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. [↩]
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.
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.
Branch profits tax for nonresident investors in U.S. real estate
This little FAQ is a simple (for certain values of $SIMPLE) explanation of the branch profits tax for nonresident investors in U.S. real estate.
As a general principle it is a Very Bad Idea for nonresidents to own income-generating U.S. real estate through foreign corporations. If you live in a country that has an income tax treaty with the United States, there may be a solution to the branch profits tax via the treaty.
What is the branch profits tax?
The branch profits tax is an extra income tax imposed by the United States on foreign corporations which earn profit from their U.S. investments or U.S. business operations.
How much will the branch profits tax cost?
The branch profits tax is imposed on a non-U.S. corporation’s after-tax net profit. Simply put, the branch profits tax works like this:
- Calculate the non-U.S. corporation’s profits derived from U.S. investments or business operations.
- Pay regular corporation income tax on that profit.
- Whatever is left over is your after-tax net income. Pay 30% of that after-tax net income as the branch profits tax.
Example of calculating branch profits tax
Let’s assume that a non-U.S. corporation owns U.S. real estate that is rented. At the end of the year, after paying all business expenses, the corporation has a profit of $100.
First, the corporation will pay income tax. The tax rate is on a sliding scale (higher income means higher tax rate). But let’s use 34%, the rate that applies for income of about $350,000 and up. After paying the regular income tax, the corporation has $66 remaining.
Then the corporation pays the branch profits tax, which is 30% of the $66 remaining after payment of the regular income tax. The branch profits tax is $19.80.
The total tax paid is $34.00 + $19.80 = $53.80, or 53.8% of net profit.
Only foreign corporations pay the branch profits tax
The branch profits tax is only imposed on foreign corporations. This means two things:
- The entity must be viewed as a corporation from the perspective of the U.S. tax authorities; and
- The entity must be formed under the laws of a country other than the United States.
People, then, do not pay the branch profits tax, even if they are nonresidents of the United States. Nor do partnerships or trusts.
What is a foreign corporation?
Be careful. Sometimes you may have an entity that is called a corporation but is treated in the United States for tax purposes as something else. Similarly, you may have an entity that is not called a corporation, but is treated as a corporation in the United States for tax purposes.
Many countries attribute residence of a corporation to its place of management. This does not matter for U.S. tax purposes. A corporation is foreign if the organizing documents (Articles of Incorporation or similar) say something to the effect of “This corporation is formed under the laws of ________” and the place named is not a place in the United States.
Why the branch profits tax exists
The branch profits tax is intended to cause non-U.S. corporations (and their shareholders) to be taxed identically to U.S. corporations (and their shareholders). The idea is that a nonresident investor should be indifferent–from a U.S. tax perspective–between investing in the United States through a non-U.S. corporation or through a U.S. corporation.
If a non-U.S. person owned a U.S. corporation which made the equivalent investment, the net profit would be taxed at 34%. Under the example I gave, this means that the corporation would contain $66.00 after paying its income tax. If the shareholder wanted that cash, the corporation would pay a dividend to the non-U.S. shareholder. As the dividend money leaves the United States there is a withholding tax imposed, at a default rate of 30% of the amount of the dividend. (It can be less if the recipient lives in a country that has an income tax treaty with the United States.)
Thus, a non-U.S. investor who used a U.S. corporation would pay two levels of tax: the regular corporate tax calculated at 34% of income, and the 30% withholding tax on the dividend paid by the corporation to the shareholder.
Compare that to the same investment made by a non-U.S. investor through a non-U.S. corporation. The non-U.S. corporation earns $100. It pays the regular income tax at 34%.
It has $66.00 remaining in its bank account. Now the shareholder wants a dividend. The United States cannot tax that dividend because it is paid from a non-U.S. corporation to a non-U.S. shareholder. The second level of tax–the 30% tax on dividends–will not be paid.
The branch profits tax plugs that hole.
The branch profits tax applies automatically
The branch profits tax automatically applies if there is a profit generated in a fiscal year for the non-U.S. corporation. Compare that to the tax on a dividend: here the corporation controls if and when the withholding tax on the dividend will be paid, by deciding to pay (or not) a dividend.
How a non-U.S. corporation avoids the branch profits tax
The branch profits tax is imposed in an automatic and mechanical way. There are only a few ways to eliminate it:
- Reinvest your profits in the United States;
- Find an exemption in the income tax treaty between the United States and the country in which the corporation was formed (the United Kingdom, for instance, has an exemption); or
- Completely terminate all business and investment operations in the United States (also know as “sell your assets and take your money home”).
When the branch profits tax is harmless to real estate investors
The branch profits tax is harmless to nonresident real estate investors if the non-U.S. corporation owns one piece of U.S. real estate, and that property is not producing income. Direct ownership of land is fine. So is direct ownership by a non-U.S. corporation of a house which is used for personal purposes.
The branch profits tax does not matter in these situations because there is no annual rental income collected. No income means nothing to tax.
In the year of sale there will be profit and the branch profits tax will apply. But there is a simple exception which can be used to eliminate the branch profits tax in the year of sale–the branch profits tax will not apply if the non-U.S. corporation ceases all U.S. business and investment operations in the year of sale.
When the branch profits tax applied to rental property
The branch profits tax will apply to nonresident investors in U.S. real estate who have rental income held directly by a non U.S. corporation. The income collected (after expenses) will be subjected to the branch profits tax.
When the branch profits tax applies to multiple properties
A non-U.S. corporation which owns many pieces of U.S. real estate will have a branch profits tax problem.
If any of the properties are rented, the rental income will be subjected to the branch profits tax.
If one of the pieces of real estate is sold, the profit on sale will be subjected to branch profits tax, and the exception traditionally used to eliminate the branch profits tax (the non-U.S. corporation ceases all U.S. investment and business operations in the year of sale) cannot be used, because the corporation continues to hold other pieces of real estate.
What to do if branch profits tax is a problem
If you have an existing situation which triggers branch profits tax, consider adding a U.S. corporation to the holding structure. Instead of the non-U.S. corporation owning U.S. real estate directly, the non-U.S. corporation will own all of the shares of a U.S. subsidiary corporation, which in turn owns the U.S. real estate.
This type of restructuring will not trigger any tax if done correctly. It is purely a paperwork exercise.
Since the owner of the real estate is now a U.S. corporation, the branch profits tax will no longer apply. (Branch profits tax only applies to non-U.S. corporations).
FIRPTA withholding credit given even when the IRS didn’t get the money
In emailed advice released today on Tax Notes Today (2010 TNT 137-56 for you TNT fans) the IRS issued a rare written piece of information on FIRPTA withholding.
When a nonresident sells U.S. real estate, Uncle Sam wants to be sure to collect tax on the capital gain that the nonresident makes. This is achieved by forcing the buyer to withhold 10% of the purchase price. The buyer then gives that money to the IRS. The nonresident seller files a U.S. income tax return, and reports the capital gain and his/her/its actual tax liability. If the tax liability is less than the amount of tax withheld and remitted to the IRS, the nonresident seller gets a refund of the difference.
What happens if the buyer withholds the 10% but never pays it over to the IRS?
In the email reproduced below, the IRS says that the nonresident seller will get credit for the tax withholding from the IRS. And in this case, the nonresident seller was entitled to a tax refund.
The buyer has a problem
The IRS won’t get caught short. Don’t worry. The buyer is sitting on 10% of the purchase price, money that should have gone to the U.S. government but didn’t. That buyer is going to visit the House of Pain soon. “It’s Uncle Sam’s money, you have it, so gimme. Now.” (More or less that’s what will happen when the IRS comes knocking at the buyer’s door.)
The IRS email advice
The text of the email follows:
Release Date: 7/16/2010
Office: * * *
From: * * *
Sent: Tuesday, June 15, 2010 5:38:37 PM
To: * * *
Subject: advice on FIRPTA
Thanks for your patience while I coordinated with the IRC section 1445 experts within Counsel (* * *). Here is a written explanation that you can provide to the Service Center in bringing resolution to your case.
A nonresident alien sold real property located in the United States, which is a United States real property interest (USRPI) as defined in IRC section 897(c)(1)(A)(i) and Treas. Reg. section 1.897-1(c)(1)(i). The buyer withheld 10% of the amount realized on the sale, as required under IRC section 1445(a) and Treas. Reg. section 1.1445-1(b)(1). However, the buyer did not pay over the amount withheld to the IRS. Consequently, the nonresident alien seller did not receive a stamped copy of Form 8288-A from the IRS.
The seller filed a U.S. tax return on which it sought a credit in the amount withheld against his tax liability, and sought a refund of the excess amount withheld. To date, the Service Center has refused to grant the credit because it has no record of receiving the amount withheld from the buyer, as in fact the buyer had not paid over the amount withheld.
Whether the seller is entitled to the credit (and thus a refund) even though the amount withheld was never paid to the IRS.
Yes, the seller is entitled to the credit (and thus a refund in this case), provided that the seller has substantial evidence (e.g., closing documents) of the amount of the credit.
Treas. Reg. section 1.1445-1(f)(1) (last sentence) provides that “[a]ny tax withheld under section 1445(a) shall be credited against the amount of income tax as computed in [the seller's] return.” See also IRC section 1462 (granting a credit for income tax withheld at the source). Treas. Reg. section 1.1445-1(f)(2) provides that generally a stamped copy of Form 8288-A (Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests) must be attached to the seller’s return to establish the amount withheld which is available as a credit. If the amount withheld under IRC section 1445(a) exceeds the seller’s maximum tax liability with respect to the disposition (as determined by the IRS), then the seller may seek an early refund of the excess pursuant to Treas. Reg. section 1.1445-3(g), or a normal refund upon the filing of a tax return.
Treas. Reg. section 1.1445-1(f)(3)(i) provides that if a stamped copy of Form 8288-A has not been provided to the seller by the IRS, the seller may establish the amount of tax withheld by the buyer by attaching to its tax return substantial evidence (e.g., closing documents) of such amount. Such a seller must attach to its return a statement which supplies all of the information required by Treas. Reg. section 1.1445-1(d), including the seller’s identifying number. The preamble to T.D. 8113 (Dec. 24, 1986), which finalized the IRC section 1445 withholding regulations, explains that Treas. Reg. section 1.1445-1(f)(3)(i) was promulgated specifically to deal with the situation in which the buyer failed to remit the withheld funds to the IRS. Accordingly, if the seller filed the requisite tax return and establishes the amount withheld through substantial evidence, the Service Center should grant a credit to the seller to the extent the amount withheld exceeds his maximum tax liability with respect to the disposition, as determined by the IRS.
It should be noted that IRC section 1461 and Treas. Reg. section 1.1445-1(e) impose liability on the buyer for the tax which it was required to withhold. In addition, IRC section 6651 imposes penalties on the buyer for failure to file Form 8288 when due, and for failure to pay the withholding when due.
* * * has spoken with the * * * attorney who previously provided you advice in this case, and all parties are now in agreement that credit for the withholding is permissible even though the amount withheld was never paid to the IRS. Thus, please disregard the advice previously provided by * * *.
Please let me know if you have any questions.