Why is this Topic Important to Wealth Managers? Discusses how international planning can impact clients’ tax position domestically.  Provides discussion on a number of common international tax concepts as they relate to U.S. taxpayers.

In a previous blog, it has been briefly discussed that there may be a number of reasons a client may consider offshore planning, generally.  Today we will focus on one major component of offshore considerations, the impact of world-wide income on U.S. taxpayers. It is generally accepted that U.S. taxpayers are expected to pay income taxes on income earned from sources worldwide.[1] This concept is commonly referred to as “outbound” taxation. [2]

It is the case that many sovereign nations will also have taxes on personal and/or corporate income that an individual or corporation could become subject to, creating in effect “double taxation.”  And some foreign nations choose to have very low or no tax rate on certain types of income, or on corporations in general, thus allowing foreign income to potentially escape foreign taxation (and current U.S. taxation in the year that it is earned).

What are some rules that that Congress has attempted to avoid double taxation or subject foreign income to U.S. taxation?

Foreign Tax Credit

Under the foreign tax credit, the “United States allows its taxpayers to reduce their U.S. tax liability by some or all of the foreign income taxes paid on income earned outside the United States.” [3] The credit, created by Congress, reduces U.S. income by “foreign income taxes paid or accrued.”  “The credit is a dollar-for-dollar reduction of U.S. income tax liability.”  [4]

Controlled Foreign Corporations

As a general rule, “the income of a foreign corporation is included on the U.S. shareholder’s U.S. income tax return only when dividend income is received.” [5] Yet for certain situations when U.S. taxpayers have a shareholding in a foreign corporation, Congress has established special rules that “deem” a dividend to have been paid by the foreign corporation, regardless of whether it is actually paid or not.  These special rules are known as “anti-deferral” rules – rules that mitigate the tax advantages of taxpayers deferring U.S. tax until foreign income has been received.

In general the rules that most impact U.S. taxpayers with a shareholding in a foreign company are known as “controlled foreign corporation” rules (aka CFC rules).  A CFC exist when “any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned by U.S. shareholders on any day during the taxable year of the foreign corporation.” [6]

Not all income earned by a CFC will be deemed as a dividend to its U.S. taxpayers.  Congress does not want to stop U.S. taxpayers from investing or doing business overseas.  However, Congress is concerned that it is common that U.S. taxpayers will “shift the income-generating activity to a foreign entity where the income earned will not be subject to U.S. tax until repatriated.” [7] Congress considers that such business activities or investment activities could have or should have occurred in the United States, or at least should have been taxed in the United States regardless of where they occurred.

Thus, Congress has established complex rules to determine which types of income it will allow to be earned overseas without the U.S. taxpayers incurring current U.S. taxation on a deemed dividend, and correspondingly which types of income for which Congress will disallow deferral.  Income that Congress disallows deferral for is known as ‘tainted’ income.  It is this “tainted” income that is included in the gross income of its U.S. shareholders without regard to its actual distribution.

Income that is subject to current taxation from a CFC, “can be characterized as income that is easily shifted or has little or no economic connection with the CFC’s country of incorporation” [8] and may include, “foreign personal holding company income, foreign based company sales [and service] income, …as well as certain insurance income, …and certain other narrowly defined categories of income [including passive income, ‘such as interest dividends rents and royalties’[9]].” [10] Well, that’s a mouthful of legal terms that we will need to discuss in future blogticles.

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[1] 26 U.S.C § 61; See also, Taxation of Business Entities.  James E. Smith, William H. Raabe, David M. Maloney.  Chapter 13.  2007 Annual Edition, citing 26 U.S.C § 61, “Gross income for a U.S. person includes ‘all income from whatever source derived’.  ”Source“ in this context means not only type of income (e.g., wages or interest) but geographic source as well (e.g., the United States or Belgium). Westlaw.

[2] Corporations, Partnerships, Estates & Trusts.  Chapter 9.  , 2007 Annual Edition.  Westlaw.

[3] Taxation of Business Entities. Ch 13

[4] Id.

[5] Id. citing, Subpart F, §§ 951-964 of Title 26 of the United States Code.

[6] Taxation of Business Entities.

[7] Id.

[8] Id.

[9] Id.

[10] 3 Legal Compliance Checkups § 20:35 (2009).  Westlaw.

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Why is this Topic Important to Wealth Managers? Today we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation. That being said each blogticle resumes discussion from the previous day.

Corporate Debt

The dream of the asset manager is to generate high returns (like those available through equity positions) while at the same time providing guaranteed payments through avenues such as debt obligations. Nevertheless, as was discussed in the beginning of this series, the risk/reward model can help determine what investments may work best in today’s economy. Any wealth manager who believes however that bonds have no risk has their head in the sand. All investment actions, including inaction, involves risk in its purest form. For that is essentially the theme of what we learned in Econ 101—“Opportunity Cost”. Even corporate debt can be defaulted upon, and has been recently noted tax-free bonds too face danger of default. Thus risk of default should be considered as one factor among many when determining asset allocation.

It is important to thoroughly understand the financial statements of corporations which are issuing debt. It has been seen that the rating agencies such as Moody’s and S&P have failed investors in the past. Personal responsibility is one key to financial success. Therefore wise wealth managers will complete a diligent analysis of the financial position of a corporation before recommending that position to a client. As one commentator notes, “[a] strong balance sheet can be even more a source of strength and competitiveness in a recession than during a boom.” [1]

One important consideration in this area is the debt to equity ratio. Generally in the corporate world, the “expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed on whether a company is in an early development phase or at maturity.” [2]

Generally, interest that accrues after the date of purchase of a corporate bond is included as ordinary income in the year in which it is received or made available. [3]

For additional information on the taxation of bonds see TaxFacts: Bonds.

For additional information on financial statement evaluation see Advisorfyi.com: Understanding Financial Statements with Warren Buffett.

Tomorrow we continue our series with U.S. government investment.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

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[1] Les Nemethy. Debt Versus Equity in Today’s Financial Climate.http://ezinearticles.com/?Debt-Versus-Equity-in-Todays-Financial-Climate&id=2381584. Last Accessed 5/31/11.

[2] Id.

[3] Treas. Reg. §1.61-7.

Why is this Topic Important to Wealth Managers? This blogticle discusses the use of business entities in estate planning. It also presents discussion on Corporations and Subchapter S of the Internal Revenue Code. The blogticle provides useful information for wealth managers who work with clients involving business entities in estate planning.

Do your clients’ estate plans include business entities? Many times the average and complex estates alike will include some form of business entity. Whether it’s creating and funding a buy/sell, or starting a new enterprise, business entity issues are peppered throughout the estate planning world. An experienced wealth manager should be familiar with business entities and understanding of corporate structures generally.

Perhaps the most advantageous reason for the use of corporate status is the “corporate veil”, which means that corporate shareholders are not personally held liable to the creditors of the corporation for any of the corporation’s debts beyond the investor’s initial investment. On the other hand, a sole proprietor or partners in a general partnership are personally liable for the debts of the organization. If the business incurs significant debts which the business does not satisfy the question becomes who do the creditors pursue for the money? A traditional corporation is one way to protect personal assets from the liabilities incurred by the business enterprise.

Another advantage of a corporation is the going concern concept. A corporation, unlike a sole proprietorship, is a separate legal entity from its shareholders and will not automatically dissolve upon the death of the owner(s). Succession planning often takes into consideration multiple generations, and the going concern of the business is generally an integral part.

Nevertheless, corporations are not perfect. The most obvious detriment for the use of corporations is the issue of double taxation. The double tax occurs when the corporation is required to pay income taxes on its profits each year; and once distributions are made to shareholders, taxes are levied on the personal income of the stockholder. Therefore, a tax is levied at the corporate level and the personal level on the same income, hence the term double taxation. To avoid this issue Congress in 1958, “acted on President Eisenhower’s recommendation” and created a Subchapter S of the Code.[1] Subchapter S-Corporations have several advantages over traditional Subchapter C-Corporations including the elimination of double taxation.

S-Corporations are “flow through” entities for tax purposes. In other words the profits or losses of the corporation are reported on the individual shareholders’ tax returns each year. The S-Corporation status has gradually gained acceptance since its introduction. Moreover, the S-Corporation Association notes that the number of S-Corporations has increased from 2.7 million to over 4.5 million during the ten year period from 1997 until 2007.[2]

Even so, the election under Subchapter S is applicable only to “small business corporations.” Such a corporation is generally defined as a domestic corporation which:

1. has 100 or fewer shareholders;
2. does not have as a shareholder a person (other than an estate, a tax-exempt organization, or a certain type of trust) who is not an individual;
3. does not have a nonresident alien as a shareholder; and
4. has only one class of stock. [3]

Tomorrow’s blogticle will continue to discuss important planning aspects of 2011.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] S-Corp.org, “S-Corp History” Link.  http://www.s-corp.org/our-history/. Last Accessed 6/17/10.

[2] Id.

[3] I.R.C. §1361(b)(1).

The Tax Court has reopened the question of whether limited partners are entitled to an exemption from self-employment taxes—an issue that’s been in hibernation for over 13 years.  The Tax Court recently concluded that status as a limited partner does not necessarily exempt a partner from self-employment taxes; the exemption depends on the partner’s level of participation in partnership business. Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of small businesses in Advisor’s Journal, see IRS Announces Lenient Lien Program for Small Business (CC 11-48)

For in-depth analysis of partnership taxation, see Advisor’s Main Library: H–Partnership Taxation

Why is this Topic Important to Wealth Managers? This blogiticle discusses how financial statements are used in connection with business insurance planning. The information is presented because valuations become an important factor in a number of situations where wealth managers are working with clients.

First, properly kept financial statement can help ensure easier access to capital as well as give a truer understanding of the business’ financial position. Second, insurance underwriters are concerned with risk exposure. Thus most businesses are required to provide financial information of the company through the financial statements when a substantial amount of insurance is purchased.

In addition, the financial statements are commonly used in the risk management processes. Assets are usually examined to determine what amount of exposure the business may have. Further, outstanding liabilities in connection with cash flow may present operational and risk issues.

But one area where financial statements are really important is: business valuation. Most if not all business valuation is based primarily on financial statement analysis. This process generally begins with an examination of the assets of the business. Further, as was discussed yesterday the amount that a business’ assets exceed its liabilities is called owner’s equity.  During personal planning situations with closely held corporations and other entities, owner’s equity is an important amount, as this is what the owners are entitled to after all liabilities are settled with assets on hand.

Moreover, business valuation is important when drafting buy-sell agreements or purchasing insurance in connection with a buy-sell or otherwise on a key employee, including but not limited to owners of such organizations.  Small businesses are especially sensitive to the exposure of ownership ending up with individuals the surviving owner(s) don’t want to do business with.

Thus, under the traditional buy-sell agreement the owners enter into a binding buy-sell agreement among themselves. They contract to purchase the interest of any other owner who dies; each stockholder agrees and contracts for the sale of his or her interest at death. Alternatively, the agreement may be between the owners and the entity, obligating the business to purchase the shares of a deceased owner and either hold the shares as treasury stock or retire them. Either route that is exercised must nevertheless be based upon some valuation. This is where the financial statements come into use.

In other words, key employee insurance and buy-sell agreements are generally based on some total dollar amount that represents the value of the business. This figure is usually based on some number that is related to the financial statements and accounting of the business. Whether it’s the total assets, a factor of revenue or income, or some other determination, the need for a basic knowledge of financial accounting for small businesses is essential.

What’s more, because a price or method of establishing the sales price is generally set out in the agreement, the accuracy of financial reporting and presentation within the financial statements is critical. Since the amount to be paid for the deceased’s stock is set out in the contract, and since the terms of payment are agreed upon in advance those keeping unsound records and accounts will likely incorrectly value the business which could negatively affect other planning aspects.

For a detailed analysis on business valuation and how it relates to buy sell agreements see Advanced Markets AdvisorFX: Insurance Needs Revealed in Financial Statements.

For sample buy-sell and cross purchase agreements see Advanced Markets AdvisorFX: Sample Close Corporation Buy-Sell Agreements.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Treasury Secretary Timothy Geithner sparked outrage when he suggested at a recent House Ways and Means subcommittee meeting that “Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they’re treated as corporations for tax purposes or not.” Geithner’s comments about pass-through entities forced a collective gasp from millions of small business owners who could lose their ability to compete if subject to a double tax regime.   Behind client referrals, professional referrals were the second biggest producer.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous Advisor’s Journal coverage of the Obama administration’s budget and tax proposals, see Obama Budget Would Undercut Utility of Life Insurance in Small Business Planning (CC-11-41) & Obama Tax Compromise Provides 100 Percent Bonus Depreciation of Business Assets Through 2011 (CC 11-01).

For in-depth analysis of S corporation taxation, see Advisor’s Main Library: B—Corporation’s Election Under Subchapter S.

Why is this Topic Important to Wealth Managers? Presents discussion on taxation of Limited Liability Companies.  Discusses basics characteristics with regards to the business structure most commonly used in the U.S. today.

A Limited Liability Company (LLC) is a business structure allowed by state statute.  LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC.  Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members.  Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities.  There is no maximum number of members.  Most states also permit “single member” LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information.  There are special rules for foreign LLCs.

However, the Federal government does not recognize an LLC as a classification for Federal tax purposes.  An LLC business entity must file as a corporation, partnership or sole proprietorship tax return.

As a default, an LLC with at least two members is classified as a partnership for federal income tax purposes.  An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes.  [1]

An LLC can file Form 8832 to elect their business entity classification.  A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.”  

If the LLC is classified as a corporation, it must file a corporation income tax return.  If it is a C corporation, it is taxed on its taxable income and distributions to the members are includible in the members’ gross income to the extent of the corporation’s earnings and profits (double taxation).  If it is an S corporation, the corporation is generally not subject to any income tax and the income, deductions, gains, losses, and credits of the corporation “pass through” to the members.

Liability Example: X, Y, and Z are the members of a domestic LLC (“XYZ”) formed in state A. XYZ is an employer for federal tax purposes and has incurred a federal employment tax liability that remains unpaid.  X, Y, and Z have assets personally that would be sufficient to satisfy all or a portion of the employment tax liability.  Under the laws of state A, the members of an LLC generally are not liable for the debts of the LLC.

If under state law the members of the LLC are not liable for the debts of the LLC, then absent fraudulent transfers or other special circumstances, the IRS may not collect the LLC’s employment tax liability from the members, including by levy on the property and rights to property of the members.

Tomorrow’s blogticle will continue our discussion on additional changes and hot topics in 2011.  

We invite your opinions and comments by posting them below, or by calling the Panel of Experts

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[1] See generally Procedure and Administrative Regulations Section 301.7701-1 et. seq.

Why is this Topic Important to Wealth Managers? Discusses self-employment taxes with regards to closely held corporations.  Provides insight from a recent court decision regarding how distributions may be treated.

Earlier this month we reported on legislation affecting closely held businesses and the self-employment tax.   We note that Stephen Sternberger, attentive AdvisorFX subscriber and tax lawyer, pointed out in his comments to that article that the the legislation had not passed.  However, that topic (Self-Employment Tax on wages versus distributions), has reared its head again – as shown by the recent Federal District Court case involving David E. Watson. [1]

The C.P.A. recently disputed and lost to the Government’s position which recharacterized dividend and loan payments from David E. Watson, P.C. (a Subchapter S corporation) to its sole shareholder and employee, David E. Watson.  The IRS assessed additional employment taxes, interest and penalties against Watson for each of tax years in which Watson’s salary was significantly lower than his total distributions.

The taxpayer made the contention that the closely held business unquestionably intended to pay Watson compensation of $24,000 per year, and that amounts distributed to Watson in excess of that amount were properly classified as dividends and/or loans.  Watson wanted to take a lower salary and larger distributions because wages or salaries are generally subject to self-employment taxes while distributions are not.  The self-employment tax rate is 15.3%.

The question the Court reviewed was whether the characterization of funds disbursed by an S corporation to its employees or shareholders is a salary or otherwise.  The Court determine that the answer to this question turns on an analysis of whether the “payments at issue were made . . . as remuneration for services performed.”

The Court made clear that a determination of whether funds are “remuneration for services performed,” must be made “in view of all the evidence.”   While intent is unquestionably a consideration in the analysis, it is by no means the only one.  Other relevant considerations include, but are not limited to:  1) the employee’s qualifications; 2) the nature, extent and scope of the employee’s work; 3) the size and complexities of the business; 4) a comparison of salaries paid with the gross income and the net income; 5) the prevailing general economic conditions; 6) comparison of salaries with distributions to stockholders; 7) the prevailing rates of compensation for comparable positions in comparable concerns; 8) the salary policy of the taxpayer as to all employees; and 9) in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.

The Court’s analysis concluded that payments to Watson were, in fact, “remuneration for services performed” and that a portion of those payments were subject to the self-employment tax.

The Wall Street Journal reported that Mr. Watson will appeal the decision. [2] Quoting Watson stating, “The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn’t give it the authority to raise pay in order to collect extra payroll taxes,”  The Journal also reported that “independent tax expert Robert Willens in New York says [Watson’s position] will be a hard argument to win.”

Tomorrow’s blogticle will revert back to 2011 market opportunities for wealth managers.

We invite your opinions or questions by posting them below, or by calling the Panel of Experts

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[1] David E. Watson, P.C. v. U.S. 107 A.F.T.R.2d 2011-311 (December 2010)(Westlaw).  Full case available at http://ia700202.us.archive.org/4/items/gov.uscourts.iasd.37557/gov.uscourts.iasd.37557.35.0.pdf.  Last accessed 10/25/2011.

[2] Laura Saunders.  Wall Street Journal.  The IRS Targets Income Tricks.  January 22, 2011.  http://online.wsj.com/article_email/SB10001424052748703951704576092371207903438-lMyQjAxMTAxMDIwMjEyNDIyWj.html.  Last accessed 10/25/2011.

Why is this Topic Important to Wealth Managers? Discusses how offshore LLCs are being used in conjunction with clients’ estate plans to maximize protection and efficiency.  Discusses one jurisdiction in particular, Nevis, which provides for beneficial company laws, similar to statutes of certain domestic jurisdictions.  .

One new and emerging area in offshore planning is the use of Limited Liability Companies or LLCs.  “Like its domestic counterpart, the offshore LLC is designed to bring together in a single business organization the best features of all other business forms…owners obtain both a corporate styled liability shield for its members and the pass through tax benefits of a partnership.”[1] Additionally, the “offshore LLC [is] a very valuable asset protection tool when structuring a family wealth preservation plan.”[2]

Asset Protection

One attorney notes the successful use of LLCs in the estate planning arena, by stating, “[i]t would be hard enough for a creditor to invade a U.S. formed Limited [Liability Company], but what about a [one] formed in a country that does not even recognize U.S. judgments!”[3]

When assets are transferred, assuming the transfer is valid in time under state law, to an LLC, the assets are “protected from member’s creditors.”  “Members of an LLC are neither co-owners of nor have a transferable interest in, property of an LLC.”[4] It is therefore the case that, “assets transferred to an LLC become the property of the LLC and not subject to the creditor claims of its individual members.”[5] And, since “a creditor’s recourse against a member is limited to a charging order, assets transferred to an LLC can be effectively protected against levy and seizure by a creditor.”[6]

Many sophisticated wealth managers agree that, “Nevis is an example of a jurisdiction that has excellent asset protection features incorporated into its LLC legislation.”  [7] Nevis in particular can provide for a number of jurisdictional advantages.  First, The Nevis LLC law is “modeled after the Delaware Limited Liability Company Act and is considered by many practitioners as the most modern offshore limited liability legislation of its kind.”  [8] Secondly, Nevis laws present for an optimal tax structure for LLCs, in that organizations “are tax-exempt so long as they transact no business on the island.”  [9]

Nevis also “offer[s] the protection normally accorded to…Limited Liability Company structures,” and “Nevis law would require independent litigation in Nevis to disband or impose judicial control over the entity, and Nevis legislation in this regard is extremely debtor friendly.”  [10]

Tomorrow’s blogticle will close the week’s discussion of offshore planning.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] ALI-ABA Course of Study Materials. “Estate Planning for the Family Business Owner”.  Volume 2.  Mario A. Mata.  July 2004.; See also, generally, 26 U.S.C. § 1362.

[2] Estate Planning for the Family Business Owner.

[3] ALI-ABA Course of Study Materials “Sophisticated Estate Planning Techniques”.  Volume II.  Alan S. Gassman.  September 1999.

[4] Estate Planning for the Family Business Owner.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] 3 Asset Protection: Dom. & Int’l L. & Tactics § 44:17 (2010), citing Nevis International Exempt Trust Ordinance, 1994, as amended, § 43; Nevis Business Corporation Ordinance, 1984, as amended, § 123(1); Nevis Limited Liability Company Ordinance, 1995, as amended, § 83(1).

[10] Id. citing Using the New Isle of Man Limited Liability Company”, Charles A. Cane, Journal of Asset Protection, May/June 1997.