The Journal Winter 2014-2015 Tax Issue
By Alexander D. Fishbane, JD, LLM
To ensure optimal tax savings, businesses and individuals must be aware of the numerous tax incentives provided by the federal, state and local governments in which they operate. Below are a few incentive options that can keep money in your pocket.
IC-DISC
Every US exporter should consider the benefits offered by an interest charge domestic international sales corporation (IC-DISC). An IC-DISC is a tax-exempt domestic corporation that exports products manufactured, grown or extracted in the U.S., or collects commissions on the international sale of such goods.
An IC-DISC can be structured in several ways, but usually it is incorporated by an owner-managed exporting company. The exporting company pays the IC-DISC a commission on its foreign sales. The parent company may deduct these commissions from its ordinary income taxed at a maximum rate of 39.6%. The IC-DISC pays no tax on these commissions. When the IC-DISC distributes these commissions to its shareholders, the shareholders pay a dividend tax rate at a maximum of 23.8%. There are two benefits here: 1) conversion from ordinary rates to dividend rates, which could result in tax savings of up to 15.8%; and 2) the IC-DISC can be used to defer tax on up to ten million dollars of export receipts. There will be no recognition until the receipts are distributed as dividends. (Distributions may be in the form of actual or deemed distributions. The IC-DISC is deemed to distribute commission income in excess of $10 million).
The IC-DISC is subject to a number of compliance burdens and hurdles. A taxpayer who wishes to pursue this strategy should work closely with a tax advisor in its implementation.
SOLAR ENERGY INCENTIVES
The federal tax credit for residential energy property applies to solar electric systems, solar water heating systems, fuel cells, small wind energy systems and geothermal gas pumps. A taxpayer may claim a credit of 30% of qualified expenditures for a solar energy system that serves the taxpayer’s residence. Under current law, the energy property must be placed in service on or before December 31, 2016.
Qualified expenditures include: 1) the cost of the property; and 2) labor costs for on-site preparation, assembly or original system installation and for piping or wiring to interconnect a system to the home. If the federal tax credit exceeds the tax liability, the excess amount may be carried forward to the succeeding taxable year. The excess credit may be carried forward until 2016, but it is unclear whether the unused tax credit can be carried forward after 2016. The maximum allowable credit, equipment requirements and other details vary by type of technology.
CAPTIVE INSURANCE
A small captive insurance company (captive) allows a business to self-insure against the risks of operations and offers significant tax savings. A captive can be structured in several ways, but it is frequently structured as a wholly-owned subsidiary within an affiliated group or within a series of LLCs.
The parent pays insurance premiums to the captive and may deduct the premiums. The internal revenue code provides an election that allows small insurance companies with less than $1.2 million of premiums collected to be taxed on their investment earnings rather than on their gross income. This means that as long as a captive collects less than $1.2 million in premiums, it will not be taxed on these premiums. Captive insurance also offers substantial benefits related to wealth accumulation, favorable distributions and asset protection.
It is essential that the captive actually function as an insurance company. All captives must comply with the following three factors: 1) the arrangement involves the existence of an “insurance risk;” 2) there is both risk shifting and risk distribution; and 3) the arrangement is for “insurance” in its commonly accepted sense. The IRS may challenge any premiums that seem excessive for the amount of risk insured.
RESEARCH CREDIT
A taxpayer who pays or incurs qualified research expenses in carrying on a trade or business is eligible for the research expense credit. The credit is equal to 20% of qualified research expenses.
The research credit is set to expire for any expenses paid after December 31, 2013, but many expect it will be retroactively extended.
Research expenses are incurred for the purpose of discovering information that is technological in nature and whose application is intended to be useful in the development of a new or improved business component.
A research expense may be incurred as either an in-house research expense or as a contract research expense.
Expenses that may qualify for the credit include wages, supplies (not including land or depreciable property), and other expenses used to advance research.
STATE AND LOCAL INCENTIVES
There are a wide variety of state and local tax credits available. While these credits vary by jurisdiction, state and local finance departments have made an effort to incentivize job creation in targeted areas and have chosen to encourage the growth of particular industries, such as technology and energy.
Taxpayers should speak to their tax advisors to explore what types of credits may be available. The application for some of these credits can be daunting, but the rewards may be well worth it.
Minimizing International Tax Compliance Risk
By Brian T. Lovett, CPA, JD, Partner
In recent years, the IRS has put an increased focus on international tax compliance. Penalties for international compliance failures are significant, sometimes as high as $10,000 per omission. To ensure that multinational companies are meeting all of their compliance obligations, they need to know the types of taxes assessed in the countries of operation, the treaties available to them and their compliance obligations.
Types of Taxes Assessed
The IRS imposes a corporate net income tax on companies with business operations located in the US. In addition to this corporate net income tax, the various states have different types of tax structures under which a company will need to remain compliant. Some states impose a net income tax, while others impose a franchise tax based on the value of the company. On a transactional level, states impose sales tax on the sale of tangible personal property into the state. Conversely, some countries impose a value-added tax (VAT), which is a consumption tax that functions similar to a sales tax. Unlike a sales tax, the tax is not collected and remitted at regular intervals. By contrast, the payment of VAT occurs continuously as purchases are made throughout the supply chain. In order for a multinational company to remain compliant, it must be aware of the taxes to which the company may be subject.
Treaties Available
Many countries have entered into tax treaties with other countries. These treaties are designed to level the playing field and clarify certain issues for companies based in one country but doing business in others. Many treaties operate to reduce or eliminate taxes due on different types of income paid by or to a corporation located in one treaty country but doing business in the other treaty country. Furthermore, treaties often lay the groundwork for various exemptions from taxation for companies operating internationally.
In order to ensure that proper tax rates are paid for income earned in a foreign country by companies, knowledge and understanding of the provisions of the applicable treaties between the resident and operating countries is critical.
Compliance Obligations
In addition to the types of tax and the potential treaty benefits, companies operating internationally need to know their filing requirements. Compliance takes two forms: 1) filing the correct tax forms and fully completing them, and 2) completing any forms or certifications necessary in order to avail the taxpayer to any potential treaty benefits. In the US, the most common tax forms required for companies operating internationally include:
| 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 |
| Form 3520 | Annual Return to Report Transactions with Foreign Trusts |
| Form 8938 | Statement of Specified Foreign Financial Assets |
| FBAR (FinCEN Report 114) | Report of Foreign Bank and Financial Accounts |
In addition, there are certain forms such as Form W-8BEN that must be provided in order for a US taxpayer to reduce certain withholding payments based on tax treaties. Many countries have similar certifications that are required in order for a company to take advantage of treaty benefits, including requirements to obtain an official certification of residency. In addition, there are a whole host of tax forms, both in the US and internationally, that a company operating in multiple countries must complete and file timely. Failure to comply with these requirements could result in significant penalties and increased tax exposure for multinational companies.
To ensure that all forms are filed and all treaty benefits are available, taxpayers must know their compliance obligations in the various countries in which they are doing business.
In assessing a multinational company’s international tax compliance risk, knowledge is power. Taxpayers who are aware of the various tax types, who know the relevant provisions of the applicable treaties, and who understand their required compliance obligations are well on their way to minimizing the potential for penalties and other issues associated with incomplete international tax compliance.
Intercompany Transactions: Risks and Opportunities
By Sara A. Palovick
An intercompany transaction is a transaction between corporations that are members of the same consolidated group immediately after the transaction. These dealings include:
- The sale of property to another group member, even if gain or loss is not recognized;
- The performance of services for another group member and the member’s payment or accrual of expense for the performance of services;
- The licensing of technology, rental of property or loan of money to another group member and the member’s payment or accrual of the expenditure; and
- A distribution to another group member with respect to the distributor’s stock.
In examining intercompany transactions, the IRS will focus on the “arm’s length” nature of the transaction in question. This arm’s length standard is important to understand when dealing with transactions between related taxpayers. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).
There are two main things to keep in mind with intercompany transactions: 1) transfer pricing, and 2) interest and repayment of intercompany loans.
Transfer Pricing. Transfer pricing is the pricing of goods and services transferred between businesses and is an area that is constantly under scrutiny by the IRS. The determination on the appropriate transfer price is based on the arm’s length standard. When examining tax returns, and particularly intercompany transactions, the IRS will review and investigate the transfer pricing methods used. Presuming companies are using consistent pricing models for both intercompany and third-party transactions, there should be no issue in meeting the arm’s length standard. If, however, favorable pricing is used on intercompany transactions, whether favorable to the buyer or the seller, issues could arise with regard to transfer pricing.
Interest on and Repayment of Intercompany Loans. Intercompany loans are another area of focus for the IRS during examination. Taxpayers should ensure that the interest rate used for intercompany borrowing is consistent with the arm’s length standard. Taxpayers may also run into trouble if they do not regularly clear out their intercompany accounts payable and receivable. If an intercompany balance exists for longer than normal payment terms, the borrowings could be treated as equity transactions, resulting in deemed dividends that would be subject to income tax.
When considering intercompany borrowings, the consideration should be one of commercial reasonableness. Interest rates and repayment terms should be tested against what would be available from third parties to determine reasonableness. The terms need not be exactly the same as those available from banks or other unrelated parties, but they should be sufficiently close as to pass the arm’s length requirement outlined above.
With both transfer pricing and intercompany borrowing, documentation is of paramount importance. Transfer pricing studies can be completed to support the pricing used for intercompany transactions. These studies look at comparable industry pricing and provide support for intercompany pricing in use. With regard to intercompany borrowings, it is important that the proper documentation of borrowing be drawn up and maintained in the company’s files. The terms of the borrowing should be outlined and followed; interest should be accrued periodically; and payments should be made as required by the documents.
Review Intercompany Loans.
Five factors must be taken into consideration to determine whether the interest in the corporation is to be treated as stock or indebtedness. It is important to periodically review the intercompany loans to ensure that the five factors are taken into consideration to make sure that a debtor-creditor relationship exists. They include:
- Whether there is a written unconditional promise to pay on demand or a specified date a sum certain in money in return for adequate consideration in money or money’s worth, and to pay a fixed rate of interest;
- Whether there is subordination to or preference over any indebtedness of the corporation;
- The ratio of debt to equity of the corporation;
- Whether there is convertibility into the stock of the corporation; and
- The relationship between holdings of stock in the corporation and holdings of the interest in question.
Minimizing the Reach of the 3.8% Net Investment Income Tax
By Joseph P. Ruppe, CPA, MBA
The Affordable Care Act (ACA) imposes a 3.8% net investment income tax (3.8% NIIT) on net investment income (NII). NII consists of interest, dividends, annuities, royalties, net passive rental income, net income from passive activities and net gains from passive property sales. The 3.8% NIIT applies to individuals with modified adjusted gross income (MAGI) exceeding the following thresholds: $250,000 for married filing jointly; $200,000 if single; and $125,000 if married filing separately.
Therefore, the goals of taxpayers are to reduce their NII, their MAGI or both. Some ways to achieve these goals are through the following:
Tax-Exempt Income. You can reduce your 3.8% NIIT by shifting your investment portfolio into tax-exempt municipal bonds. Municipal bond income is tax-exempt for both NIIT and federal tax purposes, and it also does not increase your MAGI. Taxpayers that are in the highest federal tax bracket can now realize an after-tax equivalent of 4.4% on a 2.5% tax-exempt bond.
Another possibility is to invest in whole life insurance policies and other tax-deferred annuities (TDA). Tax-deferred income is not subject to NIIT until the income is distributed, and this usually occurs in later years when MAGI is much lower. Also, the cash value in life insurance policies can be accessed through tax-free loans (which will reduce the policy’s death benefit but creates a viable alternative for those seeking to avoid the NIIT).
Asset Allocations and Income Realization. If you want some stocks in your portfolio, consider investing in growth stocks that do not pay dividends. Harvest capital losses to offset capital gains—but you must avoid the wash sale rules. Also be sure to take advantage of the installment sale rules and tax-free exchanges under Section 1031 and 1033 to time the recognition of the gain to reduce MAGI. The gain on the sale of a principal residence also will not be subject to the NIIT as long as the gain from the sale does exceed $250,000 on a single return and up to $500,000 on a married-filing-jointly return.
Retirement Accounts and Roth IRAs. Consider the timing and the amounts of the distributions from retirement accounts. Retirement accounts’ distributions are not subject to NIIT; however, they do increase MAGI so the distributions could put the taxpayer over the MAGI threshold and subject the taxpayer to NIIT. Therefore, the taxpayer should annually review the retirement account distributions to mitigate the NIIT impact. Consider giving IRA distributions directly to charity (assuming that the law is extended).
Roth IRA distributions are not subject to NIIT and also are not included in MAGI. Converting a traditional IRA into a Roth IRA will increase MAGI, so careful consideration must be given to any conversion. Conversions should be done in years when NII or MAGI is low so that the conversion will not lead to a substantial NIIT.
Passive Income. Increase participation to make passive income non-passive. This will also allow passive losses to be currently deductible to reduce MAGI as well as not subjecting any income to the NIIT. Consider a grouping election to achieve material participation as a “real estate professional.”
Gifting and Trusts. Gift away investments that generate NII to certain donees. For 2014, the annual gift tax exclusion is $14,000, and the lifetime gift/estate tax exemption is $5.34 million. Certain kiddie tax limits could reduce some of this benefit.
Consider setting up a charitable remainder trust that is funded with long-term appreciated securities. The net gain can be spread out to minimize the NIIT with proper planning. Also consider contributions of your long-term appreciated securities to charity.
WS+B Welcomes Two New Partners
Withum is pleased to announce the addition of Jay C. Shepulski, CPA, and Robert S. Schachter, CPA, as partners in the firm.
Based in the firm’s Morristown office, Jay is a licensed certified public accountant in state of New Jersey with 16 years dedicated to the profession. He provides audit, accounting and business advisory services to domestic and international clients in both publicly-traded and privately-held sectors. Jay has in-depth knowledge and experience related to registration and reporting under the Securities Act of 1933 and the Securities Exchange Act of 1934; interpretation and implementation of regulations governing filing requirements; researching and resolving SEC issues through communications with the SEC’s Division of Corporation Finance; and navigating the evolving issues and requirements of the public reporting landscape. He is a graduate of the University of Scranton with a bachelor of science degree in accounting. An active member of the Association for Corporate Growth, Jay is also member of the AICPA and the NJSCPA.
A tax partner based in WS+B’s New York City office, Robert has over 28 years of public accounting experience and is a licensed certified public accountant in the states of New York and New Jersey. His expertise includes transactions involving a variety of financial products‚ derivatives‚ tax-efficient trading and investment strategies. A respected tax consultant‚ Robert assists development-stage entities‚ investment partnerships‚ broker-dealers‚ fund of funds and private equity funds. He is often engaged to review partnership agreement allocations and consult on adverse effects reflecting such allocations. In addition‚ Robert is heavily involved with tax structuring for private equity transactions‚ including the tax ramifications to multistate consolidated corporate entities with highly-compensated employee owners. A graduate of C.W. Post–Long Island University where he earned his bachelor of science degree in accounting, Robert is a member of the AICPA, NYSSCPA and NJSCPA.
