Renting land to yourself
Today’s post is a case study of why you might avoid PFIC classification if you rent land to your own business. This post also shows why 50-50 joint ventures are rather dangerous.
The setup
Suppose you run into this setup:
You, a US person, go into business with an unrelated nonresident alien. You take 40% of the share of an operating company, and your partner takes 60%. You need to buy land for the business to use, but your investors or creditors demand that you hold the land in a separate company. So you and your partner create a separate land company and buy the land using the land company. You have the same 40-60 share split. Then land company then rents to the operating company.
To make this post shorter, I assume that both the land company and the operating companies are foreign corporations. I assume the operating company does not have any passive income or passive assets within the meaning of the PFIC rules.
PFIC defined
A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):
- Income test: At least 75% of the corporation’s gross income is passive income.
- Asset test: At least 50% of the corporation’s assets are passive assets.
Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad.
We assumed the operating company does not have any passive income or passive assets, so we win by fiat on the operating company. What is more interesting is the land company. After all, it merely collects rent on land. Is it a PFIC?
A related party exception prevents the land company from having passive income
In general, rent is passive income. IRC §§1297(b)(1), 954(c)(1)(A). But there is an exception for rent received from a related person:
Except as provided in regulations, the term “passive income” does not include any income […] which is interest, a dividend, or a rent or royalty, which is received or accrued from a related person (within the meaning of section 954(d)(3)) to the extent such amount is properly allocable […] to income of such related person which is not passive income… IRC §1297(b)(1)(C).
There are two criteria here for the rent to be non-passive income:
- The rent must be from a related person; and
- The rent must not be allocable to the related person’s passive income
The rent is not allocable to passive income
We assumed that the operating company does not have passive income, so any rent it pays to the land company is not allocable to the operating company’s passive income. In this post, we win by fiat.
Our assumption is not always true: An operating company generally has some passive income. For example, most operating companies buy cash equivalents and invest in securities rather than leaving cash in a non-interest bearing account. In most cases, we expect passive income to be low compared to nonpassive income, so to make it easy, we assumed that the operating company has no passive income.
The operating company is related to the land company
Related person has the same definition as used in IRC section 954(d)(3). IRC §1297(b). Section 954(d)(3) describes several ways of being related, but the one that is important for us is this one:
[A] person is a related person with respect to a [foreign corporation] if […] such person is a corporation […] which is controlled by the same person or persons which control the [foreign corporation].
For purposes of the preceding sentence, control means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. IRC 954(d)(3).
Here, the nonresident alien business partner owns 60% of the shares of both the operating company and the land company. Thus, the nonresident alien business partner controls both companies. The companies are related persons.
The rent is not passive income
We know that the rent is not allocable to passive income under our assumptions, and the operating company is related to the land company by having the same controlling shareholder. Therefore, the rent the operating company pays to the land company is not passive income.
The same exception should prevent the land from being passive assets
The land generates nonpassive income: rent from a related person. But it is theoretically possible for the land to generate passive income, such as gain from sale to an unrelated person. Can the land be a passive asset because of the probability of generating passive income when it is sold? The IRS has not answered this question directly.
There are two separate reasons the land should be a nonpassive asset: The text of the Code and an IRS notice.
The text of the code suggests actual use matters, not theoretical possibility
We use passive assets as a shorthand when describing the asset test, but the actual text of the Code for the asset test is as follows:
the average percentage of assets […] held by such corporation during the year which produce passive income or which are held for the production of passive income is at least 50 percent. IRC §1297(a)(2).
There are two ways for an asset to be a passive asset: It produces passive income, or it is held for the production of passive income.
The first way refers to what the asset actually is doing: Is it generating passive income or not? Here, the land is not generating passive income, because it generates nonpassive rent. Under the first way, the land is a nonpassive asset.
The second way refers to intention: Why is it being held? For land, this seems to suggest that land held as investment is passive, while land used in the business of the corporation is nonpassive. Under the second way, the land is a nonpassive asset.
By parsing the Code, it is likely that the land company’s land is a nonpassive asset.
Notice 88-22 suggests actual use matters, not theoretical possibility
Notice 88-22 is one of the few examples of guidance that the IRS has issued on how to classify assets. Unfortunately, the IRS issued this notice back when passive income for PFIC purposes was defined as passive category income under foreign tax credit rules, so it refers to section 904, which deals with foreign tax credits. Notice 88-22; 1988-1 CB 489.
Now, passive income for PFIC purposes is defined as foreign personal holding company income under controlled foreign corporation rules. Thus, it is not clear how much of Notice 88-22 still applies. But when Notice 88-22 is consistent with the text of the Code, the notice is perhaps still a reasonable point of reference.
Notice 88-22 says that generally, an asset is classified according to the type of income it generates (or is expected to generate). Notice 88-22. This is consistent with the text of section 1297(a)(2). Thus, we probably are safe classifying the land as nonpassive based on the fact that it generates nonpassive rent.
Be careful of 50-50 joint ventures
In our particular case, we used a related party exception to classify the rent as nonpassive income, because one shareholder owned more than 50% of the shares of both the operating company and the land company.
In a 50-50 joint venture, no person controls both the land company and the operating company, so they are no longer related parties. Thus, the related party exception no longer saves the rent from being passive income.
In proposed 50-50 joint ventures, it may be well worth it to give the nonresident alien business partner 50.01% of the shares (by voting power or by value) to take advantage of the related party exception.
The post Holding Business Real Estate in a Separate Company appeared first on HodgenLaw PC – International Tax.