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The Foreign Earned Income Exclusion Dilemma

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Frank J. Vari, JD, MTax, CPA

Our practice deals with many expatriate US citizens of varying income levels working abroad as well as supporting CPAs and attorneys with their expatriate clients.  We find that many clients are directed by their advisers to take advantage of the US Foreign Earned Income Exclusion (“FEIE”) rather than the US Foreign Tax Credit (“FTC”).  The problem that we see is that those taking, or many giving, this advice do not understand how these different rules apply or even how they may interact to benefit the taxpayer.

Our advice to any expatriate taxpayer is that there is no one size fits all answer to which method works best.  A US citizen working and/or living abroad must pay US tax on their worldwide income so the question of what works best is very important.  Each methodology has some rather basic pros and cons that can help the taxpayer or their adviser pick what works best for that taxpayer.  Let’s take a basic overview of these rules to outline the issues and recommended approach.  This is not meant to be a technical dissertation of these rules but rather a practical approach.

The Foreign Earned Income Exclusion

The most popular method to address US expatriate taxation is the FEIE.  It’s relatively easy to apply and understand and most US tax preparation software can do the heavy lifting.  Those are all positives for the tax preparer or adviser but not always for the taxpayer.

The FEIE only applies to foreign earned income which is generally defined as salary and wages and related income.  The FIEI for 2018 is $104,100.  This means that this amount of foreign earned income may be excluded from US taxable income provided it otherwise qualifies.  It may not be excluded from local country taxation but the US will allow it to escape US taxation.

The FEIE does not apply to foreign source passive income like, for example, any interest, dividend, or investment income earned outside the US.  It also does not shelter foreign self-employment income from US self-employment taxes.  Thus, you can have income from self-employment earned outside the US that is excluded from US income tax that is still subject to US self-employment taxes.  Determining whether the self-employment tax applies is a separate analysis that depends upon whether the US has what is known as a Totalization Agreement with the country where the self-employment income is earned.

One final point to note regarding the foreign earned income exclusion is that once a taxpayer decides to take the exclusion, and then does not take it in a subsequent year, they are barred from taking it for the following 5 years.  The only way to reverse is IRS permission via a US tax ruling which can be complicated and costly to obtain.

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The Foreign Tax Credit

The US FTC is a tax credit that reduces or offsets a US taxpayer’s US income tax liability based on the foreign income taxes that have been paid during the relevant tax period.  It sounds simple enough but it can be complex in practice and, sometimes more importantly, most US tax software packages cannot handle the FTC or are unable to properly take into account the many variables impacting a properly prepared FTC calculation.  This leads many US tax preparers and advisers to avoid it even when it would provide a better result.

The purpose of the US FTC is to avoid double taxation on US taxpayers.  In general, if the taxpayer lives and pays taxes in a country where the income taxes are higher than the US the expected result of utilizing the FTC will usually be that the taxpayer owes zero income tax to the IRS.  If the foreign taxes paid are lower than the US tax rate, then there will likely be incremental US taxes due to meet the US tax expense.

If a US taxpayer has unused FTCs from prior years, they are automatically carried forward and can be utilized in future years where the taxpayer may not have paid sufficient foreign income tax credit to offset their US income tax owing.  This is a valuable tool for US expatriates moving between high tax and low tax jurisdictions.

It must be noted that foreign social security taxes cannot be used for the US FTC since only income taxes are creditable.  This is a common error that is made and it must be noted that if the IRS audits the related personal tax return, they will disallow from the FTC any foreign social security taxes or any other taxes for that matter that are not income taxes including sales taxes, VAT, etc.

Taking Both the FEIE and the FTC?

Most practitioners understand that a US taxpayer can either take the FEIE or the FTC on the same income but not both.  This rule is simple enough but it leads to much confusion.

For example, does this mean if the US taxpayer earns over $104,100 in foreign earned income in 2018 that they have to pick one regime over the other?  The answer is no.  The US taxpayer can actually use the FEIE for the foreign earned income up to the annual limitation and then use the FTC mechanism for the remainder.  This blended approach is often the approach for high income taxpayers.

The rules tell us these two regimes can be used in the same tax year but the same foreign income taxes excluded by the FEIE cannot be credited under the FTC.  In other words, if a certain amount of foreign earned income was excluded, and there is additional income to be taxed exceeding the FEIE, then the foreign taxes paid on the income that was already excluded cannot be used to offset US income taxes on the remaining income.

Why is this so complicated and misunderstood?  As noted above, the US FTC can be very complex.  Also, most US tax software packages are not able to handle this blended approach to foreign income taxation and the FTC calculation must be performed offline and typed into the return.

The Bottom Line

The proper taxation of a US taxpayer’s foreign earned income can be very complex especially when that income exceeds the FEIE.  However, as this article points out, there are still ways to reduce or entirely avoid US income taxes for these taxpayers.  The problem is that many practitioners are not familiar with these methods and most US tax preparation software packages do not help with a blended approach of the FEIE and FTC.  As such, practitioners and taxpayers must remain aware that this approach exists and it could save them a considerable amount of current and future US taxes.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

Beware of GILTI Basis Adjustments

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Frank J. Vari, JD, MTAx, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime.  What has not been widely publicized are the basis adjustment rules for consolidated groups.  This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena.  The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice.  They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group.  They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold.  The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter.  Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all.  The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction.  When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail.  As noted above, the basis adjustments relate to the use of tested losses by the group.  The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”.  The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock.  Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

  • the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
  • the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs.  In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2.  In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2.  The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss.  The result is a net used tested loss amount of $80 to CFC1 at the end of year two.  If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs.  In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC.  Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize.  The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex.  Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

Can a Partnership With Some Service Activities Claim Section 199A Benefits?

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Frank J. Vari, JD, MTax, CPA

We recently went on the Massachusetts Society of CPAs (“MSCPA”) tax practitioner website, aka the “HUB”, to answer a question regarding the ability of a partnership that has some service type activities to claim Section 199A benefits.   We do get a number of questions on this so we felt it would be great to share on our blog.

The basic question presented was whether a partnership that manufactures and sells goods but has some consulting or service type activities may claim Section 199A benefits?

This is a very good Section 199A question that, as noted above, we’re seeing quite a bit in our business practice.  It highlights the fact that Section 199A is actually a very complicated piece of legislation lacking solid administrative guidance and detailed understanding among many professionals.  Many clients have assumed they qualify for Section 199A benefits when they actually do not.

When Section 199A was enacted and reviewed by the tax community there were more questions than answers to many specific fact situations.  In particular, the statute itself left unclear to us the treatment of trades or businesses with both a Qualified Trade or Business (“QTB”) component which is benefit eligible and a Specified Service Trade or Business (“SSTB”) component which is not benefit eligible.

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Section 199A only applies to pass-through businesses.  C Corporations received their tax break separately by reduced tax rates.  The Proposed Regulations issued in August created the term “relevant pass-through entity” (“RPE”).  An RPE is generally a partnership, other than a Publicly Traded Partnership, or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust.  In most states, including Massachusetts, partnerships are mostly multi-member LLCs.

Section 199A defines a QTB rather simply as any trade or business except a SSTB or services performed as an employee.  A SSTB includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. For practitioners familiar with former Section 199 and the former Extraterritorial Income Exclusion (“EIE”) rules, one could foresee how services besides architecture and engineering were going to be excluded from benefits – and they were but in a complicated fashion.

The Proposed Regulations provide us with our only guidance on our issue of a partnership, i.e., an RPE, with both QBI and SSTB activities.  Prop. Reg. 1.199A-5(c)(1) provides a de minimis rule based on trade or business gross receipts and the percentage of gross receipts attributable to a SSTB under which a trade or business will not be considered a SSTB merely because it performs a small amount of services in a SSTB.  The Preamble to the Proposed Regulations explains that this rule was created because the Treasury Department and the IRS believe that requiring all taxpayers to evaluate and quantify any amount of specified service activity would create administrative complexity and undue burdens for both taxpayers and the IRS.  It is simply an administrative safe harbor.

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Under this rule, a trade or business, determined before application of the aggregation rules, which I’m not addressing here, would not be a SSTB if in a specific tax year it has: (1) gross receipts of $25 million or less, and (2) less than 10% of the gross receipts are attributable to the performance of services in a SSTB.  Take note that this includes the performance of activities incidental to the actual performance of services.  For a trade or business with gross receipts greater than $25 million, the trade or business qualifies for the de minimis rule if less than 5% of the gross receipts are attributable to the performance of services in a SSTB.

The bottom line is that if the SSTB activities rise above these safe harbor amounts within a single RPE, the entire trade or business is tainted and is considered to be a SSTB.  The law does not allow you to otherwise create allocations within a single RPE.  It is either a QBI or a SSTB depending upon the results of the test outlined above.

We are assisting many of our clients with both QBI and SSTB activities with restructuring options to qualify for Section 199A benefits.  However, any restructuring alternatives are fact dependent.  There is no one option that applies to all businesses but restructuring options do exist that allow many taxpayers to claim these important new benefits.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

Global Tax Authorities Are Sharing Information – What’s Happening and How to Be Ready

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Frank J. Vari, JD, MTax, CPA

It was not that long ago that a multinational taxpayer could report information differently to one taxing authority than to another even within the same country without significant concern.  How often did a value reported for customs and duties purposes match the transfer pricing value for income tax purposes?  Probably not very often and what difference did it make?  Back then, not very much difference.  Now, it makes a huge difference.

What’s Changed in Information Sharing? 

The road to where we are today has not been difficult to follow for those that have been actively involved in international tax for the last decade or so.  Global tax authorities have been becoming considerably more aggressive for years and that is not a trend that shows any signs at all of abating.  Tax authorities have long sought complete transparency in the taxpayer’s supply chain taxation both in the home country and elsewhere.  It makes their job much easier and it forces multinational taxpayers to full disclosure of their global tax positions.

There have been many governmental bodies actively pushing these efforts for some time now but the three biggest, at least to U.S. taxpayers, have been the Organization for Economic Cooperation and Development (“OECD”), the EU, and the IRS.  Our clients feel this most directly with their Base Erosion and Profit Shifting (“BEPS”) and Foreign Account Tax Compliance Act (“FATCA”) filing requirements.

For U.S. taxpayers, this means a sharing of not only information gleaned from their Form 1120, Forms 5471 and 5472, and customs and duty filings but also what they are reporting on similar non-U.S. filings.  When you add government filed transfer pricing filings to all of this you can see how quickly a very significant database of highly confidential and valuable business and financial information can be created and shared.

The Impact of Electronic Filing

Most multinational taxpayers are slowly becoming attuned to the fact that what they are reporting to one country has a significant impact in other countries as well.  What many are not sufficiently aware of is that their tax and financial information can now be quickly cross-referenced and shared among numerous governmental taxing authorities with the click of a button.

Electronic filings and sophisticated digital data collection methods allow tax authorities to reach deeper than they ever have before into the taxpayer’s supply chain data.  Multinational taxpayers must electronically submit a variety of data that goes beyond tax records in formats specified by different tax authorities often within the same country, e.g., customs, duties, income tax, and VAT.  All of these authorities now utilize sophisticated data analytics engines to discover filing discrepancies and compare data across jurisdictions and taxpayers.  These governments then issue tax and audit assessments based on these analyses.

It is essential that multinational taxpayers understand the shift from a single country filing view to a global filing view.  Tax filings simply have to be viewed as being globally transparent in terms of information sharing, comparative risks, and tax controversy strategy and resolution.  Very little if anything is hidden and not shared.

The drivers behind this are numerous.  Over 100 countries have signed onto the OECD’s Country-by-Country reporting initiative.  The OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) desires to update over 3,000 double tax treaties to incorporate BEPS changes.  It went into effect in July 2018 with 75 countries on board.  The MLI requires a principal purpose test for a multinational taxpayer’s tax positions and creates a simplified limitation of benefits provision to curb treaty abuse.  This means that tax treaty benefits will be denied when procuring a tax benefit was a principal purpose of a business arrangement.

The OECD is offering a new tool aimed at taxpayer certainly in this new environment.  The OECD created International Compliance Assurance Program (“ICAP”) is a voluntary pilot program where, in return for transparency of their tax risks, taxpayers receive some assurance that they will not be targeted by governments participating in the program.  In theory, a successful ICAP result provides multinational taxpayers more certainty and a reduced overall global tax risk profile.  It is a program with promise but it is being rolled out as a pilot program only in the face of an ever more aggressive tax environment that is not a pilot program.

Tax Adviser Rules

One very significant change impacting practitioners both in the U.S. and worldwide is the EU’s recent update of the Directive on Administrative Cooperation (“DAC”).  Under the new DAC rules, intermediaries such as tax advisers, accountants and lawyers that design, promote or implement tax planning strategies are required to report any potentially aggressive tax arrangements directly to the tax authorities.  Very concerning , mainly due to the broad scope of definitions provided in these rules, is that reportable arrangements may include arrangements that do not necessarily have a main benefit of obtaining a tax advantage.  These new mandatory disclosure rules will have material implications for both advisers and their clients.

According to the DAC, a “reportable cross-border arrangement” refers to any cross-border tax planning arrangement which bears one or more enumerated features listed in the DAC and concerns at least one EU Member State.  The enumerated features are broadly scoped and represent certain typical features of tax planning arrangements which, according to the DAC, indicate possible tax avoidance.  Certain transfer pricing arrangements must be reported even if they do not have a primary purpose or benefit of obtaining a tax advantage.  This include arrangements that involve hard-to-value intangibles or a cross-border transfer of functions, risks, or physical property.

Creating A Global Tax Risk Strategy

Multinational taxpayers that are relying on traditional global compliance practices and reporting models will ultimately lose control of their own tax narrative.  These antiquated – and now dangerous – practices feature single country income tax reporting that is not coordinated with operational tax reporting like excise taxes and customs reporting.

When one takes into account decentralized management teams, non-integrated mergers and acquisitions, and information systems that are not coordinated or unable to provide required information in a timely manner, one can see the true scale of the problem.  Tax risk must be managed on a global basis.  Local, or even regional, management is simply not sufficient.

As tax reporting becomes even more digitally interconnected, existing problems will only grow creating more economic and legal risks to international business strategies.  What we are now experiencing has been long perceived and is the future of tax and financial reporting.  There really is no getting around it.

 Practical Strategies

We are often asked by our clients how to best manage this new global environment.  We advise that multinational taxpayers strategically address these issues proactively on a global basis.  The risk of not doing so is to hand over important financial data to numerous tax authorities without a clear understanding of how they’ll use it or how it will impact the taxpayer’s core business strategies.

There are steps that can be taken to minimize the impact of these new rules.   in a consistent and strategic way will be better equipped to manage controversies as they arise. Specific steps businesses can take to adopt a more consistent global approach to tax controversy management include:

  • Centrally manage global tax filings to ensure consistency and understanding of what is being disclosed and where.  This involves enhanced communication and processes between global reporting teams that may not have existed before.  This is, in practice, a cultural shift in how global finance teams address tax matters.
  • Modify, update, or create information reporting systems that can timely comply with global reporting rules while still allowing time for appropriate tax leadership review prior to filing.  Never has the need for information systems to be responsive to tax needs been higher.  These systems must not only produce data but do so in a coordinated and strategic manner.
  • Design and implement a global policy relative to tax compliance, reporting, and response to tax authority inquiries.  This policy must not only be nimble but it must fully comply with increasingly complex local rules.
  • Involve senior management, Board leadership, and even internal audit teams to create a corporate governance plan that complies with SOX requirements but also allows swift communication of tax related risks to strategic business plans and financial reports.
  • As an adviser/intermediary or taxpayer, understand when a transaction qualifies as a “reportable cross-border arrangement” under the DAC.  Unless a legal professional privilege applies, disclosure is necessary.  If multiple advisers are involved, each adviser must comply with the reporting obligation unless a report was filed by another adviser.

Even the most sophisticated taxpayers are having trouble keeping up with these new rules and requirements.  It truly represents a cultural shift that has been long coming and shows no signs of abating.  Only by maintaining awareness of new global reporting rules and creating strategies and processes to ensure both conformance and strategic awareness can economic risks be minimized and global business strategies preserved.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

 

New Tax Benefits for Pass-Through Entities – What’s There to Know?

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By FJV Tax Staff

There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about.  That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.

This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate.  For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.

The motivation for the new deduction is rather simple.  It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform.  Income earned by a C corporation has always been subject to double taxation.  The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend.  Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%.  Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.

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In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level.  Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates.  Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.

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What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear.  As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS.  Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.  What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.

One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction.  Service businesses are the real problem.  Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”.  That definition cast a pretty wide shadow.

Proposed regulations have come to the rescue at least a little bit.  The proposed regulations clarified several questions related to specified service businesses.  First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above.  Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business.  These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.

Some of the most complicated areas are services related to health, consulting, and real estate businesses.  Here are examples of the application of Section 199A from each of these businesses:

Health and Health Care

A qualifying health care business means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.  It excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient.  An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.

Consulting

Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems.  However, these services do not disqualify larger businesses that only involve small levels of consulting.  Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product.  For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.

Real Estate

Brokerage services are specifically excluded from Section 199A benefits.  This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers.  The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.

As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships.  As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution.  Many questions still remain.

Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to.  To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.

Transfer Pricing for Small & Mid-Size Business – What is Important Now and Why

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Frank J. Vari, JD, MTax, CPA

One of the most common questions we at FJV receive from our small business clients is what is transfer pricing and why must we address it now?  Many clients – and some practitioners – seek an answer but are overwhelmed by the complex and conflicting information generally available.

If your company plans to expand business operations into the U.S. or expand their U.S. operations into another country at least a basic understanding of transfer pricing is required.  Once there is a basic understanding, one can better comply with the legally mandated transfer pricing rules and then create a strategic pricing plan.

To best explain, let’s discuss transfer pricing basics, pricing methods, and documentation requirements.

Transfer Pricing Basics

A “transfer price” is the price at which related companies located in different countries buy and sell goods and services to each other.  This is very important to each country’s taxing authority as each country wants to tax a share of these worldwide profits.  “Transfer pricing” is generally defined as the legal mechanism that allocates the profit from that related party sale between the competing tax jurisdictions without creating double taxation.  This mechanism, as outlined in a variety of laws around the world, allocates global supply chain profits based upon the functions and risks of the related parties.  The party which performs the most important and costly functions, e.g., design and manufacturing, and takes the greatest risk, e.g., capital investment and customer credit risks, is entitled to the greater profit.

For example, let’s assume a U.S. entity manufactures medical equipment and sells it to a related party located in Germany.  The German entity then resells the equipment to its customers within Germany.  The financial elements here are as follows:

  • The medical equipment is manufactured in the U.S. at a cost of $10,000.
  • The parent sells this equipment to its German relative for $17,000 realizing a taxable profit in the U.S. of $7,000.
  • The German entity then resells this same equipment to an unrelated German customer for $20,000 thus realizing a taxable German profit of $3,000.
  • The total taxable profit for the entire global supply chain is $10,000.

How can the U.S. entity justify receiving 70% of the taxable profits, while the German entity only 30%?  In our example, the U.S. entity has performed the costly research, design, and manufacturing functions for the medical equipment.  The German subsidiary is only involved in the local German marketing and distribution of the product which requires little capital or investment.  Thus, the U.S. entity has performed the greater functions and taken the greater risk which legally entitles them to the greater profit.

This profit split may be challenged by either the U.S. or German tax authorities using their own local transfer pricing laws.  However, almost every country, including the U.S. and Germany, requires that each related taxpayer perform and document a transfer pricing analysis of their taxable profit allocation with related parties.  No exceptions.

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Transfer Pricing Methods

The IRS first enacted rules back in 1928 to address intercompany profit allocations that have evolved into present-day IRC Code §482.  These rules actually empower the IRS to reallocate income or deductions between related parties to prevent tax evasion.  If the taxpayer doesn’t perform a properly documented allocation or get it right the IRS will do it for them.  Not a good place to be for sure.

IRC Code §482 requires taxpayers to create and document a transfer pricing policy that chooses the best method to justify the transfer price of goods and services.  The IRS allows various methods for various types of transactions.  Transfers of heavy equipment, software, and consulting services are all sufficiently different that different pricing methods are required.

One of the most common pricing methods – and the one most preferred by the IRS and other taxing authorities – is the Comparable Uncontrolled Price (“CUP”) methodology.  In our example, let’s assume our U.S. entity also sells the same type of medical equipment to unrelated Chinese and Australian customers for more than it sells to the German related party.  The IRS may – and probably will – argue that the U.S. entity is not charging Germany enough and a greater U.S. taxable profit should be reported.  Alternatively, if the U.S. entity sells the medical equipment to all three customers, both related an unrelated, for the same price it could justify the intercompany transfer price between the related U.S. and German entities as an “arm’s-length” price.

IRC Code §482 provides other methods besides the CUP to be used for transfer pricing of goods and services.  These methods include the Cost Plus method, the Resale Price method, the Comparable Profits method, and the Profit Split method.  Taxpayers can even use an unspecified method if they can support it.  Taxpayers must be careful to analyze each of those methods separately and select the “best method” for that particular transaction in order to comply with IRC Code §482.

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Documentation Requirements & Penalties

One very important and often overlooked rule is that taxpayers are required to prepare and maintain contemporaneous documentation that explains in a very detailed and technical manner their transfer pricing methodologies.  “Contemporaneous” means this documentation must be compiled at the same time their U.S. tax return is filed.  If the IRS requests this documentation, the taxpayer must produce it within 30 days of an IRS request.  If the taxpayer fails to do so, two very bad things can happen.  First, as noted above, the IRS will go ahead and allocate the related party profits as they see fit.  Second, the taxpayer will be subject to the documentation penalty provisions of IRC Code §6662.

If the IRS makes a transfer pricing adjustment resulting in an underpayment of tax and the documentation requirement was not met, IRC Code §6662 permits IRS to impose a 20% or 40% percent non-deductible penalty.  The 20% penalty applies if the transfer price adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.  If the transfer price adjustment exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts the IRS may impose a 40% penalty on the adjustment.

Besides proper transfer pricing documentation, U.S. taxpayers must comply with other important requirements including:

  • U.S. taxpayers who have related party transactions with their subsidiaries located outside of the U.S. must report these transactions on Form 5471.
  • U.S. taxpayers who have related party transactions with their foreign owners and their related parties must report these transactions on Form 5472.
  • If the related party sale involves a customs or duty filing, the price on the filing must be the same as that reported in the transfer pricing documentation and the Form 5471 or 5572. The failure to “harmonize” these filings can lead to additional penalties.

These are very harsh penalties that are often incurred by U.S. taxpayers who do not perform written transfer pricing studies to properly allocate or report related party profits.  The problem is there is really no way around them for small taxpayers.  Small taxpayers around the world have long called for exemptions from transfer pricing reporting but there is no significant relief to date.

Conclusion

Transfer pricing is a complicated issue that must be addressed proactively.  If properly addressed in a timely manner, transfer pricing can be addressed at a reasonable cost.  If not, the penalties kick in and the cost of these penalties coupled with the legal and professional fees of a transfer pricing conflict with any tax authority can be very high.

Our advice to any client with related party transactions that cross a foreign border is to proactively address their transfer pricing issues in a timely manner.  Whether they sell tangible property, services, or sell or license intangible property, our advice is the same.  At the end of the day, it saves our clients time and money and brings them fully into compliance with the law.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.