Holidays are soon upon us, and many people will be making gifts to family and friends. It is very common to make gifts of cash – typically sending funds from a bank account to the recipient’s account. When gifts are made by foreign persons to US persons, there are many US tax traps for both the giver and recipient. My earlier blog post runs through the rules for the foreign giver of the gift and explains how non-US persons can get caught in making unintentional taxable gifts and be hit with US gift tax!
Today’s blog post discusses a common mistake: Using the account of a non-US entity to make the gift transfer.
It is often the case that, for the sake of convenience, the giver of the gift (whether a US or foreign individual) will send the funds from the giver’s business account rather than from his individual account. This is especially true in many Middle Eastern and Asian countries when the business owners often treat the business bank account as their own personal wallet. This is a big mistake for many reasons, but my post today will explain why this is a US tax disaster for the recipient. Very unpleasant tax effects occur when a US person receives a “gift” from a foreign corporation or a foreign partnership.
Generally, a gift is not treated as taxable income to the recipient. However, this treatment is not granted when the gift comes from a foreign corporation or partnership (unless specific conditions are satisfied). The transfer is called a “purported gift”, and the US Internal Revenue Service (IRS) can recharacterize it with nasty US tax treatment. 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).
Possible Escape Hatch – Exceptions
A transfer will not always be treated as a “purported gift”. 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. 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 purported gifts from foreign corporations or foreign partnerships, the US recipient is required to report the receipt of such purported gifts if the aggregate amount received from all entities exceeds: US$17,339 for 2022; US$18,567 for 2023 and US$19,570 for 2024.
Passive Foreign Investment Company (PFIC) Rules Apply 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 foreign family corporations 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.
Posted December 14, 2023
All the US tax information you need, every week –
Named by Forbes, Top 100 Must-Follow Tax Twitter Accounts @VLJeker
Named by Bloomberg, Tax Professionals to Follow on LinkedIn
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920
Photo Credit: https://pixabay.com/users/shortsword-673359/
Virginia - US TAX TALK 