Posts Tagged ‘increase tax refunds’

In March of 2009, the IRS issued two documents to explain the “theft loss” deduction for tax purposes and to ease the administrative burdens for those claiming tax deductions and refunds for theft losses from Ponzi Schemes.

One document known as Revenue Ruling 2009-9, (the “Revenue Rule”) spelled out in detail, the general law of theft loss deductions and Ponzi Schemes in particular.

The second I.R.S. document spelled out certain conditions under which I.R.S. would allow theft loss deductions for Ponzi Schemes without audits and administrative slow down. This document was known as Revenue Procedure 2009-20 and it spells out a tax concept known as a “Safe Harbor”. If the Taxpayer stays within the conditions of the Safe Harbor, their tax deduction was safe.

A Safe Harbor is a tax position spelled out by the I.R.S. defining guidelines within which the I.R.S. will not challenge a Taxpayer’s tax position, so long as the tax position fits within certain parameters demanded by the I.R.S. The I.R.S. knows that the Taxpayer would win in court within the parameters set in the Safe Harbor. Therefore, the I.R.S. says, let’s not fight it but rather formalize it.

However, there are many reasons a Taxpayer victim of a Ponzi Scheme will either not fit in the Safe Harbor or will be forced to waive valuable tax rights in the event they choose the Safe Harbor. Therefore it makes sense to study how to deal with the I.R.S. if you have a theft loss and you will not or cannot use the Safe Harbor.

I. No Access to Safe Harbor?

The best example of when a Taxpayer-victim will not be entitled to the Safe Harbor for not meeting a “Safe Harbor” rule is found at Section 4.02 of the Safe Harbor which holds that there is no “theft” for purposes of the (Safe Harbor) unless:

(1) The lead figure (or one of the lead figures, if more than one) was charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime, that, if proven, would meet the definition of theft for purposes of § 165 of the Internal Revenue code and §1.165-8(d) of the Income Tax Regulations, under the law of the jurisdiction of which the theft occurred; or

(2) The lead figure was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a crime described in Section 4.02(1) of the Revenue Procedure, and either -

(a)The complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or

(b) A receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

This part of the Safe Harbor in essence defines the status of the level of proof that the I.R.S. must see to be sure a “theft” has been committed before allowing the tax deduction. However, there are many Ponzi thefts that are entitled to a “theft loss deduction” that never reach this level of prosecutorial attention.

The definition of a “theft” for tax deduction purposes is spelled out in the Revenue Rule as follows. As one can see the definition of “theft” under the law is much broader than the I.R.S. definition of theft for the Safe Harbor. The I.R.S. defines a deductible theft as:

For federal income tax purposes, “theft” is a word of general and broad connotation, covering any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile . . . “theft” includes larceny and embezzlement. A Taxpayer claiming a theft loss must prove that the loss resulted from a taking of a property that was illegal and had criminal intent under the law of the jurisdiction in which it occurred. A taxpayer need not show a conviction for theft.

Many taxpayers fit this legal definition of “theft loss” for tax deduction purposes but do not fit into the Safe Harbor.

Refusing the Safe Harbor – Waiver of Amended Returns

There are also reasons why a Taxpayer may not want to use the Safe Harbor even if the Taxpayer qualifies. A major drawback of the Safe Harbor is that the Safe Harbor requires a Taxpayer to waive the right to file amended returns for prior years and eliminate only the Ponzi income in each of those years. Instead, the Taxpayer must claim the theft loss as a deduction only in the year of discovery and then carryback or carryover any excessive theft loss not applied in the year of discovery to other full taxable years.

There is a big difference between eliminating Ponzi income only, from a prior tax return and taking a theft loss for the Ponzi income in the year of discovery. It could be financially significant. After claiming a full deduction for a theft loss in the year it is discovered, losses in excess of those deducted against the income earned in the year of discovery can be carried back and carried forward. When a loss carryback or carryover is used to claim a refund it must be applied against the entire amount of income earned in the year of carryback.

The theft loss is applied against a full year’s taxable income in the carryback year or carryover year. This may average out to be a 20% tax rate for refund purposes in the year of the carryback and the actual Ponzi income (“Phantom Income”) may have been taxed at the thirty-five percent (35%) tax rate in the year it was taxed. A Taxpayer with a $1,000,000 Ponzi Scheme loss filing an amended return eliminating Phantom Income only; versus a return that claims a theft loss on that Phantom Income of One Million Dollars can mean an increase to the Taxpayer’s tax refund from $200,000 (20%) to $350,000 (35%).

Legal Support for Amended Returns

The Internal Revenue itself has recognized under certain circumstances that it is correct to amend one’s tax returns and eliminate the “Phantom Income” only from the taxable year being amended, thus making use of a tax deduction in the highest bracket.

Therefore the Taxpayer must think the calculations through before waiving the right to file an amended return that will eliminate only the Ponzi Scheme income.

Claw Backs

Another reason not to accept the Safe Harbor is if the Taxpayer is concerned that the Taxpayer may be subject to a “Clawback” as part of a Ponzi Scheme mess. If so, the Taxpayer must waive another valuable tax right in order to take advantage of the Safe Harbor. The Taxpayer is required to give up his or her rights to use Code Section 1341.1/

The Safe Harbor insists that the Taxpayer waive their right to make use of the Internal Revenue Code Section 1341 in the event they must repay money in a Clawback. Code Section 1341 gives the Taxpayer that paid tax on income from a Ponzi Scheme in a prior year who is required to pay that income back in a different year as a Clawback, a choice. The Taxpayer may take the theft loss deduction in the year that the deduction is most tax beneficial to the Taxpayer. That could be either in the year in which the payback or claw back was paid or in the year that the income that was clawed back was taxed. This is the case even if the statute of limitations is closed in the year that the original tax was paid.

This is a valuable right that the Taxpayer must waive for the benefit of the Safe Harbor.

1/ A Clawback is when the Trustee in a Ponzi Scheme after the collapse, seeks recovery against fellow Ponzi Scheme participants that may have “profited” (in a cash sense) from their participation as investors in the Scheme. For example, Mr. X invested $1,000,000 in Madoff and reported and paid tax on another $1,000,000 in Phantom Income. He also took cash distributions over the years of $1,200,000. The Trustee may wait to “claw back” the $200,000 to pay investors in the scheme that actually lost on a cash invested basis.

I. The Alternatives to the Safe Harbor

This is just a few examples of when the Safe Harbor does not fit. If it does not fit for the Taxpayer, what is the next step if one believes they have a theft loss? The best way to analyze the Taxpayer’s position is to actually compare the Revenue Ruling and the Safe Harbor rules. By studying the Safe Harbor and the law together one can see how to claim the benefits of the Safe Harbor without the Safe Harbor.

Actually, the reader will see that the two documents are really not that far apart and there is in fact complete agreement upon several points between the two documents. First we will examine where the documents differ and how to deal with the differences so that a theft loss deduction can be claimed outside of the Safe Harbor. Then we will see where they agree.

Defining Theft Loss

The two documents differ regarding the definition of the “theft” that will support a deduction. This we have already discussed. In order to use the Safe Harbor, the “theft” must be shown by a state or Federal indictment, etc. The Revenue Ruling recognizes clearly that for income tax purposes the word “theft” has a broader definition. The Safe Harbor, however, requires not only that for there to be a theft, it must result from conduct by individuals charged by an indictment, information or complaint that has been filed against the perpetrator of the theft.

This author has found that when the theft does not reach the level established in the Safe Harbor but is a theft for state criminal purposes, it is time to turn to a criminal lawyer in the state in which the theft occurred. If the incident is a theft under state law the Taxpayer should obtain a legal opinion from a criminal lawyer under the laws of that particular state that the taking of property amounted to a criminal theft under that state’s law. This is strong proof of the theft for tax purposes.

The law is clear that a taxpayer need not show a conviction for theft in order to obtain a theft loss deduction.

Year of Discovery

There are two other places where the Safe Harbor sets standards different from the law as described in the Rev. Ruling. These are the definitions for the Year of Discovery and the Amount of Deductibility of the Theft Loss in the Year of Discovery.

Both the Revenue Ruling and the Revenue Procedure are in agreement that the law requires that the theft loss deduction must be taken in the year of discovery. However, the two documents differ on defining the “year of discovery”

To enjoy the benefits of the Safe Harbor, the Taxpayer must accept that the year of discovery is directly related to the year in which the indictment, information or complaint against the perpetrator which led to the theft has been filed. Therefore, under the Safe Harbor, a fixed “year of discovery” is tied directly to the Federal or state actions against the perpetrator.

This can be a very important difference. Keep in mind that in many business and theft loss cases there will be no indictment, etc. as required by the Safe Harbor to prove theft. The Taxpayer, not in the Safe Harbor, must not only be able to prove a theft loss, he or she needs to show the year in which the theft was discovered. The “year of discovery” is proven by gathering the pertinent evidence to the year of discovery. Evidence must be preserved that shows when the fraud was first discovered. This can be such things as notices of the collapse of the investment, meetings with lawyers or other professionals regarding the collapse, letters to perpetrators, income tax returns that prove the Taxpayer either still believed in the Ponzi Scheme at a particular point in time and any other facts.

The courts in deciding the year of discovery of a theft have agreed on several principles that provide further guidance. In determining the reasonableness of a taxpayer’s belief of loss at a particular time, the courts recognize they must be practical and take the individual facts of each case on its merits.

The relevant facts and circumstances are those that are known or reasonably could be known as of the end of the tax year for which the loss deduction is claimed. The only test is foresight, not hindsight. Both objective and subjective factors must be examined.

The law provides good guidance on the year of discovery and it is very much the year in which the ordinary reasonable person knew they had a loss from the collapse of investment.

In this regard it would seem that the Safe Harbor leaves no room for flexibility whereas the case law of the Rev. Rul. are not as exacting on the determination of the year of deductibility. Proof will be the key.

Amount of Deductibility in the Year of Discovery

The only other major concept where the Safe Harbor differs from the law is in dealing with exactly how much of a theft loss can be recognized and deducted and taken advantage of in the year that it is discovered.

TO BEGIN WITH, BOTH DOCUMENTS AGREE THAT THE TOTAL AMOUNT OF A THEFT LOSS IS EQUAL TO THE TAX BASIS OF THE LOSS.

This discussion deals with how much of that loss can be taken as a deduction in the year of discovery only. There are other standards that determine the timing on the deduction for those losses not claimed in the year of discovery.

The standard that defines exactly how much of that total amount is deducted in the year that the theft is discovered is defined as the total amount of the loss reduced by any amount that represents a “reasonable prospect for a recovery”. To the extent there is a reasonable prospect of recovery, there will be no deduction in the year of discovery.

The Taxpayer’s legal rights as of the end of the year of discovery are all important and need to be studied to make a proper decision. One of the facts and circumstances deserving of consideration is the probability of success on the merits of any claim brought by the Taxpayer. This is because the filing of a lawsuit may give rise to an inference of a reasonable prospect of recovery. However, the inference is not conclusive or mandatory. The inquiry should be directed to the probability of recovery as opposed to the mere possibility. A remote possibility of recovery is not enough; they must be a reasonable prospect of recovery at the time the deduction was claimed, not later.

In the event the deduction is not taken in the year of discovery, it will eventually be taken as a deduction in later years. However, if the theft loss is not taken in the year of discovery it must meet a higher standard of proof to be deductible in any other year. Eventually at that point in time when the Taxpayer can “ascertain with a reasonable certainty” that there is no prospect of recovery, any unclaimed theft losses may be taken. This could be a significant long period of time to delay deduction for theft losses.

Safe Harbor – Fixed Percentages

The Safe Harbor has definitely delivered the Taxpayer a favor in clarifying the amount of the theft loss deductible in the year of discovery by clearly defining certain percentage amounts that can be deducted under varying circumstances in the year of discovery to account for “contingent recoveries”.

Prior to the establishment of these fixed percentages by the I.R.S., the Taxpayer has always been dependent upon case law and accounting presentations to prove the amount of the deduction available in the year of discovery.

There are three groups of potential recoveries that both documents agree will reduce a theft loss in the year of discovery. That is three groups that represent a “prospect of recovery” in the year of discovery.

1. Recoveries from Insurance, Guarantees and Agreement to Limit Losses.
Essentially the Safe Harbor and the Rev. Rul. both agree that any amount of the loss claimed in the year of discovery as a deduction must be reduced by amounts actually recovered in the year of discovery or amounts that will be recovered as a result of insurance policies of any other contractual arrangements or guarantees that would repay the taxpayer for any of the theft loss claimed. This also includes government insurance companies such as the Securities Investors Protection Corp.

However, “all reasonable prospects of recovery” cannot be so easily quantified. THIS IS WHERE THE SAFE HARBOR IS MOST HELPFUL. THE SAFE HARBOR PROVIDES TWO (2) FIXED PERCENTAGES FOR THE TWO GROUPS THAT QUANTIFY THE BALANCE OF POTENTIAL UNKNOWN AND CONTINGENT RECOVERIES THAT COULD OTHERWISE REDUCE THE AMOUNT OF THEFT LOSS IN THE YEAR OF DISCOVERY.

Those two potential contingent amounts of recovery are as follows:

2. Recovery from those Responsible for the Ponzi Scheme. “The Responsible Group”. The Safe Harbor states that if the only people from whom the Taxpayer expects recovery of the Taxpayer’s total theft loss are the people who perpetrated the crime, then in the year of discovery the Taxpayer may deduct 95% of the total theft loss.

It is presumed by the I.R.S. that the Taxpayers will not recover more than 5% of the Taxpayers’ loss from the actual perpetrators.3/

If the Taxpayer is not in the Safe Harbor the Taxpayer will still be able to deduct 95% or more of the total loss. However, without the Safe Harbor the Taxpayer is going to have to prove his or her case. There is at least one case that supports that the 5% reduction in the loss, in the event the perpetrator is the only source of recovery, is acceptable to the courts.

3/ This “concession” of 5% that is reflected in the Safe Harbor Standard obviously reflects the long history of case law and experience that shows that recovery from the perpetrators of the Ponzi Scheme’s themselves will rarely be more than 5% as recovery towards the overall loss. As major fees and litigation are involved in obtaining this recovery. These fees reduce the recovery.

The Taxpayer will need to establish that he or she is not seeking any other source of recovery than from the Perpetrators and that the chances of receiving a refund from the perpetrators is no more than 5%. The Taxpayer will need to provide the proof necessary to establish that the amount (most likely from the Trustees own records), that they will recover from the Perpetrators will be no more than 5% of their loss.

The big difference here to be overcome by the Taxpayer who cannot use the Safe Harbor is that the Taxpayer must be responsible to provide proof that the Trustees’ recovery will not be significant. This can be done with good accounting.

3. Recovery from Third Parties. The Safe Harbor also provides the Taxpayer with a percentage amount to quantify another unknown potential recovery that could reduce what a Taxpayer may claim as a deduction in the year of discovery. The Safe Harbor provides that if a Taxpayer is also seeking recovery from third parties by litigation such as the major brokerage firms or accounting firms, etc. that may be responsible for the fraud; in this situation, the Safe Harbor will reduce the amount of theft loss deduction in the year of discovery by an additional 20% of the total amount of the theft loss to account for the potential recovery loss.

In other words, if a Taxpayer is suing third parties and depending upon distributions from a Trustee representing the perpetrators, the Taxpayer must reduce their total theft loss by 25% in the year of discovery until these issues are resolved.

Again, the Taxpayer who cannot rely on the Safe Harbor is going to have to prove their case. It is here where good forensic accounting may make a major difference and where a taxpayer may be able to prove that their “third party recovery” will amount to certainly no more than and possibly even less than the 20% amount allowed under the Safe Harbor rules.

DOCUMENTS IN AGREEMENT

As we stated, there are also many places where the Safe Harbor and the law agree.

Phantom Income as a Basis for Theft Loss.

The Rev. Rul. And the Safe Harbor do not disagree on the legal point that Phantom Income, which has been taken in as income and upon which tax has been paid by a Ponzi victim, may be the subject of a theft loss and becomes part of the tax basis that is deductible as a theft loss.

In order to be prepared to establish that tax has been paid on Phantom Income, all Taxpayers should include in their claim for refund, every tax return upon which Phantom Income appears as part of any submission to the I.R.S. There is no reason not to include each and every one of the Taxpayer’s income tax returns and any other vital information relevant from previous years to prove Phantom Income. There will be many other records that will support the payment of taxes on Phantom Income. All of this needs to be preserved.

Finally, both documents are in agreement on certain legal points that make life easier for the Taxpayer. These are:

Ordinary Income Deduction

Both documents agree that the theft loss deduction is a deduction of ordinary income and is entitled to be used as a net operating loss carry back or carry forward.

A Business Deduction

Both documents agree the theft loss deduction in a Ponzi Scheme is a business deduction that is not reduced by any of the percentage dollar limitations applicable to other types of casualty and theft losses.

Pass Through Entities

Both the Rev. Rul. and the Safe Harbor Agree those Taxpayers in “pass through entities” such as limited liability companies and partnership will be entitled to take their portion of any of the theft loss directly in spite of the fact the loss is in the name of the entity.

Summary

In summary, the Safe Harbor is just the starting point for those who are victims of Ponzi Schemes and other business and investment related theft loss that do not meet its conditions. Tax refunds can be obtained without the Safe Harbor; sometimes it is even more valuable without it.

The road towards a tax refund will be slower and the Taxpayer is advised to gather the most evidence one can get their hands on to prove the “year of discovery”, the amount of the “Phantom Income” and the actual “reasonable prospects of recovery” in the year of discovery.

With the right evidence and the law on your side, theft losses from Ponzi schemes can lead to the same refunds as the Safe Harbor and even more, since interest will be paid on the refund from the time the taxes were paid in certain situations. This might not occur under the Safe Harbor, the Taxpayer may be better off without the Safe Harbor in many situations.

Personal Comments

I have always said the Ponzi Scheme is one of the best things that has happened to the I.R.S. in a long time. The reader will have heard the names Madoff, Sanford, Nadell, etc. Let’s assume that all together they created $200 Billion Dollars of Phantom Income, almost all of which was taxed by the I.R.S. in the 35% tax bracket. In other words I.R.S. made $70 Billion from the Ponzi Schemes. (35% x $200 Billion)

I have seen in my practice that a tremendous amount of this valuable theft loss tax deduction is not being used properly or at all by individual Taxpayers. It is going completely to waste because it

(i) it is not properly being used before the death of the Taxpayer, or

(ii) it can be used only against income that is taxable in the 15% tax rate because the Taxpayer’s income is now so low due to their Ponzi Scheme loss; or

(iii) deductions are being wasted by poor professional advice or lack of knowledge.

I believe the average total amount of Ponzi Scheme refunds that will be made by the I.R.S. will be at a tax rate that averages less than 15%. The I.R.S. will receive $70 BILLION in taxes from “Phantom Income” and after holding the Taxpayers’ money for ten years will return about $25 BILLION in refunds.

DO NOT GET CAUGHT IN THAT TRAP. SEEK PROFESSIONAL ADVICE.

This is principally an article about tax planning for the non resident alien individual and foreign corporate investor that is planning for larger size investments in United States real estate (“Foreign Investor”). That is investments of One Million Dollars ($1,000,000) or more.¹

As a result of 35 years of Florida real estate experiences with foreign investors that purchase shopping centers, rental apartments, rental apartment houses, warehouses, land acquisitions and real estate development deals of all types, this article also has a few practical suggestions for the Foreign Investor.

In my judgment the first suggestion is that today the Foreign Investor has the time to think about making your purchase and it need not be hurried but one cannot wait for all of the signs of correction before committing. The U.S. real estate market is very depressed. At the same time the U.S. real estate market will not be depressed forever and may turn quickly when it turns.

Next, use only a very limited amount of borrowed funds. Because the U.S. real estate market is heavily depressed, it is extremely difficult at this time and full of opportunities and traps. The first trap is to finance your real estate with debt that requires an immediate need for funds to finance real estate that may not be leased or sold for a considerable time. You must be prepared for long term holding even if you are thinking short term.

Third, one must seek good professionals in the United States who are also knowledgeable about the needs of the foreign investor. You must have an independent tax lawyer, real estate lawyer, an accountant and several property appraisers to rely on.

Next, do not buy 2nd and 3rd class just because of its price. Buy first class. You can do this today in America and buy for great prices.

Tax planning for the foreign investor acquiring real estate with cash investments in the range of approximately $1,000,000 or more requires a look at both the U.S. income tax consequences and the U.S. estate and gift tax consequences.

Definitions of U.S. Taxes

The foreign investor will need to be concerned about three separate U.S. taxes. They are the income tax, the estate tax and the gift tax.²

There is a U.S. income tax that is applied on annual net income which starts at 15% and can be as high as 35% for both corporations and individuals. There is a tax on capital gains from the sale of assets which is only 15% to an individual taxpayer, but may be as high as 35% to a corporate taxpayer.

There is an estate tax when a non resident alien individual dies owning U.S. real estate or shares of certain types of entities that own U.S. real estate. The first $60,000 of value is excluded. Thereafter this estate tax can be as high as 45% of the equity value of the real estate.

There is also a gift tax if a non resident alien individual gifts U.S. real estate to a third party. This can be as high as the estate tax, depending upon the value of the gift.

The Individual Foreign Investor – The Problem of the Estate Tax

As a general rule, the individual foreign investor that invests in United States real estate in equity amounts of $1,000,000 or more is going to be forced to use a corporation formed outside of the United States (Foreign Corporations) somewhere in their investment structure if they are going to avoid the U.S. estate tax.

There are many exceptions to this general rule but it is still the general rule. The United States Estate tax is so onerous that the individual Foreign Investor will generally not want to assume the risk of his or her estate having to pay the United States a large tax on the death of the individual foreign owner.

The estate tax may not be a factor if one of the exceptions apply. For example, if the Foreign Investor is from a country with whom the United States has an Estate Tax Treaty, the U.S. estate tax may not apply to that foreign individual.

Furthermore, if the individual Foreign Investor is from a country that has its own high estate tax, then the U.S. estate tax may not be of concern because it can be credited against the Foreign Investor’s estate tax of his or her own country, so that there is no double estate tax.

However, for the most part, the individual Foreign Investor will have to rely on owning a Foreign Corporation as a holding company or as the direct owner of the U.S. real estate investment.

The problem with this solution to the U.S. estate tax by owning a Foreign Corporation is that in protecting the Foreign Investor from the U.S. estate tax, that Investor will generally have to pay a higher income tax from rental income that may be earned and on the ultimate sale of the assets because there is a higher tax on capital gains earned by corporations as opposed to individuals.

Term Life Insurance

Another alternative to having the best of both worlds from a U.S. tax standpoint is that an investor can pay United States income taxes as an individual investor or as a limited liability company while not being concerned with the effect of United States estate taxes in the event of a premature death by buying life insurance equal to the potential U.S. estate tax exposure. That alternative is for the Foreign Investor to acquire sufficient “term life insurance” that pays only a death benefit for the contemplated life of the investment. Depending upon the age of the investors, this may be an inexpensive solution.

As an example, assume an investor invests one-half of One Million Dollars in United States real estate which doubles in value and is still held by the Foreign Investor but worth One Million Dollars upon the foreign investor’s death. Assume a United States estate tax of $350,000 on the value of United States real estate. The annual cost of a $350,000 life insurance policy for say a ten year period only of a relatively young man or woman will not be at all prohibitive from a cost standpoint.

Income and Capital Gains Tax

With all of this in mind we can review the various options of U.S. real estate ownership by the larger Foreign Investor.

1. Individual Ownership of U.S. Real Estate.

An individual Foreign Investor may own U.S. real estate in his or her own individual name. This represents the simplest form of ownership with the least amount of paperwork involved. If it is rented out the individual owner will have to file a U.S. income tax return personally reporting the U.S. income.

This form of ownership is only chosen by a small percentage of Foreign Investors. This is for at least two reasons. The first reason is liability. The owner of U.S. real estate will be personally liable for any damages that result from that real estate. While often insurance is more than sufficient to cover such claims, most investors do not want to expose themselves personally to individual liability.

Furthermore, investors from many countries are fearful of revealing their wealth for security reasons, particularly if it is a large investment. An investor’s individual name as an owner of U.S. real estate will appear in the public records where that real estate is located.

This form of ownership does however provide the best income tax benefits. The individual investor will pay tax only on the investor’s U.S. income. Because of expenses and depreciation deductions, the Investor may only pay a tax from operations in a relatively small tax bracket.

The tax on the profit from the gain from the sale of the real estate will be only 15%.

If one does choose to own U.S. real state individually, the foreign individual investor may be subject to an estate tax in the event that investor was to die owning the U.S. real estate.

2. Limited Liability Company Ownership.

Foreign Investors may use an entity acceptable in every state in the U.S. known as a limited liability company. This type of company is treated as if it does not exist for U.S. tax purposes and therefore the tax consequences of owning a United States limited liability company that owns U.S. real estate is similar to the tax consequences described for the individual foreign investor above. A U.S. estate tax will apply to U.S. real estate owned by a limited liability company.

However, the big difference is that the limited liability company, as the name says, provides the investor with limited personal liability for losses related to the real estate investment.

What this means is that the individual foreign investor’s personal assets are not exposed to the liabilities of the investment. The limited liability company provides for the best income tax treatment and limited liability for the investor’s wealth.

3. U.S. Domestic Corporate Ownership.

The use of a United States corporation by an individual Foreign Investor who invests in the United States real estate is very limited by itself. That is because shares of stock in a United States corporation that owns U.S. real estate are also included in the foreign investor’s estate, if the foreign investor dies owning those shares. Thus ownership of a U.S. corporation to own U.S. real estate does not solve any U.S. estate tax problems. It does, however, create an extra tax burden for the foreign investor in United States real estate. That is because there will be an income tax on a United States corporation on the gain of the sale of the real estate asset that can be higher than the tax on the foreign individual investor. Unlike the tax on an individual, which is limited to 15%, the corporate tax can be as high as 35%.

There is however, one situation in which investment in United States real estate by the ownership of a United States corporation does make sense. If is as follows:

Gift of Shares

If the individual foreign investor intends to ultimately make a gift of his or her shares in a United States company that owns U.S. real estate to third parties, such as family members, etc., there will be no U.S. gift tax asserted on the gift of those shares. There would have been a U.S. gift tax had the real estate been given directly. Thus, the estate tax may be avoided with no gift tax payable if shares in a United States corporation that owns U.S. real estate are transferred prior to the foreign investor’s death.

4. The Foreign Corporation.

As a general rule, it is not a good idea for a foreign investor to use a foreign corporation that will then directly invest in U.S. real estate. This is because foreign corporations that invest in U.S. real estate can be subject not only to U.S. corporate income taxes but might also be subject to a branch tax equal to 30% of the foreign corporate investors’ undistributed U.S. profits.

A foreign corporation is, nevertheless, very often the investment vehicle of choice for a foreign investor that is investing significant amounts of money in U.S. real estate, such as $1 Million or more. This is because estate tax becomes a major potential liability for substantial fortunes invested in U.S. real estate and U.S. estate taxes may be completely avoided if the individual Foreign Investor owns a foreign corporation that may in turn own the U.S. real estate.

There are no estate taxes in this situation because when the Foreign Investor dies owning the U.S. real estate indirectly, the Foreign Investor only transfers to his or her beneficiaries, shares in the foreign corporation and there is no direct transfer of an interest in U.S. real estate.

This more complicated structure, in knowledgeable hands permits many tax planning opportunities.

U.S. estate taxes may be completely avoided if the individual Foreign Investor owns a foreign corporation that may in turn own the U.S. real estate.

5. Foreign Corporations and U.S. Corporations.

A more typical structure for a large investment in U.S. real estate is for the individual Foreign Investor to establish a 100% owned Foreign Corporation that becomes the 100% owner of a United States corporation that ultimately owns the U.S. real estate. For example, if the Foreign Investor were to establish a foreign corporation that became the 100% owner of a United States corporation that owned United States real estate, the Foreign Investor will be able to avoid any United States estate tax completely since nothing in the U.S. is transferred in the event of the death of the Foreign Investor.

The Tax Planning Opportunities

The more complicated structure of establishing a Foreign Corporation that owns a U.S. corporation that owns larger U.S. real estate investments provides several opportunities for income tax planning.

Liquidation of Company

The principal tax planning tool of the use of the Foreign Corporation that owns a U.S. corporation to own its U.S. real estate is to make sure that when the United States real estate is sold by the U.S. Corporation, that U.S. Corporation must be liquidated after the sale. In this fashion only one single U.S. tax is paid at the U.S. corporation level. The proceeds of sale may be transferred free of tax by the U.S. corporation after it has paid its U.S. tax if it is liquidated after the sale.³

Portfolio Loans

Another often used tax planning tool is known as the “Portfolio Loan”. As a general rule a Foreign Corporation or a U.S. Corporation that owns U.S. real estate will be able to deduct as a business deduction all of the expenses of that ownership, which include the payment of interest on loans made to acquire the real estate. As a general rule, loans made by a Foreign Investor to his or her own Foreign Company, U.S. Company or Limited Liability Company will be deductible by the company. However, the payment of such interest to the Foreign Owner of the company may be subject to a tax as high as 30% on the gross interest paid to the investing company’s foreign shareholder.

There is, however, a major exception to this general rule provided in the Internal Revenue Code. That is that a Foreign Investor who owns less than 10% of the real estate investment will be able to receive the interest that is deductible by the Foreign Company free of any U.S. tax whatsoever. This rule does not work in the event the investor owns 10% or more of the real estate investment or the entity that owns that real estate investment.

However, it is a useful planning tool in many situations where more than one investor is involved. In those situations where a portfolio loan can be used, the U.S. taxes on the income earned from the real estate investment will be reduced for the interest expense payable to the Foreign Investor without the payment of tax on that interest.

“. . . the U.S. taxes on the income earned from the real estate investment will be reduced for the interest expense payable to the Foreign Investor…“

Portfolio Loan Sales

There is another way to take advantage of the Portfolio Loan exclusion for interest paid to Foreign Investors. This can be accomplished at the actual time of sale by a Foreign Investor of his or her U.S. investment. To understand this, it is important to keep in mind that the portfolio interest deduction and exclusion from income is only appropriate if the Foreign Investor no longer has a 10% or less interest in the property.

Therefore a Foreign Seller may wish to sell the property, not for all cash but rather for cash and the balance due in the form of a note payable by the U.S. Buyer to the Foreign Seller who no longer owns any part of the U.S. real estate. At that point the Foreign Seller will be receiving tax free interest from the note that the Foreign Seller holds as a result of the U.S. real estate and the property can be used to secure the note until its full payment. This method of converting what otherwise might be taxable sales proceeds into tax free interest income could be of significant tax value under the right circumstances.

Like Kind Exchanges

Another method used by both Foreigners and Americans alike to grow their U.S. real estate portfolios free of U.S. tax is to make use of the “Like Kind Exchange Rules”. Essentially these rules hold that an investor in U.S. real estate may exchange the U.S. real estate project that they own for a different U.S. real estate project without paying any immediate tax on any gain or profit that may be accrued in the first investment.

For example, assume a Brazilian investor owns a U.S. corporation which owns raw land that the investor purchased for $ 3 Million. Assume the raw land is now worth $6 Million and the investor wishes to terminate his investment in the raw land and instead own an income producing asset such as a shopping center. Assume the shopping center is worth $ 6 Million.

Even though the raw land has increased in the amount of $ 3 Million, none of that gain will be recognized or will it become taxable until the Corporation actually sells the real estate that it has acquired as part of the exchange. At that point the investor’s investment in the shopping center has its original cost of $3 Million and any gain over and above that would be taxable if the shopping center were later sold.

… selling shares of a foreign corporation would result in no tax whatsoever being paid by the foreign entity trust on the shares of these stock.

Sale of Stock in a Foreign Corporation

In addition, on rare occasions, it has been possible for foreign investors to sell their shares in the Foreign Corporation that owns U.S. real estate to a third party buyer. It is clearly understood that selling shares of a corporation that owns real estate, instead of the actual real estate is not typical. However, this transaction, of a foreign entity selling shares of a foreign corporation would result in no tax whatsoever being paid by the foreign entity trust on the shares of these stock. There is a market for such transaction in the U.S. in specialized cases.⁴

FOOTNOTES:

1. See article “Tax Planning for Foreign Investors Acquiring Smaller ($500,000 and under) United States Real Estate Investments” for a companion article on Tax Planning for Foreign Investors Acquiring Smaller United States Real Estate Investments.
2. In addition, several of the individual states in the U.S. charge their own separate income tax on income earned in that state.
3. Often one Foreign Corporation may be used as a holding company and will set up several U.S. corporations to own different projects. That way each U.S. Corporation may be liquidated on a deal by deal basis, leaving the Foreign Corporation in place.
4. Another estate planning tool that allows a non resident alien investor to invest in United States real estate without incurring U.S. estate tax is the use of a Non Grantor Trust. This is a devise whereby the investor purchases the U.S. real estate using a foreign trust and foreign beneficiaries, such as family members, so that trust will ultimately benefit others. This vehicle is specifically not being discussed in this article since it does involve the investor’s alienation of the property to a trust that is extremely restrictive of any powers that the investor can have over the real estate owned by the Non Grantor Trust.

---

Richard S, Lehman, Esq.
TAX ATTORNEY
6018 S.W. 18th Street, Suite C-1
Boca Raton, FL 33433
Tel: 561-368-1113
Fax: 561-368-1349

Richard S. Lehman is a graduate of Georgetown Law School and obtained his Master’s degree in taxation from New York University. He has served as a law clerk to the Honorable William M. Fay, U.S. Tax Court and as Senior Attorney, Interpretative Division, Chief Counsel’s Office, Internal Revenue Service, Washington D.C. Mr. Lehman has been practicing in South Florida for more than 35 years. During Mr. Lehman’s career his tax practice has caused him to be involved in an extremely wide array of commercial transactions involving an international and domestic client base.

By Richard S. Lehman, Tax Attorney

The headlines are now informing Madoff and other Ponzi Scheme victims about the most recent piece of bad news. That is the word “claw back”. In short, investors who received cash investment returns from a Ponzi Scheme in excess of the actual invested funds are being forced to pay that excess cash back. HOWEVER, THESE “CLAW BACK” PAYMENTS WILL BE TAX DEDUCTIBLE.

Those victims that are hit by a “claw back” may or may not have a choice about when they can deduct any moneys they repay as a “claw back”. Whether they have this choice could mean a big difference in the amount of money in tax refunds that will be payable to the “Claw Back” victim.

As an example, assume the following:

Mr. Smith invests $500,000 in 2005 and earns and pays U.S. income taxes on $125,000 in 2005, $125,000 in 2006 and $125,000 in 2007. In 2008 Mr. Smith withdraws all $875,000 from his Ponzi Scheme account and closed the account. Assume Smith paid in the 35% tax bracket on his $375,000 in earnings for total taxes paid of $131,250. Assume Mr. Jones made the same investment but never withdrew any funds. Jones loses $875,000. Assume that the $375,000 of “earnings” is “clawed back” from Mr. Smith but not paid back by Mr. Smith until 2011 when all the litigation was settled.

The law is clear that moneys clawed back from Mr. Smith, for which he had paid taxes on, would be deductible by Mr. Smith in the year 2011 when they were paid back. But what if Mr. Smith had very little income for 2008 and 2009 and 2010 and 2011 and used and carried back his $375,000 in losses in those four years, where would he be? The value of Mr. Smith’s tax refunds for the deducted repaid amounts in those years might be based on tax brackets that average 18%. In that case Mr. Smith would receive a tax refund of $67,500 even though Mr. Smith has paid taxes of $131,250 in prior years on the claw back income.

The Choice

There is a solution that will provide for a full return of all of the taxes paid by Mr. Smith of $131,250 plus interest. However, that solution may not be available to any Taxpayers that have filed previously and received tax refunds while making use of the “Safe Harbor” rules published by the Internal Revenue Service in Rev. Proc. 2009-20. The “price” of enjoying the Safe Harbor rules was to waive the Taxpayer’s rights to make use of a particular Code Section in the Internal Revenue Service that provides for this tax fairness.

Code Section 1341 of the Internal Revenue Code provides that under certain circumstances

Taxpayers who have received funds that they have reported as taxable income that must be paid back at a future time will have a choice.

They can deduct the funds that must be paid back in the year in which the payment is actually made, or go back to the years that the income that is being repaid was reported.

This refund is determined by calculating the actual year of income and excluding the repaid amount. It eliminates the repaid income from the Taxpayers’ taxable income for that year, thus recalculating the amount of taxes due and providing for a refund of excess taxes paid on the money returned from prior years.

This Code Section is very valuable in the event a Ponzi Scheme victim must pay back funds in a year in which the victim is in a very low tax bracket and those same funds had been reported in a prior year in a very high tax bracket, like Mr. Smith.

Those Taxpayers who did not rely on Rev. Proc. 2009-20 should be able to rely on Code Section 1341 to increase the amount of their refund, if appropriate.

Furthermore, refunds paid pursuant to Code Section 1341 will carry interest from the prior year’s date for the amount of the overpayment. This will be an extremely useful tool to investors suffering from claw backs in a Ponzi Scheme.

The use of Code Section 1341 can increase tax refunds and interest payments by 100% and more.