A Non-Resident's Rent-Free Living in US Real Estate - Subject to Tax?
Updated: May 14, 2021
By: William Bricker & Juliya Ismailov
When a foreign closely-held corporation owns a U.S. residence, often through a U.S. subsidiary, and allows the family to use it, taxes may be owed to the IRS, in addition to the state taxing authorities, such as in New York or California.
The law regarding whether, for tax purposes, a corporation must collect rent from a related party is unsettled. At least one case (Accipitor described below) is being currently litigated with the IRS.
For context, the IRS’ position apparently is that, as a result of the family’s rent-free occupancy, rental income is imputed to the corporate owner under Section 482 of the Tax Code. Since often the real estate-holding company has no cash, the IRS may further impute a constructive dividend paid to the foreign entity, subjecting the corporate owner of the real estate to a 30% withholding obligation on behalf of the foreign parent.
Below are case summaries providing examples of these issues:
Accipitor Trading Ltd. (“Accipitor"): A British Virgin Islands company was created almost 30 years ago through a Liechtenstein foundation (treated as a trust by the IRS). Accipitor owned real estate in California, in which the family that owned the company lived (who also happened to be involved in litigation with the IRS over $120 million in FBAR penalties). Having not filed any U.S. tax returns, the IRS helpfully prepared substitute tax returns reflecting almost $4.4 million in gross rental income from 1998 to 2017 and resulting in $2 million in taxes and penalties assessed on the rental income. Among other claims, Accipitor challenged the size of the assessment by filing a petition in the Tax Court in 2019, with the decision currently pending.
G.D. Parker, Inc. (TC Memo 2012-327): a non-resident alien (“NRA”), Mr. Parker, controlled a Panamanian corporation that wholly-owned a Florida corporation, owning through a further U.S subsidiary homes and a yacht used for personal purposes by the family. The Tax Court held that the rent-free use of the properties constituted a constructive dividend from the U.S. subsidiary to ultimately the non-U.S. individual shareholder by way of the foreign parent. (The Court disregarded as accounting fiction the reporting on the U.S. entity’s tax return of rent paid by Mr. Parker in the form of a reduction of an outstanding loan owed by the U.S. entity to Mr. Parker, because no evidence was presented of such loan or its reduction.)
Both of these cases involve accounting issues of income characterization and allocation, but the bottom-line takeaways from these taxpayers’ audit experiences are:
The occupants of the U.S. real estate should consider entering into a formal written lease agreement with the U.S. subsidiary stating the fair market value (supported by an independent assessment of rent), and should regularly update this agreement regarding the rental value. If they do not, in an audit, the IRS might assume a much-higher fair market value, creating additional costs of establishing accurate rental value, over decades of real estate market fluctuations.
The U.S. subsidiary should file a tax return reporting rental income collected and pay any U.S. taxes due. This will prevent the issue of the IRS imputing a constructive dividend as having been paid to the foreign parent. The imputation of a constructive dividend would obligate the U.S. subsidiary to act as a withholding agent for the foreign entity and to remit taxes at the maximum rate of 30% on passive income earned by a non-U.S. taxpayer (known as “FDAP,” or “fixed or determinable, annual or periodical,” income). Instead, when preparing its own tax return, the U.S. corporate taxpayer can take appropriate deductions for depreciation and maintenance costs, and the resulting net income, if any, would be subject to the current corporate tax rate of 21% (although this rate may be increasing to 28% under the current U.S. administration’s proposals).
Given the expanded budget for IRS enforcement that President Biden has been advocating, and the IRS’ long-standing plan to target rental income earned by nonresident aliens, taxpayers are reminded to pay attention to this commonly-occurring issue.