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26 U.S.C. Subpart A: Taxation of Recipients of Corporation Distributions

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This article is a second installment of our series of articles on corporate distributions. Today’s topic is the description of 26 U.S.C. Subpart A, which contains the most important tax provisions for our subsequent discussions of this subject.

26 U.S.C. Subpart A: Purpose

26 U.S.C Subpart A is the first part of Part I of Subchapter C, which deals with corporate distributions and adjustments. The main purpose of Subpart A is to establish the rules for taxation of recipients of corporate distributions. In other words, this section of the Internal Revenue Code deals with a situation where a corporation distributes or is deemed to have distributed something – a property, stocks, et cetera – to its shareholders. The focus here is not on the corporation, but on how its shareholders should be taxed.

26 U.S.C. Subpart A: §§301-307

26 U.S.C. Subpart A contains seven tax sections: IRC (Internal Revenue Code) §§301-307. All of these provisions are very important for both US domestic and international tax purposes.

IRC §301 establishes a general tax framework for corporate distributions and specifically deals with the distributions of property classified as dividends under IRC §316.

IRC §§302-304 describe the tax rules related to redemptions of stock (as defined in §317(b)), including some very specific situations. For example, §303 deals with distributions in redemption of stock to pay death taxes. The main provision, however, is §302 with its four tests which are highly important for determining whether a redemption of stock will be treated as a sale under §1001 or a corporate distribution under §301.

IRC §305 focuses on the special tax rules concerning stock dividends. It establishes the general rule that stock dividends are not taxable, but it also contains numerous exceptions to the general rule. More exceptions to the general rule may be found in §306.

IRC §306 deals with dispositions of “§306 stock” as defined in §306(c). §306 is very important to taxpayers because, with a few exceptions, it treats a disposition of §306 stock as ordinary income. This section also contains a loss non-recognition provision.

Finally, IRC §307 explains the calculation of cost-basis of stock received by shareholders as a result of a §305(a) distribution. This section has very important implications not only to stock dividends in general, but also to stock dividends made by a PFIC (Passive Foreign Investment Company). The calculation of PFIC tax and PFIC interest with respect to a disposition of such PFIC stock dividends are directly influenced by §307.

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Sherayzen Law Office is an international tax law firm highly-experienced in US and foreign corporate transactions, including corporate distributions. We have helped our clients around the world not only to engage in proper US tax planning concerning cash, property and stock distributions from US and foreign corporations, but also resolve any prior US tax noncompliance issues (including conducting offshore voluntary disclosures). We can help you!

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§318 Downstream Corporate Attribution | Corporate Tax Lawyer & Attorney

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This article continues a series of articles on the constructive ownership rules of the IRC (Internal Revenue Code) §318. Today, we will discuss corporate attribution rules, even more specifically the §318 downstream corporate attribution rules.

§318 Downstream Corporate Attribution: Two Types of Attribution

There are two types of §318 corporate attribution rules: downstream and upstream. Under the downstream corporate attribution rules, stocks owned by a corporation are attributed to this corporation’s shareholders. The upstream corporate attribution rules are exactly the opposite: stocks (in another corporation) owned by shareholders are attributed to the corporation. As stated above, this article will focus on the downstream attribution rules; the upstream attribution rules will be covered in a future article.

§318 Downstream Corporate Attribution: Main Rule

Under §318(a)(2)(C), if a person owns, directly and indirectly, 50% or more in value of the stock “such person shall be considered as owning the stock owned, directly or indirectly, by or for such corporation, in that proportion which the value of the stock which such person so owns bears to the value of all the stock in such corporation.”

There are two critical parts of this downstream attribution rule: 50% threshold and proportionality. Let’s discuss each part in more detail.

§318 Downstream Corporate Attribution: 50% Threshold

A person must own directly or indirectly 50% or more of the stock value of a corporation in order for the §318 corporate attribution rules to apply. Under Treas. Reg. §1.318-1(b)(3), in determining whether the 50% threshold is satisfied, one must aggregate all stocks that the person actually and constructively owns.

The valuation of stocks should be determined in reference to the relative rights of the outstanding stock of a corporation. All restrictions, such as limitations on transferability, should be considered. On the other hand, the presence or absence of control of the corporation is irrelevant. This means that the value of stocks may differ from the voting power associated with these stocks.

Let’s use the following fact scenario to demonstrate the potential complexity of stock valuation: C, a C-corporation, has two classes of stocks – 100 shares of common stock with a value of $1 each and 50 shares of preferred stock with a value of $1 each (i.e. the total value of common stock is $100 and the total value of preferred stock is $50) – with only common stocks having voting rights; A owns 60 shares of common stock and 10 shares of preferred stock (i.e. his common stock is worth $60 and his preferred stock $10); C owns all of the outstanding shares of another corporation, X. The issue is how many shares of X should be attributed to A?

The answer is none. A does not constructively own any of X’s shares because his total value of C’s stocks is below 50% (the value of his stocks is $60 + $10 = $70, but the total value of C’s stocks is $100 + $50 = $150). The fact that A controls C through his 60% voting power is irrelevant.

§318 Downstream Corporate Attribution: Proportionality

As it was stated above, if the 50% corporate ownership threshold is met, then the shareholder will be considered a constructive owner of shares owned by the corporation in another corporation in proportion to the value of his stock.

While this looks like a straightforward rule, there is one problem. Whether the 50% threshold is satisfied should be determined by the combination of actual and constructive stock ownership. Does it mean that the attribution of corporate stocks under §318 should be in proportion to the value of both actual and constructive ownership combined? Or, does the proportionality of attribution based solely on the actual stock ownership in the holding corporation?

As of the time of this writing, the IRS still has not issued any guidance on this problem. Hence, taking either position is fine by an attorney as long as it is reasonable under the facts.

§318 Downstream Corporate Attribution: S-Corporations

It should be emphasized that the §318 downstream corporate attribution rules do not apply S-corporations with respect to attribution of corporate stock between an S-corporation and its shareholders. Rather, in such cases, the S-corporation is treated as a partnership and its shareholders as partners. See §318(a)(5)(E). Hence, generally, corporate stocks owned by an S-corporation are attributed on a proportionate basis even to shareholders who own less than 50% of the value of the S-corporation stock.

Keep in mind, however, that the usual constructive ownership rules for corporations and shareholders apply for the purpose of determination of whether any person owns stock in an S-corporation.

Contact Sherayzen Law Office for Professional Help With US International Tax Law

US tax law is incredibly complex, and this complexity increases even more at the international level. US taxpayers who deal with US international tax law without assistance of an experienced international tax lawyer run an enormous risk of violating US tax laws and incurring high IRS penalties.

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US Information Returns: Introduction | International Tax Lawyer Minnesota

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In this article, I would like to introduce the readers to the concept of US information returns; I will also explore the differences between US information returns and US tax returns.

US Information Returns: Two Types of Returns

The US tax system is a self-assessment system where taxpayers must file certain forms or returns developed by the IRS in order to report information required by the Internal Revenue Code and the Treasury Regulations. The Internal Revenue Code specifies the due date for these returns.

There are two primary types of returns: tax returns and information returns. A tax return is a form that a taxpayer uses to compute the tax that he owes to the IRS. A tax return requires the taxpayer to set forth the relevant information and amounts for this computation.

On the other hand, the IRS requires US taxpayers to file information returns in order to obtain information on transactions and payments to taxpayers that may affect the information reflected on tax returns. In other words, the IRS uses information returns not to compute the tax liability, but to obtain information (or verification of information) to make sure that the tax returns were properly filed.

US Information Returns: Hybrid Returns

This ideal distinction between the two types of returns is often not preserved. Instead, there are many hybrid returns which possess the features of both, tax returns and information returns. For example, Part III of Form 1040 Schedule B is an information return which forms part of the overall tax return (i.e. Form 1040). Similarly, Form 8621 is a US international information return that is a hybrid return for the reporting of ownership of PFICs and calculation of PFIC tax at the same time.

US Information Returns: Domestic vs. International

The information returns are subdivided into two categories: domestic and international. The domestic information returns are usually filed by third parties with respect to US-source income or income under the supervision of a domestic financial institution. For example, US brokers provide Forms 1099-INT to report US-source interest income and foreign interest income that the taxpayer earned by investing through a domestic financial institution.

It should be mentioned that, due to the implementation of FATCA (Foreign Account Tax Compliance Act), some foreign subsidiaries of US banks also began to issue Forms 1099 to US taxpayers with respect to foreign income from their foreign accounts. The most prominent example is Citibank. However, this is a tiny minority of foreign financial institutions at this point.

On the other hand, international information returns primarily report information concerning foreign assets, foreign income and foreign transactions; there are even information returns concerning foreign owners of US businesses. Usually, these returns are filed not by third parties, but by taxpayers directly – individuals, businesses, trusts and estates. For example, Form 5471 is an international tax return which US taxpayers must file to report their ownership of a foreign corporation, its financial statements and its certain transactions.

US Information Returns: High Civil Penalties

One of the most distinguishing characteristics of information returns are high noncompliance civil penalties. This is very different from tax returns.

The tax return civil penalties are calculate based on a taxpayer’s unpaid income tax liability. The worst case scenario is a civil fraud penalty of 75% of unpaid tax liability. This is followed by negligence, failure-to-file and accuracy penalties.

The noncompliance penalties for information returns, however, do not depend on whether there was ever any tax liability connected with the failure to file an accurate information return; in fact, many information return penalties are imposed in a situation where there is no income tax noncompliance at all. This is logical, because pure information returns would never have any income tax noncompliance directly related to them.

Hence, in order to enforce compliance with information returns, the IRS imposes objective noncompliance penalties per each unfiled or incorrect information return. This divorce between income tax noncompliance and information return penalties, however, may produce extremely unjust results. For example, failure to file a Form 5471 for a foreign corporation which never produced any revenue may result in the imposition of a $10,000 penalty.

It should be emphasized that the domestic information return penalties are much smaller in size than those imposed for noncompliance with international information returns. Again the logic is clear: since the temptation to avoid compliance with US international tax laws is much greater overseas, Congress wanted to raise the stakes for such noncompliant taxpayers in order to make the risk of noncompliance intolerable for most taxpayers.

US Information Returns: Special Case of FBAR

The IRS may impose the most severe penalties out of all information returns for a failure to file a correct FinCEN Form 114, commonly known as “FBAR”. The paradox of these penalties is that FBAR is not a tax form, but a Bank Secrecy Act information return. FBAR was created to fight financial crimes, not for tax enforcement. Its penalties were originally meant to deter and punish criminals, not induce self-compliance with US tax laws – this is precisely why FBAR penalties may easily exceed the penalties imposed with respect to any other US international information return.

So, why is the IRS able to use FBAR as a tax information return and impose FBAR penalties? The reason is that the US Congress turned over FBAR enforcement to the IRS after September 11, 2001. Since then, even though FBAR is not part of the Internal Revenue Code, the IRS has used this form as an information return for tax purposes.

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§318 Upstream Estate Attribution | International Tax Lawyer & Attorney

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This article continues a series of articles concerning the constructive ownership rules of the Internal Revenue Code (“IRC”) §318. Today’s focus is on the §318 upstream estate attribution rules.

§318 Estate Attribution Rules: Downstream Attribution vs. Upstream Attribution

There are two types of the IRC §318 estate attribution rules: downstream and upstream. In a previous article, I discussed the downstream attribution rules concerning attribution of ownership of corporate stocks held by an estate to its beneficiaries. This brief article focuses on the upstream attribution rules, which means rules governing the attribution to the estate of corporate stocks held by its beneficiaries.

§318 Upstream Estate Attribution: Main Rule

The IRC §318(a)(3)(A) states the general rule for the upstream estate attribution of beneficiaries’ corporate stock: irrespective of the proportion of his beneficiary interest in the estate, all corporate stocks owned directly or indirectly by a beneficiary are deemed to be owned by the estate.

Notice the difference here between the downstream and the upstream estate attribution rules. §318 downstream estate attribution rules attribute the ownership of corporate stock proportionately from an estate to its beneficiaries. The upstream attribution rules under §318, however, completely disregard the proportionality rule; instead, all of the stocks of a beneficiary are attributed to the estate even if he has only 1% interest in the estate.

For example, let’s suppose that W owns 100 shares in corporation X; then, H dies and leaves one-tenth of his property to W. Due to the fact that W is a beneficiary of H’s estate, the estate constructively owns all of W’s 100 shares in X.

§318 Upstream Estate Attribution: No Re-Attribution

I already stated this rule in another article on estate attribution, but it is also important to re-state it here. §318 estate attribution rules contain a prohibition on re-attribution of stocks. Under §318(a)(5)(C), a beneficiary’s stock constructively owned by an estate through the operation of the §318 estate attribution rules cannot be attributed to another beneficiary.

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If you have questions concerning US business tax in general and US international business tax law specifically, contact Sherayzen Law Office for professional help. We are a highly-experienced tax law firm that specializes in US international tax law, including offshore voluntary disclosures, US international tax compliance for businesses and individuals and US international tax planning.

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§318 Downstream Estate Attribution | International Tax Lawyer & Attorney

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This article continues a series of articles on the Internal Revenue Code (“IRC”) §318 constructive ownership rules. Today, the topic is §318 estate attribution rules – i.e. attribution of ownership of corporate stock from estate to its beneficiaries and vice versa. Since this is a long topic, I will divide it into three articles. This article focuses on the §318 downstream estate attribution rules.

§318 Estate Attribution Rules: Two Types

There are two types of the IRC §318 estate attribution rules: downstream and upstream. The downstream attribution rules attribute the ownership of corporate stocks owned by an estate to its beneficiaries. On the other hand, the upstream attribution rules attribute the ownership of corporate stocks owned by beneficiaries to the estate. As I stated above, this article focuses on the first type – i.e. §318 downstream estate attribution rules.

§318 Downstream Estate Attribution: Attribution from Estate to Beneficiary

Under the IRS §318(a)(2)(A), corporate stock owned directly or indirectly by or on behalf of an estate is deemed to be owned proportionately by its beneficiaries. It is very important to understand that the actual disposition of estate property by the testator does not matter to the proportionate attribution of estate property between the beneficiaries. Thus, even if the will demands that all corporate stocks be inherited by only one beneficiary, the ownership of these stocks will be attributed to all beneficiaries in proportion to their respective interests in the estate.

Three questions arise with respect to the application of this §318 downstream estate attribution rule: (1) What stocks are considered to be owned by the estate? (2) Who is deemed to be a beneficiary of an estate? and (3) How does the proportionality rule work?

§318 Downstream Estate Attribution: Stocks Owned by Estate

Treas. Regs. §1.318-3(a) defines when an estate is deemed to be an owner of corporate stock for the §318 attribution purposes. It states that corporate stocks (as well as any other property) shall be considered as owned by an estate if “such property is subject to administration by the executor or administrator for the purpose of paying claims against the estate and expenses of administration.” This is the case even if the legal title to the stock vests immediately upon death in the decedent’s heirs, legatees, or devisees under local law. Id.

§318 Downstream Estate Attribution: Definition of a Beneficiary

I address the definition of a beneficiary for the §318 attribution purposes in more detail in another article. Here, I will only state the general rule.

Treas. Regs. §1.318-3(a) states that “the term beneficiary includes any person entitled to receive property of a decedent pursuant to a will or pursuant to laws of descent and distribution.” Hence, in order to be considered a beneficiary under §318, a person must have a direct present interest in the property of the estate or in income generated by that property.

§318 Downstream Estate Attribution: Proportionality

As in many other cases concerning attribution proportionality, there is very little guidance from the IRS and Treasury regulations concerning determination of a beneficiary’s proportionate interest in an estate. Hence, an attorney has a considerable freedom in determining the reasonable methodology with respect to the application of the proportionality requirement. It appears that one method may be particularly acceptable to the IRS: measuring the relative values of each beneficiary’s interest.

§318 Downstream Estate Attribution: No Re-Attribution

Similarly to many other IRC provisions concerning constructive ownership, §318 estate attribution rules contain a prohibition on re-attribution of stocks. Under §318(a)(5)(C), a beneficiary’s stock constructively owned by an estate through the operation of the §318 estate attribution rules cannot be attributed to another beneficiary.

§318 Downstream Estate Attribution: Example

Let’s conclude this article with an illustration of how the §318 downstream estate attribution rules actually work. The proposed hypothetical scenario is as follows: an estate owns 100 of the total 200 outstanding shares of X, a South Dakota C-corporation; A is entitled to 50% of the property of the estate and actually owns 24 shares of X; B owns 36 shares of X and has a life estate in the other 50% of the estate; and C owns 40 shares of X and only has a remainder interest in the estate after the death of B. Here is how the §318 estate attribution constructive rules would work in this case:

A actually owns 24 shares of X and constructively owns another 50 shares of X through his 50% beneficiary interest in the estate. In other words, A’s total ownership of X equals 74 shares.

B actually owns 36 shares of X and constructively owns another 50 shares of X through his life estate; his total number of shares of X equals 86.

Finally, C owns 40 shares of X only. He does not have any constructive ownership of any shares of X, because his remainder interest in the estate is not a present interest in the estate; hence, he is not a beneficiary of the estate.

Contact Sherayzen Law Office for Professional Help With §318 Downstream Estate Attribution Rules

The constructive ownership rules of §318 are crucial to proper identification of US tax reporting requirements with respect domestic and especially foreign business entities. Hence, if you a beneficiary of an estate or an executor/administrator of an estate that owns stocks in a domestic or foreign corporation, contact Sherayzen Law Office for professional help with §318 estate attribution rules.

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