INTRODUCTION

When a U.S. person disposes of a business situated in a foreign country, the nature of the gain as capital or ordinary and the source of the gain may sound like simple issues that require simple tax advice. It may, however, turn out to be far more complex as one begins to review the relevant provisions of U.S. tax law in light of the facts and circumstances that exist. However, as a deep dive is made into the facts and the law, it is not uncommon for issues to pop up, one after the other and on a never-ending basis.

This article discusses the various U.S. Federal income tax issues that must be addressed by a U.S. seller in connection with a sale of a business as a going concern held indirectly through an entity that is treated as a disregarded entity for U.S. tax purposes. It does so in the context of a hospitality business.

FACTS

  1. A is a U.S. citizen who is a successful entrepreneur.
  2. He runs multiple grocery stores in the U.S. and is actively involved in the day-to- day management of the business.
  3. He also owns a luxury boutique hilltop resort in Valencia, Spain that offers accommodation, food, beverages, spa, and other luxury services to its clientele ("Resort V").
  4. A owns Resort V through a Spanish company ("S Co"). S Co is treated as a disregarded entity for U.S. tax purposes under the U.S. entity classification rules.
  5. Because of the disregarded status of S Co, Mr. A is deemed to directly own the individual assets of Resort V and the profits earned or losses incurred in the business of operating Resort V are regularly reported on Schedule C of Form 1040, S. Individual Income Tax Return, filed by Mr. A.
  6. Resort V has not yet reached the breakeven point. Mr. A's Form 1040 for Year 2020 reported accumulated losses from the business of $2 Million.
  7. A sells the shares of S Co to a foreign buyer in Year 2021 for $10 Million.
  8. Because S Co is treated as a disregarded entity for U.S. tax purposes, the sale of the shares of S Co is treated for U.S. tax purposes as if it were a direct sale by Mr. A of all the assets of Resort V.
  9. The business assets of Resort V include real property, tangible personal property, financial assets, and intangible property, whether or not reported on the balance sheet of the hotel business, such as self-generated goodwill.

POTENTIAL ISSUES

Mr. A would like to understand how gain from the sale of the shares of S Co should be treated for U.S. income tax purposes and how it will affect his U.S. income tax liability.

A careful analysis of the simple transaction entailing a sale of Resort V, effected by a sale of shares of a disregarded entity, will indicate an influx of several interesting tax issues that should be addressed to quantify Mr. A's U.S. income tax liability from the sale. The following issues that will be discussed in the article:

1. The manner in which the following tax items are determined:

  1. The character of the gain arising from the sale transaction, as either long-term capital gain or ordinary income,
  2. The manner of bifurcating the gain between those two categories,
  3. The tax rate applicable to each type of income category, and
  4. The source of the resulting long-term capital gain and ordinary income for purposes of applying the foreign tax credit provisions of U.S. tax law for income taxes paid to Spain in connection with the transaction.

2. The extent to which Mr. A may deduct the deferred losses from the Resort V business that have been reported on U.S. Federal income tax returns filed for each year in which Resort V was owned against the gain arising from the sale of the shares of S Co in view of the limitations imposed by the Passive Activity Loss rules under Code §469.

3. The extent to which Mr. A may deduct the deferred losses from the Resort V business that have been reported on U.S. Federal income tax returns filed for each year in which Resort V was owned against the gain arising from the sale of shares of S Co in view of the limitations imposed by the foreign tax credit rules under Code §904 and its regulations.

4. The extent to which U.S. Federal income tax may be reduced by the foreign tax credit for Spanish income taxes paid on the gain from the sale of shares of S Co.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.