When a U.S. person receives certain gifts or bequests from foreign corporations, those amounts may be considered as part of the U.S. person’s gross income under US International Tax regulations. The Internal Revenue Code’s regulations specifically state that when a “purported gift or bequest” is received “directly or indirectly,” the amount is included in the U.S. person’s gross income “as if it were a distribution from the foreign corporation” (1). As a result of this characterization, the purported gift or bequest has two possible treatments for tax purposes: as a dividend to the extent of the corporation’s earnings and profits, and as capital gain to the extent of the corporation’s excess over earnings and profit.
Definition of Purported Gift or Bequest
Unless made for fair market value, a transfer of cash or other property from a foreign corporation to a person other than a shareholder is considered to be a “purported gift or bequest” (2). A transfer to a shareholder may also fall within the definition of a purported gift or bequest “if the amount transferred is inconsistent with…the shareholder’s interest in the [foreign] corporation.” In these cases, the definition of a fair market value is a transfer “to the extent of the value of property received from the [transferee], services rendered by the [transferee], or the right to use property of the [transferee]” (3). If the transferee provides some value to the transferor for the property, but that amount is less than the fair market value, then the transfer is a purported gift or bequest to the extent of the excess of fair market value over the transfer value. Finally, a transfer is not a purported gift or bequest if the IRS determines that the U.S. transferee is not related to a shareholder of the foreign corporation under § 267 or § 707(b) or “does not have another relationship with…a shareholder…that establishes a reasonable basis for concluding that the transferor would make a gratuitous transfer to the United States donee” (4).
A Gratuitous Transfer May Be Treated as a Purported Gift or Bequest
If a foreign corporation makes a gratuitous transfer to a trust, and then the U.S. donee then receives a gratuitous transfer from the trust, the U.S. donee must treat the transfer as a purported gift or bequest from the foreign corporation. However, the transfer may alternatively be treated as a distribution from the trust if the tax treatment is at least as great as the tax treatment when treated as a purported gift or bequest.
Tax Treatment of Purported Gift or Bequest
When a U.S. person receives a purported gift or bequest from a foreign corporation, the U.S. person is taxed as through the transfer were a distribution by the corporation and the U.S. person were a shareholder in the corporation with no basis in the company’s stock (5). Thus, it is treated as a dividend to the extent of the corporation’s capital gains. The purported gift or bequest is then treated as capital gains to the excess of earnings and profits (6).
Purported Gifts and Bequests – Exceptions
When a U.S. person receives certain gifts or bequests from foreign corporations, those amounts may be considered as part of the U.S. person’s gross income. The Internal Revenue Code’s regulations specifically state that when a “purported gift or bequest” is received “directly or indirectly,” the amount is included in the U.S. person’s gross income “as if it were a distribution from the foreign corporation.” However, there are some exceptions to this general rule.
The first exception relates to the value of the purported gifts and bequests. Specifically, the exception states that the rule does not apply if the purported gifts and bequests from the corporation and all entities related to the corporation amount to less than $10,000 (7). To qualify for the second exception, the U.S. person who received the purported gift or bequest must demonstrate that an individual with an interest in the foreign corporation reported the purported gift or bequest for tax purposes. Under this exception, the individual owner of the foreign corporation must reported the purported gift or bequest as a distribution to the individual, followed by a purported gift or bequest to the U.S. person (8).
The third exception applies to U.S. corporations. Under the third exception, a purported gift or bequest is not treated as taxable income to the extent it is treated as a contribution to the recipient’s capital for U.S. tax purposes (9).
A fourth exception applies to individuals described in IRC § 170(c), which specifies organizations eligible to receive gifts qualifying for the exception. For this exception, a purported gift or bequest is also exempt from U.S. taxation if 1) there exists an outstanding IRS ruling which states that the recipient is exempt for these purposes under IRC § 501(c) and 2) the gift or bequest is made “pursuant to an exempt purpose for which the [recipient] was created or organized” (10). However, a ruling or determination letter “may not be relied upon if there [has been] a material change, inconsistent with exemption, in the character, the purpose, or the method of operation of the organization.”
Finally, as is to be expected, the IRC contains a provision which does not allow taxpayers to use the exceptions “if a principal purpose for using such rules is the avoidance of any tax imposed by the Internal Revenue Code” (11) In that case, the IRS can choose to “recharacterize…the transfer in accordance with its form or its economic substance.”
How a Tax Attorney Can Help
The Tax Lawyer - William D Hartsock Tax Attorney Inc. has been successfully helping clients with tax issues related to their foreign assets since the early 1980s. Mr. Hartsock offers free consultations with the full benefit and protections of attorney client privilege to help people clearly understand their situation and options based on the circumstances of their case. To schedule your free consultation simply fill out the contact form found on this page, or call (858) 481-4844.
Tax Law References:
- Reg. § 1.672(f)-4(a)(2), promulgated under § 672(f)(4).
- Reg. § 1.672(f)-4(d)(1).
- Reg. § 1.671-2(e)(2)(ii).
- Reg. § 1.672(f)-4(d)(2)(ii).
- Reg. § 1.672(f)-4(a)(2).
- IRC §§ 301(c), 316.
- Reg. § 1.672(f)-4(f).
- Reg. § 1.672(f)-4(c)(3).
- Reg. § 1.672(f)-4(b)(3).
- Reg. § 1.672(f)-4(b)(4).
- Reg. § 1.672(f)-4(e).