wellesley

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

October 17, 2019 by Frank Vari, JD. MTax, CPA

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

Passive Foreign Investment Company (PFIC) is a term that many U.S. taxpayers and practitioners do not understand or recognize but it stands as one of the most significant risk exposures to any US taxpayers with foreign investments of any sort. Many U.S. taxpayers, primarily individual investors, and practitioners are too quick to conclude that they do not own a PFIC interest. In our experience, this is because they either don’t understand what a PFIC is or they are daunted by the complicated PFIC rules and reporting requirements. The common results on audit are unexpected severe tax consequences to unsuspecting and unprepared taxpayers. When one considers that a PFIC could be anything from a small interest in a foreign corporation to a Bitcoin investment it is easy to see how easy it is to come into contact with the complex and punitive PFIC rules. This article is intended to provide some basic guidance on the PFIC regime and to address some basic issues.

The PFIC rules were enacted in 1986 as a counterpart to the anti-deferral regime of Subpart F with an intended target of U.S. owners of foreign corporations with primarily passive income or assets. The PFIC rules, unlike the rules in Subpart F, aim to remove the economic benefit of deferral with respect to any and all U.S. PFIC investors and not just those with significant ownership interests. Extremely broad and complex, the PFIC rules discourage U.S. taxpayers from investing in PFICs assuming that they can identify whether their foreign investment is a PFIC in the first place.

The PFIC rules are primarily contained within IRC §§1291, 1297, 1298 and related authority. Primary technical guidance has historically been provided by IRS Notice 88-22 which continues to provide significant guidance to this day.

Generally defined, a PFIC is a foreign corporation that has, during the tax year, at least 75% passive income (“Income Test”) or at least 50% of assets that produce passive income (“Asset Test”). Passive income is any income that would be Foreign Personal Holding Company Income (“FPHCI”) as defined by the Subpart F provisions in IRC §954(c). Many conclude that unless the investment is considered a Controlled Foreign Corporation (“CFC) there is no PFIC exposure. This is an incorrect and false analysis that confuses PFIC with Subpart F. This is an especially dangerous conclusion when one recognizes that the PFIC rules don’t apply to a CFC after 1997 as part of the PFIC/CFC overlap rule of IRC §1297(d) exempting CFC shareholders from the PFIC regime.

Here for example, are common PFIC investments that we regularly see in our international tax practice. In any of these or similar situations PFIC testing is required:

Foreign Mutual Funds

The primary investments of a mutual fund are most often passive or generate passive income qualifying the mutual fund itself as a PFIC.

Foreign Holding Companies

Many foreign holding company investments by U.S. shareholders are tailored to avoid CFC rules due to passive share investments. However, there is often PFIC exposure which often goes untested. This is a very common PFIC scenario.

Foreign Hedge Funds

Like a mutual fund, a hedge fund is an entity often engaging in passive investment activity. We work with a number of foreign hedge funds and any U.S. investor in a foreign hedge fund has potential PFIC exposure.

Foreign Trusts

A foreign trust is most often a foreign entity consisting of passive investments generating passive income. We often see U.S. beneficiaries of foreign trusts, many of which are family trusts established many years ago, that qualify as PFICs and carry significant past tax liabilities with them.

Foreign Bank Accounts

A bank account might also be a PFIC if that account is a money market type investment rather than simply a deposit account as many money market investments are equivalent to fixed income mutual funds.

Foreign Pension Funds

PFIC rules can and do apply to passive investments held inside foreign pension funds unless those pension plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country.

Bitcoin / Cryptocurrency

If cryptocurrency is held in via a foreign fund or it is held via a foreign entity maybe a PFIC investment. The passive nature of these investments always require PFIC testing.

Learn More About Our International Tax Practice Here

As noted above, the PFIC regime is essentially an anti-deferral regime intended to remove any advantage of income deferral provided by a non-CFC offshore investment. PFIC taxation falls into three elective categories. First, income can be currently taxed as a Qualified Electing Fund (“QEF”) under IRC §1293 where a U.S. shareholder elects to have their PFIC income taxed annually. Second, the IRC §1291 “interest on deferral” regime allows annual U.S. taxes on PFIC income to be deferred but requires the U.S. shareholder to pay any tax plus interest on the deferred PFIC income when the shareholder ultimately receives their PFIC income via distribution or disposition. Third, there is the IRC §1296 mark-to-market regime where the shareholder recognize gains and losses from marketable stock on an annual basis. The most common taxing regime chosen is a QEF election if PFIC treatment cannot be avoided altogether.

One notable rule around PFICS is the “once a PFIC always a PFIC” rule. This rule states that if stock in a foreign investment meets the PFIC definition at any time during the shareholder’s holding period it continues to be treated as a PFIC forever even after it no longer meets the PFIC definition. This requires a lookback for many taxpayers to see if their investment has been tainted as a PFIC at some point in the past even if it clearly no longer qualifies as a PFIC today. This is not an uncommon event.

This article is not intended to be and should not be treated as a complete description of the PFIC testing and treatment rules. There is much more to this regime including complex Foreign Account Tax Compliance Act (FATCA) reporting rules which include filing Form 8621 for each PFIC investment.

The bottom line to any U.S. taxpayer or practitioner who believes that a foreign investment is or was a PFIC should immediately research or seek out an experienced international tax practitioner with PFIC experience to help them navigate and limit their PFIC tax exposure.

Please let us know how we can help you plan for your international investments. Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

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.

International Tax Planning Tools for US Individuals with Foreign Investments

February 4, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

There is no question that Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act (“Act”), changed the rules governing all US individuals and corporations with foreign businesses and investments. The Act was advertised to reduce taxes and compliance costs for both individuals and corporations and for most parties it has accomplished that goal. However, some of these new rules have had a decidedly negative impact on individual or non-corporate US shareholders of controlled foreign corporations (“CFC”) compared with corporate shareholders. Many non-corporate CFC shareholders actually face an expensive tax increase as well as increased compliance costs.

It is not clear whether the negative impact of these new rules was intended or simply the result of constructing very complicated tax legislation in a somewhat short time period. Whatever the cause, where care was taken in domestic legislation to place individual and corporate shareholders on a somewhat equal footing, e.g., new IRC §199A tax benefits offered along with reduced corporate tax rates, the same efforts were not made in the context of international shareholdings.

US individuals with foreign investments must immediately explore their international tax planning options to avoid these negative US income tax effects. We are actively engaged with a number of US based individuals on their individual international tax planning and we hope this article sheds some light on these important issues and related planning opportunities for you or your clients.

CFC Ownership

A CFC is generally defined as any foreign corporation where US persons own 50% or more (directly, indirectly, or constructively) of the foreign corporation’s stock (measured by vote or value) taking into account only those US persons who own at least 10% of the aforementioned stock. These shareholders are each referred to as a United States Shareholder (“USS”).

US individual ownership of CFC shares was always disadvantaged compared to corporate shareholders primarily due to the inability of individuals to use IRC §902 to credit indirect foreign taxes paid by the CFC. US individual shareholders can only use IRC §901 foreign tax credits which are basically limited to withholding taxes associated with the CFC dividend. Where the CFC’s local income taxes are high, the US individual shareholder’s effective tax rate on their CFC income is effectively equivalent to their US individual rate plus the CFC’s effective rate. It’s not uncommon for us to see an individual effective rate exceed 70% in these cases.

The benefit that US individual CFC shareholders did receive was deferral. In other words, unless an anti-deferral regime such as Subpart F was in play, the US individual did not have to recognize the CFC income until it was actually dispersed to them via dividend or otherwise. Further, if the CFC’s local income tax was a low amount, the increase in their overall effective tax rate for taxes not creditable under IRC §901 may have been worth it if deferral had true economic value to them.

Tax Reform Changes

The aforementioned CFC tax regime has significantly changed under the Act. Here are the major changes affecting individuals:

No Transition Tax Relief

IRC §965 requires the inclusion in income for all CFC shareholders of the CFC’s previously untaxed earnings and profits (“E&P”). The Act offered corporate CFC shareholders a reduced transition tax rate to cushion the blow of this unanticipated income inclusion but no such rate forbearance was offered to individual CFC shareholders. They took their inclusion at their regular individual tax rates.

No Participation Exemption

IRC §245A provides a full participation exemption, also referred to as dividends received deduction (“DRD”), for certain dividends received by a US C corporation from a CFC. However, US individuals who own CFC shares are not eligible for this participation exemption. CFC dividends received by individuals remain taxable either as qualified or non-qualified dividends at higher individual rates.

No GILTI Tax Reduction

The Act added IRC §951A which requires a USS to include in their US taxable income their pro-rata share of the CFC’s Global Intangible Low-Taxed Income (“GILTI”) which is treated, basically, as Subpart F income.

The GILTI calculation is complex by any measure. Quite basically, GILTI is the excess of a USS’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. US corporate CFC shareholders are given a 50% deduction via newly enacted 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.

Individual shareholders of CFCs are not eligible for either of these benefits afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions without any foreign tax credit offsets. It is certainly a bitter pill for 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.

The following example illustrates the disparate impact of the GILTI regime on an individual CFC shareholder who is also a USS. Assume a CFC operates an active services business in a jurisdiction that imposes a 30% income tax rate. The CFC has no tangible depreciable assets and generates $100 of net taxable income annually that is not otherwise classified as Subpart F income. The following graphic compares the tax consequences to a US corporate shareholder to those of an US individual shareholder:

	C Corporation USS of a CFC	Individual USS of a CFC
GILTI inclusion (IRC §951A)	$100	$100
50% Deduction (IRC §250)	$50	N/A
US Taxable Income	$50	$100
Foreign Income Tax (30%)	$30	$30
US Pre-Credit Tax	$10.5 (21% x $50)	$25.9 (37% x $70)
US Foreign Tax Credit	$24 IRC §960(d) 80% FTC limit	$0 No IRC §902 Credits
US Tax Liability	$0	$25.9
GILTI Effective Tax Rate	30% No GILTI FTC Carryforward	55.9%

Corporate CFC shareholders who utilize foreign tax credits to offset their GILTI tax expense are not only limited by the 80% IRC §960(d) limitation but also the inability to carryforward or carryback GILTI basket foreign tax credits. However, the IRC §78 gross-up still applies to 100% of the foreign tax expense. Even with these limitations, corporate shareholders get a much better deal than individual shareholders under the GILTI rules as a whole.

No FDII Benefits

The Act introduced, via IRC §250(a), the Foreign Derived Intangible Income (“FDII”) regime which provides C corporations with export sales important new tax benefits. These export benefits provide a reduced US tax rate on income attributable to intangible assets owned within the US in a similar manner to how the GILTI rules create income inclusions for the same activities conducted offshore. For a detailed description of the FDII rules, please see this recent article we authored on this topic.

The FDII rules were theoretically intended to provide tax benefits to offset the impact of GILTI inclusions. The result is a new benefit to US C corporations for using US based intangible property that they’ve owned all along. Even better, they don’t have to patent, copyright, or even identify the intangible property as the benefit is derived from a deemed return on assets calculation. It’s all good but it does not apply to individuals, S Corps, or partnerships. As a result, individuals take a harder hit from the GILTI rules with no corresponding relief from the FDII regime.

Learn More About Our International Tax Practice By Clicking Here

Planning Options

For a US individual with existing or planned CFC ownership, there are various options available to mitigate some of these new provisions but each involves different steps with different side effects. We continue to see new options arise depending on the facts and circumstances of each particular taxpayer but here are some of the most common planning options we’ve been using thus far:

Contribute CFC Shares to a C Corporation

The logic here is easy enough to understand. Once the CFC shares are held by the C corporation, the corporation can utilize IRC §902 credits for taxes paid by the CFC, use offsets to the GILTI provisions provided under IRC §250 and elsewhere, and utilize the FDII regime. However, double taxation still occurs to the individual shareholder and there can be considerable complexity and costs in restructuring the CFC’s ownership chain.

Making an Annual IRC §962 Election

An IRC §962 election is a rarely utilized election employed to ensure that an individual taxpayer is not subject to a higher rate of tax on the earnings of a foreign corporation than if he or she had owned it through a US C corporation. This is an annual election with respect to all CFCs for which the individual is a USS including those owned through a pass-through entity.

The primary benefits of this election are that it provides a 21% corporate tax rate on any GILTI or Subpart F inclusion as well as allowing the use of IRC §902 credits. The individual taxpayer also does not have to endure the administrative burden of actually creating a C corporation holding structure for the CFC(s). However, in addition to having to make an annual election, the election does not allow the taxpayer to take the GILTI IRC §250 deduction or utilize the FDII export incentive regime.

Check-The-Box / Disregarded Entity Election

The taxpayer may also solve many of the problems created by the Act by using the now commonly exercised tool of a CFC check-the-box or disregarded entity election. This changes the CFC into a disregarded entity or foreign branch for US tax purposes while leaving it unchanged for local country purposes.

This has long been an instrument for individuals invested either directly or indirectly, via S corporations or partnerships, in a CFC. The primary benefits have been to allow individuals to benefit foreign tax losses in the US and to convert IRC §902 taxes into creditable IRC §901 taxes thus significantly reducing their individual tax burden on foreign earnings. Now, however, a disregarded entity election also allows the US individual shareholder to escape both GILTI and Subpart F inclusions

Prior to the Act, the main downside of a disregarded entity election by an individual was that it eliminated foreign deferral via the CFC. The conversion of a CFC to a disregarded entity could also be very expensive due to rules around CFC conversion. Most of the expense and complexity are due to a disregarded entity election being treated the same as a CFC liquidation.

US individuals may not use IRC §332 to effectuate a tax-free CFC liquidation. Instead, they must rely on IRC §331 where a liquidating distribution is considered to be full payment in exchange for the shareholder’s stock rather than a deemed dividend distribution. These shareholders generally recognize gain or loss in an amount equal to the difference between the fair market value (“FMV”) of the assets received, whether they are cash, other property, or both, and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholder’s hands, the transaction qualifies for capital gain or loss treatment. The detailed tax effects of an IRC §331 CFC liquidation are outside the scope of this document but they are important and must be addressed thoroughly as part of any related analysis.

For a corporate USS, IRC §332 will generally apply to provide tax-free treatment but IRC §367(b) steps in and requires that the liquidating corporate USS include, as a deemed dividend, the CFC’s “all earnings and profits” amount (“All E&P Amount”) with respect to the CFC. The All E&P Amount generally is the corporate USS’s pro rata share of the CFC’s E&P accumulated during the USS’s holding period.

What’s important to note here is that the corporate USS’s All E&P Amount is reduced by E&P attributable to previously taxed income (“PTI”). The CFC’s E&P subject to the IRC §965 transition tax distribution, which is likely now in the past, becomes PTI. A corporate USS’s PTI amount resulting from the transition tax will likely equal the shareholder’s All E&P Amount and therefore reduce the required All E&P Amount inclusion to $0. If the All E&P Amount is $0, the disregarded entity election will not trigger any incremental US income tax to the electing corporate shareholder.

Here, we may actually have an instance where the IRC §965 transition tax, likely already incurred by the corporate shareholder, will serve to greatly reduce the cost of a disregarded entity election by making the deemed liquidation much less expensive. It’s an unusual situation for sure but one that allows a low-tax way for corporate USS’s to escape GILTI and Subpart F inclusions.

Here again we have another distinct advantage provided to corporate CFC shareholders but not individuals.

Here is a basic example of how CFC earnings are taxed to corporate, individual, and individual assuming the CFC is now treated as a disregarded entity:

	C Corporation USS of a CFC	Individual USS of a CFC	Individual Shareholder of a Disregarded Entity
Foreign Entity Income	$100 Dividend	$100 Dividend	$100 Pass-Through Earnings
Foreign Income Tax (assumed 30%)	$30	$30	$30
US Pre-Credit Tax	$21 (21% x $100)	$25.9 (37% x $70)	$37 (37% x $100)
US Foreign Tax Credit	$30	$0 No IRC §902 Credits	$30
US Tax Liability	$0	$25.9	$7
Effective Tax Rate	30% Possible FTC Carryforward	55.9%	37%
Tax on $70 Corporate Dividend to Individual Shareholder	$16.7 (23.8% x $70)	$0	$0
Post- Distribution Effective Tax Rate	46.7%	55.9%	37%

Conclusion

The US tax reform rules are certainly not advantaged to individuals as originally enacted. There is certainly the possibility that the Act will be amended to balance the negative effect on individual CFC shareholders but there is no guarantee. In the interim, there are some planning tools that the taxpayer can utilize to offset the negative impact of these new rules. This is not and is not intended to be an exhaustive list of each planning opportunity that we see or that we will see. What each shareholder should do depends upon a detailed analysis of the taxpayer’s unique facts coupled with sophisticated modeling to confirm the planning benefits. Anything short of that is likely to fail in some regard.

We’ve authored other articles on GILTI that you may find helpful by clicking here.

Please let us know how we can help you plan for your international investments. Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

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

October 22, 2018 by Frank Vari, JD. MTax, CPA

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.

Learn More about FJV’s Transfer Pricing Practice by Clicking Here

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.

Learn More About FJV’s International Tax Practice By Clicking Here

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.

Why is Personal Goodwill Good for Closely Held Corporation Shareholders?

September 17, 2018 by Frank Vari, JD. MTax, CPA

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.

Learn More About FJV’s Corporate Tax Practice by Clicking Here

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.

Maximizing IC-DISC Benefits After Tax Reform

July 9, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Those that have followed the journey of the Interest Charge Domestic International Sales Corporation (IC-DISC) through the winding legislative process behind the Tax Cuts and Jobs Act of 2017 (TCJA) know by now that it has survived intact. Those that have followed these export tax benefits from the 1970’s DISC, whose enactment was somewhat contemporaneous with the unrelated peak of disco music, to FSC to EIE and now back to IC-DISC know that it has really been quite a legislative and judicial journey for these important export tax benefits. Now that we can be sure that IC-DISC benefits have survived, where exactly do we stand post-tax reform and what can we do to maximize IC-DISC benefits?

IC-DISC one of the last remaining export incentives provided to U.S. based taxpayers. It’s been an important part of tax planning for closely held companies since the Jobs and Growth Tax Relief Reconciliation Act of 2003 cemented into law reduced capital gains tax rates making IC-DISC a profitable tax strategy. As an added bonus, it is not currently on the World Trade Organization’s radar unlike some other current U.S tax incentives, i.e., the Foreign Derived Intangible Income (FDII) regime, so IC-DISC beneficiaries can rest assured that they are playing nice with our trade partners which is comforting. Also, don’t forget that IC-DISC is probably the last remaining tax planning technique where the IRS is willing to look past substance over form, at least a little bit – more on that later, which is not something seen too often.

Everyone probably knows the bad news by now that the reduction in U.S. individual tax rates has also reduced the IC-DISC benefits. To corporate shareholders, it still provides a hefty 13.2% tax rate benefit to individuals which is only a slight reduction from the pre-TCJA rate of 15.8%. The difference is the 2.6% top individual tax rate drop from 39.6% to 37%. If the business is a pass-through, and assuming newly enacted §199A is available to the taxpayer, it still provides a 6% rate benefit. Thus, even post TCJA, IC-DISC remains an important planning tool for businesses of all types.

What many taxpayers are missing is that there are planning tools out there that can make IC-DISC an even better tax planning vehicle without increasing shareholder risk. Some are more complex than others but here are some that we’re using with our IC-DISC clients:

Ensuring IC-DISC Compliance

If an IC-DISC is not properly qualified there are no benefits and there are likely penalties. This is pretty simple to understand but it is very often a problem. IC-DISC is an attractive planning tool but it is often adopted by taxpayers who don’t want to deal with the complexities of IC-DISC qualification or by an inexperienced practitioner who fails to properly implement or advise their client on the importance of these rules. I have been part of many acquisitions of middle market companies where the seller’s IC-DISC was determined to be defective during due diligence as a result of taxpayer error. Similarly, the IRS understands this very well and disqualifies many IC-DISC benefits on this basis. It is never good when an IC-DISC fails this way but in practice many do. Please don’t be the advisor that has to tell your client their IC-DISC has been disqualified.

Utilize IRC §482 Transfer Pricing

IC-DISC is one of the few areas where the IRS cannot force a taxpayer to use IRC §482 arm’s length principles to determine the profit allocation between related parties. However, IRC §482 is best used here proactively by the taxpayer. Most IC-DISC taxpayers that I work with use the 4% of export gross receipts methodology. For many taxpayers that’s a mistake. Most often, their IC-DISC advisor doesn’t fully understand how IRC §482 works and is unable to even model what the answer would be so the taxpayer doesn’t get to see what the options truly are. By addressing the IRC §482 options, or consulting with an IRC §482 expert, an IC-DISC may see greatly enhanced profits. It is certainly fact dependent, but I’ve seen it deliver enough benefits that is part of every IC-DISC analysis we perform.

Grouping Transactions vs. Transaction by Transaction (TxT)

For those of us that practiced in the FSC days, TxT was one of the most popular tax planning tools out there and was used by FSCs with literally millions of individual transactions. We all know that FSC is long gone but the TxT method is alive and well but is a little of a lost art since the very large companies had to stop doing it. Most of the IC-DISCs out there utilize grouping(s) of transactions. Grouping is a proper methodology and it can be the best and is certainly the easiest to apply. However, like transfer pricing above, TxT often produces significantly better benefits. It requires that each individual transaction be treated separately which is beyond the capabilities of many IC-DISC practitioners. At a minimum, grouping vs. TxT must be modeled to ensure that the taxpayer is obtaining, or maintaining, maximum benefits.

Appropriate Expense Allocations

In order to properly determine the profitability of foreign sales, the taxpayer must utilize the principles of IRC Treas. Reg. §1.861-8 and its relations. These rules can certainly be complex and they are not often applied properly. For example, many U.S. based exporters spend large amounts on things like interest and selling expenses which are, in practice, mostly directed toward U.S. activities. By improperly overallocating these expenses to foreign sales they are artificially dampening IC-DISC profits. The IRC §861 expense allocation rules are not optional and it is imperative that the practitioner fully understand them.

IC-DISC for the Foreign Owned U.S. Company

There are many closely held U.S. companies with foreign shareholders that export. Please keep in mind here that sales to Canada and Mexico are also exports. Many of these corporations do not utilize IC-DISC but many should. Especially those that reside in treaty countries with low dividend tax withholding rates. This can be difficult because to properly model the results you need to understand the shareholder’s resident country tax laws as well as the shareholder’s tax posture. That said, I’ve seen this benefit work for foreign shareholders often enough that I always consider it when I see these facts.

Utilizing a Roth IRA

This has been a somewhat popular planning tool utilizing a Roth IRA to avoid annual contribution limits. The Roth IRA value grows while the IC-DISC profits are not taxed. Simple enough but it is not a risk free strategy. The IRS feels that this is a violation of substance over form and argued that, albeit unsuccessfully, in Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17). My view is that the IRS argued this case wrong but that’s another article. If you live in the 6^th Circuit, good for you. The primary risks here are that the IRS does not like this and Summa Holdings predated the enactment of IRS §7701(o) which codified the economic substance doctrine. Until the IRS makes another run at this you certainly have substantial authority for this position where it makes sense.

IC-DISC as Non-Qualified Executive Retirement Tool

You don’t see this one too often but it makes sense. I advised with a practitioner whose client was retiring along with a sibling from a leadership position in a successful family business. IC-DISC itself made sense as a planning tool but it also played a neat part in the transition of the business by placing the IC-DISC ownership in the hands of the retiring executives. Keep in mind that the IC-DISC does not have to be held by the same shareholders as the related supplier. This planning, in essence, permits the related supplier a full tax deduction and the retired executives enjoy reduced qualified dividend tax rates.

Summary

The bottom line here is that IC-DISC remains alive and well for the foreseeable future courtesy of the TCJA. Thus, it is time to start considering using IC-DISC again and, more importantly, maximizing IC-DISC benefits with proven and reliable strategies. We help our IC-DISC clients on these and other tax planning issues. Let us help you or your clients.

To learn more about FJV’s IC-DISC or transfer pricing practices and our considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.

Foreign Asset Tax Compliance and Why It Is Important Right Now

June 29, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

International tax can be a very complex subject but most associate both the topic and the complexity with multinational businesses. That may be true, but the greatest risk if often borne by individuals who do not properly understand their U.S. reporting obligations for foreign income, assets, and investments. With the U.S. Internal Revenue Service (IRS) recently declaring that the IRS Offshore Voluntary Disclosure Program (OVDP), which was started in 2009, will close for good on September 28, 2018, taxpayers with unreported foreign assets should immediately determine if ODVP would benefit them before it is gone for good. At this same time, the IRS has noted that their enhanced enforcement efforts against unreported foreign assets will not end. Thus, the time is now for taxpayers with unreported foreign assets to formulate a plan for compliance or risk what have been, in certain cases, draconian penalties.

Many individual taxpayers, including those from outside the U.S. who are not educated in U.S. tax reporting rules, own assets located in different countries. Some of these assets are as benign as a bank account they hold with an elderly relative to those with a Swiss bank account fully intended for shelter from the U.S. tax and legal system. In practice, most all of these cases lean toward the former, however, they all are covered by pretty much the same rules.

This article is intended to provide a quick overview of the issue and the avenues available to taxpayers to maintain or obtain compliance with the rules.

Reporting Basics

It is probably not news to any practitioner that a U.S. taxpayer has to report all of their income on a global basis. It is also probably not news that many individual clients do not fully disclose, or fully understand the law to disclose, each and every non-U.S. income stream. That, at a minimum, must be done even if it takes some digging to gather all of the appropriate information.

Reporting assets located outside the U.S. is a bit more tricky. Not only from an asset identification perspective but from a where and how to report perspective. For example, a U.S. taxpayer may have a small longtime family home somewhere in Europe that they occasionally rent to friends. It’s simple enough to understand that the income must be reported on Schedule E, but what about the real estate itself? More on that later but you see the issue.

Foreign Bank Account Reporting (FBAR)

U.S. residents or citizens must report a financial interest in, or signature or other authority over, specified bank and other accounts in a foreign country on Financial Crimes Enforcement Network (FinCEN) Form 114 (the successor to the beloved Form TD 90-22.1), i.e., FBAR, if the accounts aggregate maximum values exceed $10,000 at any time during a calendar year. Please note the “aggregate” and “at any time” language.

FBAR requirements apply to individuals, corporations, partnerships, trusts, estates, and LLCs as well as entities disregarded for tax purposes. The regulations under Sec. 6038D require that a specified person look through a disregarded entity for reporting foreign assets on Form 8938 (discussed below). However, the FBAR requirements impose a separate, independent reporting obligation on such entities.

There are plenty of traps for the unwary here. The most simple may be a U.S. taxpayer who has signatory authority to co-sign with an elderly relative located outside the U.S. More difficult to identify is the reporting obligation of a U.S. corporate executive who has signatory authority, likely along with many others, over a long dormant overseas corporate bank account or accounts exceeding $10,000 at some point during a calendar year. It is a very common situation that is difficult to identify and, hence, ensure compliance. Add fiscal years and foreign currency translation to the equation and you see where the simple becomes difficult even for sophisticated taxpayers.

Form 8938

Specified U.S. individuals with foreign financial assets may need to file Form 8938, also known as the Statement of Specified Foreign Financial Assets as part of their annual income tax return. A “specified individual” is a U.S. citizen, a resident alien of the U.S., or anon-resident alien filing a joint U.S. income tax return.

The “financial assets” which must be reported includes foreign bank accounts, assets held for investment by a foreign institution, foreign retirement plans, and jointly owned foreign financial assets. It is not uncommon for a business executive who has moved to the U.S. to have an interest in a foreign pension plan from a former employer. Items like this must be considered.

The Form 8938 reporting thresholds range from $50,000 of foreign financial assets on the last day of the year or $75,000 at any time during the year for unmarried U.S. individuals to $400,000 on the last day of the year and $600,000 at any time during the year for married joint filers living abroad. Be sure to reference the detailed Form 8938 reporting requirements once the assets themselves are identified.

Besides the individual nature of Form 8938, it is important to note one critical difference between Form 8938 reporting and FBAR. Form 8938 does not require reporting of financial accounts held in foreign branches or held in foreign affiliates of a U.S.-based financial institution. However, such accounts are considered financial accounts for purposes of FBAR reporting because they are located in a foreign country.

Other Common Reporting Forms

The FBAR and Form 8938 are the most widely used foreign asset reporting forms but not the only ones. There are a number of others that capture different kinds of foreign asset activity. These are:

Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, for reporting transfers of property to foreign corporations;
Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts;
Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, for reporting affiliations with foreign trusts or the receipt of gifts from non-U.S. persons;
Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations;
Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for reporting interests in foreign controlled corporations and reporting transactions with foreign corporations; and
Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, for reporting interests in foreign partnerships.

Each of these forms captures different types of investments and may apply to both individuals and businesses in different forms.

Penalties

The IRS has identified unreported foreign assets as a key element of U.S. tax evasion. So too have foreign tax authorities. As such, the IRS has enacted significant penalties which, coupled with aggressive enforcement, creates a perilous environment for individuals and entities who fail to accurately file these forms. The penalties are very severe, especially considering the fact that the IRS has not made it easy for those with foreign assets to clearly understand what must be reported and how.

The penalties can be very high and reach upwards of $10,000 per form per year. If the IRS establishes that the taxpayer willfully decided not to file the form, their can be criminal penalties as well as civil penalties reaching upwards of millions of dollars depending on the value of the overseas assets.

For practitioners who know, or reasonably should know, of these unreported or underreported foreign assets, Circular 230 still stands to require disclosure with its penalty provisions.

Resolution Options

Once the issue is identified, the appropriate course of action must be determined. If the IRS has identified the issue first or the taxpayer has engaged in willful failure to report, the only option is constructing a legal defense. Those that have experienced this know it to be a potentially very costly experience and more so if criminal penalties are involved.

The most reasonable option to those who otherwise have unreported foreign assets is the OVDP program. Taxpayers who voluntarily come forward and provide the IRS with the nature and extent of their undisclosed foreign assets and income are given assurances that the IRS would recommend against criminal prosecution of these taxpayers. In addition, taxpayers are required to pay all outstanding taxes, interest, and a 20% penalty on the amount of previously unpaid taxes for up to 8 years of noncompliance. Other various penalties apply depending on the form and the facts and circumstances of the case.

These OVDP penalties, while still sometimes steep, pale in comparison with potential penalties if the taxpayers do not enter into the OVDP and are identified by the IRS. In addition to potential criminal sanctions, taxpayers could pay up to a 75% fraud penalty for any previously undisclosed income and the greater of $100,000 or up to 100% of the entire foreign bank account balance for each year of willful noncompliance with FBAR requirements.

It is important to note that the OVPD is not the only option available as the Streamlined Procedures Program still exists. The appropriate option for the taxpayer depends again on the facts and circumstances.

What to do Now

As noted above, the IRS fully intends to continue increasing the number of criminal prosecutions of taxpayers involved in failing to report overseas assets. Additional disclosure methods continue arising and include foreign banks, e.g., UBS, continuing to enter into non-prosecution agreements with the U.S. Department of Justice. Additional tools ranging from international tax information sharing agreements to data mining will continue to aggressively identify non-complaint taxpayers.

It is very important for taxpayers who believe they may have issue to immediately determine a plan of compliance and if OVDP is their best option. Failure to fully evaluate their options before OVDP expires this fall could be very costly.

To learn more about FJV’s foreign tax compliance and tax audit and controversy practices which have considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.

This article was previously published by the Massachusetts Society of Certified Public Accountants (MSCPA).