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Common GILTI Compliance Errors

by

Frank J. Vari, JD, CPA, MTax

In our international tax practice, we both prepare and review a large number of Global Intangible Low-Taxed Income (“GILTI”) tax calculations and US corporate and individual tax returns related to same.  As is common with most new tax rules, especially those as complex and wide ranging as GILTI, practitioners and taxpayers stumble until they familiarize themselves with calculation and reporting requirements.  It is no different with GILTI and this article will help outline some of the more common errors we’ve come across.

GILTI Introduction

It is no longer news that the 2017 Tax Cuts and Jobs Act introduced a new anti-deferral tax on Controlled Foreign Corporations (“CFC”) known as GILTI.  Roughly modeled after the taxation of Subpart F income, a US shareholder of one or more CFCs must include GILTI as US taxable income, in addition to Subpart F and other anti-deferral type income, regardless of whether the US shareholder receives an actual distribution.

The GILTI calculation itself can certainly be complex especially where multiple CFCs are involved.  Quite basically, GILTI is the excess of a US shareholder’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property or Qualified Business Asset Investment (“QBAI”).  US corporate CFC shareholders are given a 50% deduction via IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

GILTI certainly aims for technology and pharmaceutical companies with significant overseas low-taxed income and, at least in theory, discourages them from mobilizing intellectual property to shift profits outside of the US.  The issue is that, as written, it really doesn’t just address income from identified intellectual property, at least not in a traditional sense, resulting in unintended consequences for corporate and noncorporate taxpayers with operations outside the US.  As such, a wide net has been cast and many taxpayers and practioners are working hard to properly address the GILTI rules.

Now that we’ve discussed the basic rules, what are the errors that we most often come across?  This is certainly not an exhaustive list and there is no particular ordering here.

No Individual Taxpayer Rate Reduction

As noted above, individual CFC shareholders are not eligible for either the aforementioned IRC §250 deduction or the use of IRC §902 foreign tax credits against their GILTI liability.  Both of these generous benefits are afforded to corporate shareholders.  Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions.  That’s a big deal to US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions.  As we’ve previously written, these issues can be addressed by proper planning but the law itself is rather unforgiving as it is currently written.

No High Taxed Exception

GILTI is somewhat similar to Subpart F as its anti-deferral brethren.  However, the commonalities do not include a high taxed exception which, as of now, only belongs to Subpart F.  This rule generally excludes from US taxable income any Subpart F income already taxed at a sufficiently high rate in foreign jurisdictions.  The kicker here is that it does not apply to GILTI that is already taxed at a high rate offshore and any related foreign tax credits are useless to individuals or corporate taxpayers in an excess foreign tax credit position.  Unintended application of the Subpart F high taxed exception to GILTI is an error until the GILTI proposed regulations containing a GILTI high taxed exception become law.

Consolidated Tax Groups

Consolidated returns for US multinational consolidated corporate tax groups are complicated enough without a GILTI calculation.  When one considers the typical reorganizations, mergers, and acquisitions that regularly occur for most consolidated taxpayers, one can easily see the room for error when the time comes for the GILTI calculation.  Some of the more common consolidated return errors are related to the following:

  • The allocation/sharing of tested losses by “loss CFCs” with “income CFCs” owned by other consolidated group members;
  • The allocation/sharing of the consolidated group’s GILTI attributes to its members;
  • Consolidated group member share basis adjustments (more on that here) via the offsetting of tested income and utilized tested losses; and
  • Nonrecognition transactions between related consolidated group members where “loss CFC stock” is transferred.

Due the inherent complexity here, more can certainly be written especially when one has to address the US tax reporting requirements.  This is certainly an area where experience with consolidated group reporting, international tax, and the GILTI rules is essential to get it right.

GILTI Basis Adjustments

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 any CFC that contributes 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.  We’ve written before about this but it remains a complex issue and common error.

State Taxation

This issue is a quagmire especially for multistate taxpayers.  We get many questions here and often have many of our own.  In many cases, GILTI represents the states’ first significant venture into the taxation of international income.  Most state tax systems were not created to accommodate international income and, as such, uncertainly abounds until state legislatures catch up with GILTI.  Often, GILTI is not given a preferential rate and some states will tax GILTI but fail to recognize Foreign Derived Intangible Income (“FDII”) as a proper offset.

For corporate consolidated taxpayers, the state GILTI calculation where the states do not recognize the full current US consolidate tax return regulations are particularly troublesome.  Corporate taxpayers must also be aware of states not recognizing the IRC §250 deduction.  This existing patchwork of state rules is made even more complex when one considers city and other local income taxes.

QBAI Calculation Errors

A CFC’s QBAI is properly calculated as the average of the aggregate of its quarterly adjusted bases in “specified tangible property” used in its trade or business.  It is not simply the year-end balance.  Furthermore, to calculate the proper asset basis for QBAI purposes, you must use an alternative depreciation system, i.e., the straight-line method.  These are both very common mistakes.

Another QBAI error is that specified tangible property, as defined here, means any property used in the production of tested income.  The upstart is that CFCs with tested losses may have a business asset investment but since they do not have tested income and they do not hold any specified tangible property they will not have any QBAI.  Please note that this exception does not apply to specified interest expense that still must be considered even if attached to a CFC with tested losses.  This is especially painful to our investment fund clients with CFC asset related debt and CFC GILTI tested losses.

No Tested Loss Carryforward Provision

The GILTI rules do not permit the IRC §172(a) Net Operating Loss (“NOL”) deduction.  This means that tested losses cannot be carried forward or backward to offset current year tested income.  If a CFC’s foreign taxing jurisdiction permits the carryforward of losses, the CFC’s local country taxable income may be significantly limited or be reduced to zero in the year when a local country NOL carryforward or carryback is used.  This would limit foreign income tax liability while a large balance of GILTI tested income, includible to a US shareholder, remains.  As a result, the amount of foreign tax credit available to offset the GILTI inclusion may be limited which raises the GILTI effective tax rate.

Consideration of Anti-Deferral Provisions

The rule is that a CFC’s gross tested income is its gross income determined without regard to:

  • Effectively connected income;
  • Subpart F income;
  • High-taxed Foreign base company income or insurance income which is taxed at a foreign effective tax rate greater than 90% of the US corporate tax rate;
  • Related party dividends; and
  • Foreign oil and gas extraction income.

The problem is that many taxpayers and practitioners fail to properly test for these items.  This can create a larger problem on audit where a taxpayer may assume that they have a GILTI inclusion that’s taxed at a reduced rate but they actually have a much higher taxed Subpart F inclusion.  The bottom line is that one must still test for all of these items as part of any tested income analysis before the IRS tests for it.

Conclusion

The GILTI rules are certainly complex, wide ranging, and continuing to evolve which creates a near perfect environment for calculation and compliance errors.  This article is by no means an exhaustive list of every potential GILTI error out these but just some of the most common we see.

If you would like our assistance or thoughts on any GILTI analysis, please visit our website at fjvtax.com or reach us by phone at 617-770-7286 or 800-685-2324.

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.

 

 

Why is Personal Goodwill Good for Closely Held Corporation Shareholders?

by

 

Frank J. Vari, JD, MTax, CPA

Personal Goodwill is a popular planning tool for sellers of closely held C Corporations.  This timely article explains this often misunderstood and improperly applied tax planning technique.

In our practice, we see a number of closely held C corporations with shareholders either actively looking to sell and/or examining the possibilities of selling their business.[1]  Many of these shareholders are actively engaged in these businesses and many have been so engaged for long periods of time.  These businesses include, but are not limited to, legal and CPA practices, insurance agencies, medical practices, and other similar entities where the shareholder’s relationships are integral to the business and customer relationships.

What we also see are a potential buyer’s general avoidance of closely held C corporation share purchases largely for tax reasons.[2]  The buyer’s primary tax reason is often goodwill.[3]  As an asset buyer, they will enjoy the tax amortizable goodwill generally resulting from an asset purchase.

For the seller, a C corporation share sale allows them to enjoy lower preferential capital gain tax rates.  On the other hand, an asset sale results in double taxation.  The asset sale proceeds are first taxed at the C corporation level and again at the individual shareholder level when the sale proceeds are distributed.  However, in practice, a C corporation share buyer can be difficult to find which forces sellers to look for ways to lower their tax bill.

For the C corporation shareholder facing a corporate asset sale and the selling shareholder has a strong relationship with his or her customers forming the basis of the business itself, attributing goodwill to the shareholder instead of the business may result in substantial tax savings to the seller.  In essence, the buyer is making two separate purchases.  First, the assets of the business are purchased from the C corporation and, second, the personal goodwill from the shareholder.

The concept that personal goodwill is a separate transferable asset in a corporate asset sale is not new or terribly unique.[4]  In general, to establish personal goodwill, one must support the premise that the goodwill’s value is attributable to the continued presence and/or abilities of a certain person and that this person is the legal owner of this goodwill and, as such, is the only person who can sell or transfer it.  The taxpayer must successfully demonstrate that the value of their personal relationships was far more valuable than the business entity itself without them.  If you envision a long time CPA practice with one primary member who built and sustained the practice you can see where this is quite often the case.

The primary issue with using personal goodwill as part of a business asset sale is that it relies almost exclusively on facts and circumstances.  This means that all relevant facts must be understood and addressed under the prism of tax case law and that the transaction must be supported by adequate supporting documentation in order to withstand audit.  Make no mistake, these transactions are quite frequently audited and the IRS is often successful when favorable facts, misapplied law, and adequate documentation are lacking.

As far as facts and circumstances, the IRS places the burden of proof on the taxpayer to demonstrate the valid separation of corporate goodwill from individual goodwill.  How, in general is this done?  In the seminal case of Martin Ice Cream v. Commissioner[5], the selling shareholder of an ice cream distributor successfully claimed that he had built his distribution business on the foundations of his personal relationships with supermarket owners and, further, that his relationships were still considerably valuable to the business at the time of sale.  One very key fact in Martin was that the selling shareholder had never transferred his personal goodwill to the corporation via an employment agreement or covenant not to compete.  That was, and is, a very significant fact (more about that later).  As a result, this personal goodwill was valued separately and was deemed to be sold separately for tax purposes.  Later cases continue to apply this same logic.

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As noted in Martin and related authority, the existence of an employment agreement or covenant not to compete agreement, or the lack therof, can significantly impact a personal goodwill analysis.[6]  These agreements can be fatal to a personal goodwill position especially where these contracts either restrict the seller’s activities outside of those benefiting the business and/or transferring their goodwill to the business itself.

In one landmark case[7], a dentist sold his C corporation practice that he had built and maintained for years.  He took the position that his personal goodwill was integral to the business and was his to sell separately to the buyer.  Points well taken, but the dentist had executed a covenant not to compete with his corporation where he was restricted from practicing with fifty miles of his corporate practice’s location.  In this case, the IRS was victorious by arguing that, by virtue of this agreement, his goodwill with his existing patients was almost nil as they would likely not travel over fifty miles to retain him as their dentist.  Even though the dentist, as sole shareholder, could have renounced this agreement prior to the sale he failed to do so.  The bottom line here is to understand all of the facts and especially any written agreements that could impact the value of personal goodwill and that a little upfront planning goes a long way.

What must a practitioner do to ensure the tax benefits of a personal goodwill sale are realized and will withstand IRS audit scrutiny?  Here are some hallmarks of a successful personal goodwill analysis:

  • Begin any personal goodwill analysis in advance of any sale discussion. This is easier said than done but trying to perform a thoughtful analysis during the timeline of negotiations is difficult and inherently dangerous particularly when the detailed analysis of historical data is required.
  • Thoroughly understand the history and the substance of the personal relationships involved in the business. Facts and circumstances are often unclear and documentation can be ambiguous.  It is absolutely essential that time and effort be taken to understand all of the facts and that they are appropriately documented.  You never want facts to come out during audit that you did not address and/or fully consider their impact.
  • Understand the authority around personal goodwill. This is especially true of authority that addresses your specific facts and circumstances that you are relying upon to support your personal goodwill position.  As with facts, you never want the IRS for any taxing authority to outline negative authority that you’ve not previously evaluated.
  • Discover and understand any existing legal agreements, written, oral, or otherwise that impact the position that the shareholder’s personal goodwill belongs exclusively to them and that this goodwill is a considerably valuable asset at the time of the sale. Is it possible that you need a lawyer’s opinion that the goodwill does not belong to the corporation and is exclusively the shareholder’s transferable legal property?    If you do, please proceed in that direction.
  • Have the buyer separately contract with the selling shareholder for the purchase of their personal goodwill. This contract should be as separate and distinct as possible from the corporate asset purchase and should recognize the personal goodwill as separate and distinct from any corporate goodwill.
  • Obtain a separate independent valuation of the seller’s personal goodwill. This valuation should be performed in accordance with Generally Accepted Valuation Principles and should properly measure both the value and ownership of the goodwill.
  • One should also consider performing an overall valuation of the entire business asset values including and excluding the selling shareholder’s personal goodwill. You may want to do this to ensure that the asset values support the economic value of the transaction.  For those that have performed IRC 1060 asset value allocations, one knows that although those allocations are binding on the taxpayers, they are not binding on the IRS per the longstanding Danielson[8]  This valuation can provide valuable substance to the transaction.
  • Analyze securing a covenant not to compete agreement with the buyer contemporaneous with the sale. Properly constructed, this helps support the position that the seller had a valuable asset that the business requires to maintain its value.
  • Raise the personal goodwill issue with the potential buyer early in the process. The buyer will likely need time to consider it with their advisors and its simply bad practice not to raise it if it will be the seller’s course of action.

Personal goodwill is a popular planning tool and is very effective at lowering a selling shareholder’s tax bill when the facts are right and the transaction is properly structured and supported.  Understanding these rules and practices will make sure your clients can enjoy this valuable tool with minimal risk.

[1] This may also apply to S corporation with earnings and profits or an S corporation subject to the built-in gains tax.

[2] There are also driving legal concerns particularly avoiding legacy legal issues around the selling corporation.  This is especially often true of smaller closely held corporations.

[3] Other tax reasons include a “stepped up” basis in depreciable assets and avoiding any undisclosed tax liabilities within the selling corporation.

[4] see Thompson v. Thompson , 576 So.2d 267 (Fla. 1991); Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998); Norwalk, TC Memo 1998-279.

[5] id.

[6] see Kennedy, T.C. Memo. 2010-206.

[7] Howard v. US, 106 AFTR2d 2010-5533 (DC WA, 2010).

[8] Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); see also Peco Foods, Inc., T.C. Memo. 2012-18.

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.