Non-Americans investing into the US post-tax reform
13 December 2018
This article provides an overview of the typical structures used by individual non-resident aliens (“NRAs”) to invest into the US, the implications of tax reform on those structures, and presents ideas on planning opportunities under the new regime. We focus on particular issues applicable to the holding of US real estate.
It is helpful to start with a brief explanation of the rules before tax reform.
- A non-resident investing into the US would typically be taxed at graduated rates (up to 39.6%) on US sourced effectively connected income (“ECI”), broadly meaning US trading income;
- The US imposes a 30% withholding tax on a gross basis on “fixed determinable and periodic” income (“FDAP”), the main example being dividends. A notable exception is for interest which is in most cases exempt. Individuals resident in treaty country are often able for a reduction in the 30% rate;
- Real estate income is by default taxed as FDAP at 30% on gross receipts unless an election is made for it to be treated as ECI at graduated rates, previously up to 39.6%. Making the election also results in rental expenses becoming deductible;
- Gains on the sale of US real estate are treated as ECI under the FIRPTA rules, but eligible for long-term capital gains rates (generally 20%) if the property is a capital asset which is held for more than one year;
- Gains on the sale of many other US situs assets are exempt for non-residents, assuming the individual’s main place of business is outside the US and they spent less than half the year in the US. The main exception to this rule is for gains “effectively connected” with a US trade or business. However, where the business is structured as a partnership, there used to be a decent argument that a sale of the partnership itself by a NRA was exempt from US tax;
- Where the US investments were held by a company (instead of an individual), the company would generally pay tax at up to 35% irrespective of the type of income. If the company were incorporated outside of the US, then the tax would be restricted to US source income. A 30% dividend withholding tax would apply to dividends subsequently paid to an NRA shareholder of a US company. If the company were incorporated outside of the US, then in place of the dividend withholding, a 30% branch profits tax would apply. The effective overall tax rate for the individual could be up to 54.5%, although could sometimes be reduced by a tax treaty;
- A non-US domiciled individual would be subject to US estate tax at up to 40% on death, on any US-situs assets, subject to an exemption for the first $60,000. The tax could be reduced under a treaty.
Tax reform introduced the following changes:-
- A reduction in the marginal individual income tax rate from 39.6% to 37%;
- A deduction of up to 20% of qualified business income (“QBI”) earned by an individual, trust or estate through a passthrough entity, such as a partnership. This applies to NRAs as well as residents and can reduce the federal rate down to 29.6%. QBI means income from an active trade or business, and the deduction is limited for higher income taxpayers to the greater of (i) 50% of the individual’s share of wages paid by the business, or (ii) 25% of the wages plus 2.5% of depreciable property used to generate QBI. An overall limitation of 20% of taxable income (excluding gains) applies;
- A reduction in the marginal corporate tax rate from 35% to 21%;
- The sale of a partnership interest is now taxable to the extent that the sale of the underlying assets would have produced effectively connected income. This applies from 27 November 2017;
- A new limitation on the deductibility of interest expense. This only applies where average gross receipts exceed $25 million, and is not considered further here.
The following pre-tax reform provisions remain unchanged:-
- The 20% individual tax rate on the sale of most assets held for more than one year (“long term” capital gains);
- The 30% FDAP withholding rate on dividends, and exemption for most interest;
- The 40% US estate tax on US situs assets exceeding a $60,000 exemption. Whilst the $60,000 exemption is unchanged, the increase in the US estate tax exemption for US citizens to $11.18m will benefit certain non-citizens domiciled in certain treaty countries;
- The availability of reduced income and estate taxes using treaty relief.
The headline reduction in both corporate and individual income tax rates makes investing into the US more attractive from 1 January 2017, irrespective of the manner in which the investment is structured.
The optimum structure for the non-American should be designed to both reduce the income tax rates on profits, and also mitigate exposure to estate taxes. The structuring considerations must take into account factors such as what form of profits the investment will produce (e.g. interest, dividends, rental income, capital gains) and whether there will be any personal use by the investor (applicable mainly to real estate).
Before designing a structure or modifying an existing structure, it is important to bear in mind that the reduction in income tax rates and the QBI deduction are only temporary, and the pre-2018 tax rates will revert back on 1 January 2026. The only exception to this is the reduction in the corporate tax rate which will remain at 21%. Individuals may wish to think twice before implementing structures which rely on tax reductions which will expire in 2026.
Direct ownership by the individual
The reduction in the marginal rate from 39.6% to 37% will result in reduced income tax exposure for direct ownership of ECI, down to 29.6% if the 20% QBI deduction is available, and no change to the 30% rate for FDAP. A capital gain realised on sale may be eligible for the 20% rate, if the investment is a capital asset held for more than one year.
The individual will need to file a US tax return, unless the US income is limited to FDAP or the investments do not produce any income. Many individuals do not want to have to file personal tax returns and therefore prefer to use a corporate holding structure, discussed below.
The clear downside of personal ownership is the liability for estate taxes on the individual’s death. Since the estate tax rules for non-domiciled individuals remain unchanged, the individual will remain exposed to US estate tax. The US investment is likely to be subject to estate tax at 40% on the individual’s death to the extent the value of the individual’s US estate exceeds $60,000. Note that some treaties allow individuals’ estates to effectively benefit from an increased exemption e.g. by electing to be treated as a US citizen so that the worldwide estate is taxable, but with a corresponding increase in the exemption from $60,000 to $11.18m.
Ownership through a partnership
Before Tax Reform, the ownership of US investments through a passthrough entity such as a partnership largely resulted in the same overall tax rates as direct ownership of the investment.
Going forward, such individuals should benefit from an immediate reduction in the marginal rate from 39.6% to 37% on US source effectively connected income (“ECI”). The the 20% QBI deduction could bring the overall rate down to 29.6%.
Although the headline income tax rate is now lower, the passthrough structure will not be the best option for all NRAs, because:-
- There is an increased likelihood of US estate tax exposure;
- They may not qualify for the QBI deduction, for example because they are not investing in an active business or because the active business may not have significant employee wages or depreciable property;
- The individuals must file individual income tax returns with the IRS. Many NRAs do not want to have to file personal tax returns.
The main downside to the partnership structure is uncertainty regarding US estate taxes. This is an unsettled area of law, revolving whether the partnership should be looked at under the “aggregate” theory (you look through to the situs of the underlying assets) or the “entity” theory (you look at the situs of the partnership itself). The leading case supporting the “aggregate” approach is Sanchez v Bowers, suggesting the aggregate theory applies if (under local law) the partnership terminates on the death of the partner. This being the case, any US situs assets owned by the partnership would remain subject to estate tax. If the partnership does not terminate on death, then arguably the “entity” approach applies, in which case the situs of the partnership would be one of the following 1) the domicile of the owner, 2) the location where the partnership is organised, or 3) the location of the partnership trade or business. The IRS is understood to take the view that the correct method for determining the situs of the partnership under the “entity” approach is 3). Therefore if a NRA holds a non-US partnership owning US real estate, the IRS is likely to take the view that the partnership is a US situs and is therefore taxable.
Ownership through a corporation
The reduction in the US corporate tax rate from 35% to 21% makes ownership of US investments through a corporate vehicle more attractive than under prior law.
However the 30% dividend withholding tax (applicable to US companies) and 30% branch profits tax (“BPT”, applicable to non-US companies) remain unchanged. After taking account of these, the overall maximum effective rate is reduced from 54.5% (before tax reform) to 44.7% (after tax reform). These rates could be lower still under a tax treaty, but are clearly much higher than for personal or passthrough ownership.
In view of the dividend withholding and branch profits taxes, corporate ownership is therefore most attractive when these taxes can be avoided, for example, in the case of a US company by not paying dividends and in the case of a foreign company, by interposing a US subsidiary to mitigate BPT.
Despite the higher tax rates, many individuals still choose to use a corporate structure to hold income producing assets. This may be for the following reasons:-
- Elimination of US estate tax exposure, where a non-US company is used, or a US company and the owner is eligible for tax treaty protection. It is critical here that the appropriate corporate formalities are respected;
- Elimination of US tax return filing requirements for the individual shareholders in the company. The company files a tax return instead of the individual.
Structuring ownership of US real estate
Where an individual purchases a US house or apartment purely for personal use (i.e. there is no rental income), direct personal ownership may often be the best option. The individual should benefit from 20% long-term capital gains rate on sale. They will be exposed to US estate tax should they die while still owning the property, but could deal with this by selling the property before death (and removing the proceeds from the US) using insurance to cover the estate tax exposure should they die while still owning the property.
A partnership structure would result in similar tax consequences to direct personal ownership.
The individual could instead use a corporate holding structure in order to mitigate US estate taxes. This might take the form of a foreign company with a US subsidiary. A sale by the lower tier company would be taxed at 21%, and the after-tax proceeds could be distributed tax-free to the foreign parent as a liquidating distribution.
If the property is going to be rented out then personal ownership may result in an income tax rate of up to 37%, whereas a partnership structure may reduce the rate down to 29.6% (if the QBI deduction is available).
Alternatively the individual could use a double corporate holding structure in order to mitigate the estate tax exposure. This will however be inefficient for income tax purposes, with an effective tax rate of up to 44.7% if the individual wishes to receive current distributions of rental profits. if the individual is prepared to forego receiving distributions then a 21% rate may be achievable by retaining the profits in the company.
The individual may also consider using a trust to own the property. Trust ownership generally results in tax at the same federal rates as those which apply to individuals, including the potential for a 20% tax rate on long-term capital gains. The trust can also provide effective protection from US estate tax provided that the individual is prepared to completely forego having any dominion or control over the trust or its investments.
Individuals considering acquiring US investments should generally seek advice in advance. The planning opportunities existing before the purchase are often not available to individuals who have already acquired investments in their own name and wish to restructure.