This week I am going to highlight the “constructive ownership” rules in U.S. tax law. This means that the IRS can pretend that you own something — we will talk about stock of foreign corporations — even though you don’t really own it.
We will talk about U.S. citizens married to noncitizens. First, a simple example, then a more complicated (and realistic) example. The realistic example — one I have seen many times — yields a “Who knows what the answer is!” conclusion.
Here is the practical advice:
If you are a U.S. citizen living abroad, married to a noncitizen, look out for the combination of foreign corporations owned by trusts. This is a normal estate planning strategy, but it can create ambiguity (at best) and U.S. tax paperwork requirements (at worst) for you.
U.S. citizens who are shareholders or officers of foreign corporations may have to file Form 5471. It gets tricky. Sometimes you can be treated as if you are a shareholder, even if you do not own a single share of stock. You are treated “as if” you own stock of the foreign corporation, usually because of family relationships. But not always.
U.S. tax law gets weird whenever there is a “controlled” foreign corporation. That’s a foreign corporation that is controlled — for certain arcane definitions of “control” — by U.S. persons. But not just any U.S. person. The foreign corporation must be controlled by U.S. persons who are “U.S. Shareholders”.
If such a corporation exists — a controlled foreign corporation — U.S. tax law fears that it will be used in ways that save tax (for the shareholders). Congress, of course, does not want U.S. taxpayers to save tax.
Consider a U.S. citizen married to a noncitizen. The couple is living outside the United States. The noncitizen spouse owns 100% of the stock of a foreign corporation. Can the U.S. citizen spouse — who does not own a single share of stock — be considered to be shareholder and in control of the foreign corporation?
When we are trying to identify the shareholders of a foreign corporation, we look at direct ownership (your name is on the stock certificate), indirect ownership (e.g., you own a corporation that owns the foreign corporation), and constructive ownership (a close family member owns the stock so we will pretend that you own it).
Here, we know that a noncitizen owns 100% of the stock. So the U.S. citizen spouse married to that noncitizen is not a direct owner of stock. And the U.S. citizen spouse is not an indirect owner of the stock: the stock of the foreign corporation is owned by a human, not by another entity.
So in order to figure out whether the U.S. citizen spouse “owns” the stock of the foreign corporation, we must look to the rules that say “if a family member owns the stock, you own the stock.” These are called “constructive ownership” rules in tax jargon.
The constructive ownership rules we care about are found in Internal Revenue Code Section 958(b). If you boil through the obtuse language, it says “Federal tax law says that you are treated as the owner of any corporate stock owned by your spouse”.
Fortunately, there is an escape. A U.S. person is not treated as if she owns stock that is directly owned by a nonresident alien.1
And so, in this situation, we can safely say the following is true:
Normally, I do not see people own stock of foreign corporations directly. Instead, they do normal estate planning, using trusts. Someone sets up a trust, and the trust owns the stock of the foreign corporation.
The people who benefit from the trust? Typically I see trusts that are for the benefit of the person who created the trust, as well as his or her immediate family.
In our practice we frequently see trusts that are created by the husband for the benefit of his wife, children, and further descendants. The trust is irrevocable, and the trustee has absolute discretion in how the funds are distributed among the beneficiaries.
Jargon alert: call this a “discretionary” trust because the trustee has discretion on how to distribute money. The trust does not mandate amounts or percentages to be distributed to the beneficiaries.
The trust does not own assets directly. Instead, the trust owns a foreign corporation, and the foreign corporation owns the assets of the trust.
Jargon alert: tax lawyers call this an “underlying corporation”.
Here’s our example. Mr. Big is a noncitizen of the United States. Mrs. Big is a U.S. citizen. They have three children, all U.S. citizens (born in the United States is the typical reason).
Mr. Big sets up one of these trusts. All of the Big family members are beneficiaries of this trust. This means there are four U.S. citizens and one noncitizen as the beneficiaries of this trust.
This is all done for normal estate planning reasons.
There are two types of trusts: grantor trusts and nongrantor trusts.
A grantor trust is simply a trust that has been carefully written so that the person setting up the trust is treated as the “real” owner of the assets in the trust, according to U.S. tax law. The trust is completely functional for transferring assets at the time of death, but it is essentially ignored for U.S. tax purposes (except to possibly spawn a megaton of paperwork).
A nongrantor trust is a trust that is not a grantor trust.
These trusts are usually nongrantor trusts, because they have not been carefully crafted to make them grantor trusts for U.S. tax purposes.
Look carefully at the situation. The trust is the shareholder of the corporation. The beneficiaries do not have any voting power for the shares: the trustee has that power. The beneficiaries may or may not get a distribution from the trust: that decision is completely within the trustee’s discretion.
So. Are the four U.S. citizens going to be treated in a way that makes the trust-owned foreign corporation be considered to be a controlled foreign corporation for U.S. income tax purposes?
Well yes. But . . . .
[S]tock owned . . . by . . . a foreign . . . trust . . . shall be considered as being owned proportionately by its . . . beneficiaries. Stock considered to be owned by a person by reason of the application of the preceding sentence shall, for purposes of applying such sentence, be treated as actually owned by such person.3
Get it? The trust owns the stock, but the beneficiaries are treated as if they are the real shareholders. Direct ownership.
But that “proportionally” word. What does that mean? Remember, we have a trust where the trustee can distribute something or nothing, give it all to one beneficiary and nothing to the others, or any variation on that theme. How can there be “proportion” when distributions from the trust as at the whim of the trustee?
This is one of the great “angels dance on the head of a pin” debating societies amongst tax professionals. There is no real answer to the question, at least as far as I know. Many opinions, of course!
We don’t want opinions. We want certainty. Mrs. Big and the three little Big children want to know whether they must file Form 5471 as shareholders of a foreign corporation.
Here’s the certainty they crave. The clue is written in the phrase “controlled foreign corporation.” Do the U.S. citizen beneficiaries have the required amount of “control” over the foreign corporation that is needed to make the corporation a “controlled foreign corporation”?
In order to make the trust-owned foreign corporation be treated as a controlled foreign corporation for U.S. tax purposes — spawning unknown tax paperwork and possibly tax liability for the shareholders — the control must be wielded by “U.S. Shareholders”. Yes, another term of art.
A “U.S. Shareholder” is someone who holds more than 10% of the voting power of the stock of the foreign corporation.4
So let’s pretend that we say Mr. Big, Mrs. Big, and the three Big children each have a proportional 20% beneficial interest in the trust. Just for argument’s sake.
The four U.S. citizens are not U.S. Shareholders (the defined term of Section 951(b)) even though they are U.S. persons who are shareholders (because of Section 958(a)(2)). Why? Because they do not have voting power over the stock of the foreign corporation. The trustee has that power.
As a result, the foreign corporation owned by the foreign trust is not a controlled foreign corporation. And because it is not a controlled foreign corporation, Mrs. Big and her three Big children (U.S. citizens all) will not file Form 5471 because of Categories 4 or 5.
In fact, life is never clean and simple.
In short, when you have a trust, you must read the trust carefully to decide whether its underlying corporation (or frequently corporations) is a controlled foreign corporation or not.
The moral of the story is: Assume nothing. Know that the constructive ownership rules exist. Know that trusts or more elaborate holding structures can introduce uncertainty.
Here’s what you need to do, if you are a U.S. citizen married to a noncitizen, and the noncitizen owns stock in any foreign corporation.
At the end of this work, you will be able to decide whether you are a U.S. Shareholder in a controlled foreign corporation.