§318 Option Attribution | International Tax Lawyers United States

A previous article defined “option” for the purposes of the IRC (Internal Revenue Code) §318(a)(4). Today, I will discuss the main §318 option attribution rule.

§318 Option Attribution: Main Rule

Under §318(a)(4), “if any person has an option to acquire stock, such stock shall be considered as owned by such person.” For the purposes of §318 option attribution rules, an option to acquire an option to acquire stock is also considered an option to acquire stock. Id. It does not matter whether the option to acquire an option is granted by the corporation or by a shareholder.

Additionally, a series of options to acquire an option to acquire stock is considered an option to acquire stock Id.; in other words, the owner of a series of options is the constructive owner of the stock. That is the subject of this series.

Let’s use the following example to illustrate §318 option attribution: A and B each own 10 shares in X, a C-corporation; A has an option to acquire 5 shares of X owned by B; A also has an option to acquire an option to acquire B’s other 5 shares of X; finally, A has an option to acquire 5 unissued shares of X. The issue is: how many shares does A own?

By applying the rules above, A would actually and constructively own a total of 25 shares: 10 shares that he actually owns and 15 shares the he constructively owns under §318(a)(4) (all 10 shares of X owned by B plus 5 unissued shares of X).

§318 Option Attribution: Special Case of Convertible Debentures

Pursuant to Rev. Rul. 68-601, an owner of a convertible debenture (i.e. a debenture that can be converted into stock of a corporation) is deemed to be in the same position as a an option owner for the purposes of §318(a)(4) as long as he has the right to obtain the stock at his election. In other words, an owner of such a convertible debenture is a constructive owner of the stock into which the debenture can be converted.

Moreover, by drawing an analogy to the main §318 option attribution rule, an option to acquire a convertible debenture would be treated in the same manner under §318 as an option to acquire an option to acquire stock. Hence, the owner of an option to acquire a convertible debenture is a constructive owner fo the stock into which this debenture can be converted.

§318 Option Attribution vs. §318 Family Member Attribution

There are certain situations where stocks may be attributed to an individual under both, §318(a)(1) (i.e. family attribution rules) and the §318(a)(4) (i.e. option attribution rules). Since there are differences in legal effect, it is important to understand which rule governs in such situations.

Under §318(a)(5)(D), §318 option attribution supercedes the §318 family attribution. In other words, where an individual is deemed to be a constructive owner of shares under both rules, only the §318 option constructive ownership rules will apply to him.

This primacy of option attribution over family attribution may have a highly important tax impact in certain situations, such as the tax treatment of redemption of stock by a corporation. Let’s analyze an example to illustrate the disparate impact of these two attribution rules in the context of the §302(c)(2) waiver.

Let’s use the following hypothetical situation: W, an individual, owns 10 shares of X, a C-corporation; her husband, H, owns the remaining 40 shares of X; W has an option to purchase all of H’s shares of X. W redeems all l0 shares of X with the idea to establish a complete termination of her interest in the corporation once she waives the attribution of H’s shares to her by using the §302(c)(2) waiver (we assume here that she also fulfills all other requirements under §302). Will this strategy work in this case?

The answer is no. The problem is that the waiver under §302(c)(2) is available only for attribution from a family member. While it is true that W is a constructive owner of H’s 40 shares by the operation of family attribution rules, she is also the constructive owner of the same shares under the §318 option attribution rules. Since option attribution supercedes family attribution, she cannot use the §302 waiver. This means that W cannot establish a complete termination of her interest in X and the redemption of her 10 stocks will be treated as a dividend (with no cost-basis offset against the proceeds) as opposed to a sale.

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

If you own foreign assets, including foreign business entities, you have the daunting obligation to meet all of your complex US international tax compliance requirements; otherwise, you may have to face the wrath of the IRS in the form of high noncompliance penalties. In order to successfully meet your US international tax compliance obligations, you need the professional help of Sherayzen Law Office.

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Noncompetition Agreement Income Sourcing | International Tax Lawyer

Oftentimes, as part of their noncompetition agreement, a taxpayer may receive income for restraining from competing with another party in certain areas. An issue often arises with respect to international noncompetition agreement income sourcing rules – i.e. should the income paid as part of such a noncompetition agreement be considered US-source income or foreign-source income? Let’s explore the answer to this question in this essay.

Noncompetition Agreement Income Sourcing: General Rule

The general rule with respect to income sourcing for noncompetition agreements was settled in the distant year 1943. In that year, the Tax Court held that the source of income from a noncompetition agreement is the location of the forbearance. Korfund Co., Inc. v. Commissioner, 1 T.C. 1180, 1187 (1943). In other words, income received from an agreement not to compete is deemed to be income earned in a place where the agreement prohibits the taxpayer from competing.

The reasoning of the Tax Court is clearly laid out in its opinion. The Court stated that the rights that a party enjoys from the noncompetition agreement “were interests in property in [the] country [of forbearance]. … The situs of the right was in the United States, not elsewhere, and the income that flowed from the privileges was necessarily earned and produced here. … These rights were property of value and the income in question was derived from the use thereof in the [country of forbearance].” Id.

In 1996, in its Field Service Advice, the IRS restated its commitment to the position adopted by the Tax Court in Korfund: “income from covenants not to compete covering areas outside of the United States is foreign source income because the income from a covenant covering areas outside the United States is from the use of a property right outside the United States.” 1996 FSA LEXIS 191, *5 (I.R.S. August 30, 1996).

Noncompetition Agreement Income Sourcing: Apportionment

What if a noncompetition agreement covers both, part of the United States and a foreign country? In this case, the IRS is likely to take a position that an apportionment of some sort is necessary. In other words, only part of the income will be deemed as US-source income, while the rest will be considered foreign-source income.

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If you are dealing with an international noncompetition agreement, you should contact Sherayzen Law Office for professional help with US international tax compliance. Our firm has helped hundreds of US taxpayers around the world with their US international tax issues. We Can Help You!

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Minsk Seminar Conducted by US International Tax Lawyer & Attorney

On June 9, 2017, Mr. Eugene Sherayzen, an international tax attorney and owner of Sherayzen Law Office, was the keynote speaker at a seminar “Introduction to U.S. Tax Compliance for U.S. Citizens and Green Card Holders Residing and Doing Business in Belarus” in Minsk, Republic of Belarus (the “Minsk Seminar”). The attorney conducted the entire Minsk Seminar in Russian, because he speaks this language fluently.

The Minsk Seminar was presented before the Minsk City Lawyer’s Association. It was a historic event, because it appears that this was the very first time that a practicing US international tax attorney conducted a seminar on this topic in Minsk. The Minsk Seminar was well-attended by close to 25-30 persons (despite the fact that it was conducted on a Friday afternoon); it appears that virtually all attendees were practicing lawyers in Minsk.

Mr. Sherayzen decided to make his presentation as broad as possible, but attended to details only as necessary. As a result, this more than two-hour presentation covered the main topics concerning US international tax reporting requirements of a U.S. citizen living and/or doing business in Belarus.

The tax attorney started the Minsk Seminar with the definition of a U.S. tax resident, emphasizing that a U.S. citizen and a U.S. Permanent Resident who reside in Belarus should be considered U.S. tax residents. Then, Mr. Sherayzen discussed the worldwide income reporting requirement and broadly covered various topics concerning specific income recognition.

The tax attorney continued the Minsk Seminar with an overview of the U.S. international information returns concerning individuals who have foreign assets, including an ownership interest in a foreign business. The severe FBAR penalties caused consternation among the attendees. As part of this discussion, he also explained the common-law concept of a “trust”.

The last part of the Minsk Seminar was devoted to the discussion of the U.S. anti-deferral regimes, such as Subpart F and PFIC rules. Mr. Sherayzen explained the potential tax consequences of income recognition under both of these regimes.

Throughout the Minsk Seminar, the Belarussian attorneys asked many questions and readily engaged in a lively comparison of the Belarussian tax rules to the U.S. tax rules. Overall, it was a very friendly seminar. Mr. Sherayzen looks forward to future presentations on this and other U.S. international tax topics in Eastern Europe.

Employment Income Sourcing | International Tax Lawyer & Attorney

Employment income sourcing is a very important tax issue for employees of US corporations sent overseas, employees of foreign corporations stationed in the United States and employees who work in different countries during a tax year. For employees who are tax residents of a foreign country, this issue will determine whether their income will be taxed in the United States; whereas for US tax residents, the source of income rules will determine the amount of the allowable foreign tax credit. In this article, I will focus on the employment income sourcing rules concerning monetary compensation of employees.

Employment Income Sourcing: General Rules

The source of income rules concerning employees are very similar to the rules that apply to self-employment income, but there are some differences. The main rule is that the location where the services are rendered determines whether this is US-source income or foreign-source income. If an employee works in the United States, then his salary would be considered US-source income; if he works in a foreign country, his salary would be sourced to that country. See §§861(a)(3) and 862(a)(3).

If the employer pays for work partly performed in the United States and partly outside of the United States, then the salary needs to be allocated between the countries. Treas. Reg. §1.861-4(b)(2)(ii)(A). The key issue arises here – how does an employee allocate this income between the countries?

Employment Income Sourcing: Time Basis Allocation

The first methodology for allocation of income between the countries is stated directly within the regulations – time basis. Id. Here, the IRS offers two choices to the employees: allocation based on specific number of days working in the United States versus separate time periods.

Under the “number of days” variation, the employee adds together the number of days worked in the United States and the number of days worked in a foreign country, figures out the percentages for each country and sources the income according to the percentage allocation. Treas. Reg. §1.861-4(b)(2)(ii)(F).

Under the “time periods” variation, a tax year is split into distinct time periods: one where employee spends all of his time in the United States and one where employee spends all of his time in a foreign country. The compensation paid in the first period is allocated entirely to the United States, whereas the salary paid in the second time period is considered to be foreign-source income. Id.

Employment Income Sourcing: Multi-Year Compensation

An interesting situation occurs with respect to employees with multi-year compensation contracts. A multi-year contract in this context means a situation where the “compensation that is included in the income of an individual in one taxable year but that is attributable to a period that includes two or more taxable years.” Reg. §1.861-4(b)(2)(ii)(F).

Generally, the employment income sourcing in this case occurs in the following manner: (1) employee first aggregates his total contract compensation for the entire year; (2) then, the employee sums up all of the days worked in the United States and all of the days worked in a foreign country for the period covered by the multi-year contract; and (3) the employee sources the income to the United States based on the number of days worked in the United States vis-a-vis the total number of days worked under the contract; the rest of the income is considered foreign-source income. Id. While this approach is specifically described in the regulations, the regulations also generally refer to the “time basis” allocation. Hence, it appears that an employee may have a choice between the “number of days” approach that was just described and the “time periods” variation.

Employment Income Sourcing: Alternative Basis Sourcing

Employees have the right to disregard completely the time basis approach to employment income sourcing and adopt an alternative basis approach. Treas. Reg. §1.861-4(b)(2)(ii)(C)(1)(i).  An employee can do so as long as he is able to establish that “under the facts and circumstances of the particular case, the alternative basis more properly determines the source of the compensation than a basis described in paragraph (b)(2)(ii)(A) or (B), whichever is applicable, of this section.” Id.

An employee is not the only person who has this right; the IRS also has the right to utilize an alternative basis for employment income sourcing “if such compensation either is not for a specific time period or constitutes in substance a fringe benefit.” Treas. Reg. §1.861-4(b)(2)(ii)(C)(1)(ii). The IRS can do so as long as the “alternative basis determines the source of compensation in a more reasonable manner than the basis used by the individual pursuant to paragraph (b)(2)(ii)(A) or (B) of this section.” Id.

A taxpayer does not need to obtain the IRS consent in order to use the alternative basis for employment income sourcing. He should, however, keep the records in order to be able to show how his method is better than the time basis approach. TD 9212, 70 FR 40663, 40665 (07/14/2005).

Special requirements apply to employees who received $250,000 or more in compensation and use the alternative basis for employment income sourcing. Not only must such employees answer the relevant questions on Form 1040, but they should also attach a detailed statement to their tax returns. Id. The statement must contain the following information: “(1) The specific compensation income, or the specific fringe benefit, for which an alternative method is used; (2) for each such item, the alternative method of allocation of source used; (3) for each such item, a computation showing how the alternative allocation was computed; and (4) a comparison of the dollar amount of the compensation sourced within and without the United States under both the individual’s alternative basis and the basis for determining source of compensation described in § 1.861-4(b)(2)(ii)(A) or (B).” Id.

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If you are a US taxpayer who receives foreign-source income and/or has foreign assets, contact Sherayzen Law Office for professional help. Our professional tax team, headed by international tax attorney, Mr. Eugene Sherayzen, has helped hundreds of US taxpayers around the world with their US international tax issues. We can help You!

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Japanese Bank Accounts : Main US Tax Obligations | FATCA Tax Lawyer

Despite the fact that FATCA has been implemented already in July of 2014, a lot of US taxpayers are still unaware of their obligation to disclose their Japanese bank accounts in the United States. In this essay, I will discuss the three most important US international tax requirements concerning Japanese bank accounts: worldwide income reporting, FBAR and FATCA Form 8938.

Japanese Bank Accounts: Japanese Income Must Be Disclosed on US Tax Returns

All US tax residents must disclose their worldwide income on their US tax returns. This requirement includes all income generated by the Japanese bank accounts. This obligation applies to all types of income: bank interest income, dividends, capital gains, et cetera.

In this context, it is important to reject two incorrect, but commonly-held beliefs concerning the reporting of Japanese-source income. First, a significant number of US taxpayers believe that Japanese income does not need to be reported if it never left Japan. This is completely false; it does not matter where the income is earned or held – as long as you are a US tax resident, you must disclose your Japanese income on your US tax returns whether or not it was ever transferred to the United States.

The second and most common myth is the belief that, if the income is subject to Japanese tax withholding, it does not need to be reported in the United States. Some taxpayers hold this belief because of their familiarity with the territorial system of taxation, while others assume that this is true due to the prohibition of double-taxation under the US-Japan tax treaty.

In either case, this myth is also completely false. All US tax residents must disclose their Japanese income on their US tax returns even if it is subject to Japanese tax withholding or reported on Japanese tax returns. However, you may be able to take advantage of the Foreign Tax Credit to reduce your US tax liability by the amount of taxes paid in Japan.

Japanese Bank Accounts: FBAR

The Report of Foreign Bank and Financial Accounts, FinCEN Form 114 (popularly known as “FBAR”) is one of the most important reporting requirements that applies to Japanese bank accounts. Generally, a US person is required to file FBAR if he has a financial interest in or signatory authority or any other authority over foreign bank and financial accounts which, in the aggregate, exceed $10,000 at any point during a calendar year.

FBAR has a severe penalty system for failure to file the form, failure to provide accurate information on the form and failure to maintain supporting documentation for the amounts reported on FBAR. The penalties range from criminal penalties (i.e. actual time in jail) to willful and non-willful civil penalties. The civil penalties are adjusted for inflation each year.

Given the fact that FBAR penalties may completely destroy one’s financial life, US taxpayers should strive to do everything in their power to make sure that they comply with this requirement.

Japanese Bank Accounts: FATCA Form 8938

In addition to FBAR, US tax residents with Japanese bank accounts may be required to file Form 8938. Form 8938 is the creation of the Foreign Account Tax Compliance Act (“FATCA”). US tax residents must disclose their Specified Foreign Financial Assets (“SFFA”) on Form 8938 in each year their SFFA exceed the form’s filing threshold.

Form 8938 has a higher filing threshold than FBAR, but it is still relatively low, especially if the owner of Japanese bank accounts resides in the United States. For example, if a taxpayer resides in the United States and his tax return filing status is “single”, then he would only need to have $50,000 or higher at the end of the year or $75,000 or higher at any point during the year in order to trigger the Form 8938 filing requirement.

Moreover, SFFA is defined very broadly to include a lot of more financial assets than what is required to be reported on FBAR; hence, it is easier for US taxpayers to meet the Form 8938 filing Threshold. SFFA includes foreign bank and financials accounts, bonds, swaps, ownership interest in a foreign business, beneficiary interest in a foreign trust and many other types of financial assets. A word of caution: even when FBAR and Form 8938 cover the same assets, both forms must be filed despite the duplication of the disclosure.

The readers should also remember that Form 8938 has it own distinct penalty structure for failure to file the form or failure to comply with all of its requirements.

Contact Sherayzen Law Office for Professional Help With Reporting of Your Japanese Bank Accounts in the United States

This essay broadly covered three most important and most common reporting requirements concerning Japanese bank accounts. There may be a lot more of these requirements depending on your particular fact pattern.

Sherayzen Law Office has extensive experience working with Japanese clients and their bank accounts. We can help you identify your US international tax requirements and prepare all of the tax documents necessary to comply with them. Moreover, if you did not comply with any of these US tax obligations in the past, we will help you with your offshore voluntary disclosure to minimize your IRS penalties and avoid IRS criminal prosecution.

We have successfully helped hundreds of US taxpayers to deal with their US international tax compliance, and We can help You!

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