September 01, 2014

Gifts by Foreign Donors: Part II

Rufus v. Rhoades

This work is derived from Rhoades & Langer, U.S. International Taxation and Tax Treaties, Chapter 33 (Matthew Bender & Co., Inc.), the publication of which derivative work is permitted by Matthew Bender & Co., Inc.

This article is Part II of a three-part review of the tax consequences of gifts made by nonresident aliens. Part I examined how gifts of U.S. real estate and tangible property by nonresident aliens (NRAs) could be subject to U.S. gift tax. Part II explores the gift tax implications of intangible property. Part III will review deductions and exclusions, as well as the applicable tax rates.

Intangible Property Subject to U.S. Gift Tax

Gifts of intangible property, with one exception (dealing with expatriate Americans), are not subject to gift tax when made by a nonresident alien, irrespective of where the donor is located when he or she makes the gift or where the intangible may be deemed located at that time.

Corporate Stock

Shares of a corporation—foreign or domestic—are intangibles. As a result, even though shares of a domestic corporation will be included in a foreign owner’s taxable estate for estate tax purposes, they are not subject to U.S. gift tax.

If a father on his deathbed gives shares of a domestic corporation to his children, he will have engaged in fairly simple estate planning. We can say that because the “gifts in contemplation of death” rule (that is, gifts within three years of death) only applies to what are essentially incomplete gifts, such as gifts with a retained life estate, revocable gifts, and gifts that don’t take effect until death.

As a result of that rather curious difference between the gift tax rule and the estate tax rule (that is, that domestic stock may be gifted tax free but is includable in an NRA’s estate if he dies with it), a foreigner may own domestic corporate stock and be concerned only with the unplanned death—the fatal accident or unexpected heart attack. Since the risk of that form of death, in numerical terms, is small, insurance to cover the estate tax may not be expensive if the risk insured is only an unanticipated death. Conversely, the cheapest and safest route may be to have the domestic stock owned by a foreign corporation that the NRA owns.

Note, however, that a gift of an intangible by a grandfather to a grandchild, while not generating gift tax, might generate a generation-skipping transfer tax.

Debt Instruments

The phrase “debt instruments” includes any form of monetary obligation, including promissory notes, debentures, bonds, contract rights, and the like. Bank deposits create a debt of the bank to the depositor, so the transfer of the deposit (in the form of a passbook or the certificate of deposit, for example) is the transfer of an intangible.

Partnership and LLC Interests

Partnerships

When discussing the estate and gift tax rules relating to partnership interests, you may note that the subject is a difficult one for the practitioner because Treasury refuses to give any guidance on whether or not a partnership is to be treated on the entity or the aggregate basis in the gift tax context. That determination—whether the partnership is an entity or simply an aggregate of assets—is so important because the gift and estate tax results may differ significantly depending on the answer. Applying the aggregate theory means that the nonresident donor of the interest in the partnership would look to the underlying assets to determine if any of them, given separately, would generate a gift tax (a partnership holding U.S. real estate, for example). Applying the entity theory, however, to partnerships, the donor could well conclude that the partnership interest is an intangible and not subject to gift tax. Without guidance from the IRS, your planning is most difficult.

You will find some authorities on the subject, although you may not feel any further advanced in your thinking even after reading them. The Supreme Court, in an old state law case, held that the interest in a partnership owned by the decedent was an intangible for purposes of calculating state inheritance tax. Treasury, in an early published private letter ruling, included a partnership interest in a list of intangibles not subject to gift tax. In a general counsel’s memorandum (GCM), Treasury reached the conclusion that the interest in a partnership is itself personal property. Although the GCM was declared obsolete, the declaration of obsolescence did not indicate that the conclusions reached in the GCM had changed. The IRS also published a ruling in the controlled foreign corporation (CFC) area that held that, at least for purposes of IRC section 956, the assets of a partnership, not the partnership interest itself, are to be examined to determine if the CFC partner had invested in U.S. property.

In the domestic arena, the question of how a transfer involving a partnership should be treated for gift tax purposes has not been an easy issue for the courts to resolve. In 2002, the Eleventh Circuit concluded that a father’s transfer of assets to an existing family partnership was an indirect gift of those assets to the other partners (the children) by the father. That case is not particularly interesting for its holding; what is interesting is what the court stated along the way:

Thus, instead of completing a gift of land to a preexisting partnership in which the sons were not partners and then establishing the partnership interests of his sons (which would result in a gift of a partnership interest), Shepherd created a partnership in which his sons held established shares and then gave the partnership a taxable gift of land (making it an indirect gift of land to his sons). Shepherd v. Comm’r, 283 F.3d 1258, 1261 (11th Cir. 2002).

In other words, had the taxpayer created a family partnership with his wife, transferred the high-value assets to the partnership, and then transferred the interests to the children, the gift would have been of partnership interests, not the underlying assets.

Although that distinction—whether the transfer of assets to the partnership before or after the children were partners—seems rather formalistic, a taxpayer’s transfer of assets is, in and of itself, formalistic.

The law, then, appears to be that the courts will treat a partnership interest as an asset separate from the underlying assets when the question of what the transferor transfers is the issue. Those authorities do not deal with whether a partnership interest is tangible or intangible, but at least we can conclude, with some degree of hope, that the transfer by a nonresident alien of his interest in a domestic partnership is not a transfer of the underlying assets.

Limited Liability Companies

In 2009, the tax court looked at the question of how a gift of a limited liability interest should be treated when the LLC was a single-member LLC. Pierre v. Comm’r, 133 TC 24 (2009), supp. op. TC Memo 2010-106. The IRS’s position was that the LLC should be disregarded and the LLC’s assets treated as if they were owned by the LLC’s single member. In a somewhat surprising (and far from unanimous) decision, the tax court found that disregarding the LLC for income tax purposes did not mean that the LLC could be disregarded when looking at the donor’s gift tax responsibility. As a result, the court treated the LLC as an entity and the subject of the gift was an interest in the LLC, not in the underlying assets. Since the likelihood of a different result had the LLC been owned by the donor and another is pretty small, one can look upon the Pierre case as further support for treating a partnership in the gift tax context as an entity.

Notwithstanding those authorities, one is left with the nagging feeling that the discussion on the issue of whether a gift of a partnership or LLC interest is a gift of the underlying assets or of the interest itself is far from finished.

Finally, when reviewing all of those authorities, the practitioner must bear in mind the partnership anti-abuse regulations, Treas. Reg. § 1.701-2. Those regulations tend to support Treasury’s authority to disregard the entity approach when Treasury determines that to treat the partnership as an aggregate of the partners’ assets will thwart whatever tax planning was the basis for the partners’ treating the partnership as an entity.

The conclusion that one reaches after reviewing the cited materials is that the IRS is very likely to succeed if it attacks the grantor of a gift of a partnership interest who does not pay a gift tax, and the assets of the partnership, if given directly, would be subject to gift tax. Another view one might take is that the outcome of such an IRS challenge depends on the type of partnership interest given. Publicly traded partnership interests are certainly more akin to stock than is an interest in a two-person partnership. A gift of that type, that is, of a public partnership interest, may well be treated as a gift of an intangible.

Patents, Copyrights, and Other Intellectual Property

Intellectual property is, by definition, intangible property. As such, an NRA can give it to others without incurring gift tax irrespective of the situs of the property or its value. As with other tax-free gifts, however, the effect of the generation-skipping transfer tax must be kept in mind.

Rufus v. Rhoades

Rufus v. Rhoades practices law in Pasadena, California. He is the co-author of Rhoades & Langer, U.S. International Taxation and Tax Treaties, a six-volume work published by Matthew Bender.