My earlier blog post explained the unpleasant tax effects that occur when a US person receives a “gift” from a foreign corporation or a foreign partnership. Yes, bad things happen. The general tax treatment for gifts will not apply.
Usually, a gift is not treated as taxable income to the recipient. However, when the gift comes from a foreign corporation or partnership, an exception applies and certain nasty rules come into play. Under these rules, the gift is given not only a nasty name – a “purported gift”, but the tax treatment itself is also nasty. The US recipient of a “purported gift” 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). Ouch!
Exceptions to the Exception
A transfer will not always be treated as a “purported gift” subject to this re-characterization by the IRS. Initially, there are two possible ways to escape “purported gift” treatment. Such re-characterization can be avoided if the US recipient can demonstrate to the satisfaction of the IRS that either the recipient: (i) is not related to a partner or shareholder of the transferor-entity or (ii) does not have another relationship with a partner or shareholder of the transferor-entity that establishes a reasonable basis for concluding that the transferor would make a gratuitous transfer to the US individual. My guess is that the burden will not be easy to meet in most cases.
There are other exceptions to the purported gift rule specifically set out in the Treasury Regulations. If any one of them apply, the US recipient need not treat the purported gift as US taxable income. A recap is below –
The Treasury Regulations provide specific exceptions to the purported gift rule that, if applicable, do not require a US recipient to treat the purported gift as US taxable income. I shall discuss only one of the exceptions since it is the most relevant to individuals receiving significant sums from foreign corporations or partnerships. The other exceptions will typically not apply (e.g., when the US recipient is a US corporation or a charitable organization, or when the total gifts each year from such foreign entities are in de minimis amounts).
The “purported gift” rule does not apply when:
The US recipient can demonstrate to the satisfaction of the IRS that either a US citizen or resident alien individual who holds an interest in the foreign corporation or partnership treated and reported the purported gift for US federal income tax purposes as a distribution to such individual and a subsequent gift to the recipient. In other words, the IRS wants to make sure that the US shareholder or partner paid US tax on the distribution (purported gift) from the entity. If this did not happen, then the distributed amounts could escape US tax entirely, since the gift would not be taxed to the recipient.
In the case when only nonresident alien individuals hold interests in the foreign entity, then the US recipient must show that the foreign individual reported the purported gift for purposes of the tax laws of his country of residence as a distribution to him (i.e., he reported to his home country that a “deemed dividend” was made to him when the entity distributed the amounts to the US recipient) and, a subsequent gift made.
With respect to this latter exception, many jurisdictions in the Middle East do not have income taxes and so, the exception will be impossible to meet. In those jurisdictions that may have an income tax, they often do not tax “deemed dividends” and therefore, the owner will not have reported such dividends since it is either not required or it is simply not possible. Furthermore, many jurisdictions do not require their residents to report gifts. Example 1 of Treas. Reg. § 1.672(f)-4(g) suggests that if reporting in the foreign country is “not applicable” under the laws of such country, the exception may still be available. However, the end result is that meeting this exception will likely be very difficult, if not impossible, for many US recipients receiving distributions from foreign corporations or partnerships that are owned by nonresident alien individuals.
US Tax Information Reporting
The US recipient must timely report the gift on Form 3520 (see Part IV), if required. You can read more about Form 3520 at my blog post here. In the case of gifts from foreign corporations or partnerships (or any foreign persons that you know, or have reason to know are related to such foreign corporations or foreign partnerships), reporting is required at a very low threshold (for 2018, per the Instructions to Form 3520 at page 14, amounts in excess of $16,076 must be reported on the Form 3520). Here is an example of how the rules apply:
Assume that during 2018, taxpayer received $8,000 from foreign corporation X that taxpayer treated as a gift, and $10,000 that taxpayer received from nonresident alien A that taxpayer treated as a gift. Assume taxpayer knows that X is wholly owned by A. Taxpayer must complete columns (a) through (g) of Form 3520 Part IV for each gift.
And, Last But Not Least …. Don’t Forget to Apply the Passive Foreign Investment Company (PFIC) Rules to that “Gift”
In addition to the already adverse US tax consequences that may result to a US recipient who gets a “purported gift”, things can get worse if they are received from foreign corporations that are characterized as so-called “passive foreign investment companies”. Many of the foreign family corporations I see in my practice hold only passive assets such as cash, securities, stocks, and other passive investments. These corporations will undoubtedly be characterized as PFICs, and a US recipient of a purported gift from such a corporation must apply the PFIC rules to the transfer with the result that a very large chunk of the gift (and maybe all of it) will be made to Uncle Sam. You can learn more about PFICs and the fury they create at my blog post here.
Posted October 3, 2019
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