Tax Planning and Structuring for Foreign Investors

We have assisted many clients with structuring foreign investment in the U.S. Investors are often surprised at the complexity of the U.S. tax system.

It’s vital to structure your investments in a tax-efficient manner, before investing. Creating an LLC or Corp without examining the tax consequences could end up being a costly mistake.

There are many companies that provide “online LLC formation”. They fill out paperwork for you (the easy part) and will not be able to provide tax planning (the hard part).

Before foreigners invest in the U.S. it’s important that investors under how they will be taxed.

U.S. Taxation of NRAs–Income Taxes

For purposes of this article, we’ll assume the investor is not a U.S. tax resident, and is therefore a non-resident alien (“NRA”).

The United States taxes the income of nonresidents under two different tax regimes:

  • Not effectively-connected income
  • Income that is effectively connected with a U.S. trade or business

Not effective-connected income

A nonresident is subject to a flat 30 percent tax on U.S.-source gross income that is not effectively connected with the conduct of a U.S. trade or business.

Items of gross income subject to the 30 percent tax include:

  • Dividends;
  • Certain interest, including original issue discount (subject to conditions)
  • Rents and royalties;

A foreign investor is free to make U.S. investments and trade for his own account through a resident broker without being engaged in a U.S. trade or business, provided the individual does not maintain an office or other fixed place of business in the United States through which the transactions are consummated.

Effectively connected income

A nonresident is subject to U.S. tax at regular graduated rates on net income that is effectively connected with a U.S. trade or business. This income generally includes:

  • Compensation for personal services performed in the United States;
  • Profits from the operation of a trade or business in the United States;
  • Income of a partner from a partnership engaged in a U.S. trade or business;
  • Income from real property operated as a U.S. trade or business;
  • Income from real property held for investment if an election is made to treat the income as effectively connected with a U.S. trade or business;
  • Income from the sale or certain other dispositions of U.S. real property interests;
  • Income from the sale of certain business-related capital assets;

In general, a nonresident is taxable on effectively connected income only from U.S. sources. However, certain income from sources outside the United States will be treated as effectively connected with the conduct of a U.S. trade or business when the nonresident has an office or other fixed place of business in the United States to which the income is attributable.

Real estate: Gain from the sale of U.S. real property is taxed as effectively connected income. Under the Foreign Investment in Real Property Tax Act (FIRPTA), when real property is purchased from a nonresident alien buyer, the seller is required to withhold 30% of the gross proceeds of the sale and remit to the IRS.

Rules for the most common investments

U.S. stock: Trading in stock, securities, or commodities in the United States for one’s own account, except in the case of a dealer, does not constitute engaging in a U.S. trade or business; nor does the volume of these transactions have any bearing on the nonresident’s engagement in a trade or business. A foreign investor is free to make U.S. investments and trade for his own account through a resident broker without being engaged in a U.S. trade or business, provided the individual does not maintain an office or other fixed place of business in the United States through which the transactions are consummated.

Real estate: Gain from the sale of U.S. real property is taxed as effectively connected income. Under the Foreign Investment in Real Property Tax Act (FIRPTA), when real property is purchased from a nonresident alien buyer, the seller is required to withhold 30% of the gross proceeds of the sale and remit to the IRS.

Interest income: An NRA is not taxed on U.S.-sourced interest received on deposits with banks and certain other financial institutions, if the interest is not effectively connected with the conduct of a U.S. trade or business. Nor are they taxed on portfolio interest on registered debt, such as U.S. Treasury bills.

U.S. Taxation of NRAs–Estate Taxes

The U.S. estate tax filing requirements of a decedent’s estate are determined by whether, at death, the decedent was a U.S. citizen or resident for estate tax purposes. And if the decedent was not a U.S. citizen nor a U.S. resident, whether the decedent had U.S. situs property.
A non-citizen non-resident decedent will be subject to U.S. estate tax on U.S. situs assets worth more than $60,000.

U.S. situs assets include:

  • Real estate located in the U.S.
  • Tangible personal property if physically present in the United States on the date of death.
  • Stock of U.S. corporations (those located in the United States or organized under U.S. law).
  • Debt obligations if they are debts of a U.S. citizen or resident, a domestic partnership or corporation, a domestic estate or trust, the United States, a state or a political subdivision of a state or the District of Columbia.
  • Deposits with a U.S. branch of a foreign corporation that is engaged in the commercial banking business are treated as property located in the United States.

Estate tax in the United States can be significant. The amount of tax consists of a.) a base amount, plus b.) a graduated rate of up to 40%. A nonresident’s estate will pay based on the following tax table on the portion of the estate in excess of $60,000.

Lower Limit Upper Limit Initial Taxation Further Taxation
0 $10,000 $0 18% of the amount
$10,000 $20,000 $1,800 20% of the excess
$20,000 $40,000 $3,800 22% of the excess
$40,000 $60,000 $8,200 24% of the excess
$60,000 $80,000 $13,000 26% of the excess
$80,000 $100,000 $18,200 28% of the excess
$100,000 $150,000 $23,800 30% of the excess
$150,000 $250,000 $38,800 32% of the excess
$250,000 $500,000 $70,800 34% of the excess
$500,000 $750,000 $155,800 37% of the excess
$750,000 $1,000,000 $248,300 39% of the excess
$1,000,000 and over $345,800 40% of the excess

Non-resident investors often do not take estate tax into account when planning their U.S. investments. Estate tax considerations should be a primary concern to such investors due to the potential tax consequences.

Example: NRA Investor purchases $1 million in stock of U.S. corporations. He passes away after 5 years. His estate is now worth $2 million. The estate will pay a $345,800 tentative tax on the first $1 million plus 40% of the second $1 million, resulting in a tax of $745,800.

Note that if NRA Investor had sold the stock prior to passing away and transferred the proceeds back to his home country, none of the investment would have been taxable in the U.S.

U.S. Taxation of NRAs–Branch Profits Taxes

The branch profits tax provision under IRC §884(a) treats a U.S. branch of a foreign corporation as if it were a U.S. subsidiary of a foreign corporation for purposes of taxing profit repatriations.

IRC §884(a), foreign corporations with U.S. branches are subject to two levels of tax: at the entity level when the U.S. branches earn income, and at the shareholder level when the earnings are repatriated.

Moreover, the branch profits tax computation’s formulary nature strongly discourages the use of branch operations because it takes away control of the timing of the payment of the dividend equivalent amount.  For example, a subsidiary can declare and pay a dividend on any date during its taxable year, but a branch must pay it only at year end.

Tax-Efficient Structuring of Inbound Investment

Structuring of foreign investments in the United states should seek to meet the following goals: 1.) minimize income taxes; 2.) eliminate estate taxes; and 3.) not result in branch profits tax. An investor should also be mindful of administrative and compliance burdens. With these goals in mind, the following are some of the potential structures available.

  1. Direct ownership by the foreign individual. This is generally discouraged, as it may create the need for a probate proceeding and payment of estate taxes. Direct ownership may be advisable for ownership of U.S. stock.
  2. Partnerships (including multi-member LLCs). Investment in U.S. real estate through such a vehicle would afford the individual member or partner the lower capital gains rates applicable to individuals if the real estate is a capital asset. However, ownership of U.S. real property through a U.S. or foreign partnership is generally discouraged because of the uncertainties concerning the situs of a partnership interest for U.S. estate tax purposes, as well as a potential withholding tax applicable to foreign partners.
  3. One-tier corporate structure. A foreign corporation purchases property directly (or through a single-member LLC). While this would avoid estate taxes, the entity may be subject to branch profits tax.
  4. Two-Tier Corporate Structure. Typically, the foreign individual (or a foreign trust) owns a foreign holding corporation (sometimes referred to as a “foreign blocker”), which in turn owns a U.S. real estate corporation. This structure provides for a high level of U.S. estate tax certainty, but at a cost of higher income tax rates in certain circumstances.
  5. Foreign irrevocable trust. Foreign trusts are often desirable in the case of personal use property or long-term passive real estate investments where it is desirable to capture the lower capital gains rates applicable to individuals (and trusts).

The right option for you will depend on your specific situation, your investment goals, and future immigration plans.

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