OOOOPS! I Received a Gift from a Foreign Corporation (or Foreign Partnership)

Here in the Middle East where I have been practicing for almost two decades, I have seen that it is very common for families to create offshore structures in various countries (outside the USA) to hold a large portion of the family wealth.  The underlying reasons for maintaining these structures outside of the family’s home country are varied, but often revolve around a need for keeping the assets in a jurisdiction that is stable both politically and economically, for expansion of the family business, or to address certain aspects of Sharia law (typically the family will have concerns with the Sharia rules governing inheritance; but many other issues can arise under Sharia principles. My article, When Sharia and US Tax Law Collide, looks at this entire novel topic in depth).  For the most part, the assets are typically held in foreign corporate entities; less so in foreign partnerships. 

US Ties Set the Stage for the Big Mistake….

Given the global economy in which we find ourselves, it is often the case that some family members will become involved in the USA, perhaps to obtain an eduation or for employment.  In time, it is inevitable that many of these individuals will become US green card holders or US citizens.  The family may financially support the individual (e.g., for advanced education or to support a business venture) and quite frequently, without any aforethought, the funds will be paid from one of the family’s foreign entities directly into the US individual’s bank account. 

Both the family and the recipient will usually view the transfer as one having been made for support based on familial obligations or simply as a gift, made out of disinterested generosity. Unfortunately, this is not how the US tax law will treat the transferred amounts. Subject to specific exceptions, the US tax rules permit the Internal Revenue Service (IRS) to treat a gift received from a foreign corporation or partnership as income to the US recipient on which he or she must pay US income tax. 

The General Rule – Gifts (and Bequests) Are Not Taxable to US Recipient

In general, money or other property received by a US person as a gift (or bequest) is not taxed to the recipient. Specifically, under Section 102(a) of the US Internal Revenue Code, gifts (or bequests) are excluded from the recipient’s gross income.  Even though the recipient, will pay no tax on what he receives, there may be reporting duties imposed on the recipient if the giver of the gift was a foreign person.  You can read more about these rules and reporting requirements at my blog posts here and here.  

The Exception – Gifts from Foreign Corporations or Partnerships

When there is a direct or indirect transfer from a foreign corporation or partnership which the US recipient treats as a gift or bequest, the tax rules found in Treasury Regulation Section 1.672(f)-4 allow the IRS to re-characterize the “purported gift”, subject to certain exceptions. The tax rules mandate that the US recipient must include in his US taxable income the value of any “purported gifts” that are transferred from a foreign partnership or foreign corporation, whether transferred directly or indirectly.  What this means is that the US recipient reports such a “purported gift” on his US income tax return. He must treat the “purported gift” as if it was in fact a distribution to him from the foreign corporation (e.g., a taxable dividend) or partnership (a taxable partnership distribution).  This result will occur regardless of whether the recipient is actually a shareholder or partner in the transferor-entity.

What is a “Purported Gift”?

Under the tax rules, a “purported gift” is generally defined as any transfer of property (including cash) by a partnership or foreign corporation, other than a transfer for fair market value (e.g., paid for purchasing a product or service), to a person who is not a partner in the partnership or a shareholder of the foreign corporation (or to a person who is a partner in the partnership or a shareholder of a foreign corporation, if the amount transferred is inconsistent with the partner’s interest in the partnership or the shareholder’s interest in the corporation, as the case may be).

Ouch – This Mistake Will Cost You!

Here’s an example how the tax rules governing “purported gifts” would work in the real world.  HoldCo is a corporation organized under the laws of the British Virgin Islands (or any other non-US jurisdiction) that is beneficially owned by A, a nonresident alien individual who is resident in Lebanon. A’s daughter, D is a US green card holder who recently finished her Master’s degree in engineering and is starting a business venture with some other colleagues. A wants to support his daughter’s endeavor and he directs that HoldCo make a gratuitous transfer of $500,000 directly to D.   

D must report on her US income tax return and treat the transfer as a dividend from HoldCo (let’s assume HoldCo has sufficient earnings and profits to support full dividend treatment).  In this example, treaty benefits will not be available for “qualified dividend” treatment, and, as a result, D may end up paying a tax of 37% (plus a net investment income tax of 3.8%) on the “purported gift. Furthermore, if HoldCo is a “passive foreign investment company” (PFIC), she must treat the amount received as a “distribution” from a PFIC under Code Section 1291 with very harsh tax results that will eat up a great portion of the “gift”.  More on this will follow in Part II of this blog post.  Part II will also examine some narrow exceptions to the “purported gift” rules.  

For those with an interest, I’ve done a series of blog posts about receiving gifts or bequests from non-US persons, foreign trusts and former Americans.  You can access them herehere, and here.

Posted September 26, 2019

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