Tag Archives: international tax strategy

International Tax Strategy with the Preparation of Form 5471 for your Controlled Foreign Corporation

The most important part of Form 5471 is not on the Form.  The Form is merely the tip of an iceberg.

You maximize your tax savings by knowing the loopholes found in the IRS regulations.  Let me say that again.  The income tax regulations contain the complex rules of Subpart F income (which is the income that you do not want if you own a small business) that will save you money.

You will find a summary of these tax breaks on the overlooked IRS worksheet (I have it below).  This worksheet ties into the IRS regulations.

The worksheet has a section for each type of subpart F income.  As you study the international income tax regulations, you will see that most active foreign income is not subpart F.   However if your foreign corporation has related party transactions, then it may have subpart F income.   The IRS has many exceptions to this general rule in their regulations.  Related party transaction includes related party purchases of inventory or services and related party sales of inventory or services.

As you will see on the image of the worksheet, you need to complete page one and two.

On the worksheet, you enter the total of each category of your subpart F income.   The worksheet then guides your arithmetic in computing the total subpart F income.

But here is the problem.  You must compute the total gross subpart F income yourself.  Next, you allocate your overall expenses related to each category.

For example,  your foreign corporation manufactures and sells products worldwide.   Some of the sales are to a related corporation.  Related party sales are often subpart F income (see an exception for contract manufacturing on this link).    You compute your gross income (this is the sale price minus the cost of the good sold).

You enter this amount on the form on line 3 (regarding foreign base company sales income).  Next, you get some special tax breaks on line 15.  On page 2 of the worksheet, you complete line 19 by including the amount from line 15.

 And there are more tax savings to come on page 2 of the Form 5471 worksheet.

Form 5471 tax planning

Form 5471’s worksheet is full of tax savings.

Lines 26, 27, 28 and 29 involve heavy duty tax planning.  They include the concept of  “earnings and profits“.     U.S. corporate taxation (for both a domestic corporation and a foreign corporation) focuses on earnings and profits.

To save taxes, you need to be an expert in this concept.   You want your CPA to know this concept like the back of his hand.  You can test your CPA by asking him about this.  If the answer is vague, this means you need someone else to prepare the Form 5471.

Lastly, you take the amount from page two line 38(b) to line 1 of Form 5471 Schedule I.

Smart tax planners use this worksheet to monitor their taxable subpart F income.  This means you should be preparing a proforma worksheet after the six months of your year.    As you read the worksheet, your will see other IRS tax saving ideas such as related party interest expense.

Bona Fide Debt Versus Non-Bona Fide Debt for International Tax Planning

International tax planning and strategy

Applying for an IRS ruling on your international tax planning will save you taxes in the long run.

The IRS has an easy tax win if you mess up your related party loans.  When a cross-border loan is classified as not being bona-fide, the transaction is not a debt.   Then, the IRS gets to determine what took place.  You can expect the IRS to decide what took place will cost you the most in taxes.

On this blog, you will learn  what to do and what not to make your  a loan a bona fide debt.

Most of the court cases are from the first part of last century involving a closely held domestic corporation.  Thus, this blog will look at those cases.   You will see that in those cases, the IRS collected the most money by classifying the transaction as a taxable dividend.

The tax issue  of a bona fide debt is not in the Internal Revenue Code.  The courts have created a tax law that the debt must be bonafide.   A law established by the courts is called a “common law.”

Many small business owners believe that if they merely record in their accounting books the transaction is a debt, then it is a debt.  No so.  Much more is required, and you will learn what to do and what not to do in this blog.

IRS agents are trained to examine an amount classified as a related party loan is whether there is a bona fide debt. The IRS uses this fundamental issue: When the loan was made, was there a genuine intent that the borrowed funds would be repaid?

Courts looked beyond mere labels or the parties’ testimony. The court looks at the objective facts and circumstances surrounding a transaction.

In Baird v. Commissioner, the judge ruled that “The treatment of petitioners’ (the taxpayer) withdrawals on the corporate (accounting) books as ‘Notes Receivable’ is not controlling.”  “It is well settled that book entries can not be used to conceal realities as a means of relieving the taxpayer from liability for income taxes.”[1]

Key Determining Factors

The IRS assumes that the loan in question is a dividend to the shareholder.  If the  transaction is between two related companies, then  two taxable events occurred.   First, a taxable dividend to the shareholder.  Next, the money going into the other corporation is treated by as a capital contribution by the shareholder to the corporation.

When a shareholder owns the majority of a company’s stock,  the IRS knows that he can exercise direct control over the business’s earnings.

Example, a shareholder controls exactly 50 percent of a corporation’s stock.  The other shareholder does not object to the loan.  This fact suggests that a bonafide loan was made.  Since the shareholder does not own a majority of the stock,  then the likelihood of a bonafide transaction is far greater.

The IRS is aware of situations where one shareholder owning only a small percentage of the stock exerted nearly total control of a corporation. [2]   This is common in family owned businesses when dad runs the family.  In these cases, the minority shareholder is treated as the majority shareholder.

 Was security was given?

The failure to provide security is an indication of a non-bonafide loan.   Most commercial lenders require security.  Your loan needs to look like a commercial loan.

Is the shareholder in a position to repay the loan?

As I wrote above, the test is the day the loan was made. The IRS looks at a  shareholder’s income and net worth in determining the shareholder’s ability to repay.   You need to have this proof in your files before you make the loan.  You want to act as if you are a commercial lender.

If the shareholder falls upon bad times, you want to document the change of status in corporate minutes.   The IRS will try to use this event to classify the loan as not bona fide.

The shareholder who is in a position to repay the advances based on his current financial status supports a bona fide loan.  An excellent credit rating is not conclusive that the shareholder is in a position to repay the loan.[3]

If a loan is a dividend,  the tax consequences are different for a S-corporation, C-corporation and a foreign company.

For a C-corporation, where the company does  have current or accumulated earnings and profits (E& P) at the time of distribution (including a loan that is later classified as a distribution because it is not bonafide), the distribution is  dividend.[4]

For an S-corporation, the classification by the IRS of a loan as a distribution can:

1. terminate the S-election if the loans are made disproportionate of the ownership.
2. disallow losses to be reported on the shareholder’s income tax return because of lack of tax basis.

Was a promissory note given to the corporation by the shareholder at the time of the loan?

The fact that  a promissory note of indebtedness wasn’t issued to the corporation is one of the determinative factors.   However, in a few court cases where no notes were issued for advances, the advances were accepted as bona fide loans because of other factors.

 Is there a repayment schedule or an attempt to repay?

Despite repayments being made, if the “loan” continues to increase over the years, the courts tend to see the transaction as a not a bona fide debt.

When the regular repayment schedule is followed the transaction looks more like a loan and not a dividend.

Is there a set due date in the written loan document.

A loan payoff time is important.[5]   Your bank would not make a loan with a due date.  You want your related party loans to be like a commercial loan.

The due date must be decided at the time of the advance.   With the absence of a fixed due date,  the advances can still be classified as a loan if it is repaid within a reasonable period.

Was interest was charged?   This a factor that by itself is not determinative.Whether the corporation has made attempts to get repaid.

If the shareholder borrower falls upon hard times and is not repaying a loan, the IRS will see this proof that the loan was not bonafide.

To counter the IRS position, the corporation must take steps to collect the loan.  If the company does not apply pressure on a borrowing shareholder for repayment, the court may not see the bonafide loan transaction.

You will want to document the steps taken to get repaid in the corporate minutes and letters (or emails) to the shareholder.

The size of the advances.   A corporation making big advances to a controlling shareholder looks like a distribution.  Proving that the shareholder has the ability (when the loan was made) is important.

Also, if the shareholder’s ability to repay is contingent on future events, the transaction looks more like a dividend.

A corporation with a history not paying dividends has high IRS risk.

Money advanced to a shareholder of a C-corporation with substantial   earnings and profits and with no history of paying dividends must be extremely careful.  A foreign corporation has the same issue.

So, while the IRS strongly emphasizes to its agents that the above-listed factors are viewed as a whole, and any one factor by itself is not determinative, the IRS will be suspicious.

In Summary:   Following the same procedures as a commercial lender may make your transaction bona fide.

Footnotes

[1] 25 T. C. 387, 395 (1955)

[2] Baird v. Commissioner, 25 T. C. 387, 395 (1955)

[3] Smith v. Commissioner, T. C. M. 1980-15

[4] IRC section 301. See IRC section 316 (Dividend Defined).

[5] United States v. Title Guarantee & Trust Co., 133 F. 2d 990 (6th Cir. 1943).

How the IRS Taxes Australian, Candadian, U.K. and Europeans Companies and Citizens Doing Business In The United States

french tax, french tax planning, job loss.

French businesses are profiting by avoiding the VAT by manufacturing in the U.S.

This blog is for Australian, Canadain, U.K. and Western European companies and citizens planning to have a business in the U.S. or business income from U.S. customers.

The United States is courting U.K., Western European, Canadian and Australian citizens to move their businesses.  The U.S. doesn’t  have a VAT (value-added tax).  The absence of this tax gives a 25% increase in a company’s purchasing power (assuming a VAT of 20%) of inventory, machinery, and employees.  Business makes more money due to the additional working capital.   

Labor unions are weak in the U.S. Employee rights are limited compared to the U.K., the EU, and Australia.

This blog explains how citizens (and their companies) from a tax treaty country are taxed in the U.S.

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Preparing and Filing a Late Form 5471 for your Foreign Corporation Can Save You Taxes

Preparing Form 5471,

Your first Form 5471 will save you taxes when you elect sophisticated tax accounting methods. The elections must be made on the first Form 5471.

Late is not always bad especially with some IRS tax return.   Of course, some such as the Foreign Bank Account Reporting (FBAR) is a disaster.  The penalties are huge if you are late.

Other forms the penalty is not huge or they can be waived if you are not willful.  In any event, if you are reading this blog and your Form 5471 is late, then you will find a blessing in disguise on this page.

The most important tax return for every business is the first year return.  We call this the “initial return”.    Your tax accounting methods are made on this return.  Smart international tax planners attached a statement of all of the tax accounting methods used by their client.

By the way,  advance international tax planning strategies are always tax accounting methods.

Boring as watching grass grow,  cross-border tax accounting has a plan for every type of transaction.   Yep, every type.   For example, advance payments for products may allow a tax deferral that can last indefinitely.   The result is legal tax avoidance.
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The Transfer of “ Know-How” To a Foreign Corporation and International Tax Planning with the IRS’s Definition of “Know-How”.

United Kingdom claims U.S. LLC is a tax haven company

The United Kingdom is beating America as the better business country with a 17% tax rate.

Jeff is the founder of a new computer based start-up.  The business is virtual in that it has no store front.  The business is e-commerce.  Its website determines the walking score of locations.   His customers are real estate website, large apartment complex promoting their location and hotels by showing a good walking score. 

Jeff is expanding into England and Ireland and would like to tax advantage of Irelands 12% tax rate.  He is in California and the businesses effective tax rate is 44%.  He needs unique e-commerce tax planning. 

Here is Jeff’s tax issue of converting his business to an Irish company.

“The tax code section 367 attempts to keep a successful domestic business within the U.S.  Small businesses want to expand into new markets and not pay U.S. tax on their non-U.S. income.  

Section 367 provides that if intangible property (also known as intellectual property) is transferred to a foreign corporation, the tax savings are reduced.  Know-how is one of the types of property and is included in this law. 

The other intangible properties are trade-secrets and those created by a government such as a patent, copyright, trade name, and trademark. 
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