Rental Income and Branch Profits Tax
I received a call today from a reader in Florida. His question was about the branch profits tax and foreign investors in U.S. real estate. The conversation triggered this blog post. (So, thanks for the call.)
There are many other tax questions to think about when a foreign corporation owns U.S. real estate–the regular income tax, the capital gains tax when the property is sold, estate tax, and gift tax. That’s too much for one blog post.
Instead, we will focus on one overlooked topic–the branch profits tax. My caller said he became aware of this when he went to a conference. He had not seen it in real life. I suspect that is the experience of many people.
Let us pretend that you are a nonresident of the United States and you want to buy a house in the USA, rent it for a few years, and then sell it. Prices are low, and you think it is a good investment.
You set up a corporation in the Bahamas, and put $250,000 cash into the bank account for the corporation. Then you find a nice house in the United States that you want to buy. The corporation signs a contract to buy the house for $250,000–all cash. Thirty days later, the purchase is complete and you have received a grant deed transferring the house to your corporation.
You rent the house to someone. In the first year the tenant pays $20,000 of rent to your corporation. There are expenses of $12,000 for repairs and property taxes. This means you have a profit of $8,000.1
Form 1120-F and Regular Income Tax
At the end of the year, your Bahamas corporation must file a U.S. income tax return reporting its rental income. It uses Form 1120-F.2
The place on Form 1120-F where this information goes is Part II.3 This is what it will look like:
The actual income tax your Bahamas corporation owes on the $8,000 of rental income is computed at Form 1120-F, Part II, Schedule J.
I won’t bother to make up numbers here. Let’s just pretend that the income tax is $2,000. In other words, your corporation made $8,000 of rental income after expenses, and paid 25% tax on it.
Form 1120-F and Branch Profits Tax
Let us now continue to the “Scary Monsters” part of this example.
Flip over to page 5 of the Form 1120-F. This is Part III. This is where the branch profits tax is computed. Look at Line 1 there. It tells you to enter the amount from Form 1120-F, Part II, Line 29. This is the corporation’s taxable income (total income minus total expenses) before a couple of adjustments that do not matter to our example.
So we put $8,000 there on Line 1. That is the taxable income for the corporation.
Line 2 is cryptic until you read the instructions, and then it is only slightly less cryptic. Honestly, I do not understand how the U.S. government expects normal people to deal with the tax laws of this country.
Line 2 asks for certain adjustments to be made. I will not get into every little detail that goes here. For our example, only one item matters: the Federal income tax the Bahamas corporation owes on its rental income. That is $2,000. We write that number in.
Simple subtraction yields $6,000 on Line 3. This is basically your corporation’s “really, truly” income, after paying corporate income tax.
Let’s skip Lines 4a through 4e for our example. They are adjustments (up or down) to the amount on Line 3. We are pretending that nothing happened to create these adjustments.
Line 5, then, is simply the same amount as on Line 3: $6,000.
Line 6 says “multiply Line 5 by 30%” and this is your corporation’s branch profits tax: $1,800.
Total Income Tax
Finally, let us go back to the first page of Form 1120-F to compute your corporation’s total tax payable to the U.S. government on its rental income.
You write in the corporate income tax computed in Part II at Line 2. You write in the branch profits tax computed in Part III, at Line 3. The total tax payable by your corporation is $3,800.
In other words, on $8,000 of profit your corporation paid $3,800 of tax. That is a 47.5% tax rate. At higher levels of income, the combined corporate income tax plus branch profits tax can be above 50%.
Note that the branch profits tax is automatic. If your corporation has a profit in the year (as shown in Part II, Line 29), the tax return automatically triggers Part III and the branch profits tax is computed.
No Income Tax, but Branch Profits Tax
There is another problem with the branch profits tax. Go back to Part II, Line 29. Do you see how this is the corporation’s income before net operating losses? Branch profits tax is computed on the corporation’s taxable income. The branch profits tax does not care about your net operating loss.
This means that you can have years where the corporation pays no income tax (because it has a net operating loss from the prior year that eliminates the taxable profit generated in the current year). But the corporation will pay the branch profits tax.
The simple solution for the branch profits tax is to hold U.S. real estate in a “foreign parent, domestic subsidiary” structure.
In this case the property is owned by a U.S. corporation. The branch profits tax only applies to foreign corporations. Therefore, if a U.S. corporation earns $8,000 of rental income (rent collected minus expenses), it will only pay corporate income tax of $2,000, based on my purely fictional tax rate of 25%, chosen to make the math really easy.
The U.S. corporation will not pay branch profits tax because the branch profits tax is only imposed on foreign corporations.
Disclaimers, Warning Shots, Waivers, Etc.
Adding a domestic subsidiary to the holding structure for U.S. real estate adds other complexities, of course. Another point: using corporations to own U.S. real estate is not terribly tax-efficient.
Do not choose a holding structure without good advice. If you think you have a bad holding structure, don’t fix it until you know what happens when you do that. The cure might be worse than the disease.
In other words, don’t rely on Internet Genius when it comes to your money. Talk to a human being who knows this stuff.4
- Yes, I know this is too simple. Yes, I know about depreciation. I am trying to keep this example really easy to understand. [↩]
- Yes, I know that there will probably be a State income tax return, too. Again, I am trying to keep this example really simple. [↩]
- The rental income goes here because your foreign corporation is engaged in the conduct of a trade or business in the United States–rental of real estate. If you are not sure if this is true, you will make a special election to force this result. The election is called the “net election” and this will be a topic for another blog post. [↩]
- I know someone. He is wearing my shoes right now. [↩]
“Simplicity is hard work. But, there’s a huge payoff. The person who has a genuinely simpler system – a system made out of genuinely simple parts, is going to be able to affect the greatest change with the least work. He’s going to kick your ass. He’s gonna spend more time simplifying things up front and in the long haul he’s gonna wipe the plate with you because he’ll have that ability to change things when you’re struggling to push elephants around.”
— Rich Hickey, Creator of the Clojure programming language
See Rich Hickey’s Rails Conf 2012 Keynote Speech. (YouTube). Quoted portion starts at 23:02.
The same thing is true for tax planning. I have been working on tax planning for U.S. corporations doing business abroad. Don’t get too caught up with cleverness and structuring. My work in the last couple of weeks has consisted of demolishing and burning bad stuff (corporations, structures, convoluted business transactions) and replacing it with K.I.S.S. stuff. Disregarded entities. “I hire you, you do this project, I pay you $X” contracts instead of messy joint ventures.
Reaching for $1,000X of tax savings frequently costs you $2,000X in accounting and legal fees to make the IRS all warm and fuzzy on your tax returns. We saw this last week where a prior year tax election was made that saved $5,000 (!) of tax, but so far has cost $40,000 to fix. Not to mention the time distraction for the principal of the venture.
More to Rich Hickey’s point, a U.S. multinational that keeps its affairs rigorously simple will be nimble. They’re executing a deal while their competitors are sitting in a law firm (or Big 4) conference room looking at PowerPoints.
The same, of course, is true of foreign businesses expanding to do business in the United States.
Keep it simple.
Hat tip: DevOpsU.
Make the net election once
Nonresidents who have U.S. rental real estate will usually make an election to have their rental income taxed as if they were residents of the United States.
They do this because it results in lower income tax. It results in lower income tax for a simple reason: if they don’t make the election their rental income is taxed at 30% of gross rental income received, and no deduction is allowed for business expenses. By making the election, they are taxed instead on their rental income AFTER deduction of business expenses.
This election is called the “net election” because it is an election to be taxed on net income (income minus expenses) rather than gross income (income without deduction of expenses).
Making the net election
You, the taxpayer, can unilaterally make this election and you do not need consent from the Federal tax authorities to do so. Treasury Regulations Section 1.871-10(d)(1)(i) says:
A nonresident alien individual or foreign corporation may, for the first taxable year for which the election under this section is to apply, make the initial election at any time before the expiration of the period prescribed by section 6511(a), or by section 6511(c) if the period for assessment is extended by agreement, for filing a claim for credit or refund of the tax imposed by Chapter 1 of the Code for such taxable year. This election may be made without the consent of the Commissioner. Having made the initial election, the taxpayer may, within the time prescribed for making the election for such taxable year, revoke the election without the consent of the Commissioner. If the revocation is timely and properly made, the taxpayer may make his initial election under this section for a later taxable year without the consent of the Commissioner. If the taxpayer revokes the initial election without the consent of the Commissioner he must file amended income tax returns, or claims for credit or refund, where applicable, for the taxable years to which the revocation applies.
The method for making the election is described in Treasury Regulations Section 1.871-10(d)(1)(ii), which says:
An election made under this section without the consent of the Commissioner shall be made for a taxable year by filing with the income tax return required under section 6012 and the regulations thereunder for such taxable year a statement to the effect that the election is being made. This statement shall include (a) a complete schedule of all real property, or any interest in real property, of which the taxpayer is titular or beneficial owner, which is located in the United States, (b) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property, (c) the location of the real property or interest therein, (d) a description of any substantial improvements on any such property, and (e) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred. This statement may not be filed with any return under section 6851 and the regulations thereunder.
In practice this means that you attach the required statement to your tax return. That is the first year that you get the desired tax treatment on your rental income.
You’re only required to do it once
You only need to make the election once. From then on it is effective until you revoke it. The authority for this is found in Treasury Regulations 1.871-10(d)(2)(i):
If the nonresident alien individual or foreign corporation makes the initial election under this section for any taxable year and the period prescribed by subparagraph (1)(i) of this paragraph for making the election for such taxable year has expired, the election shall remain in effect for all subsequent taxable years, including taxable years for which the taxpayer realizes no income from real property, or from any interest therein, or for which he is not required under section 6012 and the regulations thereunder to file an income tax return. However, the election may be revoked in accordance with subdivision (iii) of this subparagraph for any subsequent taxable year with the consent of the Commissioner. If the election for any such taxable year is revoked with the consent of the Commissioner, the taxpayer may not make a new election before his fifth taxable year which begins after the first taxable year for which the revocation is effective unless consent is given to such new election by the Commissioner in accordance with subdivision (iii) of this subparagraph.
Emphasis added by me.
We do it annually
We just completed an estate tax return for a nonresident individual who had several rental properties in the United States. He did not have a proper holding structure and as a result his heirs paid about $750,000 of estate tax on about $4,000,000 of real estate. And the probate and administration costs were gigantic. The moral of THAT story? Don’t assume that because you’re young and healthy you can get away with sloppy tax planning.
But I digress.
One of the collateral problems we faced was attempting to determine whether the deceased person had made the net election in a proper fashion. (In order to do an estate tax return, you have to make sure that all of the income taxes are paid up, which means you need to figure out if the tax returns were done correctly). For a couple of the properties, he had held them so long that we could not find the tax returns for the years in which he acquired the properties. So we did not know whether the net election had actually been made. (We were told that it had been made, and everything looked consistent with that treatment, but we couldn’t be sure).
The simple solution for this is to attach a statement to every U.S. income tax return that is filed. Every year. Attach the net election statement again but rewrite it in the past tense to say “The taxpayer made the net election for the following properties on his/her/its <year> income tax return . . . . ” and continue with the required information.
This can be set to automatically print as an attached statement for every year in the future in your software (we use Lacerte) and you just might save some work for someone in the future.
East West Bank comments on IRS requirement for nonresident interest reporting
The IRS wants all U.S. banks to report the amount of interest earned on bank deposits owned by nonresident aliens.
This last came up 10 years ago, and was resoundingly shot down for obvious reasons. Leadership at the IRS has revived the idea. Cue the obligatory George Santayana reference.
Today I saw in Tax Notes Today a letter from Douglas Krause, General Counsel for East West Bank. They happen to be headquartered right here in my hometown of Pasadena, California.
Mr. Krause succinctly identifies what’s wrong with the idea. I’m a total fanboi.
CC:PA:LPD:PR (REG-146097-09), Room 5203,
Internal Revenue Service
PO Box 7604
Ben Franklin Station,
Washington, DC 20044
February 22, 2011
RE: IRS REG-146097-09
California based East West Bank is the largest bank in the nation targeted at serving the Asian American communities throughout the United States of America. With over $ 20 billion in assets, and servicing more than half a million customers in five states including California, Washington, Texas, Georgia, Massachusetts and New York, our customer base, though Asian, is diverse, in education, profession, age and even nationality. With an overseas network that spans Greater China, our customers include Non-Resident Aliens (NRAs) who bank with us to provide them with a variety of financial services. We are writing to express our strong opposition to the subject proposed regulation.
Our bank, having grown by 64% in the last year, is healthy not by chance — but by watching our bottom line, coupled with a strategic expansion of our branch network as we continue to provide the most optimal service to our clients and customers. The proposed legislation would increase time and resources needed to gather, compile and report interest paid to every client that is a NRA. Current reporting of interest earned includes a single page document, as necessary for tax reporting purposes that is electronically compiled and sent to the Internal Revenue Service. Having to identify and separate the NRA account holders and prepare a 17 page document would involve multiple service hours to collect, validate and input data before the filing is completed for NRA customers. This not only puts a significant burden on our accounting and back office operations, but would have the potential to seriously hurt our bottom line by increasing cost of operations.
As we have expanded our branch network nationally and across the Pacific in Greater China, our growth has included the banking relationships with overseas clients. The profile of these customers are varied as they are diverse. It is not yet known what the impact of providing NRA interest income information to the customer’s homeland will have on the status of the accounts currently maintained with us. Furthermore, it is possible that the possible exposure of overseas accounts could potentially impact the political and social standing of the customer in their home country. As a nation dependent on bank deposits to fund development and homeownership leading to economic growth and prosperity, we should not raise the possibility of preventing inflow of deposits and investments from overseas, much less cause a mass exodus of funds already in deposit with our nation’s financial institutions. We ask that the implications and repercussions of providing such reports be considered.
Lastly, we wonder what the act of providing such information will bring to the table for the United States. In the spirit of exchanging intelligence and information, and we dare not presume knowledge nor assume any expertise in International Affairs, but without prior consensus, is this a mutually worthwhile goal, particularly where resources and revenues are concerned.
At a time when the nation is considerably lacking the funds to fuel the recovery of the economy, we sincerely and respectfully oppose the proposed regulation and ask the IRS to withdraw the proposed legislation.
Douglas P. Krause
East West Bank
Milestones for the nonresident investor in U.S. real estate
If you are a nonresident of the United States and are considering real estate investments in the U.S., the first thought is “Where do I start?” It is a big job to buy real estate in your home country. Investing in a faraway land adds to the complexity.
Here is a quick set of milestones to help you think through the process. This comes from an email I just sent to someone who is thinking about starting the investment process, and I edited it a bit for clarity. I hope it helps.
Your project, I think, has the following milestones:
- Investment objectives. Tentative decision on type/location/size of investments. (You’ve done this already).
- Management requirements. Determination of amount of management required. (Can you outsource 100% or will there be a lot of work from you or from people you trust?) Example: a major retail shopping center has scads of maintenance people, janitors, leasing agents, etc. and it is an all-the-time job to keep the place rented and maintained. Yes, you can job out the janitorial work etc. to outside firms, but you need to monitor the jobbed-out work to make sure it’s done right, so that means you have a manager or two on staff on your own payroll.)
- Analysis and selection on holding structure. Given the type of property you want to buy, and the practical needs for hands-on management, choose how to own and operate the real estate investments. Factors involved:
- Type/location/size of investments (from above). This helps you make the cost/benefit analysis necessary for the holding structure. Bigger investments mean more complexity expense will pay off with tax savings. Smaller investments mean “keep it simple.”
- Management structure you need to carry (from above). (Translation: do you need a dedicated property management company or not?)
- U.S. and [home country] income tax considerations on rental income
- U.S. and [home country] tax consequences on sale of the property
- U.S. and [home country] tax considerations for tax if you have the bad judgment to die
- Business considerations, such as lenders — will your structure be something that a bank will lend to?
Create holding structure taking into consideration the factors above and a rigorous eye on cost/benefit considerations Buy property. This is the fun part, right? People and operations. Find key people to help you with owning/operating the real estate and holding structure — property management, bookkeeping, legal, tax returns, etc.