The Tax Cuts and Jobs Act (the Act), signed into law on Dec. 22, 2017, heralded the most significant changes to the U.S. international tax system since the Tax Reform Act of 1986.
With respect to multinational corporations, the Act introduced a number of provisions, including a participation exemption regime, that move the U.S. closer to a territorial tax system, along with new sourcing rules, reduced tax rates on foreign-derived intangible income and a number of new anti-abuse measures to prevent the shifting of profits offshore. However, there are a number of equally significant—and in some cases much less favorable—provisions that have a direct impact on planning for international private clients.
This article explores how the Act may affect non-U.S. individual taxpayers with U.S. holdings. Part II will explain how changes in foreign anti-deferral rules and other provisions will affect U.S. individuals and trusts with offshore holdings, as well as offshore structures established for the benefit of U.S. persons. Some of these changes may require the reorganization of existing structures. Others may inform how U.S. and non-U.S. individual taxpayers choose to structure their holdings both in the United States and abroad going forward.
Four Key Changes
Four key changes affect how non-U.S. individuals may choose to structure U.S. investments, as well as what types of U.S. holdings may be beneficially owned by such individuals: (1) the increase in the lifetime exemption amount, which could benefit individuals from treaty jurisdictions; (2) the reduction in corporate tax rates, which could favor the use of foreign blocker corporations for U.S. real property investments; (3) partial look-through treatment for the characterization of gains from the sale of partnership interests, which potentially could lend support for a similar approach to the estate tax situs rules for partnerships down the road; and (4) the liberalization of rules governing S corporations to allow trusts with nonresident alien beneficiaries to be electing small business trusts.
Increase in Lifetime Exemption
U.S. citizens and domiciliaries are subject to gift and estate tax on their worldwide assets with a unified credit that translated into a $5.6 million exemption for 2018 prior to application of the new law. In contrast, noncitizens domiciled outside the United States, so-called noncitizen nondomiciliaries, are subject to gift and estate tax only on U.S. situs assets. There’s no lifetime gift tax exemption for noncitizen nondomiciliaries apart from the $15,000 annual exclusion per donee, but there’s a limited estate tax exemption of $60,000. Some estate and gift tax treaties increase the estate tax exemption allowed to noncitizens who are eligible treaty residents by providing a prorated unified credit based on the ratio of U.S. situs assets to worldwide assets.
While the Act has temporarily doubled the lifetime exemption amount available to U.S. citizens and domiciliaries to about $11.2 million for transfers made in 2018 (indexed for inflation), the $60,000 estate tax exemption for non-U.S. decedents remains unchanged. However, a noncitizen domiciled in a treaty jurisdiction who qualifies for the benefits of the treaty may see an increased exemption on a prorated basis—at least while the increased threshold remains in effect. For example, if 20 percent of an individual’s worldwide estate is comprised of U.S. situs assets, the prorated exemption would increase from just under $1.1 million in 2017 (20 percent of $5.49 million) to more than $2.2 million in 2018 (20 percent of approximately $11.2 million). The Act also modified the inflation adjustment mechanism, which likely will result in a lifetime exemption amount slightly below $11.2 million for 2018. Absent further action from Congress to make this increase permanent, the exemption returns to its pre-Act amount ($5.6 million for 2018, as indexed for inflation) beginning in 2026.
Reduction in Corporate Tax Rates and Use of Foreign Blockers to Hold U.S. Real Property
The Act reduced the top corporate tax rate from 35 percent to 21 percent. The highest rate for individuals and trusts was subject to a much more modest reduction—from 39.6 percent to 37 percent. Unlike many other provisions in the Act that sunset over the next decade, the reduction in corporate tax rates is permanent. This could make foreign “blocker” corporations, which until now were somewhat inefficient from an income tax standpoint, more attractive vehicles for structuring investments in U.S. real property.
U.S. real property is a U.S. situs asset for both gift and estate tax purposes. Further, gains from the sale of U.S. real property by a nonresident alien or foreign corporation are subject to federal income tax under the Foreign Investment in Real Property Tax Act, as well as state and local taxes in some jurisdictions. Non-U.S. investors have long used foreign corporations to acquire interests in U.S. real property. So long as corporate formalities are respected, the corporation shelters the underlying U.S. situs assets from the estate tax.
A primary drawback of a foreign blocker corporation up until the new law went into effect was that gains would be taxed at corporate rates at the federal level of 34 percent to 35 percent, as compared with a 20 percent rate for nonresident alien individuals, assuming the property wasn’t inventory and was held for more than one year. A 30 percent branch profits tax also may apply to net earnings that are deemed to be repatriated each year, although it’s possible to structure around this tax plus some treaty jurisdictions provide an outright exemption. Finally, if the property is going to be inherited by a U.S. citizen or resident, a foreign corporation isn’t an efficient tax structure for the eventual U.S. owner.
Because of the income tax inefficiency up until now of using a foreign corporation to hold U.S. real property, foreign investors increasingly have opted for noncorporate structures, including irrevocable trusts and partnerships. However, these structures aren’t without their own drawbacks or risks. For example, a grantor of a trust would have to relinquish all dominion and control to avoid the estate tax, and it’s not clear that a partnership holding U.S. real property isn’t a U.S. situs asset for estate tax purposes.
The reduction in corporate tax rates to 21 percent means that a foreign corporation may actually be taxed at a lower rate (at least at the federal level) than a U.S. nongrantor trust, which would be taxed at a 23.8 percent rate on long-term capital gains and at ordinary income rates of up to 40.8 percent (taking into account the 3.8 percent Medicare tax on investment income, which doesn’t apply to corporations). The foreign blocker would have to be appropriately structured to avoid the branch profits tax and still may not be an ideal structure if the property will ultimately pass to U.S. beneficiaries, but when ownership is likely to remain foreign, non-U.S. investors may want to give foreign blocker corporations a closer look.
Dispositions of Foreign Partnership Interests
Gain or loss from the sale of an interest in a partnership, domestic or foreign, by a foreign partner is now considered to be effectively connected with a U.S. trade or business, meaning that the gains are potentially taxable to the non-U.S. seller to the extent that a sale by the partnership of all of its assets at fair market value would have generated effectively connected income for the foreign partners. The Act effectively repeals the recent decision in Grecian Magnesite Mining, Industrial & Shipping Co.,SA v. Commissioner, 149 T.C. 3 (2017), in which the Tax Court adopted more of an “entity” approach to partnerships and held that the Internal Revenue Service couldn’t look through to the underlying assets and activities of the partnership to recharacterize the gains. The Act not only overrides Grecian Magnesite, but also imposes a new 10 percent withholding tax on sales of partnership interests unless the transferor can certify that it isn’t a nonresident alien or foreign corporation. Gifts of interests in partnerships by noncitizen nondomiciliaries should still be respected as gifts of intangible property that aren’t subject to gift tax even if a gift of the underlying assets would itself be subject to gift tax. However, the estate tax treatment of interests in partnerships remains unsettled, as there’s still an open question as to whether situs is determined based on the place of organization where the underlying assets are located or where the partnership conducts its activities. Although the new provision has no direct bearing on the estate tax treatment of partnership interests, it’s yet another reminder of how both entity and aggregate theories of partnerships can prevail in different circumstances and why foreign partnerships, unless they elect to be treated as corporations for federal tax purposes, shouldn’t be relied upon as effective estate tax blockers.
ESBTs and Nonresident Alien Beneficiaries
On a more favorable note, the Act liberalized rules governing who can be a beneficiary of an ESBT. S corps are subject to a number of ownership limitations, including restrictions on who may be a shareholder. In general, all shareholders of an S corp must be U.S. individuals, estates, certain specified trusts, including ESBTs, or certain tax-exempt organizations. Although the ESBT itself is taxed on its share of the S corp’s income, each “potential current beneficiary” of the ESBT, that is, each person who’s either entitled to distributions or who may receive a distribution at the discretion of any person, was treated as a shareholder for testing purposes under the old rules. This would have resulted in the disqualification of the S corp if a nonresident alien became a current potential beneficiary of the ESBT and the ESBT didn’t dispose of its stock within a 1-year grace period. However, under the new tax law, nonresident aliens can be current potential beneficiaries of ESBTs without disqualifying the S corp, though they still can’t own shares directly. This provision may be of particular benefit to multijurisdictional families that own closely held businesses structured as S corps, as it will allow at least some options for succession planning without having to completely cut off the interests of family members who become nonresident aliens.