Tag Archives: management fee

When International Cross Border Management Consulting Fees Can Send You to Prison

International cross border management consulting fees deducted on a U.S. tax return are traced by the IRS.    This expense can place you in jail if you can not prove why the fee was paid.  

The IRS is hunting for  management fees or consulting fees paid to or from  a foreign business.   The United States is the only country that puts you in jail for ignoring the economic substance of a transaction. 

Mr. Albert S.N. Hee was sentenced to 46 months in prison.  He was a successful businessman in Hawaii.    To get money out of his U.S. corporation, he paid his wife and children about $750,000.  He deducted the expense on his corporate tax return claiming that they were providing services to his business.

When the IRS found out the truth, he was arrested on various criminal charges.  The easiest one for the IRS to prove was filing a false tax return.  All the IRS has to prove is the Mr. Hee placed an item on his return (the expense) that was not true.  The IRS does not need to prove that taxes were avoided.

Take Mike as an example.  He is Canadian and lives in Vancouver.  He has invested in a U.S. business.  He has provided the startup money to an e-commerce business and owns 25% of the business (operating as a limited liability company).  Mike does not want the complexity (and therefore accounting fees) of filing a U.S and state tax return.

Mike is taking his share of the profits as a management fee. He spends time getting an update report from the other owners but he is not managing the business. 

He is paying Canadian taxes on the income but no American taxes.   The criminals are the LLC, its managing members, and Mike.   Often the IRS will add the criminal charge of “conspiracy to defraud” and mail fraud. 

What should have Mike have done?

For a Canadian, an American LLC is not the best choice.  Since Mike is not involved with management, a limited partnership is a good option.  Under the Canadian-United States Tax Treaty, Canada will offset his Canadian income taxes by the U.S. income tax.

The limited partnership will make the estimated tax payments for Mike.  Mike will get one or two-page report (call a Form K-1) from the partnership telling Mike the amount of his taxable income and the amount of estimated taxes.  Mike will file a U.S. and state income tax returns.

Yes, it is a hassle.  But other international businesses see this a part of the cost of being an international business.  Usually the CPA fees for the returns are less than $5,000.  By the way, the fees are a tax deduction. 

Judges are harsh on non-U.S. citizens saying to the defendant that they came to America to make money.  Unlike citizens who have no choice but to pay taxes, the nonresident alien came here by their own choosing.

If you need help in organizing your international business transactions, the email me, Brian Dooley, CPA, MBT at [email protected]

International Tax Strategy for the United Kingdom, Deutschland, and Français Business owning a U.S. Subsidiary Corporation

What is the best international tax strategy for the United Kingdom, Deutschland, and Français Business owning a U.S. subsidiary corporation?

The answer is long and complicated.  So, please get a cup of tea or coffee and spend a few minutes.    One choice is for the U.K., German or French company to merely open a branch in the U.S. and not form a U.S. corporation.

Legally; this is easy.  The company will register with the state(s) where it is doing business.  If it has employees, it will register with both the IRS and the states.   

The other choice is for the U.K., German or French company to create a subsidiary corporation in the state that will be their U.S. headquarters.  If it has employees, it will register with both the IRS and the state.

The U.S. corporation pays income tax on its worldwide income. The maximum U.S. corporate tax rate is 35% (as of October 2017).  This rate may drop to 20% starting in 2018.

Most states also have an income tax.   So far, it is simple. However, with more than 1,000,000 pages of tax law, it quickly becomes complex.

We start with capitalizing the corporation.   American tax law is anti-debt and especially shareholder debt.  

For example, Keith’s U.K. company starts a California corporation. The U.K. company invests $1,000 in the common stock and loans a $100,000 to the corporation.  The loan is evidenced by a written promissory note and has a reasonable interest rate. The promissory note was approved by the directors of both companies.

The California corporation had a successful first year and paid back the $100,000.  The U.K. company has $100,000 of U.S. taxable income. Yes, the repayment is taxable. 

Why is the loan repayment taxable?   The California corporation was “thinly capitalized”.  For the U.S. standpoint, a loan is treated as preferred stock when the loan exceeds 33% of the capital (including retained earnings).  This tax law is called debt versus equityThis link has more information. 

And there is more bad news for international debts.  If tax treaty exempts the interest income from U.S. tax, a U.S. corporation cannot deduct only a portion of the interest expense.  This law is complicated, and I have an explanation on this page. 

The goal of this law is to prevent the foreign person from removing money from a U.S. corporation free of U.S. income tax.   Luckily, the tax treaties with the U.K., France, and Germany require a U.S. tax and thus interest paid to a residence in this country is not affected by this law.

Avoiding Double Taxation with an International Tax Strategy for the United Kingdom, Deutschland, and Français Business owning a U.S. Subsidiary Corporation or a Branch.

The U.S. tax law wants double taxation on all corporate profits. For the foreign corporation with a branch, this tax is called the “branch profits tax” 

The tax law expects the corporate profits to be paid the shareholder as a dividend.  The U.S. tax rate on a dividend paid to a foreign person is the lower of 30% or the rate found in the tax treaty.  

The rate is between 5% to 15% for in the U.K., France and German tax treaty (please see more on this link).  The tax is withheld by the paying domestic subsidiary. 

For example, the  California corporation had a successful first year.  The business made $250,000.  The U.S. tax is $80,000, and the California tax is $22,000.   

The U.K. company pays out the remaining profit of $148,000 to the UK parent company.   U.S. tax law classifies this as a dividend.  Assuming that the ownership of the U.K. company qualifies for the U.K.-U.S. Tax Treaty for the direct dividend rate, the U.S. tax is $7,400. 

The California corporation withholds the $7,400 and  pays $7,400 directly to the IRS.  The U.K. parent company receives $140,600 ($148,000 minu $$7,400).   By the way, many types of payments of U.S. source income to a foreign person require the tax to be withheld and paid directly to the IRS.  Here is a link with more on this topic. 

How about foriegn  management fees, consulting fees, and other stewardship fees? 

Unlike other nations, you can go to prison for paying these fees unless you can prove that the foreign person did work and the payment is reasonable (read more on this link).

The U.S. courts will want to see your time journal (showing what you did, the day you did the work and the time you spent), proof that the hourly rate is valid and the business reason as to why the foreign person did the work and not someone in the United States.

How about international licensing the technology or a trade name or a trademark?

Much like the payment of fees above, you need to have proof as to the value to the U.S. corporation.   When the amount of the licensing payment is inflated, not only is the deduction disallowed, the event may be considered a crime.

You must be able to prove that the  price paid for  goods, services and licensing is the price that an unrelated person would pay.   

International Tax Strategy for the United Kingdom, Deutschland, and Français Business with a  Cost Sharing Agreements to Shift Profits

Cost sharing is a sophisticated international tax strategy. The courts continue to uphold international tax planning using cost sharing agreements.  You can learn more on this topic on this link.

What if the U.S. corporation does not pay a dividend?

A second corporate tax applies when a corporation does not have a business reason for not paying a dividend to a shareholder.   In the example above, if the profits are needed to expand the business, for a cash reserve for unforeseen events, then the second tax will not apply.

Assuming that the U.K. company ownership qualifies under the tax treaty of the five percent rate on dividends, then the second tax is five percent.

Does the U.S. subsidiary corporation causes the U.K. company to pay U.S. income taxes?

It might!   Here is what has happened, on  this link.  

Finally, there is the U.S. estate taxes for the non-resident alien.

 Assuming that Keith is the sole shareholder of the U.K. company, the value of the California corporation could be subject to U.S. estate taxes upon his death.  Here is more on this topic. 

If you would like to discuss your plans of opening an office in the  United States, then please email me at [email protected]

 

How European and U.K. Companies Start a Business in the United States

International small business owners starting operations in the United States face unbelievable tax laws.   Many items allowed in the U.K. and Europe is “illegal” in the U.S.   By the word “illegal” I do not mean that you will go to jail because you naively break the tax laws.  However, you will get hit with a large tax penalty.

So, I want to list the international tax transactions that are not allowed.

  1.   Thin Capitalization.  The funding of your business is where the foreign investor makes his (or her but for this blog, I will use “his”) mistake.     Corporations must be funded with $1 of capital for every $3 of shareholder debt.  For example, Samfunds his U.S. corporation with a $1,000.    $10 is for the common stock and $990 is  a loan.The loan is documented with a promissory note and director minutes.The corporation makes a profit and repays the loan.  U.S. tax law classifies that loan as capital and the repayment is taxable to Sam as dividend income.   The interest paid the on the loan is not deductible.  The interest is also taxable to Sam as a dividend.
  2.  Management Fee.  Sam, aware of the double taxation issue of a corporation, decides to remit the profits to his U.K. company as a management fee.   U.S. tax law looks at the both the form (a management agreement) and the economics.   The IRS audits the corporation and asks proof of the management services provided by the U.K. company.  Sam has a story but he has no proof.   He is taxed two times.  The corporate taxable income is increased by the management fee.Next, the payment of the management fee is treated as a dividend. Sam is taxed on the dividend income.  Both the corporation and Sam are charged a large tax penalty.     Additionally, the state where he is operating also taxes the corporation.
  3.    Salary.  Sam does not take a salary from the corporation.  He is paid by his U.K. company.  He spends one third of the year in the U.S.  One third of his U.K salary is taxable to both the IRS and to the state where the business is located. Sam is not a U.S. tax resident.   He owes U.S. income taxes because he was in the U.S. and for no other reason. 
  4.  Tax Treaties.  The French, the Netherlands and the U.K.  tax treaty provides a tax advantage by eliminating double taxation   To take advantage of the tax treaty, you must reside in the country and use a company formed in the tax treaty country.  The operation in the U.S. is considered a branch.   The U.S. has a law called “branch profits tax”.This law is designed to prevent double tax the profits.  However, the treaties don’t prevent the branch profits tax.The treaties prevent double taxation of the income tax.   The treaties provide that your home country will allow an offset of your home country tax for the income taxes your corporation paid to the U.S.

If you are looking to start a business in the U.S., then please contact me  ([email protected]) for assistance in setting up your business.    Also, I recommend my book as a resource (on this link).

Court Bust Management / Consulting Fee Tax Planning, Again

tax planning, saving taxes, how to save taxes, tax court

Tax Court explains great tax planning in this case.

Weekend Warrior Trailers, Inc., Et Al., Petitioners V Commissioner of Internal Revenue, Respondent  is an example of what not to do.  The Tax Court  was assessed every tax penalty on the books.

Many advisors use the “management fee” to shift income onshore and offshore.   The tax court and the IRS blasted this taxpayer for this naive and improper method of tax planning because the foreign corporation did not provide any services.

The tax court describes the taxpayer’s tax team as follows:

“Before 2002 Weekend Warrior engaged the services of attorney John Dana Mitchellweiler (Mr. Mitchellweiler), a partner at Smith, Mitchellweiler in Riverside, California. Mr. Mitchellweiler described himself as an outside general counsel to Weekend Warrior.

Mr. Mitchellweiler practiced law in the business and estates areas. As of the date of trial Mr. Mitchellweiler had practiced law for 15 years.”
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Tax Court Bust Novice Tax Planner’s Management / Consulting Fee Income Shifting

tax planning, saving taxes, how to save taxes, tax court

Tax Court explains great tax planning in this case.

As you may know from my other blogs, I am a fan of Great Tax Planning.  Yet, so many highly educated individuals fall prey of novice tax planners.  Take Dr. Wiley Elick and his wife Sharon for example.  Dr. Elick is a successful pediatric dentist.

Of course, he wants to save taxes.  He was informed of the tax savings of an ESOP (a type of retirement plan funded by your corporation’s stock instead of money).  

His medical corporation could not have the ESOP. In many states, only doctors can own the shares of a medical corporation.  So, he formed a new corporation. The dental practice paid the new corporation a management fee. The Doctor wanted to move the profit from his dental practice to his management company.   The ESOP cost reduced the taxable income of the management company.

Novice tax planners use “management fee” method to shift income. They believe that if they have a written management agreement that a management fee is allowed.   They do not know that management service must occur. The tax court looks at the hours of management services.

(Update: recently it (management fee and consulting fee) tax planning went criminal. Here is what happen: Mr. Albert S.N. Hee was a successful businessman Hawaii. His corporation paid family members consulting and management fees for work they never did. His family members paid income tax on the fees. Mr. Hee is going to prison because his corporate tax return was false. Merely showing the management/consulting fee on the return was a crime.)

As in this case, the Judge saw that the new corporation never provided any management services.   In other words, the management company did nothing.

It gets worse.  The amount of the management fee was decided by Doctor.  The fee was not based on hours spent or the value of the services.  I have a link to the case below.  The fee changed each year.  The fee was based on the profit of the dental practice.

 Here is a link to the court case.

To have a great tax plan, I suggest working with the IRS National Office.  They are pro small business.  If  Dr. Elick applied for an IRS private letter ruling, the National Office would have perfected his tax plan.   The ruling process reviews your plan. If it is not going to work, they IRS will guide you on how to perfect your tax plan.  Many people fear getting a ruling will cause a tax audit. None of my clients have had a tax audit because they applied for a ruling.  Learn more about our private letter ruling services with this link.

Want to take your tax planning to the next level, then contact me, Brian Dooley, CPA, MBT  at [email protected]