“Things as certain as death and taxes, can be more firmly believ’d.” - Daniel Defoe
Most U.S. nonresidents are aware these days that if you move to the United States or have U.S. investments, you may become subject to U.S. income tax laws. But what may not be as well known is that you may also be subject to U.S. estate tax, even if you don’t earn any income or file income tax returns.
The Internal Revenue Code is notoriously complex and this area is no exception. The Internal Revenue Code actually has two separate determinations for taxing a foreign person: residency for the income tax, and domicile for the estate tax. Even if you are not a resident for income tax, you can still be considered domiciled for the estate tax.
The IRS defines residency for income tax under a number of different tests, including whether the taxpayer holds a green card or if they’ve been in the country for a substantial portion of the year. You can also make the First-Year Election to declare your residency on the first U.S. income tax return you file.
When it comes to the estate tax, federal regulations determine a “domicile” as living somewhere for a period of time without any immediate plans of leaving. Domicile depends on both physical presence and intention to stay in the country. Simply put, if you intend to stay, you’re domiciled, but if you plan to leave, you need to actually leave.
If a person is deemed to be a U.S. resident for estate tax, their worldwide assets are subject to the estate tax. If someone is a nonresident, only assets with situs in the United States are subject to inclusion in his or her estate.
What Can You Do if You Are Subject to U.S. Estate Tax?
At this point, you may be thinking, “I have U.S. and foreign assets, so how can I reduce or avoid U.S. estate tax?”
The answer to that question largely depends on your current situation.
If you’re a nonresident alien who has a domicile in the United States, there’s a certain amount of preplanning you can do in anticipation of this tax, such as gifting intangible property before establishing a domicile in the U.S. There are other measures you can take, such as having U.S. real estate and equities owned by a foreign corporation, to make sure you are in the most advantageous position in the U.S. and the foreign country.
It’s also important to consider whether a nonresident’s country of citizenship has a tax treaty in force with the United States. The U.S. has active tax treaties with many countries, and depending on the country, a nonresident individual may be entitled to the full $5,495,000 estate exclusion or only a statutory $60,000 exclusion.
Expatriation might seem like a good way to avoid the U.S. estate tax—and this may be the case in certain situations—but Section 2107 of the Internal Revenue Code makes nonresident aliens subject to U.S. estate tax if they were domiciled in the United States for a period of five years or more. The window for being subject to this tax is ten years and you are taxed on any assets (tangible or intangible) that are situated in the United States.
If you are a foreign national living and owning property in the U.S. and have concerns that you may be subject to U.S. estate tax, we can help you sort out your options. We at Freed Maxick pride ourselves on our experience and expertise with these and other international tax matters. Please contact us if you have any questions.View full article
ASU 2016-16 Adds Transparency and Simplifies Reporting
The presently prescribed method of accounting for income taxes on the sale of assets between affiliated companies (intra-entity transfers) has in recent years generated discord between accounting professionals and the Financial Accounting Standards Board (FASB). With FASB’s October 24, 2016 issuance of ASU 2016-16, however, the concerns of the accounting profession in this respect have been largely addressed.
FASB stipulations to this point have required that recognition of the income tax effects of intra-entity transfers be deferred until the asset is subsequently sold outside the affiliated group, a rule running counter to the general ASC 740 principle that current and deferred income taxes be recognized in the year that the event triggering them occurs.
Under the newly enacted ASU 2016-16, this deferral methodology goes away for all intercompany asset sales other than sales of inventory (which will remain under the previous FASB guidance). Companies will now be required to recognize the income tax effects (current and deferred) of intercompany non-inventory asset sales in the period in which they occur, despite the transaction being eliminated from consolidated pre-tax income. Thus, this new guidance both simplifies the accounting procedures for intra-entity transfers and adds transparency to their financial reporting, as the income statement tax effects recorded will typically coincide with any cash tax impact incurred in the same reporting period.
While FASB did not prescribe new financial statement disclosure requirements in this pronouncement, it has commented that existing disclosure requirements may apply to intra-entity transfers and their tax ramifications. For instance, companies may have to cite the tax effects of intra-entity transfers within their effective tax rate reconciliations or in disclosing the types of temporary differences giving rise to their deferred tax assets and liabilities.
ASU 2016-16 becomes effective for publicly traded companies in years beginning after December 15, 2017, including interim periods within those years (i.e., first quarter of 2018 for calendar-year companies). For non-public entities, they become effective for annual reporting periods beginning after December 15, 2018 and for interim reporting periods within annual reporting periods beginning after December 15, 2019. Early adoption is permitted, but can only occur in the first quarter of a reporting year (e.g., first quarter 2017 for calendar year companies).
Questions? Contact us to discuss the new reporting requirements and what they might mean for your company.View full article
When you think of the Research and Development (R&D) Tax Credit, you might focus on the technology involved and costs incurred to create or enhance a product or process. Another important consideration though is whether the costs incurred in connection with any activity qualifying for the credit are “funded.” The essence of this requirement is to determine if the taxpayer claiming the credit has an adequate financial risk for the costs incurred and retains rights to the research results.
The tax concept of funding was essentially created to eliminate the ability for two taxpayers to claim the R&D credit on the same costs. Seminal questions to ask:
- Who actually bears the economic risk per the contractual terms of the relationship, particularly if the project is unsuccessful?
- Who retains substantial rights to the research results?
Is it "Funded?"
In order for a taxpayer to be eligible for the R&D credit the related activity cannot be funded. Activity is not funded if: The taxpayer is deemed to be at risk for the costs incurred and retains substantial rights.
The questions of adequate risk and retention of rights typically arise when one party hires a contractor to perform qualifying research on a product, process, or other development.
According to the IRS, if a contractor hired to perform research for another company retains no substantial rights to the research developed under the terms of their agreement, the research is treated as “funded” to the contractor and no expenses paid or incurred by the contractor in performing the research qualify for the R&D credit. This would be the case even if the contractor was deemed to be at economic risk for the costs incurred.
Who Has the Right to Use the Research?
Retention of substantial rights does not require that the taxpayer retain exclusive rights to the research. However, a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. Basically, “substantial rights” is interpreted to mean the right to use the research.
For example, does the contract say the research is exclusive to the company that the contractor is under contract with, or can the contractor use the research and resulting technology for other companies/industries without paying royalties?
Contract Language Matters
The concept of substantial rights and risk relies heavily on specific contractual language. If a contract is poorly written, possibly neither the contractor or the company can qualify for the R&D Credit. If there is potential for significant R&D credit in connection with a contract, it is prudent to carefully review the language in the agreement and speak with tax advisors to ensure the intended party or at least one party can claim the credit.
Generally, a contractor who is paid regardless of the success of the project does not bear the economic risk and cannot claim the R&D Credit (i.e. the research is “funded” to the contractor for purposes of the credit). However, if payment will only be made contingent on the success of the efforts, then the contractor bears the economic risk and may potentially claim the credit if it also retains substantial rights to the results.
Courts have held that research expenses incurred by a contractor under fixed-price contracts were not “funded research” under the R&D credit rules because the contractor was at risk for the costs unless the project was successful. Thus the qualifying costs incurred were eligible for the R&D credit to the contractor performing the research, assuming it also retained substantial rights to the results.
Other Payment Arrangements
For cost plus arrangements on the other hand the contractor is not generally deemed to be at economic risk since it is guaranteed to be paid for its efforts. Therefore, it is not eligible for the credit. On the other hand the company paying a contractor is at economic risk and could the claim the credit on the costs paid to the contractor if this company also retained substantial rights.
Other types of contractual payment arrangements can generate costs eligible for the credit to the contractor. For instance, a cap cost-plus margin pay arrangement may allow for the contractor to claim the credit for the qualifying costs incurred. Again, the major issues are whether the taxpayer is at economic risk contingent on the success of the project and whether the taxpayer retains substantial rights to use the work, which are dependent on the terms of the contract.
Whether you are a contractor or a company using a contractor, you can maximize your chances of claiming the R&D credit in the future or allowing the other party to claim the credit by careful consideration of the contract terms. This can be a complicated issue, which can be resolved with simple solutions. Contact us for guidance.View full article
So you decided to invest in a foreign mutual fund. At first glance, the US income tax reporting requirements for income received from this investment appear simple: Just report dividends, interest income, and any capital gains on your form 1040 as if the income was received from a US mutual fund, right?
Unfortunately, the answer is not that simple.
Because the IRS classifies foreign mutual funds as passive foreign investment corporations, aka “PFICs,” there not only is additional reporting requirements for you the taxpayer, but any income received from these investments could be subject to a much higher tax rate and increase your overall tax liability significantly.
What is a Passive Foreign Investment Corporation?
The IRS defines a PFIC as any foreign corporation that meets either of the two requirements below:
- At least 75 percent of the gross income from the corporation for the taxable year is passive income (e.g., dividends, interest, capital gains, etc.), or
- The average percentage of assets held by the corporation that generates passive income is greater or equal to 50 percent.
Therefore, pooled investments registered outside the United States, such as foreign mutual funds and foreign hedge funds, will qualify as PFICs under the Internal Revenue Code.
PFIC Tax Implications
So now that we know a foreign mutual fund qualifies as a PFIC under US tax law, why is this significant?
For starters, your investment in the mutual fund must be reported separately on Form 8621 each year, regardless of whether or not you received income from the fund, provided that the value of the PFIC stock owned both directly and indirectly exceeds $25,000. While failure to file Form 8621 in this situation would not result in any penalties, it would leave the statute of limitations on all tax matters on the return open indefinitely, leaving you the taxpayer more vulnerable to potential IRS audits and additional tax assessments.
The biggest implication, however, is the additional tax and interest that might be owed on any passive income received from the fund during the year. While there are various elections you can make with regard to the recognition of income from the PFIC, let's assume that you did not know that the investment had to be specially reported and never made an election.
Instead of just picking up the income in the current year, income is subject to the “excess distribution” regime. As a result, any distributions classified as excess must be allocated among all tax years in your holding period and will then be taxed at the highest rate enacted by law in that year. In addition, since that tax was technically owed in prior years, you must also calculate interest owed. This amount of interest can add up quickly especially if you have held the investment for a long period of time and are now just reporting the income properly on Form 8621.
The IRS defines “excess distributions” that are subject to this additional tax as the following:
- Any gain from the sale of the PFIC, or
- Any distribution from the PFIC that exceeds 125% of the prior three year average of distributions previously received from this investment.
Suffice it to say, when it comes to reporting your foreign mutual fund investment on your tax return, the IRS requirements can be very confusing. Not only do you need to determine if you are required to file Form 8621, but you must also consider the various elections available to you (mark to market, qualified electing fund), what (if any) election to make, and how to properly report the income received and tax owed from these investments.
Stay tuned—another post on other types of PFIC investments is coming soon. If you have any investments in foreign mutual funds or are thinking about investing in some, please contact us for advice and potential planning opportunities.View full article
Caring for a loved one with a disability or extra needs is wrought with many challenges. One of these challenges can be how to leave assets to this beloved after your death in such a way that does not disqualify them from the governmental benefits to which they are entitled. A “special needs trust” can be one solution to this problem.
Funding Special Needs Trusts
Sometimes called a supplemental needs trust, a special needs trust is established for the benefit of a person with special needs to help him or her financially after your death. Usually established by parents for their disabled children or by children for their elderly parents, it is a vehicle by which to leave money or property behind without giving direct control over the assets. In this manner, the value of the assets in trust can be excluded from being considered in federal or state means-tested benefits of the beneficiary, thus allowing them to still receive such items as Supplemental Security Income (SSI) or Medicaid.
Several kinds of assets such as cash, real estate, business interests, stocks or intangible assets can be held in a special needs trust. Property belonging to the beneficiary can be used to fund the trust or assets from another party can be used instead, but both sources of assets should not fund the same trust, meaning there can be more than one special needs trust established for someone.
Improving Quality of Life
Collectively, these assets are used by the trustee(s) (who cannot be the beneficiary) to fund expenses that improve the quality of life for the beneficiary and that are not already covered by existing government benefits. Some examples of such expenses include:
- Additional caregiving or personal therapy, including visits to or expenses of a companion
- Reasonable expenses for experiences such as travel and visits to relatives or entertainment
- Costs for special transportation
- Personal items
The trust would pay for such expenses directly rather than the beneficiary receiving cash to pay for these expenses him or herself, which might jeopardize benefits.
Finally, a special needs trust has a finite life. It will terminate either when the funds in the trust are depleted, the beneficiary no longer needs the trust, or the beneficiary passes away.
Note that there are other avenues by which to give assets or the use of assets to your disabled loved one, one of them being a 529-ABLE plan administered by each state. However, with those plans there are limitations on the annual contribution to the plan and the total value the plan can achieve.
If you are considering one of these vehicles to improve the quality of life of someone in your life with special needs, please contact us so we can help you get started.View full article
Cash is king in the early days of a new company, and you may be able to use federal R&D credits to generate much needed cash during the initial years of your new company.
R&D and the QSB Election
The R&D credit, which rewards companies for increasing research expenditures, was permanently extended by the Protecting Americans from Tax Hikes (PATH) Act of 2015. In addition, for tax years beginning after December 31, 2015, the PATH Act allows qualified small businesses (QSBs) to elect to offset the employer portion of Federal Insurance Contributions Act (FICA) payroll taxes with R&D credits.
A QSB is a corporation, including an S corporation or partnership that has gross receipts of less than $5 million for the current tax year and did not have gross receipts in any tax year preceding the five-tax-year period that ends with the current tax year.
Start-up companies generally incur losses during the initial years of operations and are unable to use R&D credits. The QSB election allows start-up companies to use R&D credits that might otherwise go unused or are not claimed. In addition, claiming R&D credits in the initial years of operations can generate larger tax credits in future years when research expenditures increase and profits grow.
The QSB election must be made on a timely filed tax return, including extensions, and can be made for up to five tax years. A QSB can elect to apply up to $250,000 of current year federal R&D credits against their employer portion of FICA payroll tax liability beginning with the calendar quarter following the date on which the tax return is filed. Any excess elected amount exceeding the employer portion of FICA payroll tax liability is carried forward to the next calendar quarter. A QSB must also file IRS Form 8974 with Form 941each quarter.
For example, let’s say your new company is a QSB and has R&D expenditures of $25,000 per year for the first five years of operations. As a result, your new company generates $2,500 of R&D credits each year. By making the election to apply R&D credits against the employer portion of FICA payroll tax, your company enjoys $12,500 of cash savings.
Do You Qualify?
Basic questions to determine whether your company is eligible to claim R&D credits include:
- Do you have payrolled employees?
- Are you developing a new products or processes? What’s in the pipeline?
- Do you have wages associated with that development? Who’s doing the R&D?
- Do you retain rights to what you developed? To qualify, you don’t need to hold exclusive rights, just significant ones. For instance, can you take what you’re developed and apply it to your next project without anyone’s legal permission?
Related companies often use intercompany master service agreements in order to allocate common costs of doing business among the related entities. Depending on the size and nature of the business conducted, these service agreements can be extensive and include several services that are used throughout the related companies.
Something that business owners may not consider when drafting these agreements is the possibility that sales tax may need to be collected on the services provided. To complicate matters, each state has different laws that dictate whether services provided are subject to sales tax. Therefore each state that the related companies are located in should be considered in any sales tax analysis of intercompany service fees.
Sales Tax in New York
In New York State, sales of services are generally exempt from sales tax. However, services related to tangible personal property, software, and real property can be subject to sales tax and should be reviewed carefully if such services are included in an intercompany services agreement.
For example, if a service agreement includes repair and maintenance or installation services to computers, equipment, vehicles, or other tangible property, those services are subject to sales tax. License fees for access to software applications, unless specifically customized for the purchaser, are also subject to sales tax in New York State.
Avoid Costly Errors in Classification
If services related to real and tangible personal property are included in a service agreement, it is crucial to segregate these services on the invoice to the purchaser. It’s very likely that the majority of the services performed under an agreement are nontaxable due to the fact that in general most administrative services are exempt from sales tax. However, in most states, bundling both taxable and nontaxable services under a general label of “management fee” will make the entire transaction subject to sales tax. Consequently, for companies with large management fee income, an error in classification could be very costly.
If your business utilizes intercompany service agreements and has not performed a sales tax analysis, you should discuss the possible audit risks that you may face and steps to ensure proper tax filing compliance with a professional.
Freed Maxick's SALT team can assist with analysis of your service agreement to determine taxable versus nontaxable sales and review invoices for proper segregation of services to make certain that nontaxable sales do not become subject to sales tax. Contact us to get started.View full article
Be Prepared, and You Can Save Time, Effort, and Money.
If your company relies on the hard sciences or uses technology to create or improve products or processes, you might be able to reduce your federal taxes by a portion of the costs incurred using the Research & Development (R&D) Tax Credit. The credit can be significant and many types of companies potentially qualify. Smart preparation early in the process can also save you time, effort and, potentially, tax dollars.
Best Practices When Exploring the R&D Tax Credit
Reach out to qualified professionals to discuss the credit.
Find out if this professional has experience with the R&D Credit. Have they worked with companies similar to yours? They should ask about your new product(s) or innovation(s), your employees’ time associated with those developments, and if you retain rights to what you developed. Being mindful that your time is valuable, an experienced professional can often make a preliminary assessment in the first meeting as to the likelihood your company is eligible for the R&D credit or provide the preliminary questions needed in order to make that assessment.
Set up a meeting at your facility.
A walk-through helps immensely to educate your chosen consultant. That time walking through your plant or watching your prototype in action tells them a lot about your operations and, in turn, your potential to qualify for the R&D credit. Plan to set aside an hour to three hours, approximately (includes meeting time after the walk-through).
Have your subject matter experts easily accessible to discuss potential R&D activities.
These persons can be your employees or even outside contractors most connected to the development. Not having the right people involved as soon as possible in the exploratory process can negatively impact the amount of credit that you ultimately claim.
Understand that you’re trying to qualify for the tax definition of R&D.
We recently visited a manufacturing company where the chief technology officer claimed the company was doing no R&D. Of course the firm was constantly researching and developing as they were coming out with new products each year and making significant functional improvements to their existing products.
We helped him to understand that the definition of R&D for tax purposes might not match his scientific definition. This a pro-taxpayer credit: The tax definition of R&D can be more liberal and more encompassing than some traditional engineering minds might think.
That same company also experienced a year where technical challenges and other factors kept many of their developments from getting to market. They thought they had no activities to potentially quality for the R&D credit—but failure can be a positive when claiming a credit. It doesn’t mean you have no qualified R&D expenses—it can actually help show that R&D did occur.
Have your documentation ready.
Any contemporaneous documentation that monitors the activities qualifying as research activities will help to support your claim for the credit: blueprints or marketing materials, project write ups, financial information, status reports, modifications’ specs, and so on. (See our recent blog regarding proper documentation when exploring qualification for the R&D Tax Credit.)
Lack of documentation or no documentation makes the process of exploring your qualification for the R&D credit more involved; however, it is often possible to reconstruct information needed to claim the credit.
Talk to our experts today about your business’s potential to claim the R&D credit.View full article
New Rules Represent Significant Easing of Requirements on Businesses That Would Like to Claim the R&D Credit
Regulations finalized by the IRS on October 3 suggest that the costs a business incurs to develop software for internal use may be more likely to qualify for the Research and Development (R&D) Tax Credit than many taxpayers previously understood.
Internal use software (IUS) has always been held to a higher standard than other types of research when it comes to qualifying for the R&D credit. But the new IRS guidance clearly suggests some software development costs that were previously thought to be IUS were in fact likely to be exempt, and the new guidance also eases some requirements on IUS software when it comes to qualifying for the credit.
The new rules don’t change the four criteria that qualify an activity for the R&D Credit:
- It must be intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a product or business component.
- It must be undertaken to discover information that is technological in nature.
- The intended result must be useful in the development of a new or improved business component.
- Substantially all of the activities must relate to a process of experimentation.
Once an activity meets these criteria, IUS must meet three additional criteria—referred to as the high threshold of innovation test—to qualify for the credit:
- The activity must involve significant economic risk.
- It must meet a high threshold of innovation.
- No comparable third-party software is available for purchase.
The concept of IUS, because of the final regulations, is going to largely be restricted to general administrative functions, such as:
- Financial management
- Human resources management
- General day-to-day support services of your company
Clarification of the 3-Point Criteria
The IRS has made it easier and less controversial to comply with the three additional criteria above that IUS must meet to qualify for the credit. For instance, the IRS concluded that the high threshold of innovation doesn’t require that you make a revolutionary discovery or that the software development be successful.
The IUS development involves “significant economic risk” if you commit substantial resources and there is substantial uncertainty, because of technical risks, that you might recover those resources within a reasonable period. “High threshold of innovation” is defined as resulting in a reduction of costs or an increase in speed, either of which are substantial or economically significant.
The new rules, which are largely consistent with the proposed regulations, clarify that some types of internally developed software are not IUS. For example, software you might have developed to interact with third parties or to enable third parties to initiate functions or review data on your business’ systems do not need to meet the additional IUS criteria to qualify for the R&D credit. The determination of whether the software was developed for third party use is based in large part on the intention of the company at the start of the software development effort.
Examples of software that may not qualify as IUS include:
- Bank transaction software
- Software apps for a mobile device
- Software developed by a manufacturer to enable its customers to order products online
Furthermore, software developed to be sold, leased, or licensed is generally not treated as software developed primarily for internal use.
On the whole, these new rules represent a significant easing of requirements on businesses that would like to claim the R&D credit for software that they develop themselves or pay outside contractors to develop. If your business incurs costs for software development, this is a great time to take a closer look at those costs in light of the new rules to find out if you may be eligible for additional credits.View full article
The Impact of the Foreign Account Tax Compliance Act (FATCA) of 2010
Breathes there the man with soul so dead, who never to himself hath said, “This is my own, my native land.” - Edward Everett Hale, “The Man Without a Country”
Poetic and patriotic words, but the reality of today is that many U.S. citizens don’t feel this way about their native land. In 2015, 4,279 U.S. persons relinquished or renounced their U.S. citizenship, a record-breaking amount. Many analysts project that the total number of renunciations or relinquishments in 2016 will exceed the 2015 mark. To put these numbers in perspective, less than 300 people renounced their U.S. citizenship in 2006.
Looking at statistics like these, you may ask yourself: “Why are so many people giving up U.S. citizenship?” And possibly, “Is this something I should consider?”
The Foreign Account Tax Compliance Act (FATCA) of 2010 and other U.S. tax reporting regulations may have something to do with why this is happening.
A simplified explanation of the FATCA legislation is as follows:
- It is primarily aimed at preventing tax evasion by U.S. taxpayers through the use of non-U.S. financial institutions and offshore investments.
- Foreign financial institutions are required to identify accounts held by U.S. persons and report account information to the IRS. Absent this information, they are required to withhold U.S. tax on U.S. source income paid and may decline account opening or terminate services.
Furthermore, the U.S. tax system is based on citizenship. A U.S. citizen pays tax on their worldwide income no matter what country they live in.
Beyond the tax compliance burden, the financial institution impact of the FATCA legislation has significantly impacted U.S. citizens living abroad. Rather than attempt to comply with FATCA reporting requirements, many foreign financial institutions are simply refusing to open or hold accounts for U.S. persons.
To alleviate the financial hardship and tax compliance burden, many U.S. citizens living abroad have decided not to maintain their U.S. citizenship. U.S. citizenship can be terminated through renunciation. A formal renunciation of U.S. citizenship must be made in a foreign state, generally at a U.S. consulate, and there are several State Department forms to file along with a processing fee.
In addition to the paperwork and fees, the exit tax under Internal Revenue Code Sec. 877A may apply. Generally speaking, in order to avoid the exit tax you must:
- be current with U.S. tax filings for the past 5 years,
- have had annual U.S. tax liabilities below $160,000 for those 5 years, and
- a net worth of less than $2,000,000.
If you find yourself in the situation where you are considering renunciation of your U.S. citizenship, there are planning opportunities and compliance requirements that must be considered. Contact Freed Maxick's International Expatriate Tax Services professionals to discuss your specific situation, or call to speak with an individual directly at 716.847.2651.View full article