Attribution Rules, Nonresident Alien Spouses, and Controlled Foreign Corporations

This blog post describes a situation when there is an exception in the attribution rules so that one spouse is not considered the owner of the other spouse's stock in a foreign corporation. There are, of course, exceptions when someone is a nonresident alien spouse.

This can have real-world impact: what you assume is a controlled foreign corporation? It isn't.

Facts

Husband is a U.S. citizen. Wife is not a U.S. citizen. Nor is Wife a resident of the United States.

Husband and Wife each own 50% of a foreign corporation's stock. Let's call it Foreign Corporation.

The 50% ownership could be because the shares are registered in the names of Husband and Wife. Or, community property rules could mandate that the shares are owned 50% each, no matter whose name appears on the stock certificate.

Question

Is Foreign Corporation a "controlled foreign corporation" if its stock is owned 50% by a U.S. citizen and 50% by the U.S. citizen's nonresident alien spouse?

Answer

Foreign Corporation is not a controlled foreign corporation in that situation.

What’s a controlled foreign corporation?

A foreign corporation is a "controlled foreign corporation" if "U.S. shareholders" own more than 50% of the stock.

IRC §957(a) General rule. For purposes of this title, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of—

(1) the total combined voting power of all classes of stock of such corporation entitled to vote, or

(2) the total value of the stock of such corporation,

is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.

Emphasis added.

More than 50% is not the same as exactly 50%. This is the crux of the argument that follows. I will demonstrate that Foreign Corporation has one U.S. shareholder who owns exactly 50% of its stock.

What’s a U.S. shareholder?

"U.S. shareholder" is a term of art, defined in the Internal Revenue Code. It does not mean a U.S. person who happens to own a share of stock.

Definition

A U.S. shareholder is someone who (1) owns 10% or more of a foreign corporation's stock, and (2) is a U.S. resident or U.S. citizen.

IRC §951(b) United States shareholder defined. For purposes of this title, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.

In this example, Husband is a U.S. shareholder because he meets both criteria:

• He is a U.S. citizen or resident, and
• He owns more than 10% of Foreign Corporation's stock.

Wife is not a U.S. shareholder:

• She meets the ownership criteria with more than 10% ownership, but
• She is not a U.S. citizen or resident so Wife is not a U.S. shareholder.

Because Husband is the only U.S. shareholder and owns exactly 50% of its stock, Foreign Corporation is not a controlled foreign corporation.

But Phil, constructive ownership!

What about constructive ownership? Wife owns the other 50% of the stock. Attribution of stock ownership between spouses is an Article of Faith amongst tax professionals.

Not here.

Constructive Ownership for U.S. Shareholders

A U.S. citizen or resident will be a U.S. shareholder by owning stock in one or both of two different ways:

• Really, truly "owns" the stock within the meaning of IRC §958(a); or
• Let's pretend. Is "considered as “owning" the stock within the meaning of IRC §958(b).

Just go read IRC §951(b), quoted above, to see how "owns" is defined.

Constructive Ownership for U.S. Shareholder Determinations

Let's now see why Husband does not constructively own Wife's stock of Foreign Corporation. The journey starts at IRC §958(b), travels to IRC §318(a)(1)(A), then returns to IRC §958(b)(1).

Constructive ownership rules consider a person (Husband in this case) to own the shares owned by someone to whom he is closely related. Husband and Wife are closely related.

IRC §958(b) tells us to use the default IRC §318(a) constructive ownership rules to determine whether an individual is a U.S. shareholder. These constructive ownership rules will help you decide how many shares a person owns, in the "let's pretend" sense of the Internal Revenue Code.

IRC §958(b). For purposes of sections 951(b), 954(d)(3), 956(c)(2), and 957, section 318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—

Emphasis added.

The next step of our journey, IRC §318(a), states:

IRC §318(a) General rule. For purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable—

(1) Members of family

(A) In general. An individual shall be considered as owning the stock owned, directly or indirectly, by or for—

(i) his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and

(ii) his children, grandchildren, and parents.

If you stopped here, you would treat Husband as constructively owning Wife's 50% of the stock of Foreign Corporation. He would then own 100% of the stock of Foreign Corporation (50% directly and 50% constructively through his wife), and Foreign Corporation would be a controlled foreign corporation.

However, there is an important exception for precisely the question we are asking ("Is Foreign Corporation a 'controlled foreign corporation'?") and here our journey returns to IRC §958(b)(1).

IRC §958(b) Constructive ownership. For purposes of §951(b), §954(d)(3), §956(c)(2), and  §957, §318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—>>

(1) In applying paragraph (1)(A) of section 318(a), stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) shall not be considered as owned by a citizen or by a resident alien individual.

In easy language, IRC §958(b) tells you:

• Use the default rule for treating a U.S. person as the owner of stock in a foreign corporation that is owned by family members; BUT
• Not if the family member is a nonresident alien.

Conclusion: Not a Controlled Foreign Corporation When The Nonresident Alien Spouse Owns 50% or Less

Let's wrap it up.

In this example, Husband is not the constructive owner of the 50% of stock owned by Wife because Wife is a nonresident alien.

U.S. shareholders (one in this case, namely Husband) of Foreign Corporation collectively own precisely 50% of the stock of Foreign Corporation. To be a controlled foreign corporation, a corporation must have U.S. shareholders owning more than 50% of the stock.

Precisely 50% is not more than 50%.

Therefore, Foreign Corporation is not a controlled foreign corporation.

Note: this little excursion applies to any family attribution, not just between spouses.

The moral of this story is . . . when you do tax research, assume your first conclusion is wrong and that the Internal Revenue Code contains an exception to the rule on which you based your conclusion. Go hunting for it and look out, because there might be an exception to the exception.