I Want to Live in America!- Part I Tax Planning Considerations for Foreign Scientists and Engineers

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Overview

As discussions regarding immigration reform continue to unfold, one point that is not under discussion or subject to debate is the contribution of foreign scientists and engineers to the New Economy. The statistics are pretty startling.

According to a 2012 report from the Information Technology Industry Council, the Partnership for a New American Economy, and the U.S. Chamber of Commerce, research has found that “every foreign-born student who graduates from a U.S. university with an advanced degree and stays to work in the U.S.  has been shown to create on average 2.62 jobs for American workers—often because they help lead in innovation, research, and development.”

A 2011 report from the Partnership for a New American Economy concluded that immigrants were founders of 18 percent of all Fortune 500 companies, many of which are high-tech giants.

A 2007 study by researchers at Duke University and Harvard University concluded that one-quarter of all engineering and technology-related companies founded in the United States from 1995 to 2005 “had at least one immigrant key founder.”

A 2006 study by the National Venture Capital Association found that, during the previous 15 years, immigrants started one-quarter of the public companies in the United States backed by venture capital. These companies had a market capitalization of more than $500 billion and employed 220,000 workers in the United States in 2006.

One of the aspects that is recently of interest to me is the tax planning of foreign scientists and engineers who emigrate to the U.S. and become part of the New Economy. In many cases, these scientists become naturalized citizens. In other cases, they are green card holders. One thing is for certain though, green card or naught, Uncle Sam taxes these scientists on their worldwide income and assets once they become citizens or obtain a green card.

Questions 67 and 68

The interesting question is the tax treatment of the sale of company shares following the initial public offering (IPO) of the technology companies for these foreign-born scientists and engineers. In many cases, these scientists still have family members living in the scientist's home country. When you consider the impact of an IPO on the personal tax planning of these scientists and engineers, the foreign-based parents become an important planning fact.

Is there an opportunity for the foreign-born scientist or engineer to avoid U.S. capital gains taxation on the sale of the shares following the IPO and restriction period on the sale of shares? Can the proceeds be reinvested without U.S. taxation? Can the foreign-born scientist, a green card holder or naturalized citizen receive tax-free distributions from a foreign trust.

The answer is "Yes" but the path to Shangri La is a minefield.

Foreign Grantor Trusts

While it is true that Congress enacted legislation in 1996 to make it very difficult for American taxpayers to utilize and exploit foreign trusts to avoid U.S. income taxes, it is not impossible. The foreign scientist who owns a million shares of founder's stock in his company that is about to undergo an IPO can minimize the impact of U.S. taxes on the value of those proceeds when the stock is sold following the expiration of a restriction period on the sale of the stock. The planning structure is a foreign trust that is treated as a grantor trust with respect to the non-citizen parents or settlors who establish the trust.

A trust is a foreign trust unless both of the following conditions are satisfied: (i) a court or courts within the U.S. must be able to exercise primary supervision over administration of the trust; and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust.

Under this test, a trust may be a foreign trust even if it was created by a U.S. person, all of its assets are located in the U.S., and all of its beneficiaries are U.S. persons. All it takes is one foreign person who has control over one “substantial” type of trust decision.

No tax consequences are imposed on a U.S. person on account of the creation of a foreign trust, but, under some circumstances, income tax may be imposed on her transfer of property to a foreign trust, whether that trust was created by her or by another. Code § 684 treats a transfer of an item of property by a U.S. person to a foreign trust as a sale or exchange for an amount equal to the fair market value of the property transferred and requires that the transferor recognize gain (but not loss) on the excess of such fair market value over her basis in the transferred property. This rule does not apply to the extent that any person (including the transferor) is treated as the owner of such trust under the grantor trust rules.

If a foreign trust to which a U.S. person has made any direct or indirect gratuitous transfers has one or more U.S. beneficiaries, Code § 679 treats the trust as a so-called “grantor trust” owned by the U.S. person within the meaning of Code § 671 to the extent of her transfer. A transfer is not a gratuitous transfer if it was made for full fair market value. If the transferor is the grantor or a beneficiary of the trust, any obligation issued by the trust is disregarded, except as provided in the regulations. A Qualified Obligation must not have a term that exceeds five years with an interest equal to the Applicable Federal Rate. This is a key exception to IRC Sec 679 and the application of the grantor trust

Strategy Example

Facts

Bobby Singh, age 35,  is a software engineer from Mumbai that came to the U.S. to attend MIT. After graduation he moved to Silicon Valley to work for a high tech start up. The company is planning an IPO later in 2013 or in early 2014. Bobby has one million of Founder's shares with negligible cost basis. The current IRC Sec 409A valuation of the shares is $10 million per share. Bobby has a sister living in the U.S. but his Mom and Dad still live in India. Bobby is married with two small children. He is an American citizen. Taxation in India for his parents on the investment income is also a planning issue  as Indian tax authorities attempt to capture more tax revenue on worldwide income for Indian domiciled and resident taxpayers. 

In California, the combined federal and state capital gains taxes on the Founder's shares would be 37.1 percent which is almost equal to the top federal marginal tax bracket on ordinary income.

Strategy

IRC Sec 679 and IRC Sec 684 would apply generally upon the transfer of  Bobby's Founder shares treating Bobby as the owner of trust assets for income tax purposes. Absent grantor trust status, the transfer of Founder's Shares would result in an immediate tax on the gain at the time of the transfer at a 35 percent tax rate. Bobby's company allows for the intra-family transfer of shares for tax planning purposes.

Bobby will rely on the exception for the sale on a fair market value basis to a foreign corporation owned and controlled by his parents. The Founder's shares are transferred to a Nevada LLC. Bobby retains a one percent managing member interest and sells the remaining 99 percent of the LLC interests to a Newco. The sales price of the LLC interests are discounted 35 percent reflecting a valuation discount for lack of control (non-voting interests) and lack of marketability (closely held) from the current 409A price of the Founder's shares.

The sales price at $6.50 per share of 750,000 shares is $4.87 million. The down payment is $243,000.  Bobby gifts the down payment to his parents. The installment not provides for interest only payments at one percent per year with a balloon payment in Year 5. Bobby will most likely forgive the balance of the loan to the foreign corporation.

The sale LLC interests should are sold on an installment sale basis to a UK corporation. Newco is incorporated in the UK but has its management and control located in Malta. As a result, under the UK-Malta tax treaty, the company is a considered a Maltese tax resident. Under Maltese tax law, the taxpayer is only taxed on income remitted to Malta. Newco is not subject to taxation in the UK. Additionally, the company is exempted from the Indian Controlled Foreign Corporation rules.

Bobby's parents are the settlors of irrevocable trust in Jersey. They contribute the shares of the company to the trust. Under U.S. tax law, they will be considered the grantors of the trust for U.S. taxpayers. Hence, the trust will not be taxed on the sale of the Founder's shares for U.S tax purposes following the IPO and restriction period.  The trust will not be taxed on U.S. income unless it is effectively connected to a U.S. trade or business or fixed and determinable or periodic income (FADP). Additionally, Bobby's parents will be able to avoid current taxation for Indian tax purposes.

Following the sale of Founder's shares in the foreign trust, the trustee's appoint some of the trust assets to domestic irrevocable trust in a Nevada which has not no income taxation on trust income. Bobby's parents take distributions from the trust and make tax-free gifts to Bobby and his sister each year.

Summary

The foreign trust rules and income taxation of foreign trusts are extremely complex. The rules are designed to prevent the legal avoidance of U.S. income using foreign trusts. While the rules are complex, it is not impossible to achieve the objective. This is the first installment of several installments focusing on the foreign trust planning and taxation. The fact pattern above is not that rare and presents a planning opportunity for foreign-born scientists and engineers that find themselves in the fortuitous position of realizing their American Dream. Unfortunately, many may have missed the planning opportunity but better late than never.

Topics:  Foreign Trusts, Foreign Workers, Immigration Reform, Tax Planning

Published In: Finance & Banking Updates, Immigration Updates, Science, Computers & Technology Updates, Tax Updates, Wills, Trusts, & Estate Planning Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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