Foreign Investment In U.S. Rental Real Estate

We have spoken about Congress’ and the IRS’ increasing reliance on penalties.

Here is one from the new Taxpayer First Act of 2019:

The minimum penalty for filing a return more than 60 days later will now be no less than the lesser of:

·        $330 or

·        100% of the amount required to be shown on the tax return.

The previous marker was $205, adjusted for inflation.

Thanks for saving the republic from near-certain extinction there, Congress.

There is another one that has caught my attention, as it impacts my practice.

By happenstance I represent a fair number of foreign nationals who own rental real estate in the U.S.

Why would a foreign national want to own rental real estate in Georgetown, KY, Lebanon, OH or Arlington, TN?

I don’t get it, truthfully, but then I am not a landlord by disposition. I certainly am not a long-distance landlord.

There is a common structure to these arrangements. The foreign national sets up an U.S.-based LLC, and the LLC buys and operates the rentals. Practitioners do not often use corporations for this purpose.

There is a very nasty tax trap here.

There is special reporting for a foreign corporation doing business in the United States. As a flip to that coin, there is also special reporting for a U.S. corporation that is 25%-or-more owned by nonresidents. We are referring to Form 5472, and it is used to highlight “reportable transactions,” with no dollar minimum.

“Reportable transactions” sounds scary. I suppose we are looking for laundering of illicit money or something similar, right?

Here is an example of a “reportable transaction”:

·        borrowing money

Here is another:

·        paying interest on borrowed money

Yep, we are going full CSI on that bad boy.

Let’s play with definitions and drag down a few unattentive tax practitioners, why don’t we?

An LLC with one owner can be considered to be the same as its owner for tax purposes.

Say that Emilio from Argentina sets up an Ohio LLC.  He is the only owner. The LLC goes on to buy rental properties in Cincinnati and Columbus.

For federal income tax purposes, the LLC is disregarded and Emilio is deemed to own the properties individually.

For purposes of information reporting, however, the IRS wants you to treat Emilio’s single-member LLC as a corporation.

A “corporation” that is more-than-25% owned by a nonresident.

Meaning that you have a Form 5472 filing requirement.

What happens if the tax practitioner doesn’t catch this wordplay?

An automatic penalty of $10,000 for not filing that 5472.

Granted, the practitioner will fight the penalty. What choice is there?

Let’s up the ante.

Buried in the new tax law for 2018 (that is, the Tax Cuts and Jobs Act), Congress increased the minimum penalty from $10,000 to $25,000.

So a foreign national buys a rental house or two in name-a-city, and somehow he/she is on par with an Alibaba or Banco Santander?

The IRS automatically charges the penalty if the form is filed late. The practitioner would have to provide reasonable cause to have the penalty abated.  

Remember next that the IRS does not consider an accountant’s error to be necessarily provide reasonable cause, and you can anticipate how this story may not turn out well.

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

The 6707A Tax Penalty Is Outrageous

I have attached a penalty notice to this blog. Take a look . The IRS is assessing $14,385 for the 2008 tax year, and the description given is a “Section 6707A” penalty.

This is one of the most abusive penalties the IRS wields, in my opinion. As too often happens, it may have been hatched for legitimate reasons, but it has degenerated into something else altogether.

Let’s time travel back to the early aughts. The IRS was taking a new direction in its efforts against tax shelters: mandatory disclosure.  There was a time when tax shelters involved oil and gas or real estate and were mostly visible above the water line, but the 1986 changes to the tax Code had greatly limited those schemes. In their place were more sophisticated – and very hard to understand – tax constructions. The planners were using obscure tax rules to separate wealth from its tax basis, for example, with the intent of using the orphaned basis to create losses. 

The IRS promulgated disclosure Regulations under Section 6011. At first, they applied only to corporations, but by 2004 they were expanded to include individual taxpayers. The IRS wanted taxpayers to disclose transactions that, in the IRS’ view, were potentially abusive. The IRS quickly recognized that many if not most taxpayers were choosing not to report. There were several reasons for this, including:

·       Taxpayers could consider a number of factors in determining whether a transaction was reportable

·       The gauzy definition of key terms and concepts

·       The lack of a uniform penalty structure for noncompliance

The IRS brought this matter to Congress’ attention, and Congress eventually gave them a new shiny tax penalty in the 2004 American Jobs Creation Act. It was Section 6707A.

One of the things that the IRS did was to disassociate the penalty from the taxpayer’s intent or purpose for entering the transaction. The IRS published broad classes of transactions that it considered suspicious, and, if you were in one, you were mandated to disclose. The transactions were sometimes described in broad brush and were difficult to decipher. Additionally, the transactions were published in obscure tax corners and publications. No matter, if the IRS published some transaction in the Botswana Evening Cuspidor, it simply assumed that practitioners – and, by extrapolation, their clients – were clued-in.

If the IRS decided that your transaction made the list, then you were required to disclose the transaction on every tax return that included a tax benefit therefrom. If the IRS listed the transaction after you filed a tax return but before the statute of limitations expired, then you had to file disclosure with your next tax return. You had to file the disclosure with two different offices of the IRS, which was just an accident waiting to happen. And the disclosure had to be correct and complete. If the IRS determined that it was not, such as if you could not make heads or tails of their instructions for example, the IRS could consider that the same as not filing at all. There were no brownie points for having tried.

There’s more.

The penalty applied regardless of whether taxpayer’s underlying tax treatment was ultimately sustained. In fact, the IRS was publishing reportable transactions BEFORE proving in Court that any of the transactions were illegal or abusive. If you took the IRS to Court and won, the IRS said it could still apply the penalty. There was no exception to the imposition of the penalty, even if you could demonstrate reasonable cause and good faith.  

But there was some mercy. Although you could not take the penalty to Court, you could request the IRS Commissioner for rescission if it would “promote compliance … and effective tax administration.” Oh please.

Can this get worse? You bet.

Let’s decouple the penalty from any possible tax benefit you may have gotten. If the transaction was particularly suspicious (termed “listed’), the penalty was $100,000. Double that if you were a company. What if the transaction occurred in your S corporation and then on your personal income tax return because of the K-1 pass-through? Well, add $200,000 plus $100,000 for a penalty of $300,000. Per year. What if the tax benefit was a fraction of that amount? Tough. 

This was a fast lane to Tax Court. Wait, the penalty could not be appealed. Think about that for a moment. The IRS has a penalty that cannot be appealed. What if the system failed and the IRS assessed the penalty abusively or erroneously?  Too bad.  

The Taxpayer Advocate publicly stated that the 6707A penalty should be changed as it “raises significant constitutional concerns, including possible violations of the Eight Amendment’s prohibition against excessive government fines and due process protections.”

In response to public clamor and pressure from Congress, the IRS issued moratoriums on 6707A enforcement actions. It wound up reducing the penalty for years after 2006 to 75% of the decrease in tax resulting from the transaction. There was finally some governor on this runaway car.

My client walked into Section 6707A long before I ever met him/her. How? By using a retirement plan.

Yep, a retirement plan.

The plan is referred to as a 412(i), for the Code section that applies. A company would set up a retirement plan and fund it with life insurance. Certain rules relaxed once one used life insurance, as it was considered a more reliable investment than the stock market. I was a fan of these plans, and I once presented a 412(i) plan to a former client who is (still) a sports commentator at ESPN.

Then you had the promoters who had to ruin 412(i)) plans for everyone else. For example, here is what I presented to the ESPN person. We would set up a company, and the company would have one employee and one retirement plan. The plan would be funded with life insurance. The plan would have to exist for several years (at least five), and - being a pension plan - would have to be funded every year. Because life insurance generally has a lower rate of return than the stock market, the IRS would allow one to “over” fund the plan. After five years or more, we would terminate the plan and transfer the cash value of the insurance to an IRA.

The promoters made this a tax shelter by introducing “springing” life insurance. They were hustling products that would have minimal cash value for a while – oh, let’s say … the first five years. That is about the time I wanted to close the plan and transfer to an IRA. Somehow, perhaps by magic, all that cash value that did not previously exist would “spring” to life, resulting in a very tidy IRA for someone. Even better, if there was a tax consequence when the plan terminated, the cost would be cheap because the cash value would not “spring” until after that point in time.

I thought a 412(i) plan to be an attractive option for a late-career high-income individual, and it was until the promoters polluted the waters with springing insurance nonsense. It then became a tax shelter, triggering Section 6707A.

My client got into a 412(i). From what I can tell, he/she got into it with minimal understanding of what was going on, other than he/she was relying on a professional who otherwise seemed educated, sophisticated and impartial. The plan of course blew up, and now he/she is facing 6707A penalties – for multiple tax years.

And right there is my frustration with penalties of this ilk. Perhaps it makes sense if one is dealing with the billionaires out there, but I am not. I am dealing with businesspeople in Cincinnati who have earned or accumulated some wealth in life, in most cases by their effort and grit, but nowhere near enough to have teams of attorneys and accountants to monitor every fiat the government decides to put out. To say that there is no reasonable cause for my client is itself abusive. He/she could no more describe the tax underpinnings of this transaction any more than he/she could land a man on the moon.

What alternative remains to him/her? To petition the Commissioner for “rescission?” Are you kidding me? That is like asking a bully to stop bullying you. I have ten dollars on how that exercise will turn out.