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’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.
International tax planning for the Contract Manufacturing
Our researchers found this internal IRS document on the auditing of the garment and other clothing manufacturing. The IRS audit issues are the same for other small manufacturers and distributors that assemble products.
I have the IRS document below in blue print. If you find yourself under an IRS audit or just want to be ready for one, this blog will tell you what to do and not do. If you need help, then please call me, Brian Dooley, CPA, MBT at 949-939-3414.
Though some of these areas will be addressed in detail later in this document, the following are examples of adjustments that were made:
Imputed interest under IRC section 7872, loan write-offs against salary payable that is not included in Form W-2 income.
Related Party Transactions.
Sales of assets, excess payments to related contractors, management fees, consulting fees, unreported income received from a related party.
Relief of Liability Income.
Acquired Net Operating Loss.
IRC section 269.
Disallowance of Entertainment Facilities.
Condominiums, boats, country clubs, etc.
Unallowable Accruals/Reserves for Sales Discounts and Returns and Allowances.
Travel and Entertainment; IRC section 162 and section 274.
Trips abroad, excessive auto deductions, restaurants, payments of various personal expenses.
Auto Expenses and Depreciation.
Unreported by shareholders or employees, particularly when no Forms 1099 are issued.
Bad Debt Disallowance.
Shareholders, key employees.
Pick-up of Related Shareholder Returns.
For issues related and unrelated to manufacturer’s return.
Employment Tax Adjustments.
Independent contractors versus employee issues, bonuses to employees, other payments to employees constituting “wages,” backup withholding.
Form 1099 Penalties.
Failure to file, incorrect ID number of the recipient on the Form 1099.
Examiners are sometimes contacted by individuals (informants) who offer information of sales “off the books,” and these leads are always evaluated as potential audit leads.
A significant portion of the total deficiencies generated by an examination of a garment manufacturer may be attributable to “spin-off” returns. These are returns that, if not for the examination of the manufacturer, may never have been audited. Given the frequency with which these returns were found to contain significant adjustments, take more than a quick glance at any returns provided for inspection as part of the Required Filing Checks. Also, returns provided for inspection purposes should be referred to at various points of the examination for consideration of audit potential.
What follows is a brief discussion of the most common types of spin-off returns. Continue reading →
Saving taxes after this year will require a new approach! With the new low corporate tax rate of 15% and the elimination of most itemized deductions, you need to work harder to get save the most in taxes.
The two parties are working together to: 1. limit total itemized deduction. 2. lower the tax rate on active business income. The rate will be 15% to 25%.
If you want to brainstorm your international tax planning, please call me, Brian Dooley CPA, for a free one-hour consultation. If you need other tax planning ideas, I recommend these books.
How to save taxes in 2016:
1. You want to move income from your individual return to related party corporate return. Corporate taxes start at a 15% tax rate and top out at 35%. The lower in Form 1040 income, the more you get in itemized deduction and tax credits. 2. If you have investment income, you will pay an excise tax of 4% on your investment income. The excise tax does not apply if your total income is less than $250,000.
Here are some ways to use a corporation to save taxes including state income taxes. 1. Have the company provide your business administrative support such as payroll, inventory control, and computer services. Charge a fee for this activity. Take advantage of a tax haven state such as Nevada. You can use this to avoid California income taxes. 2. Use health reimbursement arrangement (“HRA”) tax law from last century. This plan does not need to cover everyone. The IRS provided easy to use in IRS Notice 2002-45. If you need a copy, then please email[email protected]. 3. Corporate retirement plans can be funded with shares in the corporation versus money. The newest is the self-directed Solo 401(k) plan. Learn how on this link. 4. Consider having a corporate defined benefit plan to save taxes and to protect assets. If you are older then fifty years old, your tax savings will be substantial. 5. Learn how to avoid taxes with this episode of my Blog Tax Talk below. This audio is about 12 minutes.
Saving taxes with back to back related party loans. Onshore and offshore tax planning will profit from these new IRS rules.
The removal of the capital from a corporation requires the owner to be liable for the debts. The prudent small business owner funds the corporation with part capital and part loan. The ratio of shareholder debt to capital is five to one. This avoids the legal and tax problem of a “thinly capitalized” corporation.
But there is a problem for small business with the tax court.The IRS won several court cases where the shareholder borrowed money from one of his corporations and loan the money to his other corporation. This is known as a “back to back loan.”
Entrepreneurs use money in a successful business to fund a new business. When he/she borrows the money from the successful business, the loan must first go him/her and then to the new business. If the loan is directly from the successful business to the new business, then the “at risk” tax law causes a problem. In other words, the intercompany loan is bad tax planning.
An example of the “at risk” tax law”: One corporation would have $500,000 in income and the other $500,000 in losses. The shareholder can not deduct the loss because one corporation borrowed directly from another corporation. However, if the shareholder borrowed the money and loaned the money to the other corporation, the loss can be deducted.
The best small business tax planning and asset protection planning for a corporation involves loans from the shareholder. Besides asset protection, there are two tax reasons: 1. Shareholder loans (and only shareholder loans) are exempt from the “at risk” tax loss restrictions (more on this link) and 2. The “thin capitalization” rules (found in Section 385) do not apply to subchapter S corporation. When “thinly capitalize,” a corporation shareholder loan is treated as stock (and not debt). Without this exception, only $3 of loans are allowed for each $1 of capital.
What about an LLC? If you are using a limited liability company, you might have heard the misinformation that they do not exist for tax law. A Schedule C (self-employed income) reports a single member LLC’s (SMLLC) income and expenses. The “at risk” rules prevent losses from being deducted. Here is an easy to read blog on the “at risk” rules for small businesses.
International tax planners have used back to back loans for almost a century. With this new regulation, you can fund your controlled foreign corporation with money in your U.S. business.
More IRS Tax Savings: New IRS rules allow the interest rate on related party loans to be one percent or less. This is the time to set up your offshore structure with a related party loan.
If you need to up the quality of your tax planning, then contact me, Brian Dooley, CPA, MBT, [email protected]
Saving taxes with the pending tax reform requires an innovative tax plan.
Related party loans are an excellent way to shift income and protect assets. Congress told the IRS to update its regulations to take into account credit risks of the related party. The IRS said “no.”
Shifting income to a lower tax entity is easy when using debt to transfer the income producing asset. The IRS required related party loan interest rate is below one percent regardless of the financial strength of the related party.
The flaw in the tax law is that all promissory notes have the same economic substance irrespective of the creditworthiness of the borrower. The IRS requires an interest rate of about one to three percent on an unsecured loan to a related party. Yes.. it is a sham rate and it is necessary. No need to look at the credit worthiness. The IRS rules require an abusive tax sham for you to use.
The promissory note must be signed at the time of the loan. Currently, the IRS informal and unofficial policy has allowed loan agreements to be signed before the tax return is due. Never backdate a document. The promissory note states the effective date, which is the time the loan was made. You must have a double-entry general ledger and record the transaction as a loan.
The most famous case in the Rushing Trust case (on this link) where a related party installment sale note of a family trust was considered to be for adequate consideration. The trust issued the note and purchased the asset from the settlor. The trust had almost no capital. The trust was not creditworthy. The court held that section 482 (related party transactions) and section 1001 (sale of property) were satisfied.
If you would like to brainstorm your tax planning ideas, then please call me, Brian Dooley CPA, at 949-939-3414 for a free one-hour consultation. You can learn other great international tax planning strategies with my easy to read book, International Taxation in America for the Entrepreneur. Amazon has the Kindle on sale for $9.50 on this link.
Hear my episode of Tax Talk on related party loan tax strategies by clicking below.
The Great Recession caused Congress to demand all Federal agencies to look their regulations and to correct them if they did not take into account creditworthiness under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Well, the IRS started to follow the law; and then decided to say “No” to Congress. If you would like to brainstorm your tax planning, then please call me, Brian Dooley CPA, at 949-939-3414 for a free one-hour consultation.
Below is the IRS’s announcement. We recommend that you work with the IRS and get their okay of your tax plan with a private letter ruling (get more information on this link).
Section 939A(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (124 Stat. 1376 (2010)), (the “Dodd-Frank Act”), requires each Federal agency to review its regulations that require the use of an assessment of credit-worthiness of a security or money market instrument, and to review any references or requirements in those regulations regarding credit ratings.
Section 939A(b) directs each agency to modify any regulation identified in the review required under section 939A(a) by removing any reference to, or requirement of reliance on, credit ratings and substituting a standard of credit-worthiness that the agency deems appropriate. Numerous provisions of the Code are affected.
These temporary regulations amend the Income Tax Regulations (26 CFR part 1) under sections 150, 171, 197, 249, 475, 860G, and 1001 of the Code. These sections were added to the Code during different years to serve different purposes. These temporary regulations also amend the Manufacturers and Retailers Excise Tax Regulations (26 CFR part 48) under section 4101 that provides registration requirements related to Federal fuel taxes.
Explanation of Provisions
These temporary regulations remove references to “credit ratings” and “credit agencies” or functionally similar terms in the existing regulations. Some changes involve simple word deletions or substitutions. Others reflect the revision of a sentence to remove the credit rating references. In some cases, multiple sentences have been modified.
Where appropriate, substitute standards of credit-worthiness replace the prior references to credit ratings, credit agencies or functionally similar terms. Language revisions serve solely to remove the references prohibited by section 939A of the Dodd-Frank Act and no additional changes are intended.
Section 1.150-1. Section 1.150-1 provides definitions for purposes of sections 103 and 141 through 150. Section 1.150-1(b) defines issuance costs to mean costs to the extent incurred in connection with, and allocable to, the publication of an issue within the meaning of section 147(g). Section 1.150-1(b) lists as non-exclusive examples of issuance costs: underwriters’ spread; counsel fees; financial advisory fees; rating agency fees; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in § 1.148-4(f)); and similar costs.
These temporary regulations replace the § 1.150-1(b) reference to rating agency fees with “fees paid to an organization to evaluate the credit quality of the issue.” No substantive change is intended.
Section 1.171-1. The temporary regulations change credit rating in § 1.171-1(f) Example 2 (i) to credit quality. The change does not affect the analysis in the example. Also, the temporary regulations make other nonsubstantive changes to the example (for example, the dates in the example are updated).
Section 1.197-2(b)(7). The temporary regulations remove “the existence of a favorable credit rating” from the examples of supplier-based intangibles in the third sentence of § 1.197-2(b)(7). No substantive change in the treatment of a favorable credit rating as a supplier-based intangible under Section 197 is intended.
Section 1.249-1. The temporary regulations change credit rating and ratings of credit rating services in § 1.249-1(e)(2)(ii) to credit quality and widely published financial information. In the existing regulations, a change in the credit rating of an issuer or obligation is one of the facts and circumstances used to determine how much of a repurchase premium is attributable to the cost of borrowing and not to the conversion feature of a convertible bond. Credit rating services are used as a means to determine the credit rating of an issuer or obligation. None of these changes affect the substantive rules in the existing regulations.
Section 1.475(a)-4(d)(4). Example 1, Example 2, and Example 3 in § 1.475(a)-4(d)(4) are revised to remove references to credit ratings or credit rating agencies. In these three examples in the existing regulations, credit rating or specific references to certain ratings by certain credit ratings agencies (such as AA/aa or AAA/aaa) were used to set up the factual scenario that illustrates the factors that go into the determination of whether it is appropriate for a dealer to take a credit risk adjustment.
These terms were also used to describe the credit risk adjustment implicit in the yield curve used to discount the present value of the cash flows. This adjustment affects whether any additional credit risk adjustments are warranted.
These examples also used credit rating agency to set up the factual scenario that a counterparty’s credit-worthiness was based upon an industry standard of a certain credit quality and illustrates the factors that go into the determination of whether it is appropriate for a dealer to take a credit risk adjustment. The changes that have been made to the language of the examples do not alter the purpose of the illustrations and present the factual issues in a more generalized way.
Section 1.860G-2. Section 1.860G-2(g)(2) defines qualified reserve fund as an amount that is reasonably required to fund expenses of the REMIC or amounts due on regular or residual interests in the event of defaults on the underlying pool of mortgages. In defining the amount reasonably required, § 1.860G-2(g)(3)(ii) refers to the amount required by a nationally recognized independent rating agency as a condition of providing the rating for the REMIC interest desired by the sponsor. Because an alternative and fully adequate standard of reference are already outlined in these regulations, these temporary regulations remove the rating agency alternative standard.
Section 1.1001-3. Section 1.1001-3 provides rules for determining whether a modification of a debt instrument results in exchange for purposes of § 1.1001-1(a). These temporary regulations remove the terms rating and credit rating from § 1.1001-3 and replace those terms with credit quality. Section 1.1001-3(d) Example 9 is revised so that the event that triggers an option to increase a note’s rate of interest is a breach of certain covenants in the note, rather than a specific decline in the corporation’s credit rating.
The temporary regulations also revise § 1.1001-3(g) Example 5 so that the debt instrument described in the example allows a party to be substituted for the instrument’s original obligor by the party’s credit-worthiness, rather than the party’s credit rating. The temporary regulations also revise § 1.1001-3(g) Example 8 to explain that a bank’s letter of credit supporting a debt instrument is substituted for another bank’s letter of credit when the first bank encounters financial difficulty, thus removing references to rating agencies and either bank’s credit rating.
Section 48.4101-1(f)(4). Section 4101 requires certain persons to be registered by the IRS for purposes of several fuel tax provisions of the Code. Under § 48.4101-1, the IRS will register an applicant for registration only if, among other conditions, the applicant has adequate financial resources to pay its expected fuel tax liability. To make this determination, § 48.4101-1(f)(4)(ii)(B) instructs the IRS to look to the applicant’s financial information. These temporary regulations remove the examples of the types of documents the IRS should review and instructs the IRS to look at all information relevant to the applicant’s financial status.
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), please refer to the Special Analysis section in the preamble to the cross-referenced notice of proposed rulemaking in the Proposed Rules section in this issue of the Federal Register. Under section 7805(f) of the Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.
These regulations were drafted by personnel in the Office of Associate Chief Counsel (Financial Institutions and Products), the Office of Associate Chief Counsel (Income Tax and Accounting), the Office of the Associate Chief Counsel (International) and the Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and the Treasury Department participated in their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 48
Excise taxes, Reporting and recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 48 are amended as follows:
PART 1 — INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.150-1 is amended as follows:
1. Paragraph (a)(4) is added.
2. In paragraph (b), the definition of Issuance costs is revised.
The additions and revisions read as follows:
§ 1.150-1 Definitions. (a)
(4) [Reserved] For further guidance, see § 1.150-1T(a)(4).
(b) * * *
Issuance costs [Reserved]. For further guidance, see § 1.150-1T(b), Issuance costs.
* * * * *
Par. 3. Section 1.150-1T is added to read as follows:
§ 1.150-1T Definitions (temporary).
(a) through (a)(3) [Reserved]. For further guidance, see § 1.150-1(a) through
(4) Additional exception to the general applicability date. Section 1.150-1T(b), Issuance costs, applies on and after July 6, 2011.
(5) Expiration date. The applicability of § 1.150-1T(b), Issuance costs, expires on or before July 1, 2014.
(b) Bond through the definition of Governmental bond [Reserved]. For further guidance, see § 1.150-1(b) Bond through the definition of Governmental bond.
Issuance costs mean costs to the extent incurred in connection with, and allocable to, the publication of an issue within the meaning of section 147(g). For example, issuance costs include the following costs but only to the extent incurred in connection with, and allocable to, the borrowing: underwriters’ spread; counsel fees; financial advisory fees; fees paid to an organization to evaluate the credit quality of an issue; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in § 1.148-4(f)); and similar costs.
(c) Issue date through paragraph (e) [Reserved]. For further guidance, see § 1.150-1(b) Issue date through paragraph (e).
Par. 4. Section 1.171-1(f) Example 2 is revised to read as follows: § 1.171-1 Bond premium.
* * * * *
(f) * * *
Example 2. [Reserved]. For further guidance, see § 1.171-1T(f) Example 2.
* * * * *
Par. 5. Section 1.171-1T is added to read as follows:
§ 1.171-1T Bond premium (temporary).
(a) through (f) Example 1 [Reserved]. For further guidance, see § 1.171-1(a) through (f) Example 1.
Example 2. Convertible bond — (i) Facts. On January 1, 2012, A purchases for $1,100 B corporation’s bond maturing on January 1, 2015, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $30 on January 1 and July 1 of each year. Also, the bond is convertible into 15 shares of B corporation stock at the option of the holder. On January 1, 2012, B company’s nonconvertible, publicly-traded, a three-year debt of comparable credit quality trades at a price that reflects a yield of 6.75 percent, compounded semiannually.
(ii) Determination of basis. A’s basis for determining loss on the sale or exchange of the bond is $1,100. As of January 1, 2012, discounting the remaining payments on the bond at the yield at which B’s similar nonconvertible bonds trade (6.75 percent, compounded semiannually) results in a present value of $980. Thus, the value of the conversion option is $120. Under § 1.171-1(e)(1)(iii)(A), A’s basis is $980 ($1,100 – $120) for purposes of §§ 1.171-1 through 1.171-5. The sum of all amounts payable on the bond other than qualified stated interest is $1,000. Because A’s basis (as determined under § 1.171-1(e)(1)(iii)(A)) does not exceed $1,000, A does not acquire the bond at a premium.
(iii) Effective/applicability date. This Example 2 applies to bonds acquired on or after July 6, 2011.