Posts

Establishing Cost-Basis in Foreign Real Estate | IRS Audit Tax Lawyer & Attorney

One of the most challenging issues during an IRS audit is establishing cost-basis in foreign real estate.  This issue most frequently comes up in the context of real estate that was obtained through inheritance or gift many years ago.  In this article, based on my IRS audit experiences, I would like to discuss the main challenges and case strategies associated with establishing the cost-basis in foreign real estate in a manner that would satisfy the IRS during an audit.

An important note: I will not be discussing this issue in the context of an IRS audit of an offshore voluntary disclosure and how it would affect the calculation of an Offshore Penalty.  This essay is strictly limited to an IRS audit that involves US international tax issues without the taxpayer ever going through a voluntary disclosure.

Another important note: this article is written more for the benefit of other international tax lawyers, not the general public.

Establishing Cost-Basis in Foreign Real Estate: Importance

Before we discuss the problems associated with establishing the cost-basis in foreign real estate, we need to first understand why this issue is so important.  There are three main consequences to establishing cost-basis in the context of an IRS audit. 

First, the income tax impact of failure to establish cost-basis in a foreign property on the audited taxpayer may be truly disastrous.  Obviously, if you cannot prove any cost-basis in a property (or you can only convince the IRS that there was minimal cost-basis), you will have to recognize all proceeds from the sale of this property as capital gains (or potentially subpart F income if you owned a property though a foreign corporation).

Second, there is a very important psychological impact on the entire audit if you have a large unreported gain from sale of foreign real estate.  The IRS agent in charge of an audit is likely to take a more aggressive position not only on this issue, but also on other issues irrespective of whether they are directly related to unreported gain.   The most frequent victims of this hardened attitude of an IRS agent are the legal arguments in support of a reasonable cause.

Finally, a large gain from a sale of foreign real estate is likely to encourage the IRS to dig deeper and even expand the audit to more years.  In one of my audit cases, an IRS agent initially believed that there was a large capital gain and expanded the audit to five prior years; however, he reversed this decision once I was able to show that the sold real property had a much higher cost-basis due to numerous improvements that were made by my client over a number of years.

In other words, establishing cost-basis in a sold real estate property may be one of the most crucial issues in an IRS audit.

Establishing Cost-Basis in Foreign Real Estate: Top 3 Challenges

The challenges to establishing cost-basis in foreign real estate are highly dependent on the facts of the case.  However, there are three main themes that usually appear in one form or another in every IRS audit case.

The first challenge is absence of documentation.  This is by far the most common and most important battleground between the IRS and the taxpayer during the vast majority of IRS audits in this area, especially if the direct documentation is absent due to passage of time.

The second challenge is the potential opposition from the IRS to proving cost-basis indirectly through usage of circumstantial evidence and third-parties.

The third challenge is establishing the credibility of evidence. For example, in one of my cases, the IRS initially refused to accept a valuation report prepared by a local professional valuation expert because the report lacked a proper explanation of how he arrived at the proposed values.

Establishing Cost-Basis in Foreign Real Estate: Top 4 Strategies for Overcoming Challenges

There are numerous strategies to deal with the cost-basis establishment challenges. Your choice among them should depend on the facts and circumstances of your case.  Sometimes, you will even come up with a brand-new strategy tailored specifically to the unique challenges of your case.

Nevertheless, there are four common themes to the strategies used in overcoming the aforementioned challenges.  First, you need to recreate the logical history of the property and capital improvements to the property in order to convince the IRS that the valuation your client supplied is logical and reasonable.

Second, demonstrate to the IRS agent in charge of your client’s audit that you are a reliable source of information.  The more objective you appear (and you actually are), the more the IRS sees that you will not allow false facts or statements to enter the record, the more the IRS sees that your client shares both of these traits, the more likely the IRS agent will accept your position or be willing to achieve a compromise with you (see below).

Third, utilize indirect and circumstantial evidence as well as third-party affidavits/testimony to support the valuation of the property.  In other words, if you have no ability to directly establish the cost-basis of a property, then you need to find creative ways to build the necessary records and establish their credibility through usage of supporting documents and/or testimony. 

For example, in one of my previous audits, the client had no documentation whatsoever except one isolated receipt to prove the substantial improvements made to her foreign real estate over the past almost forty (!) years.  My solution to this problem was to first get an affidavit from my client fully stating all improvements made with approximate cost based purely on her memory.  Then, I obtained additional signed statements from neighbors largely supporting the estimates as well as the fact that these improvements were indeed made. Finally, I obtained a statement from a local construction company owner who stated that he recalled these improvements and confirmed the estimated amounts.  Additionally, all of the improvements were properly explained by the history of how the property was obtained, for what purpose and why so many improvements were needed.  All of these facts and circumstances were explained in a letter to the IRS agent together with the legal basis (i.e., case law) showing how courts have accepted similar evidence in the past. Under the weight of this substantial record (and some other circumstances of this case), the IRS finally agreed to accept all improvements as part of an overall compromise.

Finally, use creative legal strategies to convince the IRS to accept a different cost-basis in a property through operation of tax rules.  This is a very complex strategy, but it is more commonly employed than one may believe.  For example, in one of my prior audit cases, the IRS agreed to disregard the foreign corporation that owned the foreign property allowing the stepped-up basis for this inherited property.

Contact Sherayzen Law office for Professional Help with IRS Audits Involving Foreign Real Estate

If you have foreign assets and you are audited by the IRS, contact Sherayzen Law Office for professional help.  We have helped hundreds of US taxpayers around the world to bring their tax affairs in full compliance with US tax laws, including during IRS audits.  We can help you!

Contact Us Today to Schedule a Confidential Consultation!

Tax Residency Starting Date | International Tax Lawyer & Attorney

In situations where a person was not classified as a resident alien at any time in the preceding calendar year and he became a resident alien at some point during current year, a question often arises concerning the tax residency starting date of such a person. This article seeks to provide a succinct overview of this question in three different contexts: US permanent residence, substantial presence test and election to be treated as a tax resident.

Tax Residency Starting Date: General Rule for Green Card Holders

Pursuant to IRC (Internal Revenue Code) §7701(b)(2)(A)(iii), the starting tax residency date for green card holders is the first day in the calendar year in which he or she is physically present in the United States while holding a permanent residence visa.  However, if the green card holder also satisfies the Substantial Presence Test prior to obtaining his green card, the tax residency is the earliest of either the green card test described in the previous sentence or the substantial presence test (see below).

Tax Residency Starting Date: General Rule for the Substantial Presence Test

Generally, under the substantial presence test, the tax residence of an alien starts on the first day of his physical presence in the United States in the year he met the substantial presence test. See IRC §7701(b)(2)(A)(iii).  For example, if an alien meets the requirements of the Substantial presence test in 2022 and his first day of physical presence in the United States was March 1, 2022, then his US tax residency started on March 1, 2022.

Tax Residency Starting Date: Nominal Presence Exception & the Substantial Presence Test

A reader may ask: how does the rule described above work in case of a “nominal presence” in the United States. IRC §7701(b)(2)(C) provides that, for the purposes of determining the residency starting date only, up to ten (10) days of presence in the United States may be disregarded, but only if the alien is able to establish that he had a “closer connection” to a foreign country rather than to the United States on each of those particular ten days (i.e., all continuous days during a visit to the United States may be excluded or none of them). There is some doubt about the validity of this rule, but it has never been contested in court as of the time of this writing.

This rule may lead to a paradoxical result.  For example, if X visits the United States between March 1 and March 10 and leaves on March 10; then later comes back to the United States on May 1 of the same year and meets the substantial presence test, then he may exclude the first ten days in March and his US tax residency will start on May 1.  If, however, X prolongs his visit and leaves on March 12, then none of the days will be excluded (since March 11 and 12 cannot be excluded under the rules) and his US tax residency will commence on March 1.

I want to emphasize that the nominal presence exception only applies in determining an alien’s residency starting date. It is completely irrelevant to the determination of whether a taxpayer met the Substantial Presence Test; i.e. the days excluded under the nominal presence exception are still counted toward the Substantial Presence Test calculation.

Tax Residency Starting Date: Additional Requirements for Nominal Presence Exception & Penalty for Noncompliance

The IRS has imposed two additional requirements concerning claiming “nominal presence” exclusion (again, both of them have questionable validity as there is nothing in the statutory language about them).  First, the alien must show that he had a “tax home” in the same foreign country with which he has a closer connection.

Second, Treas. Regs. §301.7701(b)-8(b)(3) requires that an alien who claims the nominal presence exception must file a statement with the IRS as well as attach such statement to his federal tax return for the year in which the termination is requested. The statement must be dated, signed, include a penalty of perjury clause and contain: (a) the first day and last day the alien was present in the United States and the days for which the exemption is being claimed; and (b) sufficient facts to establish that the alien has maintained his/her tax home in and a closer connection to a foreign country during the claimed period. Id.

A failure to file this statement may result in an imposition of a substantial penalty: a complete disallowance of the nominal presence exclusion claim.  Since IRC §7701(b)(8) does not contain the requirement to file any statements with the IRS to claim the nominal presence exception, the penalty stands on shaky legal grounds.  However, as of the time of this writing, there is no case law directly on point.

Additionally, as almost always in US international tax law, there are exceptions to this rule.  First, if the alien shows by clear and convincing evidence that he took: (a) “reasonable actions” to educate himself about the requirement to properly file the statement and (b) “significant affirmative actions” to comply with this requirement, then the IRS may still allow the nominal presence exclusion claim to proceed. Treas. Regs. 301.7701(b)-8(d)

Second, under Treas. Regs. §301.7701(b)-8(e), the IRS has the discretion to ignore the taxpayer’s failure to file the required nominal presence statement if it is in the best interest of the United States to do so.

Tax Residency Starting Date: Election to Be Treated as a US Tax Resident

In situations where a resident alien elects to be treated as a US tax resident (for example, by filing a joint resident US tax return with his spouse), the tax residency date starts on the first day of the year for which election is made.  See Treas. Regs. §7701(b)(2)(A)(iv).

Contact Sherayzen Law Office for Professional Help with US International Tax Law, Including the Determination of the Tax Residency Starting Date

If you have foreign assets or foreign income or if you are trying to determine your tax residency status in the United States, contact Sherayzen Law Office for professional help.  Our law firm is a leader in US international tax compliance; we have helped hundreds of US taxpayers around the world and we can help you!

Contact Us Today to Schedule Your Confidential Consultation!

Offshore Voluntary Disclosure Seminar | MSBA, February 22 2022

On February 22, 2022, Mr. Eugene Sherayzen, an international tax attorney and founder of Sherayzen Law Office, Ltd., presented at a seminar “IRS Voluntary Disclosure Options for U.S. Owners of a Foreign Business” (the “Offshore Voluntary Disclosure Seminar”). The Offshore Voluntary Disclosure Seminar was sponsored by the International Business Law Section of the Minnesota State Bar Association. Due to the ongoing COVID-19 pandemic restrictions, the seminar was conducted online.

Offshore Voluntary Disclosure Seminar: Focus on Business Lawyers’ Needs

The seminar’s structure was shaped by its audience’s needs. Since Mr. Sherayzen presented to a group of mostly international business lawyers, he adopted a relatively broad approach in his presentation in attempt to cover a large number of topics rather than discuss a few points in depth. The idea behind the seminar was to provide international business lawyers with analytical tools to understand if there was problem with a client’s US international tax compliance that would require a utilization of an offshore voluntary disclosure option.

Offshore Voluntary Disclosure Seminar: Three Main Parts

Mr. Sherayzen divided the Offshore Voluntary Disclosure seminar into three parts. In the first and smallest part, he discussed the link between Offshore Voluntary Disclosures and international business law. The second part focused on US international tax reporting requirements. Finally, in the third part, the international tax attorney provided a broad overview of the existing offshore voluntary disclosure options.

Offshore Voluntary Disclosure Seminar: Link between Offshore Voluntary Disclosures and International Business Law

In the first part of the seminar, Mr. Sherayzen discussed the potential relevance of the IRS offshore voluntary disclosure options and US international tax law in general to the audience’s international business law practice. The international tax attorney even described three main scenarios where international business lawyers will need to have awareness of: US international tax reporting requirements and IRS offshore voluntary disclosure options for US owners of a foreign business. At that point, Mr. Sherayzen gave an example from his own practice illustrating his main points.

Offshore Voluntary Disclosure Seminar: Overview of US International Tax Reporting Requirements for US Owners of a Foreign Business

In the next part of the Offshore Voluntary Disclosure seminar, Mr. Sherayzen provided a broad overview of two major categories of US international tax reporting requirements for individual US taxpayers: US international information returns and income tax recognition.

The international tax attorney first focused on international information returns. After defining the term “information return”, Mr. Sherayzen stated that the type of an information return one needs to file should correspond to the type of a foreign entity for which the return is filed. Then, he described three types of entities that may exist under US international tax law: corporations, partnerships and disregarded entities. Mr. Sherayzen proceeded with a discussion of the most common information returns associated with each of them.

Moreover, the attorney explained that FinCEN Form 114 or FBAR is the main form for reporting of foreign bank and financial accounts in a business context. He also warned the audience against a potential tax trap associated with FBAR reporting for foreign business entities.

Then, Mr. Sherayzen proceeded with an explanation of three major categories of income recognition: distributions, passthrough income and US anti-deferral tax regimes. The latter received the most attention due to their complexity. Three anti-deferral tax regimes were covered: PFICs, Subpart F rules and GILTI.

Offshore Voluntary Disclosure Seminar: Offshore Voluntary Disclosure Options

Mr. Sherayzen began this last major part of his presentation with a definition of the term “offshore voluntary disclosure”. Then, he focused on explaining two critical factors in choosing a voluntary disclosure option: (a) willfulness vs. non-willfulness; and (b) reasonable cause.

After defining these highly-important terms, the attorney laid out all major offshore voluntary disclosure options available to US owners of a foreign business. The presentation covered: IRS Voluntary Disclosure Practice, Streamlined Domestic Offshore Procedures, Streamlined Foreign Offshore Procedures, Delinquent FBAR Submission Procedures, Delinquent International Information Return Submission Procedures and Reasonable Cause (Noisy) Disclosure.

Mr. Sherayzen also discussed the concept of quiet disclosure and why it presented potentially huge risks to noncompliant taxpayers. He emphasized that the IRS stated in the past that it would specifically target this type of a disclosure.

Offshore Voluntary Disclosure Seminar: Conclusion

The international tax attorney concluded the seminar with a concise due diligence plan of action for business lawyers. He emphasized that, upon discovery of potential US international tax noncompliance, business lawyers should not attempt to fix it themselves. Rather, he argued, they need to contact an international tax attorney for professional help.

Contact Sherayzen Law Office for Professional Help

If you are a US owner of a foreign business and you have not properly complied with your US international tax reporting requirements, contact Sherayzen Law Office for professional help. We have helped hundreds of US taxpayers around the globe to bring their US tax affairs into full compliance with US international tax law, and we can help you!

Contact Us Today to Schedule Your Confidential Consultation!

Factual Basis & Tax Planning | International Tax Lawyer & Attorney

In a previous article, I discussed the necessity of balancing international tax planning priorities in order to obtain an optimal tax result. In this article, I will explain why international tax planning should be based on a carefully-studied factual basis.

Factual Basis as the Foundation for International Tax Planning

Young inexperienced lawyers often come up with a particular tax strategy and then they try to implement it independent of the actual facts on the ground. Irrespective of how brilliant such a strategy would be in the abstract, it is almost always doomed to become a failure.

Why? The answer is very simple: these lawyers turn international tax planning on its head. They build the second level of a house without ever building a foundation for it. No matter how well they plan out a strategy, it will fall apart almost immediately when it comes in conflict with the facts – how the business is run, its capital structure, its needs, its goals, its cash flow source, its operating model, its E&P, its foreign tax credit and numerous other important considerations.

Hence, the starting point of any tax planning should be a careful factual study of the business.

Studying Factual Basis as a Way to Uncover Potential Opportunities

In my practice, I have found that a careful study of a business may generate a number of potential planning opportunities that may have otherwise been ignored. For example, during a study of a company’s loan structure, one can sometimes find opportunities to treat these loans as equity investments and utilize much better currency exchange rates to build up the client’s basis in the company (potentially even resulting in a reversal of an entire capital gain upon the sale of this company).

Factual Basis: Four Most Important Components

While an attorney should study all relevant facts, there are four main components that he must cover. The components are: (1) organizational chart and capital structure; (2) operating model; (3) tax status and characteristics; and (4) analysis of financial statements. Let’s analyze each component in more detail.

Factual Basis Components: Organizational Chart and Capital Structure

You should start your factual analysis by building the organizational chart of the business and understanding its capital structure. What you need to do is to understand each entity within the corporate structure and the place it occupies in the overall business structure, identify the tax status of each business, understand the sources of cash and where it is used, create a diagram of debt and equity instruments (including whether these are related or unrelated party instruments), study how the business operates across the entire corporate structure, uncover which currencies are used in business (as well as any currency hedging) and review the withholding tax exposure/compliance.

This first component is likely to help you to identify the tax inefficiencies of the existing corporate structure and seek structural alternatives. I recommend that at this stage you plan for creating a more tax-efficient financing of foreign affiliates to maximize foreign country deductions, minimize tax imposed on interest income, reduce withholding tax and assure sufficient cash flow throughout the structure.

Factual Basis Components: Operating Model

The second component of your factual analysis (though it will probably come at about the same time as you start working on the first component) is the operating model of the business. In other words, what type of a business is it: manufacturing, sales, services or IP (development, ownership and/or usage of IP)? How does the business operate: local country manufacturing, local distributing/franchising, global service contracts, et cetera?

I recommend that you especially focus here (as a goal of your tax planning strategy) on: tax-efficient structuring of current and anticipated foreign operations to maximize tax deferral, tax-efficient financing of capital needs and development of strategy concerning IP development and licensing.

Factual Basis Components: Tax Characteristics

The third component is the one that tax attorneys are likely to like the most, because it is very close to their training and professional interest – the study of the tax characteristics of the corporate structure: income/losses, NOL, AMT, foreign tax credit position (carryovers), E&P, transfer pricing, local tax position and PTI (previously taxed income through Subpart F, 965 tax, GILTI tax, et cetera).

The focus of your tax planning goals here are centered around foreign tax credit, repatriation of earnings, minimizing Subpart F income and transfer pricing (i.e. allocation of profits between the US head office and its foreign affiliate companies).

Factual Basis Components: Financial Statements

Finally, the fourth component of your factual basis study consists of the financial statement analysis. You need to carefully review the financial statement with the focus on: Effective Tax Rate (“ETR”) reconciliation, deferred tax analysis, reinvestment, valuation and foreign currency. The focus of your tax planning goals here should be on low-tax deferral structures (for example, through indefinite reinvestment outside of the United States at a lower tax rate) and the most optimal foreign tax credit utilization.

Contact Sherayzen Law Office for Professional Help With International Tax Planning

If your US company conducts business outside of the United States, contact Sherayzen Law Office for professional help with your international business tax planning. We have helped companies plan their inbound and outbound transactions for US and foreign companies, and we can help you!

§318 Option Definition | US International Tax Lawyer & Attorney

This article continues our series of articles on the IRC (Internal Revenue Code) §318 constructive ownership rules. In this article, I would like to introduce the readers to the infamous §318 option attribution rules. Before we delve into the discussion of the constructive ownership rules for options, however, it is important to understand what “option” actually means for the purpose of §318. Hence, today, I will focus on the §318 option definition.

§318 Option Definition: Main Rule

An option is a right to obtain stock at a certain price and date. I want to emphasize that option is not an obligation, it is a right which a taxpayer may or may not ever exercise.

Such a broad §318 option definition includes a great variety of options: options to purchase stock, option to acquire unissued stocks (as long as a shareholder has the right to obtain stock at his election – see Rev. Rul. 68-601), certain warrants and debentures that may be converted into stocks (as long as there are no contingencies, other than time, that must be met before the conversions rights can be exercised – see FSA 200244003), et cetera.

§318 Option Definition: Rights Not Considered Options

Not all rights to acquire stock, however, are considered options for the purposes of §318 option definition. There is a large number of exceptions, but all of them are centered around the concept of some type of restrictions on the exercise of the option. I will list below the five most popular exceptions which are not considered options under §318(a)(4):

First, a right to acquire stock is not an option if the optionee does not have control over the exercise of the option. For example, if there are many contingencies which can prevent exercise of an option, then this is not an option of the purposes of §318(a)(4). See FSA 199915007.

Second, a corporation’s right to buy back its own stocks is not an option for the purposes of §318. Rev. Rul. 69-562.

Third, a right of first refusal is not an option for the purposes of §318. For example, if the right to purchase stock is contingent on the obligor’s decision to sell, then this is not an option under §318(a)(4). TAM 8106008. We can even broaden the rule not only to a right of first refusal, but to almost all situations where the exercise of option depends on the other party’s decision to sell.

Fourth, certain stock appreciation rights are not options if they only entitle the owner of these rights to cash benefits, but do not permit acquisition of stock. Of course, if contract entitles the owner to the right to acquire stocks, then such stock appreciation rights may actually be options §318. See PLR 9341019.

Finally, the right to acquire stocks is not an option under §318 if such transfer is restricted and requires consent. For example, the IRS held in TAM 9410003 that such an arrangement (i.e. restriction on the transfer of shares without other shareholders’ consent) combined with the right of first refusal did not constitute an option to acquire those shares.

§318 Option Definition: Exceptions to Restrictions

I would like to warn the readers, however, that not all restrictions on exercise of an option automatically exclude a right to acquire a stock from the §318 option definition. We can outline two broad exceptions to restrictions here.

First, where the control over the decision to exercise the option rests with the holder of the right to purchase a stock, such a restriction is insufficient to prevent this arrangement to be treated as an option. See Rev. Rul. 68-601.

Second, where the restriction is fixed in time. For example, under FSA 200244003, a warrant is an option if there are no contingencies or limitations on the right to exercise other than time limitation. Similarly, if the right to acquire shares can only be exercised on a fixed date, it is an option. Rev. Rul. 89-64.

Contact Sherayzen Law Office for Professional Help With US International Tax Law Concerning Foreign Corporations

If you are an owner of a foreign corporation, you are facing a very difficult task of working through the enormous complexity of US international tax compliance requirements and trying to avoid the high IRS noncompliance penalties. In order to be successful in this matter, you need the professional help of Sherayzen Law Office.

We are an international tax law firm that specializes in US international tax compliance and offshore voluntary disclosures. We have successfully helped hundreds of US taxpayers worldwide with this issue, and we can help you!

Contact Us Today to Schedule Your Confidential Consultation!