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December 9, 2016 - Phil Hodgen

Who’s On the Hook for Withholding Tax Failures?

This week I want to cover a real estate situation, and the perils of being a withholding agent when there is a foreign seller of U.S. real estate.

Foreign Corporation as Seller

From time to time I see foreign corporations as direct owners of U.S. real estate. This can work from a U.S. tax point of view (i.e., it can block the application of estate tax on the real estate if the shareholder dies).

But it creates a host of practical problems. And solving those practical problems will sometimes beget more practical problems.

This time I am going to explore the fine points of withholding tax on the sale of U.S. real estate by nonresidents. If you are involved (on the buyer’s side or the seller’s side) you may be potentially on the hook if withholding should happen, but doesn’t.

Is This Grant Deed Valid?

One common problem is proving the corporation’s good standing. Is this a real corporation? Are the people who say they can sign the deed really empowered to do so? Is this a valid grant deed that the buyer will receive?

I have handled many such transactions, and they always end up working. But many times there is a rush to order Certificates of Good Standing from far away, get signatures from nominee directors, and other practical issues.

Here, the title insurance officer is God. Whatever he or she wants, we get. No title insurance, no sale. It’s that simple.

If you use a foreign corporation as the owner of U.S. real estate, and if you are thinking of selling, start early. Select a title company. Do the footwork ahead of time so you are not sprouting grey hairs and paying ridiculous expedite fees to get the documents you need to close the sale.

Banking Problems

Current world reality is that banking is hard. All of us are under suspicion of being reprobate Communist terrorist drug lord money laundering tax evaders, and banks worldwide seem to be the lapdogs of the U.S. government.

But I’m not bitter.

As a consequence, it is typical for complex holding structures to have no bank accounts for any of the offshore corporations.

This creates a problem at the time of sale. The cash from the sale must go somewhere. And because we are all evil cybercriminal hacker fraudsters impersonating innocent grandmothers, title companies, escrow companies, and other settlement agents will sometimes insist that cash from sale can only be paid to a bank account in the name of the seller.

Well. If the seller is a foreign corporation, has no bank account, and has no realistic prospect in this decade or the next of being permitted the privilege of opening a bank account, what are you to do?

Answer: create a different seller.

The Quick LLC Trick

Here’s what I do. Form a limited liability company in the State where the real estate is located. The sole member of the LLC will be the foreign corporation.

As a result, this LLC will be a disregarded entity by default for U.S. tax purposes.

Go to your favorite bank and open a bank account. This is achievable.

Now record a grant deed, transferring the real estate from the foreign corporation to the LLC. This is a nonevent for tax purposes. No tax. Just some recording fees.

Now the seller (in the eyes of the real estate contract, the title company, and everyone involved–except the IRS) is the LLC. The LLC has a a bank account and can receive the cash from sale of the real estate.

Finish the sale. Collect the money in the LLC. Once the money is in the LLC’s bank account, you (the sole shareholder of the foreign corporation) can send the money anywhere you want.

Withholding Tax Still Applies

The quick LLC trick doesn’t change the tax withholding requirements for the sale. Until proven otherwise, the buyer is required to withhold 15% of the sale price.2

The true transferor (for withholding purposes) is the foreign corporation, not the LLC that holds title to the real estate.3

That means (in the average transaction) that the true transferor (the foreign corporation) must either give the withholding agent a Certificate of Nonforeign Status,4 apply for and receive a withholding certificate from the IRS permitting withholding of less that 15%,5 or accept the fact that 15% will be withheld and remitted to the IRS.

Critically, the Certificate of Nonforeign Status requires the seller to certify that it is not a disregarded entity:6

[Name of transferor] is not a disregarded entity as defined in § 1.1445-2(b)(2)(iii).

The withholding agent is entitled to rely on this certification unless it is known to be false.7. This is actual knowledge, not any kind of suspicion stuff. With a clean Certificate of Good Standing or the Articles of Organization in hand, the withholding agent is safe from personal liability for withholding errors.

What If There’s No Withholding?

What if there should be withholding, and there isn’t?

This situation would occur because of one of two facts:

  • The seller lied, saying the LLC was not a disregarded entity, when in fact it was.
  • The withholding agent screwed up somehow, e.g., did not get the Certificate of Nonforeign Status signed.

Somehow, withholding should have been imposed, but wasn’t.

Who Is At Risk?

Technically, the transferee has the tax withholding responsibility.8 But other people involved in the transaction also can be on the hook to the IRS, with personal liability for the withholding tax failure.

Seller’s Agents

On the seller’ side, anyone who represents the transferor “in any negotiation with the transferee or any transferee’s agent related to the transaction” is on the hook. So is anyone who represents the seller in settling the transaction.9

That’s pretty inclusive. That would include real estate agents, lawyers, and all sorts of people.

Buyer’s Agents

The same set of people on the buyer’s side are potentially on the hook for withholding tax errors: people who helped in the negotiations, and people who helped settle the transaction.10

But Not People Doing Minor Settlement Functions

People who merely collect and disburse the purchase price in the transaction are not treated as the buyer’s agent or seller’s agent for personal liability purposes.11 Nor will the poor soul who merely records a document at the County Recorder.12

Apparently the IRS figures that these people are just performing clerical functions, and should not be given potential personal liability for withholding failures.

What Must They Do To Be Liable?

What, exactly, must these people do in order to be liable for withholding tax failures?

They must see a Certificate of Foreign Status delivered by the seller, know it is false, and tell the buyer.13

In other words, “If you see something, say something.”

The buyer, then, has everyone working on the transaction looking out for the truth about the seller and the withholding obligation.

What Is the Total Liability?

If you see something and don’t say something, you have exactly the same theoretical withholding obligation that the buyer has:14 15% of the gross sale price.

Fortunately, there is a practical limit to an agent or professional’s personal responsibility for withholding failures: the total compensation you earned for working on this transaction.15

If You Are Involved in Real Estate Sales

The moral of the story is this: if you are involved in real estate sales, keep an eye out. Be sure the Certificate of Nonforeign Status is accurate.

If you think something hinky is going on, tell the buyer. You have nothing to lose and everything to gain.

If A Withholding Failure Occurs

If a withholding failure occurs, someone is going to be holding the bag.

I hope it’s not you.

Disclaimer

Yeah, as usual there is a disclaimer. You can write your own, I bet:

Everything you read on the internet is fake news and Russian propaganda. Of course it is. The New York Times, Washington Post, and CNN told you so. You can believe them. They are always correct, and are happy to tell you so on their websites.

This little explanation of a backwater of U.S. tax law is probably fake news and I’m probably Russian.

Don’t believe what you read here. Find a tax pro who can quote the Code and Regulations the way an old-fashioned evangelist quotes the Old Testment. You won’t go wrong.

But me? Don’t believe me, despite my fifteen footnotes.

See you in a couple of weeks.

Phil.


  1. This is life. There is no final exam. We’re all winging it.  
  2. IRC §1445(a). 
  3. Regs. §1.1445-2(b)(2)(iii). 
  4. Regs. §1.1445-2(b)(2)(iv). 
  5. Regs. §1.1445-2(d)(7). 
  6. Regs. §1.1445-2(b)(2)(iv). 
  7. Regs. §1.1445-2(b)(4)(iii). 
  8. IRC §1445(a). 
  9. IRC §1445(d)(3). 
  10. IRC §1445(d)(4). 
  11. IRC §1445(d)(5)(A). 
  12. IRC §1445(d)(5)(B). 
  13. IRC §1445(d)(2)(A). 
  14. IRC §1445(d)(2)(A). 
  15. IRC §1445(d)(2)(B). 
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