Pre-Residency Tax Planning with the Check-and-Liquidate Strategy

by John Anthony Castro, J.D., LL.M.

Introduction

The “check-and-liquidate” strategy is a pre-residency tax planning strategy pioneered by our firm as a result of a court case titled Dover v. Commissioner.[1] You can read some background in this article, but we will still explain here.

Background

In the Dover case, a U.S. taxpayer owned a foreign corporation in the United Kingdom. The UK corporation had a subsidiary. The UK parent company was planning on selling the subsidiary. However, there was a problem. If they sold the stock of the UK subsidiary, the resulting capital gain would be considered Subpart F income subject to immediate U.S. taxation. On the other hand, if it were an asset sale, it would be considered ordinary income of the UK parent company and enjoy tax deferral unless and until there was a distribution to the U.S. owner. After consulting with international tax attorneys, the UK parent company simply filed a Form 8832 on which they elected to have their UK subsidiary treated as a disregarded entity for U.S. federal income tax purposes. The legal theory was that this would trigger a de facto liquidation of a corporate subsidiary, which is tax-free under Section 332.

The IRS didn’t buy it, and they challenged the legal theory in court. After realizing the law was against them, the IRS conceded that it was, in fact, an asset sale as a result of the entity classification election, which did, in fact, trigger a deemed corporate subsidiary liquidation under Section 332. The court also clarified that they agreed with the taxpayer’s position. This gave rise to international corporate transactions now known as “check-and-sell” transactions. You check the box on IRS Form 8832 to have the entity taxed as a disregarded entity for U.S. federal income tax purposes and then you sell; hence, check-and-sell.

In other words, the mere filing of a single one-page IRS form had substantial tax implications; it gave rise to the legal recognition of a de facto corporate subsidiary liquidation that was entitled to tax-free treatment under Section 332.

Now, knowing the power of an entity classification election, we apply this legal rule in the context of pre-residency tax planning.

It is no secret that the U.S. inherits the taxability of built-in gains in worldwide assets of all new U.S. tax residents. In other words, if you purchase stock of a company 50 years ago for $1, it increases in value to $100, you then move to the U.S. for the first time in your life and, after being in the U.S. as a mere visa holder for only one year, you sell the stock at $110, the U.S. will tax all historical gains even though all of those gains accrued prior to you ever establishing U.S. tax residency. This is understandably viewed as unfair since most countries would only tax the $10 of gain that accrued during periods of residency, but the U.S. is very tax aggressive and failure to report all gains is criminal tax evasion, so you never want to simply not report.

Check-and-Liquidate

The strategy requires a client to create the foreign equivalent of an LLC (i.e., flow-through tax treatment). The client funds the partnership with all of his assets that have built-in gains. The client then elects to have the entity taxed as a foreign corporation for U.S. federal income tax purposes. The client then liquidates the entity.

From the foreign perspective in the client’s home country, a partnership was created and then dissolved; no tax implications whatsoever. In fact, the most common result is the foreign tax advisors being perplexed as to why the client would do that.

From the U.S. perspective, however, there is substantial tax implications. Because the foreign entity was treated as a corporation for U.S. federal income tax purposes, the liquidation of the entity is treated as a corporation liquidation, which is a taxable event. Now, because the client has not yet acquired U.S. tax residency or is claiming nonresidency under an applicable income tax treaty’s residency tie-breaker provisions, there is no resulting U.S. tax. However, the U.S. still views it as a taxable corporate liquidation, which means the client receives all assets with an artificial step-up in basis to fair market value.

You first have to apply for a tax identification number for the foreign entity by filing IRS Form SS-4 to have the IRS recognize the foreign entity by default as a foreign corporation. Thereafter, you have two options. If you wish to maintain the entity, you check-the-box on IRS Form 8832 to have the entity treated as disregarded for U.S. federal income tax purposes, which triggers the de facto corporate liquidation. If you do not wish to maintain the entity, you would actually dissolve the foreign entity to trigger a corporate liquidation.

As a result, the client can now enter the U.S. and sell assets without fear that all historical gains will be exposed to U.S. tax. In other words, this strategy eliminates all built-in gains by artificially stepping up basis in worldwide assets to their current fair market value to eliminate exposure to U.S. tax on historical gains.

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[1] See Dover Corp. v. C.I.R., 122 T.C. 324 (2004).

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