Branch Profits Tax -Winning the IRS Audit on the Foreign Corporation

This post is a heavy-duty tax post on the branch profits tax.   

It is the cornerstone of taxation of a foreign corporation doing business in the United States. This post provides the mathematical equation to win an audit with the IRS on an insidious tax that applies only to foreign corporations.  

If you are under audit, then give me, Brian Dooley, CPA, MBT at 949-939-3414.

To learn more about this tax, I recommend my book, of course.  But not the book that you see on this blog site.  I have a unique book for the CPA and attorney on this link.

Back to winning the IRS audit. 

When the IRS audits the Form 1120F, they examine the balance sheet.  If the IRS agent sees that you have invested your profits in liquid investments (such a savings accounts and stock funds), the IRS will want to charge you the branch profits tax.   The tax is a flat tax at 30% of the excess accumulation.  This tax also applies if you distribute money to the foreign home office or shareholders.

The branch profit tax uses the concept found in section 531.  This is an old law from the 1950s that applies to domestic corporations.  It is because of this law that S-corporations and LLCs were invented.  

The IRS explanation is found in regulation 1.537-2, “Grounds for accumulation of earnings and profits” and  is on this link

Section 531 applies a second tax to a domestic corporation that accumulates “earnings and profits” to avoid paying a dividend.  The branch profit tax has the same concept.   You can learn  more about “earnings and profits” on this link.

Since there are no cases on the branch profits tax, this blog posting discusses the concept.  The leading case is the Bardahl Case (Bardahl Intl. Corp. v. Commissioner, T.C. Memo. 1966-182).  From this case, an equation has been created.  The IRS accepts this equation.

During a branch profits tax audit, this equation can be used to justify the accumulation of liquid assets.  Additionally, corporate minutes of meetings held during prior years discussing expansion can be used to avoid the branch profits tax.

If you need help for a branch profits tax audit, then call me, Brian Dooley, CPA, MBT at 949-939-3414.

Branch Profits Tax and Working Capital: The Bardahl Formula

The accumulation of earnings and profits beyond the reasonable needs of the business triggers the application of the accumulated earnings tax.  [1] The starting place for determining the reasonable requirements of the business is to determine its need for working capital — i.e., the amount of cash and liquid assets necessary to meet ordinary obligations during the usual course of business.

Your pro-active tax team will save you money

If working capital needs justify the accumulation, then the corporation will not be forced use more speculative reasons to justify the accumulation.  There is where your tax team needs to be proactive. 

Corporate minutes of future expansion can avoid the tax.  However, they can’t be backed dated.  The directors must meet regularly to discuss the future reinvestment of profits into expansion.  Minutes must be taken.

Also, the relatively objective nature of the working capital inquiry makes a prediction of reasonableness in this context somewhat easier than in others.  Thus, the importance of establishing working capital needs early in an accumulated earnings challenge cannot be overstated.

Working capital is the excess of current assets over current liabilities.  Courts generally include as current assets cash, obligations that will be reduced to cash within a year, and cash equivalents such as Treasury bills, securities, and demand notes. 

Current liabilities are those liabilities that are expected to be due within the year, including demand notes.[2]

The excess of current assets over current liabilities (working capital) allows the business to operate while it is manufacturing, selling and waiting to be paid for inventory.  This period is called the “operating cycle”.  It is the time between the acquisition of materials or services for the manufacturing process until the final cash realization on the sale of the inventory.

After many years of subjective determinations of businesses’ needs for working capital, the Tax Court in the case of Bardahl Manufacturing Corp. v. Commissioner, T.C. Memo.  1965-200, attempted to make the courts’ approach more objective by utilizing the operating cycle in estimating working capital needs. 

Although the “Bardahl formula” is only a rule of administrative convenience, over the years it has become the generally accepted method of determining working capital for most businesses.[3]

Branch Profits Tax and the operating cycle of a business is the combination of three cycles: 

(1) The production (or inventory) cycle;
(2) The collection (or accounts receivable) cycle; and
(3) The credit (or accounts payable) cycle.

The first two cycles, production, and collection, measure the time during which the taxpayer has expended its own funds for the production and sale of inventory, without receipt of sales proceeds attributable to that particular inventory.

Thus, the production cycle begins when the taxpayer purchases raw materials, continues through production and ends on sale.  The collection cycle starts at the sale of inventory and ends when the taxpayer collects cash or a money equivalent.  Together, these two periods measure how long it takes during the year for inventory to turn over and for receivables to be collected.

Unlike the production and collection cycles, which focus on the period of time during which the taxpayer has money out of pocket, the credit cycle measures the period of time that the taxpayer is able to use someone else’s money.  The credit cycle is the length of time between the taxpayer’s receipt of raw materials and its payment to suppliers.

No credit cycle exists if payment is made at the time of receipt of the product.  However, delays of 30, 60, or even 120 days in paying suppliers are common and result in a significant benefit to the taxpayer from the use of the supplier’s money.  Since this benefit may reduce the taxpayer’s needs for working capital, it is often appropriate to consider the length of time credit is extended as a component of the operating cycle.

Each component of the operating cycle is expressed as a fraction of the year.  This is converted to days by multiplying the fraction by the number of days in the year.  In computing the operating cycle, the credit cycle is subtracted from the sum of the production and collection cycles.

This fraction of a year is multiplied by the sum of the cost of goods sold and operating expenses for the year.  The resulting amount is the working capital needs for one operating cycle and the amount that can be kept for the reasonable needs of the business for working capital.

The IRS and taxpayers have very different interests in constructing these cycles.  The taxpayer facing a potential accumulated earnings challenge wishes to maximize the length of the production and collection cycles while eliminating or minimizing the credit cycle. 

The IRS’s litigating position will be the opposite, of course, as it seeks to shorten the production and collection cycles and lengthen the credit cycle.

In some situations, the Bardahl formula may be inappropriate as a means of determining working capital.  Service businesses, for example, do not have inventory in the traditional sense. 

Their inventory is really work in progress for which no bill has been issued.  Some early cases, therefore, rejected the Bardahl approach in favor of a more subjective approach to estimating working capital.

The approach for service businesses is a modification of the Bardahl formula for the lack of inventory, taking into account the necessity for maintaining staff during periods in which no billings are paid.  As a CPA, I know how expensive this is.

The Bardahl formula is “one test” and does not apply to every branch profits case.  The operating cycle approach is still a useful tool and should provide a basic facet of working capital considerations. 

Therefore, taxpayers facing accumulated earnings challenges should be prepared to fashion their defense within the Bardahl framework or to establish convincingly that the Bardahl approach is unworkable in the particular context.

Foreign Real estate holding companies will face a different branch profits tax challenge.

Another type of business that needs special attention is U.S. rental real estate that has accumulated money.   Here the Bardahl formula needs adjusting.   A deadly issue for the branch profits tax is a foreign corporation that owns real estate through an limited liability company (LLC). 

LLCs are popular because they shield the owners of the LLC from the debts of the LLC.  Unless the owners have guaranteed the debts, it is difficult to show the IRS why the accumulation of cash (or other liquid assets) is reasonable. 

The branch profits tax is one of the reasons that a corporation should not own U.S. real property.  The other reason is the U.S. Estate Tax.  The foreign investor’s exemption is $60,000 of value. 

I suggest that the foreign investor uses an “inheritance planning trust” and a domestic single member LLC on own U.S. assets.  You can learn more about this on this link.

[1] Code Section 533(a)
[2] Bardahl Intl. Corp. v. Commissioner, T.C. Memo.  1966-182.
[3] Suwanee Lumber Mfg. Co. v. Commissioner, T.C. Memo. 1979-477

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