Hi, it’s Phil.
This week’s episode was inspired by an email from reader N in France, and was written on the grassy field in front of the Rose Bowl in beautiful Pasadena, California. It is a glorious Thursday evening. My youngest daughter’s soccer team is going through conditioning drills and I’m sitting on the grass instead of running a 5K loop around the stadium. Yay T-Mobile and unlimited high-speed internet tethering.
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Here’s the situation that N described in her email.
A nonresident owns a non-U.S. corporations to hold assets, including normal portfolio investments like stocks and bonds.
When such a person immigrates to the United States, that holding company runs the risk of being treated as:
- a Controlled Foreign Corporation (Form 5471) or
- a Passive Foreign Investment Company (Form 8621).
Paperwork burdens and punitive tax consequences are the immigrant’s reward for entering the United States.
One easy way to solve the problem is, of course, to dissolve the corporation before immigrating. All of the corporation’s assets are then directly owned by the individual immigrant and there is no pesky foreign corporation to create IRS problems.
That is not always possible, for practical reasons.
Here is one solution. If successful, the immigrant keep the foreign holding company intact and avoid having to deal with Controlled Foreign Corporation or Passive Foreign Investment Company problems.
The U.S. has a system where you can choose the way that the U.S. tax system perceives a various entities (foreign corporations are an example). We are going to use this to make a foreign corporation not be taxed as a corporation by the IRS, but instead be treated as if it does not exist for U.S. tax purposes.
The jargon (in case you feel like making a detour through Google) is “check the box”. All the work happens on Form 8832. It is a one-time form that you file to change the U.S. tax treatment of your foreign corporation.
The nice thing about this method is that your foreign corporation continues to exist, so it can continue to do whatever you wanted it to do: have a bank account, etc. But for U.S. tax purposes, it gets out of your way.
The corporation will be, as people sometimes call it (warning: tax slang) a “tax nothing” or a partnership. It will be a “tax nothing” if your corporation has only one shareholder. The shareholder will be treated for tax purposes as the direct owner of the corporation’s assets.
It will be a partnership if there are two or more shareholders. A partnership’s income is passed through to the partners — the partnership does not pay tax itself.
I am going to discuss the situation where one person is the owner of a foreign corporation, and that person is planning to become a U.S. resident.
There are a bunch of pre-requisites for making this election. See the instructions to Form 8832 for these.
The most important one is that your corporation is an “eligible entity”. You will find a list of corporation types by country in the instructions to Form 8832.
If your corporation is one of the types on that list, you are out of luck. You cannot make the election on Form 8832.
But let’s assume that all of these pre-requisites are satisfied.
There is a second requirement for the election (to make your foreign corporation be taxed as a tax nothing or as a partnership): the election must make a difference for U.S. tax. If filing a piece of paper with the IRS has no immediate impact on U.S. tax, then the election will just sit there, ineffective, until the election will make a difference.
This idea is called (warning: tax jargon) “relevance”. The election is not effective unless it is relevant.
Treasury Regulations Section 301.7701-3(d) contains this explanation:
Special rules for foreign eligible entities—(1) Definition of relevance—(i) General rule. For purposes of this section, a foreign eligible entity’s classification is relevant when its classification affects the liability of any person for federal tax or information purposes. For example, a foreign entity’s classification would be relevant if U.S. income was paid to the entity and the determination by the withholding agent of the amount to be withheld under chapter 3 of the Internal Revenue Code (if any) would vary depending upon whether the entity is classified as a partnership or as an association. Thus, the classification might affect the documentation that the withholding agent must receive from the entity, the type of tax or information return to file, or how the return must be prepared. The date that the classification of a foreign eligible entity is relevant is the date an event occurs that creates an obligation to file a federal tax return, information return, or statement for which the classification of the entity must be determined. Thus, the classification of a foreign entity is relevant, for example, on the date that an interest in the entity is acquired which will require a U.S. person to file an information return on Form 5471.
In summary, the election to change the classification (for tax purposes) of a foreign corporation will be effective only if it changes tax liability, or if it changes reporting requirements (i.e., who is the taxpayer).
An immigrant wants the election (made by filing Form 8832) to be effective before becoming a U.S. resident. If it is effective when the immigrant is a U.S. taxpayer, assorted tax headaches are possible.
So our objective is to make the election “relevant” when the sole shareholder is a nonresident of the United States, owning stock of a foreign corporation, where all of the assets are outside the USA and will not generate any taxable income.
That scenario means that an election will not affect U.S. taxation, and will not affect tax information reporting.
So let’s create some relevance before the immigrant actually starts U.S. residence.
The easiest way (and the one I favor) is to have the foreign corporation buy a United States Treasury Bill – a T-Bill. Worst case if your foreign bank will not do this for you? Buy it directly from the U.S. Treasury. 🙂 Spend $5,000 or $10,000 on the T-Bill.
For purposes of tax reporting, the owner of the T-Bill must give the payor (the U.S. government) a Form W-8. If the owner of the T-Bill is a corporation, the form used is Form W-8BEN-E. If the owner of a T-Bill is a human, the form used is Form W-8BEN.
I like this method because of the estate tax results and the income tax results.
A nonresident is taxable on U.S. assets only if he dies. All of the assets inside that corporation are now treated as owned directly by the nonresident. The foreign assets (foreign stocks and bonds) are outside the United States, so no estate tax is possible. (The USA really can’t tax a nonresident on stuff outside the United States).
The T-Bill is a U.S. asset. But there is a specific exemption in the tax law that makes these things not subject to estate tax if they are owned by nonresidents who die. The reason for the specific exemption is obvious: the U.S. government wants to encourage people all over the world to buy T-Bills.
Finally, the T-Bill is nice because the interest income is tax-free to nonresidents.
Do this before becoming a U.S. resident and you will start your life in the United States as the direct owner of all of the assets inside that foreign corporation for U.S. tax purposes. Yet the foreign corporation will continue to exist for all of the good business reasons that you thought of when you set it up.
You do not have any U.S. estate tax exposure in the time before you become a U.S. resident.
You do not have to worry about your corporation being a Controlled Foreign Corporation or a Passive Foreign Investment Company, with the extra tax cost and the extra expense of preparing these complicated forms.
Everything is butterflies and rainbows . . . except that there is a form to file, as usual. 🙂 In this case, the paperwork is Form 8858. Once you become a U.S. taxpayer, you will be filing this form every year to report the existence and operations of your foreign corporation.
But to my mind, this is an order of magnitude simpler to deal with than Forms 5471 (Controlled Foreign Corporation) or 8621 (Passive Foreign Investment Company).
There are other ways to do this. But I’m hitting my word limit for the week. The single most important thing to remember is this: before you become a U.S. resident, strive to eliminate Controlled Foreign Corporations and Passive Foreign Investment Companies from your life.
Yeah, this is not legal advice. While IAAAL, IANYL and TINLA. Go hire someone competent before you do anything and get some good advice. Screwing up tax stuff gets expensive.
See you next Friday.