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Foreign Corporation Challenging IRS Treatment of Imputed Rental Income

Paul J. D'Alessandro, Jr.
Practitioners have long dealt with the question of whether an individual must pay rent for the use of property that is owned through a closely held corporation. A recent case reaffirms that from the IRS’s perspective, the answer is a resounding yes.

The taxpayer in the present case is a British Virgin Islands company, Accipitor Trading Ltd., which was created in 1994. U.S. individuals owned the company through a tiered Liechtenstein foundation structure. As many international tax practitioners are probably aware, in Lichtenstein, this type of arrangement is known as a “Stiftung” and is generally viewed by the IRS as a trust.  Accipitor owned real estate in California, which the individuals lived in under a verbal lease agreement during the 20 years at issue. The same individual taxpayers (one of whom is now deceased) are also presently involved in litigation with the IRS over $120 million in FBAR penalties.

Because the company did not file any U.S. tax returns for the years at issue, the IRS prepared substitute returns showing almost $4.4 million in gross rental income from 1998 to 2017. The IRS assessed nearly $2 million in taxes and penalties on the rental income. Accipitor filed a petition in the Tax Court late last year arguing, among other things, that the fair rental value of the real estate is less than what the IRS determined. 

This is not the first time that the Tax Court has dealt with the personal use of corporate-owned property in the cross-border context. In a 2012 case, G.D. Parker, Inc., TC Memo 2012-327, the Tax Court analyzed a situation involving U.S. real estate owned through a two-tier corporate structure (i.e., a foreign corporation that owns a U.S. corporate subsidiary that owns real estate). The owner of the foreign corporation and his family members would use the properties from time to time for their own personal use. The Tax Court found that no rent had been paid to the U.S. company and concluded that the rent-free use of the properties was a constructive dividend from the U.S. subsidiary to its corporate parent, and ultimately to the non-U.S. individual shareholder.

The foregoing illustrates the dangers of not respecting the form of a holding structure, particularly when it comes to the ownership of residential real estate. This is not only an income tax issue, but also an estate tax issue. Foreign corporations are often used as “blockers” against U.S. estate tax; however, the appropriate corporate formalities must be observed in order for the blocker to serve its intended purpose. 

The Accipitor case also sheds light on a couple of issues. By not entering into a formal lease agreement and not filing tax returns, the taxpayer left it in the hands of the IRS to determine the value of the rental payments. Additionally, the taxpayer was subject to tax on the rental payments at a flat 30% rate under the gross basis withholding regime that applies to most types of passive income earned by a non-U.S. taxpayer (commonly referred to as “FDAPI,” which stands for fixed or determinable, annual or periodical income). Alternatively, had Accipitor filed a tax return, it could have elected to be taxed on a net basis under the rules applicable to the taxation of “ECI,” which stands for effectively connected income. Net basis taxation is often beneficial in this setting as it allows the taxpayer to benefit from available deductions such as depreciation and maintenance costs associated with the property (not to mention it results in a lower federal tax rate of 21% in the case of a corporation). 

Tax noncompliance related to foreign ownership of U.S. real estate is an area that continues to gain momentum. In an August 2017 report, the Treasury Inspector General for Tax Administration pointed out the inefficiencies in policing U.S. tax compliance related to rental income from foreign-owned U.S. real estate. This March, the IRS announced a new compliance campaign focusing on rental income earned by nonresident alien individuals.

The recent issues being litigated in the Tax Court, coupled with the IRS’s compliance campaign, would indicate that this is not an issue that is likely to drop off the radar anytime soon. Practitioners and clients would be wise to review any real estate holding structures and determine if all is in order from a compliance and administration standpoint.  

For those interested in reading Acciptor’s petition to the Tax Court, the citation is Accipitor Trading Ltd. v. Commissioner, No. 18842-19.
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