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U.S. Business Reporting Requirements: Payments to Foreign Contractors or Individuals


3 Questions that Define Reporting and Withholding Obligations  

Reporting Requirements for Payments to Foreign ContractorsMost U.S. businesses understand that payments to U.S. contractors trigger reporting obligations at the end of the year. Once the amount paid to a contractor crosses certain thresholds, a Form 1099 is prepared and sent both to the business that performed the services and to the IRS. As the economy has become more global and work can easily be performed virtually from around the world, some U.S. businesses have been slow to realize that payments to foreign contractors may trigger similar reporting obligations.

It’s important to note that payments to foreign contractors may trigger reporting and withholding obligations on the part of the U.S. payor—but not in all cases.  The reporting and withholding requirements on the U.S. payor depend on the answers to 3 questions.

    1. Is the payee a U.S. person or business?

      It’s never safe to assume that a contractor is or is not a U.S. person. The Internet makes it easy for a business to create a virtual presence almost anywhere. The only safe way to determine whether or not the contractor is a U.S. person is to ask. If the contractor replies that the business is a U.S. business, most payors know to have that contractor fill out a Form W-9 to provide the information that will be used to report payments to the IRS.

      If the contractor is not a U.S. business, the payor should require a Form W-8BEN-E (for entities) or Form W-8BEN (for individuals). Once the U.S. business receives this form, it does NOT forward it to the IRS. The U.S. payor simply maintains the form in its records. In the event of an audit, the form will substantiate why payments were not reported.

        2. Where did the payee perform the services?

          If the U.S. payor has one of the Forms W-8BEN on file and the contractor performed all services outside of the U.S., it is likely that no reporting or withholding obligations exist regarding the payments made by the U.S. payor to the foreign contractor.

          If the foreign contractor performed some or all of the work related to the contract in the U.S., the payor may have a reporting and withholding requirement related to those payments.

            3. If the payee performed services in U.S., what does the payor do?

              If the foreign contractor did some or all of the work related to the contract in the U.S., the payor has additional obligations under IRS rules. Typically, the U.S. payor will have to report the payments related to the U.S.-sourced work to the IRS on a Form 1042. The payor is expected to not only report the amounts paid to non-U.S. contractors for work done in the U.S. but also to withhold U.S. taxes (typically 30%) from those payments. Note, the 30% rate could potentially be reduced if the payments are made to a country with which the U.S. has a treaty. Like other withholding requirements, failure to comply with them can subject the U.S. payor to penalties and interest. Failure to withhold also could entitle the IRS to go after the payor for the amount of tax that should have been withheld. Depending on the amount of U.S.-sourced work a company pays foreign contractors to perform, failure to properly withhold can quickly snowball into a significant tax obligation.

              We’ve provided a quick overview here of the rules that apply when U.S.-based businesses make payments to foreign contractors. If your business engages contractors who may be based outside of the United States, it’s important to consult with a professional who is familiar with the details of the reporting and withholding rules. Contact us for help navigating complex U.S. and international tax rules.

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              3 Types of Common Prohibited Transactions (and Penalties) Made by Employee Benefit Plan Fiduciaries


              Education on Fiduciary Responsibilities are Key to Avoiding Civil and Tax Penalties

              Employee benefit plan fiduciairy responsibilitiesOffering a retirement plan can be one of the most challenging, yet rewarding decisions an employer can make. All those involved, including employees, beneficiaries, and the employer benefit from having a plan in place. However, employers and plan fiduciaries have specific responsibilities they should be aware of in administering a plan and managing its assets. These responsibilities help employers and fiduciaries stay within the laws and regulations of the plan.

              What is a Prohibited Transaction?

              A prohibited transaction is a transaction between a plan and a disqualified person that is prohibited by law. Disqualified person(s) are those who, by virtue of their relationship to the plan, may be in the position to self deal. Disqualified person(s) cover a range of people including fiduciaries, employers, unions (and officials), employee organizations, and persons providing services to the plan such as lawyers and accountants. Prohibited transactions are exactly that, a prohibited transaction of a plan.

              A plan fiduciary shall not cause the plan to engage in a transaction that generally includes the following:

              • A fiduciary’s act by which they deal with the plan income or assets in their own interest;
              • Sale, exchange, or leasing of any property between a plan and a disqualified person;
              • Lending of money or other extension of credit between a plan and a disqualified person;
              • Furnishing of goods, services, or facilities between a plan and a disqualified person;
              • Transfer to, use by, or for the benefit of a disqualified person, of any assets of the plan;
              • Acquisition or holding, on behalf of the plan, of any employer security or employer real property that would be in violation of the plan; and
              • The receipt of any consideration for the personal account of a fiduciary from any party dealing with the plan.

              Most Common Prohibited Transactions

              The most common prohibited transaction is the failure of plans to timely deposit employee deferrals and loan repayments to the plan.  The timely deposit of employee deferrals has been a highly publicized issue for the Department of Labor (DOL). The DOL’s audit procedure is to review the Plan sponsor’s pattern for depositing deferrals. If, for example, a sponsor is able to deposit deferrals within three business days after the pay date, but deposits one pay date’s deferrals ten business days after the pay date that payroll is deemed to be a prohibited transaction. The DOL reasons that the sponsor has shown an ability to deposit the money within a shorter time frame, therefore the funds for that one pay date were not deposited “as soon as reasonably segregable.”  

              When this occurs, the DOL deems the Plan sponsor to have taken a loan from the Plan. This loan is prohibited under ERISA’s party-in-interest rules and has ramifications, which are different from other compliance errors. Prohibited transactions are required to be disclosed in a supplemental schedule to the Plan’s audited financial statements.

              As such, the Plan sponsor is required to file Form 5330 and pay an excise tax on the amount of earnings lost by the Plan due to the loan. Finally, the Plan sponsor must ensure that the employee deferrals are remitted to the Plan, along with the earnings lost by the Plan due to the loan. 

              Multi-employer plans may meet the same fate as employee deferrals regarding timeliness of contributions. Multi-employer plan fiduciaries are required to collect all contributions owed to a plan by participating employers. These plans need to establish and implement collection procedures which are reasonable, diligent and systematic or they may be found to be engaging in a prohibited transaction for failing to collect delinquent contributions. In order to comply with the law, a plan must have a written delinquency collection policy which addresses the timing of contributions and the steps to be taken when the contributions are not received by the plan.

              A second form of prohibited transaction involves 12b-1 fees. There’s a reason why self-dealing transactions have been verboten in all forms of trust. It’s because the action is too often misaligned with the best interests of the beneficiary. In the case of 401(k) plans that use 12b-1 fees and revenue sharing (the primary source of legal 401(k) self-dealing) underperform by 3.6 percent versus funds that don’t involve self-dealing. 12b-1 fees are ongoing fees paid out of fund assets.

              When may 12b-1 fees be used? Often times they are used to pay commissions to brokers and other salespersons, to pay for advertising and costs of promoting the fund to investors, and to pay various service providers of a 401(k) plan pursuant to a bundled services arrangement. That this is not currently defined by the DOL as a breach of one’s fiduciary duty does not mean the liability has been removed from the plan sponsor. A great example is International Paper (who settled for $30 million) and Cigna (who settled for $35 million). Both were accused of paying “excessive fees” for investing in funds that offer 12b-1 fees and revenue sharing. 

              The third most common prohibited transaction involves entering into a lease with a related party or party-in-interest. It is common in the Multi-employer plan arena to share space with the union, another plan, or an employer. As there are union members and employers representatives that make up the board of trustees, this transaction is considered “self-dealing”. However, there are certain exemptions and steps that can be taken to ensure this transaction is not considered a prohibited transaction.

              There should be a formal written lease agreement and the parties involved need to ensure that the compensation for the lease is reasonable. Lastly, any trustee with possible conflicts should recues themselves during the decision to enter into the lease agreement.

              Fall Out from Prohibited Transactions in both the Civil and Tax Arenas

              Prohibited transactions may also trigger monetary penalties. Qualified pension plans engaged in prohibited transactions with a disqualified person are subject to the IRC section 4975 excise tax. A disqualified person who is in violation of IRS section 4975 must correct the transaction and pay the excise tax based on the amount involved in the transaction. The initial tax on a prohibited transaction is 15% of the amount involved for each year, in the taxable period.

              If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.

              Prohibited transactions will require the inclusion of certain ERISA supplemental schedules in a plan’s financial statements, but are correctible through the DOL’s Voluntary Fiduciary Correction Program (VFCP). There are various forms that will need to be filed with the DOL, which include Part III of Schedule G, Form 5500, Schedule H line 4a-Delinquent participant contributions, Form 5500 and Form 5330. 

              What You Can do to Correct or Avoid Future Prohibited Transactions

              Freed Maxick wants to make sure you fully understand the importance of avoiding prohibited transactions. As part of future audits or engagements, it might be wise to have your service provider(s) review your plans to ensure a prohibited transaction hasn’t taken place.

              Carefully look at prohibited transactions that cause implications related to management integrity, cause and effect of a breach of fiduciary duties, and inclusion of ERISA supplemental schedules in financial statements.

              Be diligent before entering into a transaction and be consistent when you file. Educate yourself ahead of time on what the fiduciary responsibilities are; this will help you avoid prohibited transactions in the future.

              Freed Maxick CPAs can help you identify possible prohibited transactions, aid in the preparation of additional schedules and governmental reporting forms that may be required, and help implement controls and policies to avoid future incident. If you have any questions or concerns about a prohibited transaction or would like to know more information about our audit and tax services for employee benefit plans, call us at 716.847.2651

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              Heads Up for Foreign Companies: Good and Bad News About U.S., State & Local Taxes


              State Revenue Needs Create Opportunities and Pitfalls for Foreign Companies Doing Business in the United States

              State tax issues for foreign companyStates need money. If you remember nothing else about state and local taxes in the United States, remember that. Each state has some type of obligation or demand that requires revenue and the elected officials in that state know that their jobs are at risk if they propose a tax rate increase. Once you take tax increases off the table, there are only a few options available to increase state revenue.

              Two of those options should be of particular interest to foreign companies that do business in the U.S. The first is to create incentives designed to draw new business into the state. The second is to interpret existing tax rules more broadly and enforce them more stringently.

              The Carrot—State Incentives

              States want your business. Almost every state offers some type of program that provides incentives for companies to begin or augment operations there. Incentive programs include items like credits for hiring and property tax credits on real estate purchased.

              To participate in these programs, you must plan ahead. Many incentives are available only before you start doing business in a state or before your activity in the state crosses certain thresholds. Unfortunately, there is no uniform system of state taxation or state incentives. As a result, most businesses looking to build operations in the U.S. should work closely with a U.S.-based accountant who is experienced in state and local tax incentives.

              The Stick—State Enforcement

              The driving force behind state taxation is the concept of “nexus,” or the extent of a business’ connection to a state. Until recently, states focused on an analysis of 3 criteria to measure the presence of a business within their borders: sales, property, and payroll. Today, states focus much more on the gross receipts a business generates within the state. This shift has left many companies surprised by a tax liability that they never knew existed until they were notified by the state. Many multi-national businesses that start operations in the U.S. will conduct activities that trigger filing and tax obligations in individual states before they reach any threshold that requires a federal filing.

              For foreign companies with existing U.S. operations, a nexus study can provide some comfort that current activities have not triggered state or local obligations, or it can provide a valuable heads-up that a filing or tax obligation has been missed. States have shown a willingness to work with businesses that voluntarily disclose that they have failed to meet a requirement. As long as there’s no reason to suspect a willful failure to comply, a state may reduce the number of back years a company is required to file and waive some or all of the penalties that have accrued.

              FBAR compliance and penalty mitigationThe complex requirements of each state’s system demand meticulous attention to detail from the businesses that would operate within its borders. Advance planning can help your business qualify for significant incentives that could reduce the cost of operating in a state and reduce the costs of getting your business compliant. Whether your business is planning new operations within a state or trying to bring existing operations into compliance with state laws, it’s important to work with an advisor who understands the unique rules of each state. 

              Top 100 CPA firm Freed Maxick supports international business’ expansion into the U.S. Contact us to learn about how we can help you avoid the pitfalls while realizing the benefits of doing business in New York or another U.S. state.

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              Growing Into the U.S.? Consider These Tips on Choice of Entity


              4 Reasons Why You Should Consider a “C” Corporation

              C Corporations for doing business in the USThe United States economy represents the pot of gold at the end of the rainbow for many businesses around the world. Its citizens and businesses consume trillions of dollars in products and services.

              If you’re planning for growth into the U.S. or you’re already operating there, you should consider whether an American subsidiary makes sense for your business. When U.S. operations have grown to a point that justifies creating a subsidiary in-country, there are four good reasons why most businesses choose to form a type of entity known as the Subchapter “C” corporation.  

              • Protection from liability. One downside of operating in the U.S. is the litigious nature of its residents. The creation of a corporate entity in the States helps to protect the foreign parent from many of the “slings and arrows” directed at commercial enterprises in the country.
              • Financing. If your plans include getting loans from a U.S. bank, you will almost certainly need a U.S. subsidiary. Financial institutions in the states rarely lend to foreign businesses. Formalizing your presence in the country opens doors to financing options not available to businesses based outside its borders. As noted above, forming your U.S. business as a corporation also provides protection for your non-U.S. interests if the business has difficulty repaying the loans.
              • Returning capital to the foreign parent. Some argue that forming a pass-through entity in the U.S. avoids the double taxation that occurs when corporations are taxed once on earnings and shareholders are taxed again on distributed earnings. A corporation can manage this obligation through careful planning. The parent can provide loans to the subsidiary or perform back office support and other business functions. Payments made for such things serve the dual purpose of returning money to the parent and reducing the subsidiary’s taxable income.
              • Tax impact to the parent. Multinational businesses are required to create transfer-pricing plans that set prices for inter-company transactions. Those transactions must be made “at arm’s length” to comply with the various countries’ transfer-pricing laws, and the more formal structure of a corporate subsidiary makes that standard easier to achieve.

              While planning to create a U.S. subsidiary, seek out business advisors in your home country and in the states who are familiar with creating multi-national parent/subsidiary relationships.

              Review of US and state tax structuringThey need to coordinate on the project to make sure that the new organization is structured in a way that maximizes efficiency, observes the rules of both countries, and makes every legal effort to minimize taxes and fees.  

              Once you’ve determined what type of subsidiary to form, the next question to answer is, “Where in the U.S. should you form it?” We’ll look at some of the considerations at the U.S. state and local level in a future post.  

              Top 100 CPA firm Freed Maxick can help you navigate the complexity of doing business in the U.S. Learn more here.

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              Good News from the IRS for S-Corp Shareholders!


              Bona fide indebtedness determination lowers hurdle to obtain debt basis.

              S Corp ShareholdersFor S corporation shareholders, borrowing from one company they own to fund another is a common way to inject some cash into a growing business—especially in these days of conservative lending. But previously, if the funded company experienced losses and you wanted to take deductions for those losses on your personal tax returns, you had to meet a high bar to prove that loan increased your debt basis in the company.

              As a result of the previous position of the IRS and tax courts, shareholders who borrowed from one related entity in order to loan to another had a particularly hard time defending their debt basis. But thanks to final rules from the IRS, that bar has been lowered and S corporation shareholders are now more likely to qualify for tax deductions for entity losses that have been passed through to them.

              Bona Fide Indebtedness Determination

              On July 23, the IRS issued final regulations on debt basis determinations for S corporation shareholders (T.D. 9682). These final rules implement a “bona fide” debt basis determination as opposed to the controversial “economic outlay” doctrine that has been developed by the courts over the last several years. 

              Under the economic outlay doctrine, in order to obtain debt basis an S corporation shareholder must incur a true economic outlay through a transaction, which when fully consummated, left the taxpayer poorer in a material sense.

              On the other hand, bona fide indebtedness is determined under general Federal tax principles and depends on all the facts and circumstances. Basically, a bona fide debt is one that creates a true debtor-creditor relationship that is based on a valid and enforceable obligation to pay a fixed or determinable amount of money. This means that shareholders who structure and document their loans to an S Corporation in the correct way can now qualify for debt basis in that S corporation, and as a result, can claim current tax deductions for their share of any losses that S corporation experiences.

              This is a win for both the shareholder and the company.  The shareholder has potential for additional deductions and the company gets a cash infusion that has potential tax minimizing opportunities for the shareholder.

              Back-to-Back Opportunity

              Previously, the IRS and tax court often used the economic outlay doctrine to deny debt basis to shareholders for funds borrowed from a related entity and then loaned to the S corporation by the shareholder. These transactions are often referred to as back-to-back loans. The reasoning was that, by borrowing from Peter to pay Paul, the shareholder was not considered to be making a true economic outlay.

              But with the new debt basis rules, shareholders who structure and document their back-to-back loans to qualify as bona fide indebtedness (see below) are more likely to obtain debt basis—and claim tax deductions—as result of those loans.

              The Look-Back Opportunity

              While the final debt basis rules were issued with minimal changes to the proposed regulations, one significant highlight is that the final rules did expand their application to open tax years.

              What does this mean for you? In addition to the potential tax benefits of restructuring related entity loans going forward, shareholders who have made back-to-back loans in any open tax year and didn’t increase their debt basis now have the opportunity to go back and claim deductions for any previously disallowed losses—if they can demonstrate there was bona fide indebtedness.

              Determining Bona Fide Indebtedness

              While there is no bright-line test to prove that a debt is bona fide, the key is to demonstrate that there is a true debtor-creditor relationship. Based on federal tax principles, the following steps can help support the determination of bona fide indebtedness:

              1. Make sure there is documentary evidence of the transaction (i.e. a written loan agreement).
              2. Both parties should reflect the transaction as a loan in their records.
              3. Setup a fixed repayment schedule and make efforts to follow the schedule in order to create a history of regular repayments.
              4. The loan should require interest and the rate should be at least as much as the Applicable Federal Rate (AFR).
              5. Consider collateral to secure the debt.
              6. A demand for repayment should be issued if necessary.
              7. There needs to be intent to create a valid debtor-creditor relationship and the lender must have an expectation of receiving repayment at the time of the loan.

              Review S Corporation Financing Strategy

              If you are a shareholder in one or more S corporations, work with your tax advisor to review any existing or prospective loans for the opportunity to demonstrate bona fide indebtedness—and therefore obtain debt basis to claim current tax deductions for any entity losses in the future and/or any suspended losses in open tax years.

              Going forward, you and your CPA might find that funding S corporations with properly structured back-to-back loans provides a tax-advantaged way to finance a new venture with funds from a more established company.

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              Samuel C. DiSalvo to Speak at the Knowledge Group’s ASC 740


              New York, NY, May 17, 2014 --( The Knowledge Group/The Knowledge Congress Live Webcast Series, the leading producer of regulatory focused webcasts, has announced today that Samuel C. DiSalvo, Tax Director, Freed Maxick CPAs, P.C. will speak at the Knowledge Group’s webcast entitled: “ASC 740: Income Tax Accounting for 2014.” This event is scheduled for October 16, 2014 from 12:00pm – 2:00pm (ET).

              For further details, please visit:

              About Samuel C. DiSalvo
              Samuel C. DiSalvo is a Director with Freed Maxick’s Tax Practice. Prior to joining the Firm, Sam spent over 25 years in the accounting profession with both Big Four firms and private industry. During this time, he gained significant experience with mergers and acquisitions, corporate taxes and compliance, and financial statement tax accounting.

              Sam is responsible for providing day-to-day tax advisory services, coordinating, and supervising the preparation of the corporate income tax returns, and reviewing the annual and quarterly provisions for income taxes for both publicly held and privately held corporations. Sam concentrates his practice on joint venture tax matters, merger and acquisition issues, and corporate taxes as well as ASC 740 issues such as purchase accounting, valuation allowances, and international issues. He also has significant experience in identifying tax opportunities in connection with the due diligence reviews of companies’ prior year tax returns.

              About Freed Maxick CPAs, P.C.
              Freed Maxick CPAs, P.C. is one of the largest accounting and consulting firms in Upstate New York and a Top 100 largest CPA firm in the United States. Serving SEC companies, closely held businesses, governmental and not-for-profit clients across New York as well as nationally and internationally, Freed Maxick mobilizes high-performance professionals to guide client growth, compliance, and innovation. They specialize in the healthcare, manufacturing, real estate, banking, agribusiness and private equity sectors and have more than 280 professional and administrative personnel, with offices in Buffalo, Batavia, Rochester and Syracuse, New York. Freed Maxick’s Tax Practice is the largest of any accounting firm in Upstate New York with over 110 personnel, including 12 tax directors. Freed has built a significant SEC Practice through years of experience in auditing a wide variety of companies and has extensive knowledge in handling public and private capital transactions.

              Event Synopsis:
              In this two-hour Live webcast, a panel of distinguished professionals and thought leaders will help Finance Executives, CPAs, Attorneys, Enrolled Agents, Tax Practitioners, and other related professionals understand the important aspects of this significant topic. They will provide an in-depth discussion of the significant issues related to tax accounting rules and latest developments in ASC 740. Speakers will also offer best practices in developing and
              implementing an effective income tax accounting strategies.

              Key topics include:

              − An overview of ASC 740: Income tax accounting

              − Review issues/considerations on significant areas including valuation allowances, business combinations and uncertain tax positions

              − Guidelines and best practices

              − Latest tax accounting and regulatory developments and a lot more.

              About The Knowledge Group, LLC/The Knowledge Congress Live Webcast Series
              The Knowledge Group, LLC was established with the mission to produce unbiased, objective, and educational live webinars that examine industry trends and regulatory changes from a variety of different perspectives. The goal is to deliver a unique multilevel analysis of an important issue affecting business in a highly focused format. To contact or register to an event, please visit:


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              Are tax issues making dividing a CRT difficult?


              As you know, dividing assets in divorce can be complicated. But, typically, charitable remainder trusts (also known as CRTs) are divided 50-50 into two separate trusts, in accordance with IRS Revenue Ruling 2008-41. But tax issues can make these divisions trickier than they might first appear.

              How do you Spell Relief from Excise Tax?

              charitable remainder trustsThere are two types of CRTs: 1) charitable remainder annuity trusts (CRATs) and 2) charitable remainder unitrusts (CRUTs). They are considered “split-interest trusts,” which means they generally are subject to Internal Revenue Code (IRC) Section 507(a) just as if they were private foundations. The provision levies a termination or excise tax when a private foundation’s tax status is terminated. But the question remains: Does transferring assets from a private foundation (or CRT) to another private foundation (or CRT) — as when divorce assets are split — trigger that tax?

              According to Revenue Ruling 2008-41, if a transfer is pursuant to an “adjustment, organization or reorganization” that includes a significant disposition of assets, the transferee foundation isn’t treated as a newly created organization. Thus, the excise tax doesn’t apply. Significant disposition of assets encompasses the transfer of a total of 25% or more of the fair market value (FMV) of the net assets of the original private foundation to one or more private foundations. In the above scenario, 100% of a CRT’s FMV would be transferred. Therefore, no excise tax applies.

              Defining Disqualified Persons

              CRATs and CRUTs also are subject to IRC Sec. 4941(a)(1). It imposes an excise tax on each act of self-dealing between a private foundation and a disqualified person. Self-dealing may include any direct or indirect transfer of the assets or income of a private foundation to a disqualified person. It also includes use of such assets or income by — or for the benefit of — a disqualified person. Disqualified persons encompass (among other substantial contributors to the foundation) foundation managers, and members of the family of a substantial contributor or foundation manager.

              Revenue Ruling 2008-41 states that divorcing spouses can be disqualified persons with respect to their original trust, which creates the potential for self-dealing. But it also concluded that spouse recipients are protected from self-dealing with respect to their interests upon the trust’s division. Because distributions are made pro rata, neither spouse will receive any additional interest in the original trust’s assets, the original trust’s remainder interest is preserved for charitable interests and no self-dealing transaction occurs.

              Dividing Trusts

              Typically, trusts which are properly divided during divorce will still qualify as CRTs — avoiding certain excise taxes. Make sure you and your clients work with experienced financial professionals when it’s time to handle these types of assets.

              © 2014

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              When Are Daubert Challenges Justified?


              A district court strikes testimony in a patent case

              Daubert ChallengesRecently, a district court judge noted that the overall percentage of successful Daubert challenges to damages in patent cases is “exceedingly small.” Yet, he went on to say that, “every once in a great while, a Daubert challenge to a patent damages expert is justified.” This judge found that to be the case in Dynetix Design Solutions, Inc. v. Synopsys, Inc., where the patent expert’s reasonable royalty testimony was neither tied to the facts nor reliable.

              The ins and outs of the expert’s testimony

              As you know, calculating a reasonable royalty is a two-step process. In the first step, an expert determines the revenue pool that’s implicated by the infringement (that is, the royalty base). Next, the expert determines the percentage of that pool adequate to compensate the plaintiff for that infringement (that is, the royalty rate).

              In the Dynetix case, the plaintiff’s expert started by determining the royalty base. The patented feature was just one of numerous features in the defendant’s product. Nonetheless, the expert determined that the royalty base would be the entire sales of the product simply because the defendant hadn’t separately sold any smaller unit with the patented component. And he also didn’t further apportion the royalty base to account for nonpatented features.

              As to the royalty rate, the expert divided the gross margin of the infringing product equally between the two parties. And then he applied the Georgia-Pacific factors for determining reasonable royalties in order to alter the rate. When focusing on the third and fourth factors (the nature and scope of the hypothetical license in terms of exclusivity and the licensor’s policy for maintaining its patent monopoly by limiting licensing), he then reduced the royalty rate to 19%.

              After he made a couple more adjustments, the expert arrived at a royalty rate of 14.25%. He then applied that rate to the royalty base for the relevant time period, thus concluding that the reasonable royalty would be around $156 million. Because only one of the two components originally accused of infringement remained in the case, he then apportioned 75% of the royalty to the remaining component, which resulted in a royalty of some $117 million.

              The court weighs in

              The district court ultimately rejected the royalty base, finding that the expert had failed to apportion profits between the numerous noninfringing features in the defendant’s product and the patented feature. So, even though he was correct that the smallest salable infringing unit was the defendant’s entire product, he should not have ended his analysis there. Moreover, he needed to determine the infringing component’s value relative to the entire product’s other components. This failure to apportion justified the exclusion of his opinion.

              But the court also rejected the royalty rate. It found that the expert’s analysis only compounded the problems with his opinion. Although half of the gross margin for the infringing profits may indeed have been “one reasonable starting point,” the law required the expert to customize the royalty rate to the specific facts of the case — including the particular industry, technology or party. And, as the court explained, “an arbitrary starting point is impermissible under Uniloc.”

              The Federal Circuit in Uniloc rejected a “25% rule of thumb” profit margin for starting the royalty rate calculation. And the 50% starting place, the district court said, was even more arbitrary because the expert based it solely on his own judgment and experience, without even considering analogous licenses offered in the industry or the nature of the patented component as an optional and small feature in the product.

              The court’s striking of the expert testimony wasn’t the end of the matter. The court then granted the plaintiff five days to submit a new expert report on the damages.

              The bottom line

              Many have questioned the “gatekeeper” role of courts in evaluating and admitting the reliability of expert testimony. But many courts still exclude testimony based on Daubert objections. It’s critical that attorneys keep on top of developments in this area and work with qualified experts who’re unlikely to face Daubert challenges.

              Sidebar: Limits to the gatekeeper role

              The Supreme Court’s decision in Daubert assigned district courts a type of “gatekeeper” role in admitting expert testimony and evaluating its reliability. A recent case, Manpower, Inc. v. Insurance Co. of the State of Pennsylvania, demonstrates that this role has limits.

              The “Manpower” case involved a dispute over reimbursement for business interruption losses under an insurance policy. The insured’s forensic accounting expert expressed an opinion on the total loss, and the insurance company moved to exclude the testimony, saying it wasn’t the product of reliable methodology.

              The district court found that the expert had, indeed, followed the insurance policy’s prescribed methodology for calculating losses. But the reliability of the expert’s calculations turned on whether he’d used reliable methods when he selected numbers for the projected total expenses and revenues. The court held that the method for projecting revenues was unreliable due to his estimated growth rate, so it excluded his testimony. The insured party then appealed.

              The court of appeals acknowledged that district court judges have a lot of leeway when determining whether particular expert testimony is reliable. It pointed out, however, that a district court “usurps the role of the jury … if it unduly scrutinizes the quality of the expert’s data and conclusions rather than the reliability of the methodology.”

              The appellate court determined that the district court’s concerns weren’t due to the reliability of the expert’s methodology, but the resulting conclusions. The district court then took issue with his selection of particular data. But the selection of data inputs to apply in a model is a question that’s separate from the reliability of the methodology reflected in the model itself.

              The appellate court warned that it wasn’t saying that an expert can rely on data with no quantitative or qualitative connection to the methodology. Experts should use the type of data on which specialists in the field would reasonably rely.

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              Understanding Standards of Value


              Lawyers aren’t expected to be valuation experts. That’s why they choose to hire professional appraisers when their clients need a company or business interest valued for tax, litigation or other purposes. But having a basic understanding of the various standards of value allows you to work more effectively with your expert — and better serve your client.

              The ins and outs of FMV

              fair market valueDid you know that the most widely recognized standard of value is fair market value (FMV)? It’s almost always used for valuing business interests for estate and gift tax purposes. The IRS defines FMV as “the price at which the property would change hands between a hypothetical buyer and seller who have reasonable knowledge of the relevant facts and are under no compulsion to enter into the transaction.”

              Fair market value reflects the price at which a transaction would occur under the conditions that existed as of the valuation date. For many standard-setting bodies, FMV represents the highest and best use that the property could be put to on the valuation date, taking into account special uses realistically available. It doesn’t matter if the owner has actually chosen that use for the property.

              Understanding “Fair Value”

              According to the Financial Accounting Standards Board (otherwise known as FASB), fair value is the price it would take (in an orderly transaction between market participants) to transfer a liability or sell an asset in the market where the reporting entity would typically transact for the asset or liability.

              The fair value standard is often applied for financial reporting purposes. But it’s also used in shareholder or divorce litigation, and is typically defined by state law in such cases. In many states, fair value for litigation involving dissenting shareholders is considered to be the pro rata share of a controlling level of value. So, control and/or marketability discounts generally aren’t applied.

              Understanding Investment Value

              Investment value (also known as “strategic value”) represents the value of an asset to a specific investor. For real estate purposes, it’s often defined as the value of an investment to a particular investor or class of investors based on their investment requirements. Value is determined by discounting an anticipated income stream while also considering potential benefits from synergies such as lower expenses or revenue enhancement.

              Investment value varies from FMV for a couple of reasons, such as contrasting estimates of future income and different perceptions of risk. There may also be income status differences and synergies with other operations that are owned or controlled by the investor.

              When it comes to shareholder litigation, investment value carries a different meaning, however. Here, investment value is based on earning power, but the appropriate capitalization rate or discount is typically a consensus rate that isn’t specific to any investor.

              Understanding Intrinsic Value

              Intrinsic value is usually employed when valuing an equity share to determine its “real worth.” Intrinsic value (also known as fundamental value) is calculated by looking at an asset’s primary value factors. Relevant factors include:

              • The value of the company’s physical assets,
              • Expected future earnings,
              • Expected dividends payable and future interest, and
              • Expected future growth rate.

              It’s true: Defining intrinsic value can be rather tricky. Many appraisers use the term to refer to investment value, while others use it to describe the independent analysis of an investment analyst, banker or financial manager. Trouble is: Courts don’t always clearly define the term, either. So, appraisers are challenged to establish an upfront, clear definition with their clients and attorneys.

              Understanding the options

              So, with so many options to choose from, how do valuation experts decide which standard to apply when performing a business valuation? The appropriate standard is often determined by specific court orders, state or federal statute, or case or administrative law. Corporate documents, such as articles of incorporation or buy-sell agreements, also might dictate the applicable standard.

              A valuator’s professional judgment factors into the decision, as well. For this reason, it’s important that you work with an experienced and qualified appraiser. It might just mean the difference between testimony that’s accepted in court or that which is rejected.

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              Ways That Financial Statements Can Reveal Corporate Fraud


              At long last, the U.S. economy seems to be recovering from the effects of the recession. But at least one major financial risk remains — corporate fraud. The good news is: A fraud expert can help investors and companies minimize losses from fraudulent conduct by simply scrutinizing a business’s financial statements.

              Fictitious finances

              fraudCorporate fraud often is concealed when a business intentionally misrepresents material information in its financial reports. These misrepresentations may result from overly aggressive estimates of figures, the misapplication of accounting principles and material omissions. For instance, financial statements may conceal expenses or liabilities or report fictitious revenues in order to make a business appear more profitable than it really is.

              In order to cover fraud, a perpetrator often conceals or omits information that can damage or improperly change the bottom-line results appearing in financial statements. Such omissions might include:

              • Liabilities such as loan covenants or contingency liabilities.
              • Significant events that are likely to affect future statements, such as potential lawsuits, impending product obsolescence and new competition.
              • Accounting changes that materially affect financial statements and are subject to disclosure rules, such as methods of accounting for depreciation, revenue recognition or accruals.

              Perpetrators also might engage in fraudulent manipulation, particularly in the areas of revenues, reserves, expenses and one-time charges. A falsified financial statement can improperly value sales transactions (by, for example, inflating the per unit price), recognize sales prematurely or report phantom sales that never occurred. On the other hand, expenses can be manipulated by simply delaying their recognition — whether to match expenses with their corresponding revenue or to avoid reporting a loss. Another scheme is to improperly capitalize expenses so they appear on the business’s balance sheet rather than on its income statement.

              In many cases, fraudulent financial statements may show reserves that have been calculated using bad-faith estimates. For instance, a fraudster can justify a smaller amount of reserves simply by underestimating the percentage of uncollectible receivables. One-time charges, such as a charge for research and development costs for a specific product, or a write-off of goodwill, can further distort financial statement figures and help hide fraudulent activity.

              Unusual trends and relationships

              When fraud is suspected, a CPA can examine complex financial statements and uncover manipulation that might not be apparent to the untrained eye. A fraud expert typically begins by reviewing suspicious statements for unusual trends and relationships. Any leads are then followed by more intensive forensic accounting work. This may include analysis of journal entries, specific transactions, work papers and supporting documentation — going far beyond a standard annual audit.

              Moreover, a CPA may employ several types of analyses. For instance, a vertical analysis compares the proportion of every financial statement item — or groups of items — to a total within a single year that can be measured against industry norms. A horizontal analysis compares current data with data from prior years in order to detect patterns and trends. And a financial ratio analysis can calculate ratios from the current year’s data and then compare those with previous years’ ratios for the business, comparable companies and the relevant industry. Of course, the expert must have tremendous experience in the subject industry and be able to recognize any noncompliance with Generally Accepted Accounting Principles.

              Noncompliance is a huge red flag for financial statement fraud. The Association of Certified Fraud Examiners (ACFE) has identified several behavioral red flags, including executives who exhibit a cavalier attitude toward internal controls, live beyond their means, have excessive organizational pressure to perform, and are unwilling to share duties or information with colleagues.

              fraudFraud costs

              The ACFE has estimated that the median loss in financial statement fraud schemes is around $1 million. But there are other damages as well, such as the public relations damage that rogue executives who manipulate the numbers can cause. A qualified CPA can help limit your clients’ losses by finding critical omissions and manipulations.

              © 2014

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