Certain business entities can be treated as "nonexistent" for federal income tax purposes. That is, from a US tax perspective, they are simply "disregarded" and the entity is ignored by the Internal Revenue Service (IRS). For other purposes, the entity is not disregarded, however. A simple way to look at the effect of being a ‘disregarded entity' is to view the business that is being carried on as separate from its owner for legal purposes (such as who has legal liability in the event of being sued), but not separate from its owner for tax purposes (such as who has to file tax returns and pay tax on the income earned in the business). From a US tax point of view, the business' assets, its liabilities and all of its activities are treated as those of its owner. The beauty of a disregarded entity is that it is used most often by its owner to obtain limited liability, while at the same time, without causing any federal income tax consequences due to the structure.
In the US tax world, the most frequently encountered entities that are referred to as "disregarded entities" are single-member LLCs that are formed in the United States, so-called "qualified subchapter S subsidiaries", grantor trusts and certain foreign (non-US) entities that make a so-called "check-the-box" (CTB) election on Form 8832. Form 8832, "Entity Classification Election" permits an eligible entity to freely elect how it will be classified for federal income tax purposes as: a corporation, a partnership, or an entity disregarded as separate from its owner, called a "disregarded entity" or "DRE". In the case of a foreign (non-US) corporation making an election to be treated as "disregarded", this is called a "foreign disregarded entity" or "FDE".
In dealing with international tax matters I have seen that there are many misconceptions with disregarded entities, FDEs and LLCs that can lead to significant tax problems for the unwary. Some of them are discussed in this series of blog posts.
Investment in real property through a vehicle offering limited liability, as opposed to direct ownership, offers numerous protections. Should any legal claims arise, such as in the case of tenant injury when renting out property owned through a corporation, the liability of a shareholder will be limited to their share of the corporate assets. If, for example, a shareholder owns 35% of a corporation and the corporation is sued but cannot pay the debt, the shareholder may lose his entire 35% investment since the corporation's property will be used to satisfy the debt owing. If debt is still owing to the injured party after the corporate property is fully liquidated, the shareholder's personal assets remain safe.
When non-US individuals invest in US real property, many often consider owning the real estate through a single-member US LLC. This structure provides for ease in US tax filing as well as limited liability protection.
What many forget, however, is that US Estate tax issues must also be considered. If the non-citizen is treated as "non-resident" of the US at the time of death, his estate will be subject to the US Estate tax on assets located, or deemed to be located, within the US. Real property located in the US is considered to have a US-situs. Since the single-member LLC is a "disregarded entity", the foreign individual will be treated as directly owning the real estate at death and thus has exposure to US estate tax. While an estate tax exclusion amount is available, it is limited to a paltry US$60,000 of value of US assets owned at death for non-citizen/nonresidents.
US Estate tax is assessed on the fair market value of the property at a maximum 40% current rate. You can learn more about how the US Estate tax rules apply to nonresident foreign individuals at my blog post here. While the foreign individual can consider making a "check-the-box" election on Form 8832 to have the entity treated as a "corporation" for tax purposes, the problem will not be solved since the value of the US corporation's shares are treated as US-situs assets. Thus, the estate tax result would be the same, since the value of the shares will reflect the value of the underlying real property owned by the corporation. Various planning techniques can be implemented with professional tax advice to achieve a holding structure that is most optimal in light of the facts of the specific case. These planning techniques go beyond the scope of this blog post.
Part II of this post will cover the topic of using a CTB Election to avoid having a foreign corporation with US owners and holding foreign real property classified as a "Controlled Foreign Corporation" or a "Passive Foreign Investment Company". This can save significant tax dollars as well as costly and very time-consuming tax preparation.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
Virginia La Torre Jeker J.D.
Virginia La Torre Jeker J.D., is based in Dubai. Virginia has been a member of the New York Bar since 1984 and is also admitted to practice before the United States Tax Court. She has over 30 years of experience specializing in the international aspects of US tax, including FATCA. She has been quoted in the New York Times and Newsweek, and is regularly quoted in many local news articles and publications."
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