On March 13, 2018, the IRS announced that the Offshore Voluntary Disclosure Program (OVDP) will be closing on September 28, 2018. This program has been in place since 2009.

In general, US persons, that is, citizens and residents of the US, must report their worldwide income on their US income tax returns. They also must report their financial accounts held outside the US on an annual FBAR (FinCEN Form 114) if the aggregate balance of their accounts exceeds $10,000.

The OVDP offers a structured program for taxpayers to amend income tax returns to report any unreported foreign income, submit any unfiled international tax filings, and disclose the existence of financial accounts outside the United States.

To participate in the OVDP, taxpayers have had to pay a substantial civil penalty based on the value of the unreported accounts, in addition to paying back taxes with a 20% penalty and interest.

The incentive to participating in the OVDP is that the IRS will not criminally prosecute the taxpayer for the failure to report his or her accounts and that all other potential civil penalties will not be assessed in lieu of the one OVDP penalty.

The OVDP is intended for those taxpayers who knew that the law required reporting of their foreign accounts but who decided to not report such accounts on an FBAR or on other international tax filings. These taxpayers have the most to gain from participating in the OVDP and remain exposed if they choose to not come into compliance.

The OVDP requires eight years of amended return filings, six years of FBAR filings, as well as several other items to be submitted to the IRS. The IRS requires a complete OVDP submission by the September 28 deadline. These submissions require time to compile the necessary documentation and to prepare amended returns. It is important for those not in compliance to decide on participating now – well before the September deadline – or you will not be able to complete the OVDP.

What options do taxpayers have if they didn’t file FBAR’s or report their foreign income but their mistakes were inadvertent? This is referred to as a “non-willful” case and is common for many taxpayers who have accounts from their home country that were opened before moving to the US or for those whose tax return preparer did not advise them as to what the tax law requires. The IRS is continuing a program known as “Streamlined Filing Compliance Procedures,” for non-willful violations. These procedures, which may also require a penalty, will continue past September. There are also other ways to return to compliance.

What will IRS enforcement in this area look like once the OVDP is ended? We believe that examinations in this area will only increase. The IRS has gathered a decade’s worth of material on foreign institutions and bankers through the OVDP. This data, along with the information that the IRS now receives from many foreign countries pursuant to a law known as FATCA, allows the IRS to identify non-compliant taxpayers much more easily today than in the past. These international audits are quite intrusive and can expose taxpayers to substantial penalty. We expect the number of these audits to increase.

Once the OVDP option has ended, taxpayers will still be able to voluntarily come forward to disclose past misdeeds. (The IRS has stated that the precise details how to do so will be forthcoming.) It is clear, though, that as onerous as the OVDP penalty is now, the toll to come into compliance in the future will only be greater.

The recently enacted 2017 Tax Act (originally called the Tax Cuts and Jobs Act – “Tax Reform”) made major changes to the US tax system.  Because C corporations (“C corps”) are now taxed at a flat 21% federal income tax rate, many business owners are asking whether they should structure their businesses as C corps.  The answer, unfortunately, is not simple.  Business owners should discuss the various considerations of this decision with their tax advisors.  Here are some of the pros and cons of using a C corp after Tax Reform:

1. Benefits.  C corp income is taxed at a flat 21% rate whereas partnership income flowing through to an individual partner is subject to tax at a maximum 37% rate.  In addition, C corps can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.

2. Pass-through income (eg, S corporation or partnership) may be eligible for a 20% deduction for qualified business income (QBI), but that still leaves the effective tax rate at 29.6% (ie, higher than the C corp 21% tax rate).  Furthermore, the 20% QBI deduction is not allowed for most service businesses (except for partners or S corp shareholders whose taxable income is less than $315,000 ($157,500 if not married filing jointly), with the benefit phased out over that amount so it is totally lost once the partner’s taxable income equals $415,000 ($207,500 if not married filing jointly).  There are also other limitations that only generally allow the QBI deduction to be claimed if the business employs many people or owns depreciable tangible property (such as real estate).  Bottom line – you have to run the numbers.

3. The drawback to C corps, of course, is that they are subject to two levels of taxation, one at the corporate level on earnings and one at the shareholder level, for example, on dividends.  Dividends usually are taxed at the qualified dividend rate of 20%, though there is usually no preferential tax rate at the state and local level.  Dividends also may be subject to the 3.8% net investment income tax.  If only federal taxes are considered, the effective federal double tax rate is 39.8%.

This may be the deciding factor for many businesses.  If a business does not make distributions to its owners (for example, the owners generally take only salary and perks and profits are reinvested), then a C corp structure may result in income tax savings.  On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C corp structure will be disadvantageous.

4. If the C corp accumulates cash, it can be subject to one of two penalty tax regimes – accumulated earnings tax and personal holding company tax.

Closely held C corps are subject to the personal holding company tax if 60% or more of their income is passive income, which they retain in the C Corp and do not distribute to their shareholders, though the personal holding company tax often can be avoided.  In addition, a C corp is subject to the accumulated earnings tax if it accumulates earnings beyond the reasonable needs of the business.

5. Sale of company.  If a company is sold, it is most often structured as an asset sale, which results in two levels of tax for a C corp – one tax to the corporation when it sells its assets in exchange for cash (or a note, etc.) and a second tax if the corporation is liquidated and the stockholders exchange their (low basis) shares for the sale proceeds.  For a company that may be sold in the near future, C corp status would be disadvantageous.  On the other hand, if there are no plans to sell the company (eg, children in the business), this may not be a concern.

The owner may consider whether he or she can own goodwill, client lists or other intangible assets in his or her own name rather than in the corporation to avoid double tax.  See Martins Ice Cream, Norwalk, and related tax cases on “personal goodwill.”

6. Step-up at death.  If an owner dies owning C corp stock, the stock will receive a step-up in basis to its fair market value.  This will avoid a shareholder level tax if the C corp liquidates.  However, it does not avoid a tax to the corporation on any appreciated assets that are distributed in liquidation or later sold by the C corp.

7. Losses.  If a partnership has losses that flow through to its partners, those losses would not flow through if the entity becomes a C corp, so C corp status would be disadvantageous.

8. Timing and related issues.  A company that is an LLC can elect to be treated as a corporation for tax purposes.  If a decision is made to terminate S corp or partnership status, then termination would have to be completed by March 15 to be effective this year.  Also, an S corporation that terminates its S status has a five year waiting period to convert back to S status.  If the C corp converts to S corp status in the future, then it may be subject to a built-in gain tax and other concerns if it later converts to an S corp and has accumulated earnings and profits.

If an S corp converts to a C corp, there is a two-year post termination period to take out AAA.  The Tax Reform bill provides that distiributions within this period will be partly treated as AAA (tax-free) and partly treated as previous C corp E&P (taxable 23.8 dividend).

Also, given the uncertainty surrounding the Tax Reform bill and the possibility that the rules could be changed again, some business owners may be reluctant to convert to C corp status and then get “stuck” if the rates or rules change.

9. Outbound foreign.  Under the new international tax rules, ownership of foreign corporations by a C corp rather than an individual has several advantages.  Dividends paid by a foreign corporation to a C corp can escape any tax while dividends paid to an individual are fully taxable.  If a foreign corporation has income that exceeds a base threshold amount (generally, 10% of the book value of its assets) and the foreign corporation does not distribute those excess earnings to its US shareholder, then the new “GILTI” tax applies to treat the US shareholder as receiving a deemed taxable dividend of that excess amount.  But C corps pay a lower tax rate on this income or may not pay any tax at all.

If you, as a business owner, are asking yourself, “Should I be a C corp?” note that there is not a “one size fits all” answer.  Have your CPA run the numbers using the new tax rules and rates.  Speak to your tax attorney to review the specifics of your situation.  Revisit this decision periodically.

The new tax bill passed by Congress is expected to be signed into law by President Trump in the next few days.  Based on the changes that will take place as of January 1, 2018, there are several items that taxpayers should consider implementing prior to December 31, 2017.

Please note that each taxpayer’s situation is different and each suggestion below should be discussed with the taxpayer’s tax and financial advisors to determine what steps, if any, should be implemented now or deferred until next year or whether it should be implemented at all depending on the taxpayer’s business and tax attributes.

Items to consider:

  • Prepay real estate property taxes if you have amounts due for 2018 (cannot prepay NJ or NY state income taxes)
  • Prepay home equity interest (no deduction after this year)
  • Make charitable contributions this year, especially if not itemizing deductions in 2018
  • Accelerate business deductions
  • Medical expense deduction floor reduction to 7.5% only lasts through 12/31/18, so incur medical expenses if possible before then
  • Delay or accelerate Roth conversion
  • Defer or accelerate income*
  • If you are a US person with foreign businesses, potentially converting to an S corporation before year end could be beneficial due to a “deemed repatriation” of profits in the new bill
  • If you have children in private elementary, junior high or high schools and have not already been funding 529 plans, consider use of 2017 annual exclusions not otherwise exhausted to fund 529 plans

 

*Deferral of income until 2018 could save taxes for some taxpayers because of the lower marginal rates, while acceleration of income could save taxes for others due to the limitation on deductions of state and local taxes.  Whether or not a taxpayer is subject to AMT also plays a role.  Again, each taxpayer should consult his or her own tax and financial advisors for specific advice.

Beginning January 1, 2018, the IRS will begin implementing Section 7345 of the Internal Revenue Code to certify tax debt to the State Department.  This will allow the State Department to revoke or withhold the issuance of passports to delinquent U.S. taxpayers.

To warrant IRS certification to the State Department, the IRS debt has to be deemed “seriously delinquent tax debt.”  This is defined as: (a) an amount exceeding $50,000, as adjusted annually for inflation and including penalties and interest; (b) a levy or notice of federal tax lien has been issued by the IRS; and (c) all administrative remedies, such as the right to request a collection due process hearing, have lapsed or been exhausted.  This only relates to Title 26 of the United States Code and does not include other tax-related penalties, such as FBAR penalties.

The IRS will be required to notify the taxpayer in writing at the time it issues a tax debt certification to the State Department. Before denying a passport, the State Department will hold a passport application for 90 days to allow the taxpayer to resolve the tax debt or enter into a payment alternative with the IRS.

It is also possible to seek relief in U.S. Tax Court or District Court.  The court can order the IRS to reverse the certification if it was erroneously issued, or was required to be reversed but the IRS failed to do so.

The certification will not apply or will be reversed in the following scenarios:

  • The debt is paid in full. (The IRS will not reverse the certification if the taxpayer pays down the debt to an amount below $50,000.)
  • The taxpayer enters into an installment agreement with the IRS to pay off the debt.
  • The IRS accepts an offer in compromise to satisfy the debt, or the Justice Department enters into a settlement agreement with the taxpayer to satisfy the debt.
  • Collection is suspended based on a request of innocent spouse relief, or for collection due process based on a notice of levy, but only if the request is with respect to the debt underlying the certification.
  • The debt becomes unenforceable based on statute of limitations.

The law affects expatriates living abroad and individuals traveling regularly overseas for work.  If the taxpayer finds himself or herself traveling or living outside of the country with a revoked passport, the Secretary of State has the discretion to limit the existing passport, or issue a limited one, for return travel to the United States.

It is not clear if this statute will ultimately pass constitutional challenges.  In the meantime, starting January 1, 2018, you may be at risk of having your U.S. passport revoked if you travel outside of the U.S. without first addressing delinquent tax debts exceeding $50,000 through any administrative remedies and/or collection alternatives available to you.

The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.