Month: September 2017

How Your 1031 Exchange Can Benefit from a “Zero” Deal

In previous blog posts I’ve discussed benefits of entering into a 1031 exchange. Also known as a like-kind or tax deferred exchange, a 1031 exchange affords significant tax benefits to property owners.

How 1031 exchanges benefit from zero cash flow dealsSpecifically, a 1031 exchange allows a taxpayer to sell an investment property and reinvest in replacement property(ies) while deferring ordinary income, depreciation recapture and/or capital gains taxes. By deferring tax on the transaction, taxpayers will have more cash available for reinvestment.

What is a zero cash flow purchase?

In a zero cash flow or “zero” deal, the net operating income on a net-leased property matches the debt service, and the loan amortization matches the term of the lease. If the property is retained for the full term of the lease, there is no debt at the end of the term.

Many real estate investors purchase zeros to offset taxable income from other investments through losses associated with depreciation deductions and interest expenses. These transactions are not without drawbacks, as taxable income will occur when the annual loan amortization exceeds the annual depreciation.

Benefits of a zero in a like kind exchange

One of the largest benefits of a zero in a like kind exchange is the pay-down or re-advance feature, whereby the buyer can access cash from the exchange without triggering gain recognition. Once the property is acquired and the exchange is completed, the loan provides the owner an option to refinance a portion of the equity. The options are exercised within the existing loan documents, and there is no renegotiation of terms with the lender. The proceeds can then be deployed to cash-flowing assets.

For example, a taxpayer has a property worth $10 million, comprised of $4 million in equity and $6 million in debt. She found a zero property that can be purchased for $10 million, putting down $1 million as equity and assuming $9 million of debt. The buyer applies $4 million in cash to purchase the replacement, covering the equity requirement of the 1031 exchange. Of that, $3 million (excess of the $4 million of equity from the down-leg over $1 million of equity required for purchase of the property) is used to pay down the debt balance. The interim debt balance is $6 million, fulfilling the debt requirement of the buyer’s 1031 exchange. After closing, the debt is re-advanced from $6 million to the original $9 million, with loan proceeds of $3 million going to the buyer. The exchange has been completed, income deferred and the taxpayer has extracted $3 million in non-taxable proceeds.

We’ve got your back

If you’re interested in structuring a 1031 exchange as a zero cash flow purchase, be sure to consult a real estate broker who specializes in these investments. You’ll also want to coordinate the deal with your tax advisor so that you’re following all the 1031 exchange rules. That’s where the tax experts here at KRS can help and ensure that you receive the maximum tax benefits. For more information, contact me at 201.655.7411 or [email protected]

For Tax Savings, Consider an IC-DISC for Your Exporters

Did you know there is an underutilized tax incentive that can reap federal tax savings for manufacturers?

For Tax Savings, Consider an IC-DISC for Your ExportersOne middle-market manufacturer recently saved approximately $300,000 in current year federal taxes by implementing this tax incentive, which promotes exporting goods manufactured in the United States that have an ultimate destination outside of the U. S. The federal tax savings will continue to increase as this client expands its export operations. The tax saving strategy was executed by forming an interest charge-domestic international sales corporation (“IC-DISC”).

To determine if an IC-DISC might be beneficial for your client, all of the following should apply:

  1. Does the company sell or lease export property or provide services that are related to any exchange of property outside the United States?
  2. Is the company generating taxable profits?
  3. Is the company closely held?

An IC-DISC is typically formed as a wholly-owned U. S. corporate subsidiary of a domestic exporting company. The IC-DISC serves as the exporting company’s foreign sales agent (not to be confused with a Foreign Sales Corporation, which was discontinued in 2000).

After the IC-DISC is incorporated, it must file an election with the Internal Revenue Service to be treated as an IC-DISC, which is not subject to federal income tax and certain state income taxes. The election must be made within 90 days of incorporation and is made on Form 4876-A, Election To Be Treated as an Interest Charge DISC. All of the corporation’s shareholders must consent to this election.

Qualifying as an IC-DISC

To qualify as an IC-DISC, a corporation must maintain the following requirements[1][2]:

  1. Be incorporated in one of the 50 states or District of Columbia
  2. File an election with the IRS to be treated as an IC-DISC for federal tax purposes
  3. Maintain a minimum capitalization of $2,500
  4. Have a single class of stock
  5. Meet a qualified exports receipts test and a qualified export assets test.

To expand on the last requirement, at least 95 percent of an IC-DISC’s gross receipts and assets must be related to the export of property whose value is at least 50 percent attributable to U.S. produced content.

The newly formed IC-DISC enters into a commission agreement with the seller of export goods. By virtue of the C corporation meeting all of the IC-DISC qualifications, it is presumed to have participated in the export sales activity, and due to that participation, is entitled to earn a commission.

The related exporter is allowed to pay a tax-deductible commission to the IC-DISC, which is the greater of 4 percent of the company’s gross receipts from qualified exports, or 50 percent of the company’s net income from qualified exports.[3] The IC-DISC commission is a current deduction to the U.S. exporter at ordinary income rates (currently a maximum of 39.6 percent).

The IC-DISC, as a tax-exempt entity, pays no federal tax on the commission income. When the IC-DISC distributes its income to its shareholders, it becomes qualified dividend income taxed at the qualified dividend rate of 23.8 percent when including the new 3.8 percent tax on net investment income.

If the company is a pass-through entity, such as a partnership, S corporation, or LLC, you can form an IC-DISC as a subsidiary. Dividends the IC-DISC distributes will retain their character and be passed through to individual shareholders and qualify for the 23.8 percent qualified dividends rate (20 percent qualified dividends rate plus 3.8 percent tax on net investment income).

If your company is a C corporation however, you will need to have the corporation’s individual shareholders form the IC-DISC as a sister corporation to obtain the lower tax rate on dividends.

Tax Benefits for Shareholders

Assume an S corporation has $20 million in qualifying export sales and $5 million in net export income on those sales. If the company has an IC-DISC subsidiary, it can pay a deductible commission to the IC-DISC equal to the greater of 50 percent of its export net income ($2.5 million) or 4 percent of its export gross receipts ($800,000). In this case, the maximum commission is 50 percent of net income or $2.5 million.

The IC-DISC distributes the full $2.5 million of commission income as a dividend to its S corporation shareholder. The S corporation receives a $2.5 million dividend, which retains its character and passes through to the S corporation’s individual shareholders. The S corporation shareholders pay 23.8 percent federal income tax on the IC-DISC qualified dividend income. If the commission had not been paid, the S corporation individual shareholders would have additional ordinary income passed through to them taxable at a maximum 39.6 percent federal tax rate.

Federal Tax Savings:

Tax on $2.5 Million at 39.6% rate                               $990,000

Tax on $2.5 Million at 23.8% rate                               $595,000

Federal income tax benefit to shareholders               $395,000

Taxpayers can also use IC-DISCs to defer the recognition of income related to foreign sales, however the discussion above focused primarily on using an IC-DISC to convert ordinary income into qualified dividend income, reducing the income tax liability of a corporation’s shareholders.

We’ve got your back

It is important for practitioners and advisers to be aware of tax incentives available to their manufacturing and export clients that are producing goods in the United States and shipping them overseas. For help establishing an IC-DISC, contact me at [email protected] or 908.655.7411.

References

[1] Trea. Reg. 1.992-2(b).

[2] IRC Sec. 992(a)(1) and Treas. Reg. 1.992-1.

[3] IRC Sec. 994.

IRS Form 5472: What Foreign-Owned Companies Need to Know to Avoid Penalties

Is your company doing business in the US market? If you’re not filing IRS Form 5472, you could face large penalties.

The United States continues to see more investment from foreign companies and individuals who want a business presence here. When a foreign company decides to conduct business in the U.S., not only must it decide what legal entity structure to use, but after the entity is established, it must comply with all applicable U.S. tax laws. Filing the right tax returns and informational forms is critical to avoiding penalties.

IRS Form 5472 for foreign owned companiesFor the purposes of this post, a foreigner is a corporation from outside the U.S. or an individual who is not a U.S. citizen or a resident. Generally, foreigners can use two types of legal entities in the US market to conduct business here: a limited liability company (LLC), or a C-corporation.

Tax filing requirements for foreign-owned corporations

Generally, a corporation doing business in the United States is required to file applicable federal and state income tax returns following each annual tax period. A U.S. corporation with non-U.S. shareholders who own 25% or more of the corporation’s stock are generally required to file Form 5472, which has the long-winded title, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.”

Form 5472 is a separate filing requirement from the U.S. entity’s obligation to file income tax returns under the U.S. Internal Revenue Code (Code). This form must be attached to the reporting corporation’s federal income tax return. It requires certain information disclosures about the corporation’s foreign shareholders and any transactions between it and such shareholders during the tax year.

For example, two shareholders, one from the U.S. and one from Germany, form Reliant Panel, Inc., to manufacture industrial control panels in the U.S. They each own 50% of the company’s shares. Under the Code, Reliant Panel must file Form 5472.

Requirements for LLCs taxed as partnerships

In addition to filing Form 1065 (U.S. Return of Partnership Income), a partnership with foreign partners could be responsible for complying with other filing requirements such as Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), Partnership Withholding, and Nonresident Alien Withholding.

A partnership that has income effectively connected with a U.S. trade or business is required to pay a withholding tax on the effectively connected taxable income that is allocable to its foreign partners. A foreign partner is anyone who is not considered a U.S. person, which includes nonresident aliens, foreign partnerships, foreign corporations, and foreign trusts or estates.

The partnership must pay the withholding tax regardless of the foreign partner’s U.S. income tax liability for the year and even if there were no partnership distributions made during the year. Withholding tax must be paid on a quarterly basis.

Form 5472 for LLCs with a single foreign owner

When a U.S. LLC has a single owner (defined in U.S. law as a “member”), it is disregarded as an entity separate from its owner (“disregarded entity”). Newly issued regulations treat such disregarded entities as domestic corporations rather than as disregarded entities for the purpose of the foreign reporting requirements. Under these new rules, such disregarded entities are required to file Form 5472.

For example, Forco, Inc., a Polish corporation, forms Domeco LLC in New York, a wholly-owned LLC that is treated as a disregarded entity for income tax purposes. Under prior IRS rules, Domeco had no foreign reporting obligations. However, under the new regulations Domeco is required to file Form 5472.

Form 5472 requirements

Form 5472 requires the disclosure of the foreign shareholders’ names, address and country of citizenship, organization or incorporation, principal business activity, and the nature and amount of the reportable transaction(s) with each foreign shareholder.

Whether a reportable transaction has occurred is a complex determination. For example, a loan to a U.S. LLC by the foreign shareholder is considered a “reportable transaction” and requires the disclosure on Form 5472. In general, a reportable transaction is any exchange of money or property with the foreign shareholder, except for the payment of dividends.

Filing deadlines for Form 5472

Form 5472 is filed with the U.S. Corporation’s federal income tax return, including any extensions of time to file same.

Why is filing Form 5472 is so important?

Penalties for failure to file information returns are separate from payments relating to underpayment of income taxes. Under certain circumstances, the penalties for failure to file information returns can be significantly greater than the U.S. income tax liabilities. Failure to maintain the proper records, failure to file the correct Form 5472, or failure to file a required Form 5472 may result in a $10,000 penalty for each failure per tax year.

Additionally, if a failure to file continues for more than 90 days after notification of a failure to file by the IRS, an additional $10,000 may apply for each 30-day period, or fraction thereof, that the failure continues.

These fines can’t be appealed to the IRS! That is why foreigners doing business in the U.S. are strongly encouraged to consult with their tax advisors and ensure compliance with all U.S. tax and reporting obligations.

We’ve got your back

Whether you’re new to investing in U.S. companies or quite experienced, it is always important to have knowledgeable CPAs behind you to ensure that you are making the right moves when it comes to complying with the often confusing U.S. tax code. The experts at KRS CPAs are here to guide you through tax season and beyond. For more information or to speak to one of our partners, give us a call at 201.655.7411 or email me at [email protected].

 

Special thanks to attorney Jacek Cieszynski for his assistance in developing this post.