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.
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. ((Yes, I know this is too simple. Yes, I know about depreciation. I am trying to keep this example really easy to understand.))
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.
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%.
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.
Simple Example
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. ((Yes, I know this is too simple. Yes, I know about depreciation. I am trying to keep this example really easy to understand.))
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. ((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 place on Form 1120-F where this information goes is Part II. ((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.)) 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%.
Automatic
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.Simple Solution
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.
a couple add – ons with regards to my research into “streamlined program“. The $1,500 tax owed p.a. and filing 3 year tax and 6 year FBAR is not firm.
I have heard that the IRS has moved many overseas expats currently into the SP without giving notice and have done 5/6 years under the Streamlined a number of times. I have been told by IRS agents that they have no problem with this approach, and it will not lead to additional penalties, audit, or other enforcement. Their view is that since you’re meeting the program’s requirements, there’s no evil in an additional 2/3 years. The streamlined approach has no guaranties against penalties being levied. The IRS has said that individuals who are considered “low risk” will not have penalties levied. It has provided some guidelines for what constitutes low risk, but that’s all that exists to date. So the bottom line is : it depends – no FBAR penalties in any case but with regards to FTP,FTF,FTD civil tax penalties it is discretionary depending how your examiner sees your case as simple or more complicated.
Thanks for the correction Michael. Brain fart by me on the 3.8%. 🙂
This comment is posted from the Rose Bowl where the Bruins just scored again.
I’m a big proponent of very seriously considering noncorporate structures, so as to avoid the double tax and loss of LTCG rates that accompanies corporate structures. But the estate tax is definitely an issue, and one needs to have a well thought out plan for addressing estate taxes before embarking on a noncorporate structure. Also, one small nit, NRAs are not subject to the 3.8%.
@bubblebustin,
Yoikes. A big question. But as a practical matter look at the financial bogey they tell you in the streamlined procedure — $1500/yr in tax. Penalties on top of that are going to be a few hundred dollars per year, at worst.
Yes I know that for some people even $400 per year or so will matter. But still. File, pay at $50 per month, and move on with life.
sorry Phil but can I ask you a question which is a bit off-topic : during a dinner party conversation yesterday I was discovering that a certain expat couple unfortunately has not filed their 1040 returns because they thought paying taxes in the country where they lived and worked would have been enough. Through our conversation I told them that they should qualify for the streamlined procedure and saying that in the Streamlined Program there are no FBAR and no tax penalties . So you will have any FTF (Failure to File) and FTP (Failure to Pay) penalties you paid returned to you. Those are the Section 6662 and Section 6651 penalties you had to pay because you did not file and pay when the return was originally due. Unfortunately, interest that was paid on any taxes due after the original filing due date is never returned. Was I correct in saying that FTF, FTP, FTD tax penalties do not apply within the streamlined procedure/program ?
I am still looking for a reference to that within the IRM`s.
http://www.irs.gov/uac/Instructions-for-New-Streamlined-Filing-Compliance-Procedures-for-Non-Resident-Non-Filer-US-Taxpayers
@bubblebustin – My point is that if the US isn’t an attractive place to invest, the above doesn’t matter to foreign investors.
If a foreign investor sees the US as a riskier place to invest because of FATCA, they may very well goes elsewhere in the world.
Homelanders see FATCA as a non-issue, but I can assure you foreigners and Americans living abroad see it totally different.
I will do another post explaining choices for owning U. S. real estate if you are a nonresident. But here is a quick summary.
The two taxes are the income tax (what capital gains tax rate will you pay if you sell the real estate at a profit?) and the estate tax (what is the tax if you die while owning the real estate?).
Using a foreign corporation to own U. S. real estate will defeat the estate tax. You can die knowing that the U. S. estate tax will not be imposed. But capital gains of corporations are taxed at a high rate (34% is typical).
Conversely, if you own the property in your own name, you will pay capital gain tax at a lower rate (20%
plus 3.8%EDIT: brain fart by Phil; thanks Michael Miller) but if you die the estate tax is imposed.The way to get the best of both worlds is an irrevocable trust. But this is expensive and cumbersome. It isn’t cost effective for small properties.
….using corporations to own U.S. real estate is not terribly tax-efficient….. Sorry Phil I forgot to ask : what would be the most efficient way for a NR to own US real estate.
sorry but I am not sure what this readers comment has to do with “Rental Income and Branch Profits Tax“ besides stirring up some controversy and the stereotype hate and fear mongering between the “rich“ and so called “working class“ folks.
IMO FATCA-DATCA-GATCA are reality and here to stay and everybody needs to accept that and comply.
But lets talk about Rental Income and Branch Profits.. interesting post Phil and I was not aware that the combined corporate income tax plus branch profits tax can be above 50%. This is why one should look for those deductions like expenses for repairs and property taxes but what I do not understand is that you excluded mortgage debt and assumed a cash deal. Keep in mind that banks are lending a lot more freely in the Bahamas 🙂
At the end of the day the USA is like one big Prospectus, you can invest in the US, risk FATCA, complicated tax rules and after all that you may, repeat may end up with a profit.
No thanks sell up and find a better Prospectus elsewhere.
FATCA is a bit like telling people the dangers of HIV or Smoking, people take a period of time to digest the news and then make a risk assessment. It’s evolution not revolution.
The rich can avoid FATCA just by jettisoning US citizenship at the extreme with us working folks keeping this issue as work in progress.
The US is writing a bad Prospectus.
My prediction –
As the world economy recovers tax evasion will become lesser of an issue as government revenues recover.
Civil Liberties groups in different countries will have to take on board FATCA as a discrimination issue with some countries’ court ruling against IGAs thereby slowing its progress.
Upcoming Swiss Referendum campaign interesting
FATCA is mirroring the shift in global political / economic power, If the US fails to implement this across the world or at least the G20, the shift in economic power has been confirmed. The US’ role in the world has been diminished. However people who follow this blog and others one will find this no surprise except the Homelanders.