Beware of Withholding Tax Requirements on Proceeds of Real Property Sales
By Rosen, Charles*
How can relatively obscure provisions of the Internal Revenue Code and the California Revenue and Taxation Code dealing with sale of interests in real property by foreign nationals make it difficult or impossible for a receiver to liquidate real property owned by US citizens? Never underestimate the subtleties and potential ramifications of the tax codes.
The Internal Revenue Code and the California Revenue and Taxation Code require the withholding and payment to the taxing agencies of 10% and 3.5%, respectively, of the gross sales proceeds from a sale of an interest in real property unless the owner/seller of the property signs a form avowing that the seller is not a foreign national ( i.e. a non-resident individual, a foreign corporation, a foreign partnership, a foreign trust or a foreign estate). The purpose is to ensure collection of tax that may be due from a foreign seller who sells real property in the United States. [Certain exceptions to and reductions in the amount to be withheld based on tax treaties are set out in the table in IRS Publication 515.] See Internal Revenue Code ‘ 1445 (26 U.S.C. ‘ 1445) and California Revenue and Taxation Code ‘ 18662, and IRS Form 8288-B and FTB Form 597-W.
If these forms are not signed, the withheld amount must be paid by the buyer to the IRS and FTB as a credit toward potential income tax liability of the seller for the year of the sale. This withholding requirement can cripple a sale or prevent it from being completed where the seller won’t cooperate with the receiver. Even if the sale does go forward, the seller’s not signing will trigger the withholding requirements and can result in a windfall tax credit for the seller even if the seller is not a foreign national or entity.
For example, assume several individuals jointly purchased a commercial income-producing property for $100,000 many years ago, which is now worth $3 million. As the property appreciated new secondary loans secured by the property were taken out to improve the property, enhance its revenue stream, and generate cash for the owners. The joint owners are now at odds over whether to sell the property and, if sold, how the sales proceeds or profits are to be split. To resolve their irreconcilable conflict, the court appoints a receiver to take control of the property, manage it, and sell it (after noticed motion and approval of the court).
On the date of the receiver’s appointment there is $2.2 million in secured debt and unpaid property taxes encumbering the real property. The receiver has found a buyer for the property at $3 million and the court has authorized the sale. Through escrow the receiver will have to pay the $2.2 million of secured debt and property taxes, a broker’s commission, and additional costs of sale. If just one of the joint sellers refuses to sign the requisite IRS and FTB forms, the buyer of the property (and more likely the buyer’s title insurer) will require the escrow to withhold from the sale proceeds and pay over $300,000 to the IRS and $105,000 to the FTB. There will be insufficient net funds generated to pay the capital gains tax on a capital gain of $2.9 million (less the costs of sale) after $2.2 million is paid to the secured lenders and the property tax collector. Result: likely there is no sale.
So, if the $300K and
$105K are withheld and used to pay the cap gain tax,
what is the problem?
How can this dilemma be resolved?
The IRS is not so easily moved. The United States Attorney will not agree to a non-court stipulation, and the appointing court may not independently implement such an alternative. The Anti-Injunction Act contained in the Internal Revenue Code (26 U.S.C. ‘ 7421(a)) prohibits any court from enjoining the Federal government from assessment or collection of any tax.
But there is a judicial approach to avoid this problem. The buyer (or the title company for the buyer) may file a suit in interpleader in the United States District Court to achieve the same result. The receiver cannot be the plaintiff in the suit (since the receiver will be one of the defendant claimants to the money), but once the interpleader suit is filed a motion may be made to the court to have the receiver hold the funds in a separate interest-bearing account for later distribution.
An interpleader suit is filed under the Federal interpleader statute. (28 U.S.C. ‘ 1335.) While such a suit is sometimes filed in state court as part of a state court receivership, be prepared to have the suit removed to the United States District Court on request of the United States Attorney (a statutory right). Assistant U.S. Attorneys (AUSAs) will do this almost automatically because this is their known, comfortable home court. If at all possible, save time and expense and have the buyer initiate the interpleader action in the U.S. District Court.
In the first of my two recent encounters with this problem, the sellers were an estranged husband and wife who may or may not have held title to the property as partners. During the course of ownership they received funds from an out-of-state corporation which they secured by a grant deed to the property intended only as a security instrument. Thereafter the corporate beneficiary of the grant deed assigned its interest - as either a security interest or an outright transfer — to another out-of-state corporation. Complicating matters, the primary owner of both corporations was believed to be the same individual. While these corporations were U.S. entities, the owner of the corporations was not an American and it was not known whether he was subject to U.S. or state taxation.
problems requires creativity and flexibility.
The second matter was in U.S. District Court, where the receiver was appointed in a FTC enforcement action. The sellers, two of the targets of the FTC litigation, were a foreign-based trust and a foreign corporation, each of which was believed to be wholly owned by different American citizens residing in the U.S. In this case it appears the trust and corporation would have been subject to the required withholding for foreign sellers.
But if funds had been withheld and paid over to the taxing authorities, it was feared the withheld amounts would pass through the trust and the corporation as tax credits to the returns of the controlling individuals. The individuals might have claimed the sale income and the withholding credits to pay their personal income tax liabilities and pocket the difference (or otherwise have applied the tax credits to offset other taxes they might owe). This would have thwarted the intent of the FTC action, i.e. to recover as much money as possible for the individuals who had allegedly been fleeced by the defendants.
Here the possible solutions were less straightforward. The receiver was powerless to stop the funds from being withheld and paid over, but he was able to minimize the financial loss such a withholding might cause. It was recommended that the receiver obtain a district court order requiring the controlling individuals to prepare but not file their personal income tax returns and any U.S. returns required from the foreign trust and corporation. The returns were to be given to the receiver for filing, with any tax refunds to be deposited into the court’s registry pending the outcome of the litigation. An alternative suggestion was that the individuals be compelled to turn over to the court any refunds they received from any original tax returns where withholding tax from the sale was claimed, and that the individuals be barred from claiming such credits on other returns they might otherwise be legally able to adjust.
As can be seen, a receiver must be aware of problems that may be caused
by these mandatory tax withholding requirements for real property sales
and act creatively to preserve those withholdings for the benefit of the