Although virtually all of the tax community’s coverage related to the 2017 Tax Act focuses on its impact on U.S. taxpayers, the new law also provides historic opportunities for non-U.S. families, family offices and trust structures currently or otherwise interested in investing in the U.S. to dramatically reduce their U.S. federal tax exposure. Widely considered the most significant overhaul of the U.S. tax code since 1986, existing U.S. inbound structures should be reviewed to optimize the effect of the 2017 Tax Act’s new changes, and new structures should be designed to realize maximum benefit from these new changes.
In short, the old rules and conventions used to design U.S. inbound investment and family structures prior to the 2017 Tax Act may no longer result in the lowest U.S. income tax exposure and may unnecessarily increase a non-U.S. client’s exposure to U.S. estate and gift taxation.
McGuireWoods’ global private client team has compiled highlights of the 2017 Tax Act that impact non-U.S. family investment structures. It is critical that non-U.S. families, family offices and trust structures with existing or planned future U.S. investments be mindful of these changes. This client alert is the first in a series to be published in the coming year addressing the 2017 Tax Act and opportunities for non-U.S. families, family offices and trust structures to avail themselves of the tax benefits afforded by the new law.
Most Tax Benefits Sunset
Most of the tax benefits passed in the 2017 Tax Act will expire after 2025 and the affected laws will revert to their state as of Dec. 31, 2017. For example, the 2017 Tax Act’s reduction of federal income tax rates applicable to individuals, trusts and estates (discussed in more detail below) applies for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026 (for calendar year taxpayers, individual, trust and estate federal income tax rate reductions will disappear beginning in 2026).
However, one important exception exists. The reduction in U.S. federal corporate income tax rates from 35 percent to 21 percent is permanent (assuming that future legislation does not modify the 21 percent federal corporate rate).
How this affects you: Be wary of relying on tax benefits that will expire, especially if the underlying U.S. investment in question will be held beyond the applicable sunset date. For example, any analysis of a new or existing investment structure should account for the fact that the 2017 Tax Act’s pass-through income tax benefits will expire, while the new 21 percent corporate income tax rate will continue absent new law.
Reduction in Individual and Trust Income Tax Rates
The 2017 Tax Act lowers the income tax brackets applicable to non-U.S. individuals, trusts and estates. Under the new law, the highest income tax bracket has been reduced from 39.6 percent to 37 percent. Note that these rate reductions will automatically terminate for tax years beginning on or after Jan. 1, 2026 (i.e., the reduction in the top federal income tax rate for individual, trust and estate taxpayers using a calendar year will expire beginning in 2026). Thereafter, the federal income tax rates applicable as of Dec. 31, 2017 will be imposed going forward (including the highest federal income tax rate of 39.6 percent).
How this affects you: Non-U.S. individuals, trusts and estates, including such persons holding U.S. investments through pass-through structures (generally, limited liability companies (LLCs) and partnerships), will immediately benefit from an across-the-board reduction in U.S. federal income tax rates. However, the reductions in non-corporate federal income tax rates are temporary. As a consequence, any analysis of existing or future U.S. investment structures subject to individual, trust or estate income tax rates should account for the return of higher tax rates beginning in 2026 for calendar-year taxpayers.
Corporate Structures Look More Attractive/Leak Less U.S. Income Tax
The 2017 Tax Act reduces the federal corporate income tax rate from 35 percent to 21 percent. However, the second layer of income tax on dividends paid from a corporation continue to be subject to additional U.S. taxation. That is, dividends paid from a U.S. corporation held by a non-U.S. structure generally continue to be subject to a 30 percent withholding tax. Moreover, the additional 30 percent branch profits tax continues to apply to non-U.S. corporations earning active U.S. income directly or via pass-through structures. Nonetheless, opportunities continue to exist to reduce these taxes by use of an available tax treaty or otherwise.
Assuming that a non-U.S. individual or trust structure utilizes a corporate structure to hold a U.S. investment, and that structure is subject to a 30 percent withholding tax on dividends, the 2017 Tax Act lowers the effective federal tax rate on income realized at the corporate level and distributed to a non-U.S. person from 54.5 percent pre-2017 Tax Act to 44.7 percent post-2017 Tax Act. But the availability of favorable tax treaties that reduce the dividend withholding tax and other considerations (e.g., scenarios where there will be limited distributions to shareholders or proper use of so called “portfolio debt” whereby interest payments made by the corporation are not subject to U.S. withholding taxes) could significantly reduce that effective 44.7 percent rate. Unlike most provisions of the 2017 Tax Act, the reduction in the federal corporate income tax rate is permanent and not predestined to expire.
How this affects you: Given the dramatic reduction in the federal corporate income tax rate, especially coupled with the fact that this reduction is permanent absent new legislation, non-U.S. individuals, family offices and trust structures should take a hard look at their U.S. structures.
In addition to a dramatic reduction in U.S. federal income tax leakage, corporate structures can provide important advantages for non-U.S. individuals, families and trusts investing in the U.S. when compared to pass-through structures. These advantages include:
- Elimination of U.S. Estate Tax Exposure. A corporate structure can provide, when coupled with the proper use of a non-U.S. corporation, the most proven method to block a non-U.S. person’s exposure to the onerous U.S. federal estate tax regime.
- Blocking of U.S. Income Tax Payment and Filing Requirements. Most non-U.S. families and individuals investing in or otherwise owning U.S. assets (such as personal-use real estate) detest the thought of personally filing U.S. income tax returns with the Internal Revenue Service and becoming subject to U.S. tax payment obligations. The proper use of a corporate structure can block a non-U.S. person’s exposure to these requirements.
In light of the reduction in corporate rates and the distinct advantages a corporate structure can afford, non-U.S. families and advisers have good reasons to consider corporate structures for both existing and new U.S. investments.
However, Pass-Through Entities May Be More Income Tax Efficient
The 2017 Tax Act introduced a new deduction related to pass-through and disregarded entities (such as LLCs and partnerships) of up to 20 percent of “qualified business income” earned by the pass-through. Importantly, the deduction available for qualifying income will expire for tax years beginning after Dec. 31, 2025. If all of a pass-through’s income constitutes qualified business income and applicable limitations do not reduce the deduction, the rate of federal income tax imposed on a non-U.S. individual or trust holding an interest in such a pass-through is reduced from 39.6 percent pre-2017 Tax Act to 29.6 percent post-2017 Tax Act.
Generally, “qualified business income” is income derived from an active trade or business. The deduction is limited, for taxpayers above a certain threshold, to the greater of (i) 50 percent of the W-2 wages paid by the qualified business (i.e., wages paid by the business to its employees), or (ii) 25 percent of the W-2 wages plus 2.5 percent of the depreciable property used to generate “qualified business income.”
How this affects you: When compared to a generic corporate structure where all income will be paid out as dividends subject to 30 percent withholding, investing through a pass-through or disregarded entity in most instances will result in lower U.S. federal income tax exposure. The income tax differential in favor of pass-throughs will be even more pronounced if the pass-through derives income from an active trade or business such that the non-U.S. individual or trust can avail itself of the 20 percent deduction for qualified business income and that deduction is not otherwise limited.
However, many non-U.S. individuals, family offices and trusts investing in the U.S. do not invest in active businesses and, in any event, their investments may not require significant employees or depreciable property. As such, non-U.S. persons making such investments may not receive the full benefit of the 20 percent deduction for pass-through income, and the effective U.S. federal income tax rate imposed on such income may therefore approach 37 percent. For these investors, a properly designed corporate structure may result in lower U.S. federal income tax exposure and better serve the long-term needs of the underlying non-U.S. individual or family.
In addition, a non-U.S. family choosing to invest in the U.S. via a pass-through structure will need to consider its U.S. estate tax exposure and U.S. federal income tax reporting and payment obligations. Although subject to debate in the U.S. tax practitioner community, there is little doubt that a properly executed corporate structure will provide more certainty as to eliminating U.S. federal estate tax exposure when compared to alternatives using a pass-through structure. In addition, many non-U.S. individuals desire to avoid becoming personally subject to U.S. federal income tax reporting and payment obligations.
As always, the choice between corporate and pass-through structures requires thoughtful analysis of both the underlying investment’s features (e.g., investment terms, anticipated holding period, and need to distribute income earned from the investment), risk appetite for U.S. federal estate tax exposure, and willingness of a non-U.S. individual or trust to be personally subject to U.S. federal income tax reporting and payment obligations. A successful analysis not only will result in a dramatic reduction of U.S. federal income and estate tax exposure, but should also account for important non-tax considerations of a non-U.S. individual, family office or trust structure.
Regardless of the Structure Chosen, the 2017 Tax Act Imposes New Limitations on Interest Deductibility
Business interest expenses once deductible under Section 163 of the Internal Revenue Code now may be limited to 30 percent of the taxpayer’s (i) earnings before interest, tax, depreciation and amortization (EBITDA) for taxable years beginning after 2017 and ending before 2022, or (ii) earnings before interest and tax (EBIT) for taxable years beginning on or after Jan. 1, 2022. Notably, this limitation does not apply to taxpayers with average annual gross receipts for the current and prior two taxable years that do not exceed $25 million. Additionally, at the taxpayer’s election, the limitation does not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
How this affects you: Current and prospective structures that utilize debt should be reviewed to analyze the impact of the 2017 Tax Act’s interest deductibility limitations on bottom-line U.S. federal income tax leakage. This is especially important for non-U.S. investors as they commonly utilize portfolio debt strategies to realize interest income free of U.S. withholding taxes. For these investors, the entities that make payments of portfolio interest may find their interest deductions limited by these new rules. Importantly, however, many non-U.S. investors have deployed capital in U.S. real estate, and the new interest deduction limitations do not apply to many real estate-related investments.
No Change in Estate and Gift Taxation of Non-U.S. Persons
The 2017 Tax Act does not grant non-U.S. domiciliaries (i.e., non-U.S. individuals without domicile in the U.S.) any relief from U.S. federal estate and gift taxation. However, the reduction in the U.S. federal corporate income tax rate to 21 percent makes the use of non-U.S. corporate vehicles to block non-U.S. domiciliaries’ exposure to U.S. estate tax much more attractive than in the past.
How this affects you: Non-U.S. families, family offices and trust structures investing in the U.S. must continue to be vigilant in protecting against exposure to onerous U.S. estate (generally 40 percent gross taxation at death) and gift taxes. As the estate tax exemption for non-U.S. domiciliaries remains a paltry $60,000, structures should continue to be designed to reduce exposure to the U.S. estate and gift tax regime.
The McGuireWoods Global Private Client Bottom Line
The 2017 Tax Act’s headline federal income tax rates make U.S. investments more attractive than before and likely lower a non-U.S. person’s U.S. federal income tax burden no matter what structure is chosen. However, the optimal structure for a non-U.S. individual, family or trust under the new law will minimize U.S. income tax leakage while reducing or eliminating U.S. estate and gift tax exposure. The selection of the optimal structure requires a thorough understanding of the tax benefits available under the 2017 Tax Act, coupled with a thorough analysis of the underlying U.S. investment in question and family considerations, including exit assumptions, projected gains, use of investment gains, appetite for risk of U.S. estate tax exposure, and a non-U.S. individual’s or trust’s willingness to be subject to U.S. federal income tax reporting and payment obligations.