To Withhold, or Not to Withhold, That Is the Question: A Step-by-Step Approach to the FIRPTA Income Tax Withholding
The Florida real estate market has fluctuated over the last few years. Nevertheless, Florida continues to be a popular place for foreign investors to purchase real estate. In 2017, the National Association of Realtors (NAR) revealed that 22 percent of international investments in real estate within the United States were in Florida, the highest among all states, followed by California and Texas.1 A ccording to the NAR’s study, foreign buyers and recent immigrants purchased approximately $153 billion of residential property between April 2016 and March 2017.2 T hese foreign buyers will eventually become foreign sellers, and these foreign sellers may then be subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).3
Under FIRPTA, a foreign seller of U.S. real property is subject to a tax withholding at closing, and the buyer in such transaction is obligated to submit the tax withholding to the IRS.4 T his article provides a brief history of FIRPTA and lists the different types of sellers involved in transactions. Furthermore, it guides the reader through a step-by-step approach in determining 1) whether the seller is a U.S. person or foreign person (be it an individual, limited liability company, corporation, partnership, or trust); 2) whether the FIRPTA withholding applies to a given transaction or if it falls under an exception; and 3) what is the amount of the tax withholding. To help guide real estate practitioners through the analysis, included is a FIRPTA paradigm (decision matrix) divided into Part A — Seller Analysis and Part B — Residential Exceptions. Similarly, endnotes list many references and examples as resources to learn more about FIRPTA. The idea is for the real estate practitioner to be better equipped to handle real estate transactions in which FIRPTA issues arise. More importantly, the article increases awareness of FIRPTA and ensures compliance with its requirements, as noncompliance of FIRPTA requirements may result in late fees, payment of interest, civil liabilities, and even criminal penalties.5
Foreign Investment in Real Property Tax Act of 1980
In general, the IRS imposes an income tax on any given individual’s or entity’s net taxable income (the gross income earned minus any deductions, if applicable).6 T his income tax is mandatory and generally paid by all U.S. persons. In the late 1970s, a large number of foreign investments took place in the U.S.7 w ay of loopholes in tax laws at that time, foreign investors were able to avoid paying income tax on the gain earned on the sale of their U.S. real property, while U.S. persons still had to pay the income tax on their gains.8 T his meant that foreign investors were receiving tax advantages that exceeded those of U.S. persons9 ( i.e. , foreign sellers were getting away with not paying income tax on their gains), which was viewed by many, understandingly so, as unfair.10 T he common argument among foreign investors then was that simply owning rental income property and receiving rental income did not rise to the level of being “effectively connected to a U.S. trade or business” qualifying the foreign investor to pay income tax in the U.S.11 T o balance the scale between foreign and U.S. real estate investors, on December 5, 1980, President Jimmy Carter signed the Omnibus Reconciliation Act of 1980, which included the Foreign Investment in Real Property Tax Act of 1980.12 A fter FIRPTA was passed, a foreign individual or entity had to pay income tax on any gain from the sale or exchange of U.S. real property as if such gain was effectively connected to a U.S. trade or business during a given taxable year.13 T his meant that foreign investors could no longer avoid the payment of income tax.
Under FIRPTA, a buyer who purchases U.S. real estate from a foreign seller is obligated to withhold from seller’s proceeds, and submit to the IRS, a percentage of the sales price of the U.S. real property.14 T his tax withholding is a sort of prepayment or credit to be applied toward the foreign seller’s potential U.S. income tax liability. The foreign seller then files an income tax return for the transaction. However, in the event the seller flees the country without filing a tax return, then the IRS at least collected the income tax or a substantial portion of it. This prevents the foreign seller from avoiding income tax liability. A foreign seller may claim a refund, where the actual income tax liability due after deductions is less than the amount of the tax withheld, provided the claim is filed within a certain time period after the sale.15
The rate of the FIRPTA tax withholding was increased in February 2016. Prior to February 2016, a buyer who purchased real property from a foreign person was required to withhold from the seller’s proceeds the amount equal to 10 percent of the sales price, subject to certain exceptions.16 O n December 18, 2015, President Barack Obama signed into law the Protecting America from Tax Hikes (PATH) Act,17 w hich became effective on February 16, 2016.18 T he Path Act was responsible for the increase and, today, a foreign seller of U.S. real property is subject to a tax withholding equal to 15 percent of the sales price.19 T he PATH Act also amended the residential exceptions criteria, thereby, maintaining the withholding rate at 10 percent for qualifying transactions.20
FIRPTA Paradigm decision matrix: Part A Seller Analysis
The Seller
The main purposes of the FIRPTA analysis is to determine whether the seller is a U.S. person or a foreign person. A “U.S. person” is defined as 1) a citizen or resident of the U.S.; 2) a domestic partnership; 3) a domestic corporation; 4) any estate, where its income derives from within the U.S. or such income is effectively connected with the conduct of a trade or business within the U.S.; and 5) a trust, where such trust allows for a U.S. court to exercise primary supervision over its administration and at least one U.S. person has the authority to control all its substantial decisions.21 T he term “domestic” refers to an entity created or organized in the U.S. or under the law of the U.S. or of any state.22 N ote that this definition omits limited liability companies from the definition of a “U.S. person,” which is further discussed below. This article focuses on transactions involving sellers who are individuals, limited liability companies, corporations, partnerships, and trusts, because these are the types of sellers that real estate practitioners are more likely to encounter in their transactions. Trusts are discussed on a limited basis, and estates (as sellers) are not discussed.
Individuals
An individual is deemed a “U.S. person” if he or she is either a citizen or a resident of the U.S.23 A “citizen” is, generally, a person born in the U.S.24 A “resident” of the U.S. is someone who is lawfully admitted for permanent residence25 & #x2014; a person issued an alien registration card, or Form I-551, more commonly known as a “green card.”26 F or tax purposes, an individual may also be deemed a resident of the U.S. for a specific calendar year if the individual meets the “substantial presence test,” which is a numerical formula measuring the days an individual is present in the U.S.27 T he substantial presence test can be met if the individual is physically present in the U.S. for at least 183 days during the most recent three-year period (the current year and two preceding years), with a minimum of 31 days in the current year.28 T he term “current year” means the calendar year for which an alien individual is attempting to determine his or her resident status.29 F or purposes of this test, each day of presence in the current year is counted as a full day, each day of presence within the first preceding year (the year right before the current year) is counted as one-third of a day, and each day of presence within the second preceding year (two years before the current year) is counted as one-sixth of a day.30 T he Code of Federal Regulations provides various examples (See Figure 1).31 O nce the substantial presence test is met, one must obtain evidence of seller’s presence in the U.S. The U.S. Customs and Border Protection website32 n ow has a function that permits individuals to access their most current five-year arrival and departure history after inputting information from the individual’s passport.33 W hen reviewing the travel history and calculating the days present, note that certain days are excluded and do not count toward the number of days the individual is physically present in the U.S.34
Figure 1: Examples and charts
When an individual seller is a U.S. citizen or a U.S. resident (either by obtaining a green card or meeting the substantial presence test), the tax withholding is not required. This individual may issue a nonforeign affidavit35 a t the closing of any given transaction indicating his or her status along with supporting evidence. Otherwise, the individual seller is deemed a foreign person or “nonresident alien,” and the tax withholding is required.36
A factor to consider is whether the “seller” consists of two or more individuals ( i.e. , husband and wife, multiple investors, etc.). If this is the case, the real estate practitioner must determine the status of each individual seller separately, even if the sellers are a married couple.37 I f the individual sellers are all U.S. persons, the tax withholding is not required. If the individual sellers are all foreign individuals, then the tax withholding is required (subject to allocation of ownership and amount earned by each seller). When at least one of the multiple sellers is a foreign individual, the amount subject to withholding shall be determined by allocating to the foreign seller the share of the sales price based on the capital contribution of each seller.38 T he capital contribution percentage formula is, generally, the following: [individual foreign seller’s amount of contribution to real property at time of purchase] ÷ [total price paid for real property at time of purchase] = percent capital contribution, unless the sellers previously agreed to a different percentage. Based on this formula, the capital contribution is then used to allocate the share of the sales price to each of the sellers.39 N ote that when the individual sellers are a married couple, unless stated otherwise, each will be deemed to have contributed 50 percent of the aggregate capital contributed by them as a whole.40
Limited Liability Company
In general, a business entity is considered a “domestic” entity if it is created or organized under the laws of the U.S. or of any of its states.41 However, when the seller is a limited liability company, the fact that it was formed or created in the U.S. does not necessarily mean that it is a U.S. person for tax purposes. The reason is that a company is not listed in the definition of a “U.S. person.”42 This complicates the analysis in determining whether the tax withholding applies to a selling company. A domestic company is an entity created by state statutes, and a person cannot tell how the company is structured solely from the abbreviation “LLC” or the word “company” in its name. The difference between a company and other business entities is that a company has options as to how it is to be treated or classified by the IRS for tax purposes.43 T he members (also known as the owners of the company) can elect to treat the company as either a 1) corporation; 2) disregarded entity; or 3) a partnership. A domestic company can elect to be classified as a corporation regardless of the number of members it has.44 O therwise, it would either be deemed a disregarded entity or a partnership.45 F or those companies whose members do not make an election, the Code of Federal Regulations46 p rovides the default classifications, which are the following:
• Disregarded Entity — Unless the company elects to be treated as a corporation, a company with a single member defaults to being a disregarded entity (an entity separate from its owner)47 a nd is treated in the same manner as a sole proprietorship.48 A ny tax reporting is done through the single member and not the company.
• Partnership — Unless it elected to be treated as a corporation, a domestic company with two or more members defaults to a partnership.49
Regardless of how a company is classified or how it obtained its classification, the FIRPTA analysis needs to be performed to determine if the tax withholding applies to the company’s sale of U.S. real property. The analysis for a company begins by determining whether a company elected to be treated as a corporation. If a company elected to be treated as a corporation, the only inquiry is whether the company was created or organized in the U.S. If it is domestic, then the tax withholding does not apply in connection with the sale of its real property. The domestic company, in this case, may issue a nonforeign affidavit at closing, after providing documentation from the IRS confirming its election as a corporation. However, if the seller is a foreign company, then the tax withholding is required.
Because a company not classified as a corporation may have other classifications, the more crucial facts are the number of members a company has and who they are. This information can be found in the company’s organizational documents, membership certificates, operating agreements or previously filed tax returns. If a company is made up of a single member, the next question is whether that single member (be it an individual, corporation, company, partnership, or trust) is a U.S. person. If the company’s single member is also owned by another company with a single member, the cycle is repeated until a point of decision is reached.50 I f the single member is a U.S. person, the tax withholding is not required, and the single member may issue a nonforeign affidavit at closing with a statement indicating that he or she is a U.S. person. If it is determined that the single member is a foreign person, the tax withholding is required, regardless of the fact that the company is domestic.
Be aware that it is possible for a foreign company to be deemed a U.S. person. In order for the foreign company to be classified as a U.S. person, the foreign company must be owned by a single member and that single member must be a U.S. person. In this case, the foreign company is a disregarded entity, so the single member of the foreign company may issue a nonforeign affidavit at closing with a statement indicating that it is a U.S. person. The tax withholding is not required. Otherwise, the tax withholding is required.
Lastly, when a company has two or more members, it is considered a partnership.51 T o determine whether the company classified as a partnership is a U.S. person, the sole inquiry is whether the company was created or organized in the U.S. If such company was created or organized in the U.S., then the tax withholding is not required in connection with the sale of the company’s real property. Therefore, the company may issue a nonforeign affidavit at closing. Otherwise, the tax withholding applies. Note that when the company is deemed a partnership, it is irrelevant whether its members are foreign individuals or business entities.52
Corporations
The definition of a “U.S. person” lists domestic corporations.53 F or corporations, the sole inquiry is whether the company was created or organized in the U.S. If the corporation was created or organized in the U.S., then the tax withholding does not apply in connection with the sale of its real property. The domestic corporation may issue a nonforeign affidavit at closing. On the contrary, if the seller is a foreign corporation, then the tax withholding is required — maybe.
As with a foreign company, a selling foreign corporation may avoid the tax withholding if it previously elected to be treated as a domestic corporation. I.R.C. §897(i)allows a foreign corporation the option to be treated as a domestic corporation, if it meets all of the following conditions: 1) The foreign corporation holds a U.S. real property interest at the time of the election; 2) the foreign corporation is entitled to nondiscriminatory treatment with respect to its U.S. real property interest under any treaty to which the U.S. is a party; and 3) the foreign corporation submits the proper application to the IRS.54 I f the foreign corporation previously elected to be treated as such, then it simply has to provide a copy of the acknowledgment from the IRS as evidence confirming the domestic election.55 Once the acknowledgment is provided, then the foreign corporation may issue a nonforeign affidavit, and the tax withholding is not required. Otherwise, the tax withholding is required.
Partnerships
As with corporations, the definition of a “U.S. person” also includes domestic partnerships.56 F or federal tax purposes, a partnership means a business entity that is not a corporation and that has at least two members.57 A partnership is further defined to include a syndicate, group, pool, joint venture, or other unincorporated organization (other than a trust, estate, or corporation) that carries on a business, financial operation, or venture.58 C ommon types of partnerships include general partnerships, limited partnerships, limited liability partnerships, and limited liability limited partnerships. To determine whether a partnership is a U.S. person, the sole inquiry is whether the partnership is domestic. If the partnership was created or organized in the U.S, then the tax withholding does not apply in connection with the sale of the partnership’s real property. Consequently, the partnership may issue a nonforeign affidavit at closing. Otherwise, the tax withholding applies.
Trusts
A trust is deemed a U.S. person if it meets a two-part test. The first part is whether a court within the U.S. is able to exercise primary supervision over the administration of the trust, also known as the “court test.”59 T he Code of Federal Regulations provides several examples of the application of the court test.60 T he second part is whether one or more U.S. persons have the authority to control all substantial decisions of the trust, also known as the “control test.”61 T he Code of Federal Regulations also provides several examples regarding the control test.62 T he trust becomes a U.S. person, and not subject to the tax withholding, on the day it meets both of these tests.63 U ntil that time, the trust is deemed a foreign trust and the tax withholding is required.64 T his is a very difficult analysis. As a precaution, be cautious of any mention of foreign fiduciaries or countries in any trust.
Exceptions to FIRPTA Withholding
At this point in the analysis, it was determined that the seller is a foreign person and subject to the tax withholding. The issue that follows is whether the seller falls within an exception to the required tax withholding or qualifies for a reduced withholding. The included Part B — Residential Exceptions of the FIRPTA paradigm serves as a guide in analyzing exceptions to the tax withholding and cites references to the laws.
FIRPTA Paradigm desicion matrix: Part B Residential Exceptions
The initial step for exceptions is to determine whether the real property being sold is residential property.65 I f the real property is commercial property, then no exception applies and the foreign seller is subject to the 15 percent withholding rate.66 P rovided the real property is residential property, the next question is whether the buyer, not the seller, is an individual.67 I f the buyer is other than an individual person ( i.e. , corporation, partnership, company, etc.), then no exception applies, and the foreign seller is subject to the 15 percent withholding rate.68 I f the buyer is an individual person, the next question is whether the buyer will acquire the real property for personal use as a residence.69 A ccording to the Code of Federal Regulations, real property is acquired for use as a “residence” if on the date of the transfer the buyer has definite plans to reside at the real property for at least 50 percent of the number of days that the real property is used by any person during each of the first two 12-month periods following the date of the transfer.70 N o form or other document needs to be filed with the IRS to establish a transferee’s entitlement to rely upon the exception.71 I t is only recommended that the buyer sign an affidavit acknowledging the residence requirement timeline previously mentioned.72 I f the buyer provides such affidavit, then subject to the other qualifications, the seller may be exempt from the withholding or qualify for a reduction depending on the sales price (further discussed below). On the other hand, if it is known that the real property is to serve as a rental property or other commercial investment, then no exception or reduction applies, and the tax withholding is required.
Some concern exists with this “residence” requirement. At the time of the transfer, no one is really certain as to whether the buyer will actually use the real property as a residence for the next two 12-month periods, even if the buyer tells you he or she is. A buyer may move out for a number of reasons ( i.e. , financial hardship, divorce, rental of residence, foreclosure, etc.) or simply decide to sell the property prior to the end of this 24-month period. If this happens, then both the seller and buyer will be liable to the IRS for noncompliance with FIRPTA and its withholding requirements. A potential problem is that if the foreign seller has already left the country, the only recourse the IRS has will be against the buyer. The buyer assumes all the risk in this scenario.
Moving on, provided that all other requirements or qualifications above are met, the two remaining steps deal with the sales price. If the sales price is $300,000 or less, then the tax withholding is not required.73 I f the sales price is equal to or greater than $300,001, but equal to or less than $1 million then the seller would qualify for a reduced withholding in the amount of 10 percent (instead of 15 percent).74 I f the sales price is greater than $1 million, then no exception applies, and the buyer is responsible for withholding 15 percent of the amount realized by seller.75 R efer to FIRPTA Paradigm: Part B — Residential Exceptions for assistance and guidance.
Given that Florida has the highest percentage of foreign investments in real estate within the U.S., it is crucial for real estate practitioners to become familiar with FIRPTA and its requirements. After reading this introductory article, the reader should be able to identify the status of the seller, determine if the tax withholding applies to the transaction, and calculate the amount of such tax withholding. Between the FIRPTA paradigm and the references provided, real estate practitioners should be better equipped to handle real estate transactions involving FIRPTA issues and ensure a smooth closing. Lastly, when in doubt as to the FIRPTA tax withholding, it is always safer to withhold.
1 Research Division of the National Association of Realtors, 2017 Profile of International Activity in U.S. Residential Real Estate 15-16 (July 2017), available at https://www.nar.realtor/sites/default/files/documents/2017-Profile-of-International-Activity-in-US-Residential-Real-Estate.pdf ) [hereinafter International Activity in U.S. Real Estate ]; and see Amid U.S. Real Estate Buying Binge by Foreign Investors, Florida Remains First Choice, Tampa Bay Times, January 1, 2018.
2 International Activity in U.S. Real Estate at 10.
3 Omnibus Reconciliation Act of 1980 (Foreign Investment in Real Property Tax Act of 1980), Pub. L. No. 96-499, §94 Stat. 2682 (1980) (codified as I.R.C. §897).
4 I. R.C. §1445(a); 26 C.F.R. §1.1445-1(b)(1).
5 See 26 C.F.R. §1.1145-1(e)(1); I.R.C. §6672(a); 26 C.F.R. §301.6672-1; I.R.C. §7202; I.R.C. §6651. These sections indicate who is responsible for the withholding, as well as the consequences for failing to pay or withhold the tax, which include interest, penalties, and, possibly, incarceration.
6 I. R.C. §63.
7 William D. Metzger, Foreign Investors Real Property Tax Act: Historical Perspective and Critical Evaluation, 5 W. New Eng. L. Rev. 161, 162 (1982).
8 Lisa B. Petkun, The Foreign Investors Real Property Act of 1980, 1 Penn. St. Int’l L. Rev. 11, 11 (1982).
9 Metzger, Foreign Investors Real Property Tax Act: Historical Perspective and Critical Evaluation, 5 W. New Eng. L. Rev. at 161.
10 Petkun, The Foreign Investors Real Property Act of 1980, 1 Penn St. Int’l L. Rev. at 14.
11 See Lewenhaupt v. Commissioner, 20 T.C. 151, 163 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955); I.R.C. §864(c)(2) and 26 C.F.R. §1.864-4(c) (factors in determining what income is effectively connected with a U.S. trade or business).
12 See note 3; see also Leonard R. Olsen, Jr., Analysis of Foreign Investment in Real Property Tax Act of 1980, 7 Int’l Tax J. 262 (1980-1981).
13 I.R.C. §897(a)(1).
14 26 C.F.R. §1.1445-1(b)(1).
15 See I.R.C. §6511(a). (“A claim for refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within [three] years from the time the return was filed or [two] years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within [two] years from the time the tax was paid.”).
16 I. R.C. §1445(a) (2015).
17 See Protecting America from Tax Hikes Act (PATH Act) of 2015, Pub. L. No. 114-113, §324 (2015) (amending I.R.C. §1445).
18 Id.
19 Id.
20 Id.
21 I.R.C. §§7701(a)(30)-(31)(A).
22 I.R.C. §7701(a)(4).
23 I.R.C. §7701(a)(30)(A).
24 8 U.S.C. §1401.
25 I.R.C. §7701(b)(1)(A)(i).
26 26 C.F.R. §301.7701(b)-1(b)(1).
27 26 C.F.R. §301.7701(b)-1(c)(1).
28 Id.
29 26 C.F.R. §301.7701(b)-1(c)(3).
30 26 C.F.R. §301.7701(b)-1(c)(1).
31 Examples based on the examples listed at 26 C.F.R. §301.7701(b)-1(e), Examples 1-3. See Figure 1.
32 Dep’t of Homeland Security, U.S. Customs and Border Control, Official Site for Travelers Visiting the United States: Apply for or Retrieve Form I-94, Request Travel History and Check Travel Compliance, https://i94.cbp.dhs.gov/I94/#/home.
33 Department of Homeland Security, U.S. Customs and Border Control, View Travel History, https://i94.cbp.dhs.gov/I94/#/history-search.
34 26 C.F.R. §301.7701(b)-3(a) (“The following days shall be excluded and will not count as days of presence in the United States — (1) Any day that an individual is present in the United States as an exempt individual; (2) [a]ny day that an individual is prevented from leaving the United States because of a medical condition that arose while the individual was present in the United States; (3) [a]ny day that an individual is in transit between two points outside the United States; and (4) [a]ny day on which a regular commuter residing in Canada or Mexico commutes to and from employment in the United States.”).
35 Sample language for certifications or nonforeign affidavits can be found at 26 C.F.R. §1.1445-2(b)(2)(iv)(A-B).
36 I.R.C. §7701(b)(1)(B).
37 26 C.F.R. §1.1445-1(b)(3).
38 Id.
39 Example 4 — Maria, a Mexican citizen, and Joshue, a U.S. citizen, own residential real property in Miami as tenants in common. They purchased it for $350,000, at which time Maria contributed $87,500 (25 percent) and Joshue contributed $262,500 (75 percent). Maria and Joshue sold the real property for $400,000, which is the amount realized by both sellers. The amount Maria realized herself, which is the amount subject to the FIRPTA tax withholding, is $100,000 (25 percent of $400,000). Therefore, the buyer of this transaction must withhold and submit to the IRS 15 percent of the $100,000 realized by Maria, which amounts to $15,000.
40 26 C.F.R. §1.1445-1(b)(3).
41 26 C.F.R. §301.7701-5(a).
42 I.R.C. §7701(a)(30)-(31)(A).
43 26 C.F.R. §301.7701-3(a-b).
44 26 C.F.R. §301.7701-3(a).
45 26 C.F.R. §301.7701-2(a).
46 26 C.F.R. §301.7701-3(a-b).
47 26 C.F.R. §301.7701-3(b)(1).
48 26 C.F.R. §301.7701-2(a).
49 26 C.F.R. §301.7701-3(b)(1).
50 Example 5 — Miami LLC, a Florida limited liability company, is a single-member company. Miami LLC did not elect to be treated as a corporation. Its single-member is Harvard LLC, a Delaware limited liability company. Harvard LLC did elect to be treated as a corporation and has correspondence from the IRS confirming the election. Miami LLC has only one member and is not a corporation. Since it only has one member, then it is a disregarded entity. The fact that it is a domestic (Florida) company is irrelevant. Next, one looks at the single member to determine if the single member is a U.S. person. The facts indicate that Harvard LLC is a corporation for tax purposes, it is a domestic (Delaware) company, resulting in it being a U.S. person. No withholding in the event of a sale of its property.
51 26 C.F.R. §301.7701-3(a-b).
52 Example 6 — A company organized in the U.S. that is owned by an individual Canadian citizen and a French corporation is deemed a U.S. person, even though its members are foreign persons.
53 I.R.C. §§7701(a)(30)-(31)(A).
54 See I.R.C. §897(i)(1); 26 C.F.R. §1.897-3(b-c).
55 See 26 C.F.R. §1.1445-2(b)(2)(ii); see also 26 C.F.R. §1.897-3( d)(4).
56 I.R.C. §7701(a)(30)(B).
57 26 C.F.R. §301.7701-2(c)(1).
58 I.R.C. §7701(a)(2).
59 26 C.F.R. §301.7701-7(c)(1, 3, and 4). (A trust satisfies the court test if all the following are met: 1) The trust agreement does not direct for the trust to be administered outside of the U.S.; 2) the trust is, in fact, administered exclusively in the U.S; and 3) the trust is not subject to an automatic migration provision. Other circumstances considered that cause a trust to satisfy the court test (although not an exclusive list) include 1) an authorized fiduciary registers the trust in a court within the U.S.; 2) the trust was created under a will probated within the U.S. (other than an ancillary probate) and all trust fiduciaries have been qualified as trustees of the trust by a court within the U.S.; 3) the fiduciaries of a trust (other than a testamentary trust) take steps with a court within the U.S. that cause the administration of the trust to be subject to the primary supervision of the court; and 4) both a U.S. court and a foreign court are able to exercise primary supervision over the administration of the trust. Otherwise, the trust is deemed a foreign trust.).
60 Examples based on the examples listed at 26 C.F.R. §301.7701-7(c)(2 and 5):
Example 7 — Mirtha creates a trust for the equal benefit of her two children, Elsa and Jeanne. Per the trust agreement, ABC Corp., a Florida corporation, is the trustee of the trust. Although the trust is silent as to where the trust is to be administered, ABC Corp. administers the trust exclusively in Florida. The trust is not subject to an automatic migration provision. In this example, the court test is met because, although silent as to where it is to be administered, the trust agreement does not direct for the trust to be administered outside of the U.S. Also, the trust is, in fact, administered in the U.S.; and the trust is not subject to automatic migration provisions.
Example 8 — Janet, a U.S. citizen, creates a trust for the equal benefit of her two children, Michael and Michelle, who are U.S. citizens. The trust instrument provides that DC Corp., a California corporation, is to act as trustee of the trust and that the trust is to be administered in Argentina. DC Corp. maintains a branch office in Argentina with personnel authorized to act as trustees there. The trust instrument provides that the law of California governs the interpretation of the trust. Under Argentina law, a court within Argentina is able to exercise primary supervision over the trust administration. An Argentinian court applies California law to the trust as stated in the trust documents. Under the terms of the trust, the trust is administered in Argentina. No court within the U.S. is able to exercise primary supervision over the administration of the trust. Under those facts, the trust fails the court test and is, therefore, deemed a foreign trust.
Example 9 — Eric, a U.S. citizen, creates a trust for his own benefit and the benefit of his spouse, Mara, also a U.S. citizen. The trust instrument provides that the trust is to be administered in New York by Ladi Corp., a New York corporation. The trust instrument further provides that in the event a creditor sues the trustee in a U.S. court, the trust will automatically migrate from New York to Cayman Islands so that no U.S. court will have jurisdiction over the trust. A court within the U.S. is not able to exercise primary supervision over the trust administration because the U.S. court’s jurisdiction over the trust administration is automatically terminated in the event the court attempts to assert jurisdiction. Therefore, the trust fails to satisfy the court test from the time of its creation and is deemed a foreign trust.
61 I.R.C. §7701(a)(30)(E); 26 C.F.R. §301.7701-7(a)(2) and (d)(1)(i-iii). (A trust satisfies the control test if one or more U.S. persons have the authority to control all substantial decisions of the trust. The term “control” requires power to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions (and not ministerial decisions). It is necessary to consider all persons who have authority to make substantial decisions. Decisions that are “ministerial” include decisions regarding details, such as bookkeeping, collection of rents, and execution of investment decisions. Substantial decisions include 1) whether and when to distribute income or corpus; 2) the amount of any distributions; 3) the selection of a beneficiary; 4) whether a receipt is allocable to income or principal; 5) whether to terminate the trust; 6) whether to compromise, arbitrate, or abandon trust claims; 7) whether to sue on the trust’s behalf or to defend suits against the trust; 8) whether to remove, add, or replace a trustee; 9) whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic, or vice versa; and 10) investment decisions (this includes the decision to hire an investment advisor if the U.S. person can terminate the investment advisor’s power to make investment decisions at will.).
62 Examples based on the examples listed at 26 C.F.R. §301.7701-7(d)(1)(v):
Example 10 — A trust has three fiduciaries: Juan, Jose, and Julio. Juan and Jose are U.S. citizens; Julio is a foreign person from Chile. No persons, except the fiduciaries, have authority to make any trust decisions. The trust instrument provides that no substantial trust decisions can be made unless there is unanimity among the fiduciaries. The control test is not satisfied because U.S. persons do not control all the substantial decisions of the trust. No substantial decisions can be made without Julio’s agreement.
Example 11 — Same as Example 10, but the trust instrument provides that all substantial trust decisions were to be decided by a “majority” vote among the fiduciaries. In that case, the control test is satisfied because a majority of the fiduciaries, Juan and Jose, being U.S. persons can control all the substantial decisions of the trust.
Example 12 — Same as Example 10, but the trust instrument directs Julio to make all of the trust’s investment decisions, subject to veto by Juan and Jose. Juan and Jose cannot act to make the investment decisions on their own. The control test is not satisfied because the U.S. persons, Juan and Jose, do not have the power to make all of the substantial trust decisions.
Example 13 — Same as Example 10, but Juan and Jose have the power to either accept or veto Julio’s investment decisions and can, on their own, make investments that Julio has not recommended. The control test is satisfied because the U.S. persons control all substantial trust decisions.
63 26 C.F.R. §301.7701-7(a)(2).
64 I.R.C. §7701(a)(31)(B).
65 I.R.C. §1445(b)(5)(A). (The code does not have a definition for the term “residential property.” In Florida, “residential property” is generally real property made up of one multi-family structure containing one to four residential units or a single-family home, which also includes residential condominiums, townhouses, and mobile homes. Fla. Stat. §475.801(4) (2017)).
66 I.R.C. §1445(a).
67 26 C.F.R. §1.1445-2(d)(1).
68 I.R.C. §1445(a).
69 I.R.C. §1445(b)(5)(A).
70 26 C.F.R. §1.1445-2(d)(1). (Under I.R.C. §267(c)(4), the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants.).
71 Id.
72 Id.
73 I.R.C. §1445(b)(5).
74 I.R.C. §1445(c)(4); see also 26 C.F.R. §1.1445-1(b)(2).
75 I.R.C. §1445(a).
Gil O. Acevedo is a shareholder at the Miami office of Fowler White Burnett, P.A. He practices real estate law, mainly acquisitions and dispositions, financing, leasing, and title insurance. He received his LL.M. in real property development from University of Miami School of Law; J.D. from Western Michigan University-Cooley Law School; and B.A. from the University of South Florida. Acevedo thanks Jason Warner, Linda Monaco, and Alyssa Razook Wan for their assistance.
