Hello again, and welcome to the Friday Edition. More international tax goodies this Friday and every other Friday.
It’s Phil Hodgen and you signed up for this road trip. (I never add people to the mailing list — I hate getting spam and I will not inflict it on others). If you want to stop getting this, there is an unsubscribe link at the bottom of this email that will do the trick.
This week’s episode is for nonresident investors in U.S. real estate. Specifically, I am going to talk about an expedient method I have used before (and will use again) to get around a banking problem.
The question popped up in an email from a CPA in San Francisco who I know:
Our client owns a property in CA that is held by a foreign corporation. The foreign corporation doesn’t have its own bank account. The house is being listed shortly and the title company is not authorized to wire the proceeds to a bank account that isn’t owned by the foreign corporation on title.
Consider a situation where a nonresident investor sets up a non-U.S. corporation and that corporation owns U.S. real estate. (Yes, it happens. Not necessarily the most intelligent way to arrange your affairs, but still. It happens.)
As is usual in situations like this, the non-U.S. corporation does not have a bank account, because it is hard work to open bank accounts. (This is not sarcasm. This is the truth.)
In the United States, real estate transactions are usually handled by a middleman. In some parts of the United States, that middleman is a lawyer. In other parts of the United States, it is a title company (an insurance company that guarantees — for a fee — that the buyer will be the true owner of the property) or an escrow company. In all cases, the buyer transfers the purchase price to this middleman. All of the signed purchase documents are given to the middleman. The seller signs the transfer deed and gives it to the middleman. When all of the requirements of the contract have been satisfied by the buyer and the seller, the middleman gives the money to the seller and the transfer deed to the buyer.
But if the seller does not have a bank account, how does that middle-man deliver the money to the seller?
That is the problem we will solve here.
It is usual to use corporations formed in countries like The Bahamas or the British Virgin Islands for holding structures like this. These corporations are cheap and easy to create.
Unfortunately, it will be difficult to open a bank account for this corporation. My experience with U.S. banks is “forget it”. Sometimes people willing to travel to The Bahamas or the British Virgin Islands can somehow open a bank account there. But for anything touching the United States, non-U.S. banks tend to be extremely reluctant to establish a banking relationship.
So these holding structures tend to have corporations in them, and those corporations tend to not have bank accounts.
Back to the middleman in this real estate transaction. For reasons of liability, a middleman will want to deliver money to the seller of real estate — and no one else.
So if there is a foreign corporation that owns real estate, sells real estate, and has no bank account, how will it get the money?
Start with the basic premise that it is fairly easy for a U.S. limited liability company or a U.S. corporation to open a U.S. bank account. I have done this repeatedly at major U.S. banks, even if the owner of the corporation or limited liability company is a nonresident, and the person with signature power over the bank account is a nonresident. It requires a personal visit to the bank branch, but with suitable identification (a passport is sufficient) and the right company documentation, you will have a bank account for that U.S. company in an hour or two.
But that’s not good enough. You have a foreign corporation that owns the U.S. real estate, and a U.S. corporation or U.S. limited liability company that has a bank account. Let’s put the two together, so that the company that owns (and sells the real estate) has a bank account and can receive the cash from the sale.
The first (and easier) method is to create a U.S. limited liability company. Do this in the state where the real estate is situated. Do all of the paperwork for the limited liability company so it is completely formed.
Now, make the limited liability company be owned 100% by the non-U.S. corporation that also owns the U.S. real estate.
With this structure in place, go to your favorite bank and open an account in the name of the U.S. limited liability company.
Finally, transfer the real estate from the non-U.S. corporation to the U.S. limited liability company.
From a tax point of view, the limited liability company is called a “disregarded entity”. It has no independent status as a taxable entity, so the transfer of the real estate from the non-U.S. corporation to the U.S. limited liability company is a nonevent for U.S. income tax. No tax risk.
Now the U.S. limited liability company, as the owner of the real estate, can sell it. Since it has a U.S. bank account, the title company will happily wire the funds to that account.
Remember that the U.S. limited liability company is a disregarded entity, so the sale is reported on a tax return for the non-U.S. corporation, exactly as it would have been if the limited liability company had never existed.
The same tax liability will result from the sale, and the same tax return paperwork will be filed.
The U.S. limited liability company is the seller but is a disregarded entity, so for withholding tax purposes, the non-U.S. corporation is the seller.
With non-U.S. sellers of U.S. real estate, a withholding tax is imposed: 15% of the sale price. IRC §1445. Because the non-U.S. corporation is treated as the seller, the withholding tax will be imposed.
This tax is a credit against the actual income tax liability on capital gain received on sale by the non-U.S. corporation. If too much tax is withheld, the excess will be refunded after a tax return is filed.
A second way to do this (more tax paperwork and hoo-hah, but some benefits exist) is to use a domestic corporation.
The foreign corporation starts as owning the U.S. real estate.
It forms a domestic corporation, again in the state where the real estate is located. This domestic corporation is a wholly-owned subsidiary of the foreign corporation.
The domestic corporation gets a bank account.
Then the non-U.S. corporation transfers the real estate to its domestic subsidiary corporation.
This will be treated as a taxable sale by the foreign corporation. IRC 897(a). It can be made to be a non-taxable transfer by some extra tax paperwork. Use IRC §897(e) and Regs. §1.897-6T.
Now the domestic corporation is the owner of the real estate, and the domestic corporation has a bank account. It sells the real estate. The same capital gain will result, and the same income tax will be payable — compared to a hypothetical sale by the non-U.S. corporation.
Both corporations will have corporate income tax returns to file, in order to report the creation of the domestic subsidiary and the transfer of the real estate from the non-U.S. corporation to the domestic corporation.
Since the withholding rules apply only to foreign sellers, there will be no tax withholding. The seller is a domestic corporation, remember?
Finally, you have the problem of a domestic corporation that has paid all of its income tax and has a bank account full of money. It is time for that money to be transferred outside the United States to the foreign corporation. Remember, the foreign corporation still has no bank account.
Liquidating the domestic corporation will be a nontaxable event. All of the cash now belongs to the sole shareholder — the non-U.S. corporation.
The domestic corporation (controlled by the non-U.S. corporation) will be able to transfer that cash anywhere. The title company might have fears of liability if it transfers cash to third party bank accounts, but the title company is now out of the picture. We can do anything we want.
There is a third way to work around the “title company will not send cash to a third party bank account” problem.
The foreign corporation can distribute the real estate to its sole shareholders. This is rarely used (me = never) but it is theoretically possible.
The first step is to record a deed transferring the property from the foreign corporation to the foreign corporation’s shareholder. This might be a human being or it might be another corporation. Presumably this person or corporation has a bank account.
The withholding tax is 35% of the foreign corporation’s capital gain when there is a distribution of real estate to the shareholder. (Compare this to “15% of the gross sale price” in the other scenarios).
Now the shareholder sells the property, and because he/she (as a human) or it (as a corporation) presumably has a bank account, the title company will be happy to send money there.
The foreign corporation (which distributed the real estate to its shareholder) and the shareholder (who sold the real estate) will both file tax returns.
Talk to your favorite banker first. The most important factor here is your ability to open a bank account in the name of the domestic entity (limited liability company or corporation) that you create.
There are two critical elements to success in using one of these strategies. These are operational, not intellectual challenges:
There will be a metric ton of extra tax work required. Put up with it. Paperwork and professional fees are the cost of doing business and getting your money at the end of the sale.
That’s the story. Remember this is not legal or tax advice. There are a bunch of things to do and you have to get them right. Hire someone to help you. Personally, I think if you do one of these strategies it will be hard to create extra tax costs for yourself. But you could blow your real estate deal if the plan gets hung up mid-stream because you can’t get the paperwork processed by the Secretary of State fast enough.
I hope that helps, Brian. See you soon, I hope.