
In creating these underlying foreign corporate structures, it is essential that to demonstrate the legal purpose, the parties involved engage in formalities legitimizing the purpose. In the case of Acciptor, it would have benefited the taxpayer had there been a legally binding lease agreement between himself and the US subsidiary. In so doing, there would have existed less wiggling room for the IRS to impose its version of fair rental value.
Further, rental payments are subject to a flat 30% tax for foreign taxpayers under the gross basis withholding regime because it is passive income categorized as FDAP. This is an acronym standing for fixed or determinable, annual or periodical income, which is certainly characteristic of rental income. If the foreign taxpayer had been compliant with his US tax filings, he could have elected to be taxed on a net basis pursuant to the rules applicable to effectively connected income, of ECI. Without this election, a non-US taxpayer with rental income on a US property would otherwise not benefit from deductions such as depreciation and maintenance fees. In making such an election, a corporation also incurs other tax benefits such as a favorable new flat corporate tax of 21%, now levied on corporations as a result of the passing of the Tax Cuts and Job Act of 2017.
Foreign owned real estate has been a floating target missed by the IRS due to inefficiencies in enforcement for US tax compliance purposes. As a result, the Service has renewed its efforts in enforcement by focusing their energies in this area as evidenced by Accipitor. The sooner taxpayers accept Accipitor, the sooner they will realize that tax compliance is extremely beneficial for their own fiscal good. To maintain that by having a tiered structure, one is able to get something for nothing is a misnomer. Remember Ted Hughes, accept Accipitor, and one will not become the next target on the IRS hit list.
About the Author
Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high net worth families and their advisors. Alicea has more than 17 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm. Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates and foundations that have a U.S. connection.
Alicea also specializes in foreign investment in U.S. real estate property, and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, FATCA registration, and foreign companies wanting to do business in the U.S. Alicea is fluent in Spanish and has a working knowledge of Portuguese.
Alicea is an active member of the Society of Trusts & Estates Practitioners (STEP), the New York City Bar, the New York State Society of Certified Public Accountants (NYSSCPAs), the American Institute of Certified Public Accountants (AICPA) and the International Fiscal Association (IFA). She is the New York/Northeast Regional Representative of the Women of IFA Network (WIN). Distinctly, in 2020, Alicea was awarded with a prestigious NYSSCPA Forty Under 40 Award. She was selected as someone that has notable skills and is visibly making a difference in the accounting profession.
Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.