Category: Tax

Form 5471 – A Harsh New Reality for US Shareholders of Foreign Corporations

Who is required to File Form 5471?

Certain US persons who are shareholders (both corporate and individual shareholders), officers or directors of a foreign corporation may be required to file Form 5471 on an annual basis. Here, is a link to the IRS Website on filing requirements l.

There are four categories (including corporate shareholders) that may be required to file the form, as follows:

1. A US person who is an officer or director of a foreign corporation in which any US person owns or acquires 10% or more of the stock of the foreign corporation.
2. A person who becomes a US person while owning 10% or more of the stock of the foreign corporation.
3. A US person who had control of a foreign corporation for at least 30 days.
4. A US shareholder who owns stock in a foreign corporation that is a controlled foreign corporation for an uninterrupted period of at least 30 days and who owned that stock on the last day of the that year.

What Information is Required?

The required information may be as minimal as the identification of the US shareholder and the name and address of the foreign corporation – or it may be as extensive as a comprehensive balance sheet and income statement converted from multiple foreign currencies into US dollars, including computations of cumulative earnings & profits and disclosure of related party transactions.

When is Form 5471 Due?

Form 5471 is due with the income tax return of the affected shareholder. For most corporations, that would March 15th or the extended due date. For most individuals, that would be April 15th or the extended due date.

How Long does it take to Prepare?

The IRS estimates the average time to prepare Form 5471 is approximately 38 hours, exclusive of record keeping time and the time required to learn about the relevant law and the instructions. The learning time could be much longer for someone who is not familiar with the pertinent sections of the tax law.

Harsh Penalties – A New Reality

For many years, it was extremely rare to get any IRS reply regarding a filing, even if the form was very late. The IRS has been warning in public statements that the Form 5471 penalties were coming and would be automatically assessed by the IRS computer. The penalty under IRC Section 6038(b)(1) is $10,000 for each late or incomplete Form 5471.

Remember, very often, the information on this form does not result in any taxable income or tax due for the taxpayer.  So, the $10,000 penalty is a “disclosure” penalty, unrelated to the actual tax consequences of the information provided on the Form 5471. The $10,000 penalty is real and is now being automatically assessed.

If the failure continues for more than 90 days after the date the IRS mails notice of the failure, an additional $10,000 penalty will apply for each 30-day period or fraction thereof during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000.

Why should a US Corporation with NOLs still be Concerned?

With the economic downturn, many US corporations have build-up significant net operating losses (NOLs). Thus, management may not be overly concerned about filing Form 5471, based on its belief that the company’s NOLS will shelter any potential exposure. However, because the failure to file Form 5471 results in a penalty (not a tax), NOLs do not any shelter this exposure.

Thus, the often unforeseen result is a FIN 48 liability and hit to the P&L for $10,000 for each unfiled Form 5471. For example, a US corporation with four foreign subsidiaries for which Forms 5471 have not been filed in the three most recent tax years would be required to accrue a $120,000 (a $10,000 penalty for each unfiled Form 5471 x 4 subsidiaries x 3 tax years) FIN 48 liability and current year P&L expense, which can be a huge P&L hit for company with no US taxable income.

Additionally, the three year statute of limitations with respect to the underlying tax income tax return (Form 1120, 1040, etc.) does not start running until Form 5471 is properly filed, as the return was not complete at the time it was originally submitted.

 

 

 

Why You Shouldn’t Kill Your Rich Uncle Just Yet: Things You May Not Know About the Estate Tax Repeal

Estate and FInancial PlanningThe day is finally here. After hearing about it for the past nine years, the estate tax is repealed as of January 1, 2010. Yet, many questions remain. For example, one may wonder what will happen next year when the estate tax (presumably) returns and one is puzzled why U.S. Congress did not address the “estate tax issue” during the 2009 tax year.

The one-year repeal of the “death tax” was a typical congressional compromise. It involved the gradual decrease in marginal tax rates and increase in tax free amount (unified credit) through 2009 and the repeal of the tax for just one year in 2010. The current law reads that in 2011 the rates from 2001 will apply again (P.L. 107-16, 115 Stat 38 (June 7, 2001)).

What does this mean for taxpayers? Let’s assume Uncle Joseph’s taxable estate is valued at $5 million. If he died in 2001, $675,000 of the estate would have been tax free and the rest would have been taxed with a top marginal rate of 55%. Tax liability would have been about 2.17 million and effective tax rate about 43%. Had Uncle Joseph died in 2009, his tax due would have been $675,000 and his effective tax rate around 14% while a 2010 death would mean zero liability (see Table).

Year Top Marginal Tax Rate Unified Credit
(Exemption Equivalent)		 Tax due after credit on $5 million estate Effective Tax Rate
2001 55% $220,550 ($675,000) $ 2,170,250 43%
2002 50% $345,800 ($1,000,000) $ 1,930,000 39%
2003 49% $345,800 ($1,000,000) $ 1,905,000 38%
2004 48% $555,800 ($1,500,000) $ 1,665,000 33%
2005 47% $555,800 ($1,500,000) $ 1,635,000 33%
2006 46% $780,800 ($2,000,000) $ 1,380,000 28%
2007 45% $780,800 ($2,000,000) $ 1,350,000 27%
2008 45% $780,800 ($2,000,000) $ 1,350,000 27%
2009 45% $1,455,800 ($3.5 million) $    675,000 14%
2010 NA NA No tax N/A
2011 55% $220,550 ($675,000) $ 2,170,250 43%

Questionable Policy Incentives

The stated policy reason for estate taxes has been that too much concentration of wealth is not good for a society. Aside from the fact that the estate tax has not done much in terms of reducing income and wealth inequality, the fact that Congress did not change the one-year repeal before January 1 of 2010, is an example of implementing quite questionable incentives. As the situation above shows, all else equal, the best year for Joseph to die is 2010. His heirs will receive the entire $5 million instead of only $4.3 million if he died in 2009 or $2.8 million if he dies in 2011. Of course, death of natural causes cannot be timed. What happens though if Joseph was in a serious accident in late 2009 without a DNR order in place? Would his heirs insist that he’d be kept alive until January 1 and then taken off life support? What if Joseph has an accident in December of 2010?

In order to prevent anybody of literally making life or death decisions in order to save taxes, Congress should have addressed the estate tax in 2009 before the repeal-year started. There were several proposals on the table. Considering the current budget shortfall and the Democratic majorities in both the House and the Senate it is not unlikely that the legislators will pass a law retroactively changing the 2010 repeal. Since tax returns are not due until nine months after the decedent’s death, a retroactive change is possible. For example, it may be possible that a “patch” (i.e., keeping rates and credit like it was in 2009) will pass for 2010. Thus, contemplating death in light of a possible tax free year would be unwise considering the irreversibility of such action.

Other Negative Consequences

During 2001–2011 inflation was relatively low (around 2.3% on average). Using consumer price index measures, the value of a dollar in 2001 is about 1.25 more than in 2011. Given that in 2001, over 108,000 estate tax returns were filed, compared to only 38,000 in 2008 , we can assume that reverting back to 2001 law would mean that at least 130,000 returns will be due in 2011. This is good news to tax accountants but bad news for many individuals who did not expect to be subject to estate taxes.

In addition, the repeal of the estate tax for 2010 means that assets transferred at death during this year do not get a stepped-up basis. Thus, beneficiaries will have to pay larger amounts in income taxes when they sell the inheritance.

Last, the one-year repeal is also bad news for estates below the exemption equivalent. For these estates, the tax savings are zero while the elimination of the step-up in basis increases beneficiaries’ income tax when they sell the assets received. One can make the argument that this is a rule against the middle class and upper middle class since presumably most of these individuals would have never paid estate tax anyway but their heirs would benefit from the step-up in basis. If the law reverts back to 2001 law in 2011, the step-up will be back next year. Thus, while individuals with large estates have an incentive to die in 2010, others (most middle and upper middle class taxpayers) who have an estate below the exemption equivalent should not die in 2010.

S Corporation Pitfalls – Part 1

S Corporation PitfallsS Corporations are a popular business entity – they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection.  There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status.  This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…

First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.

This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments.  These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income.  If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.

Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.

Taking the Life out of LIFO

Taking the Life out of LifoFor many companies the transition to IFRS will not result in a major change… the big exception is in the manufacturing and retail industries, as IFRS does not allow the use of LIFO (the Last In First Out method of accounting for inventory). Because LIFO treats the last item to be purchased as the first item to be sold, the use of LIFO generally increases the cost of goods sold during periods of inflation.  This reduces a company’s assets and earnings, but can result in large tax savings. It is because of this dichotomy that the IRS requires businesses to use LIFO for their book accounting records and financial statements if they wish to use it for tax purposes. Additionally, use of LIFO is generally restricted to mid-to-large sized companies, as it requires additional administrative work to track multiple LIFO layers for each type of inventory, and to prepare tax Uniform Capitalization adjustments on each layer.

Enter IFRS (from 2014 to 2016 for publicly traded companies – transition dates for privately held businesses have not yet been announced). Exit LIFO.  If companies can no longer use LIFO for book accounting purposes, they will not be able to use it for tax accounting. This will give rise to a flood of paperwork to the IRS, as each company requests permission to change accounting method (which must be formally requested, even though the change is required and unwanted). More importantly, it will  result in a huge income tax liability for nearly all companies required to make the transition.

So far the IRS has not offered any hint of resolution on this matter… and it looks like our manufacturers and retailers may pay the price.

A Matter of Trust

Mexico InvestmentsA number of countries don’t allow foreign people (including foreign business entities) to own land in certain areas. The most well known of these countries is Mexico, but I have recently come across a similar situation in Canada, and know of cases in Great Britain. As a work-around, the land is usually held in trust for the foreign owner. This may not seem as though it creates any tax issues, but it does. Unfortunately foreign trusts have at times been used to try to shelter income off-shore in foreign tax havens, so the IRS has strict reporting requirements for foreign trusts… and the penalties for not filing the related forms are huge! (In some cases 35% of the trust assets per year).  Even if you don’t think of the trust as a “real trust” – the IRS probably will (they are commonly referred to as “Land Trusts” or “Mexican Land Trusts”). We recently enlisted the services of tax attorney, Jean Ryan at Sideman Bancroft, LLP, to analyze a Canadian land trust.  Although the client “never thought of it as being a real trust,” her answer was that it the IRS may treat it as trust, because of the language in the document. So if you own beachfront property in Mexico – lucky you, but in all seriousness, talk to your tax advisor to make sure that you don’t lose it all in penalties.