Tag: Tax

Delaware Franchise Taxes Are Around the Corner

If you are a Delaware corporation, you likely received a notice from the Secretary of State of Delaware informing you that your company’s Annual Report and franchise tax payment are due by March 1, 2020. These notices are sent to the corporation’s registered agent. You are still required to file an Annual Report and pay the franchise tax even if your corporation never engaged in business or generated revenue. Delaware requires these to be submitted online.

There are two ways to calculate your Delaware franchise taxes (the Authorized Shares Method and the Assumed Par Value Capital Method). Delaware defaults to calculating its franchise taxes owed by using the Authorized Shares Method, which almost always results in a higher tax liability for startups with limited assets. However, by using the Assumed Par Capital Value Method, startups are often able to significantly lower their franchise tax burden.

For example, a typical early-stage startup corporation with: (i) 10 million authorized shares of stock; (ii) 9 million issued shares of stock; (iii) a par value of $0.0001; and (iv) gross assets of $100,000, would result in the following franchise tax obligations under the different methods:

  • $85,165 under the Authorized Shares Method

  • $400 under the Assumed Par Value Capital Method

    If you are incorporated in Delaware, but conducting business in another state, you must be qualified to do business in that state – meaning, you might be subject to that state’s franchise tax (if any) as well. For example, a Delaware corporation doing business in Texas must still register for a foreign qualification to conduct business in Texas ($750 filing fee), submit a Texas annual Franchise Tax Report (due by May 15 of each year), and pay the associated tax.

Texas franchise taxes are based on an entity’s margin (unless filing under an EZ computation),

and are calculated based on one of the following ways:

  • total revenue times 70 percent;

  • total revenue minus cost of goods sold (COGS);

  • total revenue minus compensation; or

  • total revenue minus $1 million (effective Jan. 1, 2014).

© 2020 Winstead PC.

For more on franchise taxation, see the National Law Review Tax Law section.

Choosing a Trustee for Your Children – Should Foreign Family Members Apply?

Often the most difficult decision parents need to make when writing a Will is whom to appoint as the trustee for their children. The choice becomes particularly tricky for clients whose families live outside the U.S. since choosing a foreign trustee will cause the children’s trusts to be classified under U.S. income tax laws as “foreign trusts” – with lots of ensuing complications.

Under the Internal Revenue Code, trusts are by default “for­eign trusts” for U.S. income tax reporting purposes unless a U.S. court exercises both primary supervision over the administration of the trust (the “court test”), and one or more U.S. persons have authority to control all substantial decisions of the trust (the “control test”). The choice of a foreign trustee causes the trust to flunk the control test because a non-U.S. person controls substantial decisions of the trust. Being classified as a foreign trust results in some problematic U.S. income tax consequences. For example:

  •  U.S. beneficiaries who receive distributions from the trust will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution. Normally, non-U.S. source income and realized capital gains are not deemed to constitute any part of a distribu­tion to a beneficiary unless specifically allo­cated to a beneficiary. The foreign trust rules change this tax treatment such that non-U.S. source income, as well as capital gains, are deemed to be part of any taxable income distributed to a U.S. beneficiary.
  • Trust income not distributed in the year it is earned becomes undistributed net income (UNI). If, in a later year, a trust distribution to a U.S. beneficiary exceeds that year’s trust income, the distribution carries out UNI and is deemed to include the accumulated income and capital gains realized by the foreign trust in prior years. These gains do not retain their character but rather are taxable to the U.S. beneficiary at ordinary income tax rates.
  • Also, to the extent that a distribution to a U.S. beneficiary exceeds the current year’s trust income, a non-deductible interest charge will be assessed on the tax that is due with respect to the accumulated income and capital gains that are now deemed distributed. This charge is based upon the interest rate imposed upon underpayments of federal income tax and is compounded daily.
  • Finally, accumulated income and capi­tal gains are taxable to the U.S. beneficiary at the beneficiary’s ordinary income tax rate for the years during which it was earned under a complex formula designed to capture the U.S. tax that would have been payable if the accumulations had been distributed in the years earned – called the “throwback tax”.

Foreign trusts also trigger additional reporting obligations that carry heavy pen­alties for failure to comply. A U.S. beneficiary who receives a distribution from a foreign trust must file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts”) reporting the distribution and the character of the distribu­tion. The failure-to-file penalty is equal to 35 percent of the gross distribution.

Recognizing, however, that a domestic trust can inadvertently become a foreign trust through changes in the identity of the trust­ee – such as a trustee’s resignation, disability, or death (but not removal) or the trustee ceasing to be a U.S. person (i.e. change of residency or expatriation) – U.S. Treasury Regulations pro­vide for a 12-month period within which to cure the unintentional conversion. The trust can replace the foreign trustee with a U.S. per­son trustee, or the foreign person can become a U.S. person during these 12 months. The foreign per­son can effectuate the cure simply by making the United States his place of residence; he need not become a U.S. citizen.

Rather than rely upon the 12-month cure period, however, a trust agreement should provide for a means to remove a non-U.S. person trustee to assure that the trust qualifies as a domestic trust. Trustee removal and appointment provisions are critical but should be reserved to individuals or entities in the United States. These powers can also create inadvertent gift and estate tax issues, so consulting a qualified trusts and estates lawyer to draft them is critical.

To avoid these problems, it might seem to make sense to allow the for­eign trustee to appoint a U.S. co-trustee or to grant certain reserved powers over the trust to a foreign family member in lieu of naming them as trustee (for example, reserving to them the power to remove and replace the U.S. trustee.) But this will not solve the problem. A trust is defined as foreign unless it satis­fies both the court test and the control test.

  • The safe harbor provisions of the court test require that the trust must “in fact” be administered exclusively within the United States, meaning that the U.S. trustee must maintain the books and records of the trust, file the trust tax returns, manage and invest the trust assets, and determine the amount and timing of trust distributions.
  • The safe harbor provisions of the control test provide that, in addition to making decisions related to distributions, the U.S. trustee must be entirely responsible for a laundry list of decisions including selecting beneficiaries, making investment decisions, deciding whether to allocate receipts to income or principal, deciding to termi­nate the trust, pursue claims of the trust, sue on behalf of or defend suits against the trust, and deciding to remove, add or replace a trustee or name a successor trustee.

And just to be sure, a well-written document should include a backstop provision that requires the trust to always qualify as a U.S. trust for income tax purposes and to have a majority of U.S. trustees. The inclusion of such a provision, at the very least, alerts those administering the trust to consider these issues before making any changes to the trustee or after an inadvertent change in trustees has occurred.

The increase in cross-border families and multinational asset portfolios have added complexities to the financial planning of families. Familiarity with the impact that these rules may have to existing or proposed estate plans is critical when designing a comprehensive plan for clients.

© 1998-2020 Wiggin and Dana LLP

For more on wills and inheritance trusts, see the National Law Review Estates & Trusts law section.

Why is Section 962 Back in the Spotlight? [Podcast]

In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.

Transcript:

PAUL D’ ALESSANDRO

Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris.  How are you doing this morning, Megan?

MEGAN FERRIS

Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.

PAUL D’ ALESSANDRO

Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?

MEGAN FERRIS

Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income.  Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures.  One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC.  Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate.  Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate.  But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income.  And that’s great for corporations.  An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC.  The individual pays up to 37% U.S. tax on GILTI, end of story.  So, as you can see, the disparity between individual and corporation taxation can be quite dramatic.  And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.

PAUL D’ ALESSANDRO

Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?

MEGAN FERRIS

Right.  So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election.  So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s.  Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. Section 962 gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings will be no heavier than they would have been had they invested in an American corporation doing business abroad.”  So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics.  This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election.  So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.

PAUL D’ ALESSANDRO

Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?

MEGAN FERRIS

An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.

PAUL D’ ALESSANDRO

So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on.  The election applies to all CFCs that are owned by the individual.  So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances.  So I think we kind of gave an overview here of Section 962 and why it matters now.  But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?

MEGAN FERRIS

Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%.  There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI.  But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes.  With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement.  There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders.  And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion.  Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation.  And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion.  So, I’ll give an example.  We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC.  The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income.  From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client.  And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid.  We recommended making a Section 962 election, which he did.  Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation.  U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid.  And when CFC eventually distributes the income, the client is taxed on their distribution.  However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%.  So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.

PAUL D’ ALESSANDRO

So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit.  On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise.  So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now.  Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?

MEGAN FERRIS

That’s a great question, Paul.  Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France.  But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%.  And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations.  Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual.  As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction.  Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required.  On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer.  Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC.  Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.

PAUL D’ ALESSANDRO

So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said.  The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%.  Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions.  And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about.  That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located.  Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation.  So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation.  And with that, I think we’ve concluded our first podcast.  I hope you all enjoyed it and found it useful.  We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year.  Megan, is there anything you want to say before we sign off?

MEGAN FERRIS

Thanks, Paul. I think you made some great points just to wrap up there.  And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.

PAUL D’ ALESSANDRO

Okay.  Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.

 

© 2020 Bilzin Sumberg Baena Price & Axelrod LLP

More tax guidance on the National Law Review Tax Law page.

IRS Penalties Assessed Against Your Client May Not Be Valid

Internal Revenue Code section 6751(b) provides that no penalty shall be assessed under the Code unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination, or such higher level official as the Secretary of the Treasury may designate.  This section defines penalty as any addition to tax or any additional amount.  The requirement for prior written approval does not apply to penalties for failure to file a return or pay tax, or to penalties that are automatically calculated through electronic means, but does apply to negligence and substantial understatement penalties, as well as the “responsible party” penalty for failure to withhold or remit payroll taxes.

In Graev v. Commissioner, 140 T.C. 377 (2013), the IRS imposed accuracy related penalties on a taxpayer.  The taxpayer argued that the penalties were invalid because no supervisor’s approval was obtained.  The Tax Court ruled in favor of the IRS, stating that the taxpayer’s challenge was premature because the IRS could comply with approval requirement any time before the Tax Court issued a final determination.  The Graev case was appealable to the Second Circuit Court of Appeals.

In Chai v. Commissioner, 851 F. 3d (2nd Cir. 2017), the Second Circuit Court of Appeals held that Code Section 6751(b) requires the IRS to obtain written approval of an initial penalty determination no later than the date that the IRS issues a notice of deficiency or files an answer asserting the penalty.  In light of the Second Circuit decision in Chai, the Tax Court issued a supplemental opinion in Graev v. Commissioner, 149 T.C. 485 (2018)  and reversed its prior holding regarding Code Section 6751(b).  In the supplemental opinion the Tax Court held that under Code Section 6751(b), the IRS must obtain  written supervisory approval of an initial penalty determination no later than the date that the IRS issues a notice of deficiency or files an answer and that the Government bears the burden of showing that it has complied with Code Section 6751(b).

It is likely that the IRS is now aware of this requirement and will seek the required supervisory approval.  However,  taxpayers should challenge any penalty covered by Code Section 6751(b) and require the IRS to provide proof that the required written supervisory approval was timely obtained.

© 2020 Mitchell Silberberg & Knupp LLP

For more on IRS Code guidance, see theNational Law Review Tax Law section.

Swap New Year’s Resolutions for Real Property with a 1031 Tax-Deferred Exchange

A 1031 Tax-Deferred Exchange (“§ 1031 Exchange”) is an extremely useful tax strategy for taxpayers that maintain real property for productive use in trade, business or for investment. It allows a taxpayer to defer payment of capital gains tax on investment properties that are sold.

A taxpayer continues to qualify for a § 1031 Exchange if the following rules are met: (1) the properties being exchanged must be “like-kind”; (2) the taxpayer must transfer property held for productive use in a trade, business or for investment (the “Relinquished Property”) and subsequently receives property to be held either for productive use in a trade, business or for investment (the “Replacement Property”)”; (3) the Replacement Property value must be greater than or equal to the Relinquished Property value; (4) the taxpayer must not receive “boot” in order for the exchange to remain tax-free; (5) the name on title of the Relinquished Property must mirror the name on the title of the Replacement Property; (6) the taxpayer must identify a replacement property within 45 days after the taxpayer transfers the Relinquished Property; and (7) the taxpayer must receive the Replacement Property within 180 days of the transfer of the Relinquished Property, or on the date the taxpayer’s tax return is due, whichever is earlier.

Section 1031 Exchanges, while an excellent tax deferral tool, are not without complications. Section 1031 Exchanges must be used exclusively for the exchange of real property held for investment or business purposes. Section 1031 Exchange rules also require the title of the Replacement Property to be under the same name as the title of the Relinquished Property. Any real property interests owned by a limited liability company or a partnership must be reinvested by the entity in real property of “like-kind” nature for investment or business purposes in order for it to qualify under § 1031. This is a problem if an individual member or partner of the entity wishes to “cash out” or reinvest in something other than “like-kind” real property. To remedy this problem, many transactions are structured as a “drop and swap” where the interests in the real property are transferred to the individuals as tenants in common and those tenants in common, as individuals, deed the Relinquished Property to the buyer. Because the taxpayers, as individuals, sold the Relinquished Property, it is the individuals that must reinvest in the Replacement Property to utilize the tax deferrals under § 1031. Because the individuals are tenants in common, each is able to choose independently whether to reinvest in a Replacement Property and defer tax under § 1031 or cash out and pay the tax on their individual earnings from the sale of the property.

However, this “drop and swap” technique is increasingly disfavored by the IRS and may create tax implications for the taxpayers if the real property is acquired by the individual taxpayers immediately prior to the sale. Since real property must be for investment or business purposes to be eligible under a § 1031 Exchange, it is best practice to distribute the interests in the property to the individuals well in advance of the date of the relinquishment so each individual holds the property long enough to constitute an investment. While the IRS has not provided guidelines on the length of the holding period, it is recommended that such transfer, or “drop” to the individuals occur at least a year in advance before the closing on the Relinquished Property and that records be kept of the transfer and the intent of the taxpayers to hold the real property for business or investment. Moreover, taxpayers need to take care when transferring (“dropping”) the interest in the real property from the entity to individual tenancy-in-common interests to ensure the taxpayers aren’t viewed as operating as a partnership and thus, subject to ownership constraints of a partnership (this would likely negate the drop and swap technique and require the individuals, as tenants-in-common but operating as a partnership, to all invest in the Replacement Property for some to benefit from tax deferral under a §1031 Exchange).

There does not appear to be any limitation on how an individual taxpayer uses their proceeds if they are cashing out, and have no intent to defer tax under a § 1031 Exchange. However, for a taxpayer to defer tax under a § 1031 Exchange the above requirements must be met, and there can be no actual or constructive receipt of money or other property before the taxpayer actually receives the Replacement Property. Even if the taxpayer may ultimately receive the like-kind Replacement Property, any receipt of cash or other property, including an interest in an additional entity or personal property, prior to that Replacement Property will make the transaction a sale rather than a deferred exchange and prevent the taxpayer from gaining the tax deferral under a § 1031 Exchange.

© 2020 Davis|Kuelthau, s.c. All Rights Reserved

See more on the topic via the National Law Review Tax Law page.

2020 Inflation Adjustments Impacting Individual Taxpayers

Last month, the IRS released the 2020 inflation adjustments for several tax provisions in Rev. Proc. 2019-44. The adjustments apply to tax years beginning in 2020 and transactions or events occurring during the 2020 calendar year.  A select group of key provisions relative to trusts and estates are identified below.

Income Tax of Trusts and Estates

The taxable income thresholds on trusts and estates under Section 1(e) are:

If Taxable Income is: The Tax is:
Not over $2,600 10% of the taxable income
Over $2,600 but not over $9,450 $260 plus 24% of excess over $2,600
Over $9,450 but not over $12,950 $1,904 plus 35% of excess over $9,450
Over $12,950 $3,129 plus 37% of excess over $12,950

The alternative minimum tax exemption amount for estates and trusts under Section 55(d)(1)(D) is:

Filing Status Exemption Amount
Estates and Trusts ((§55(d)(1)(D)) $25,400

The phase-out amounts of alternative minimum tax for estates and trusts under Section 55(d)(3)(C) are:

Filing Status Threshold Phase-out
Estates and Trusts ((§55(d)(3)(C)) $84,800

Estate and Gift Tax

For an estate of a decedent dying in 2020, the basic exclusion amount, for purposes of determining the Section 2010 credit against estate tax, is $11,580,000.

The Section 2503(b) annual gift tax exclusion for gifts made in 2020 is $15,000 per donee.

For an estate of a decedent dying in 2020 that elected to use the Section 2032A special valuation method for qualified property, the aggregate decrease in value must not exceed $1,180,000.

For gifts made to a non-citizen spouse in 2020, the annual gift tax exclusion under Section 2523(i)(2) is $157,000.

Additionally, recipients of gifts from certain foreign persons may be required to report these gifts under Section 6039F if the aggregate value of the gifts received in 2020 exceeds $16,649.

For an estate of a decedent dying in 2020 that elect to extend the payment of estate tax under Section 6166, the 2% portion for determining the interest rate under Section 6601(j) is $1,570,000.

2020 Penalty Amounts

In the case of failure to file a return, the addition to tax under Section 6651(a)(1) is not less than the lesser of $215 or 100% of the amount required to be shown on the return.

The penalties under Section 6652(c) for certain exempt organizations and trusts failing to file returns, disclosures, etc., which are required to be filed in calendar year 2020, are:

Returns Under §6033(a)(1) (Exempt Organizations) or §6012(a)(6) (Political Organizations)
Scenario Daily Penalty Maximum Penalty
Penalty on Organization (§6652(c)(1)(A))  $20 Lesser of (i) $10,500 or (ii) 5% of gross receipts for year
Penalty on Organization with Gross Receipts Greater than $1,049,000(§6652(c)(1)(A))  $105 $54,000
Penalty on Managers (§6652(c)(1)(B)(ii))  $10 $5,000
Public Inspection of Annual Returns and Reports (§6652(c)(1)(C))  $20 $10,500
Public Inspection of Applications for Exemption and Notice of Status (§6652(c)(1)(D))  $20 No limits

Returns Under §6034 (Certain Trust) or §6043(b) (Terminations, etc., of exempt organizations)
Scenario Daily Penalty Maximum Penalty
Penalty on Organization or Trust (§6652(c)(1)(A)) $10 $5,000
Penalty on Managers (§6652(c)(2)(B)) $10 $5,000
Penalty on Split Interest Trust (§6652(c)(2)(C)) $20 $10,500
Split Interest Trust with Gross Income Greater than $262,000 (§6652(c)(2)(C)(ii)) $105 $54,000

Disclosure Under §6033(a)(2)
Scenario Daily Penalty Maximum Penalty
Penalty on Tax-Exempt Entity (§6652(c)(3)(A)) $105 $54,000
Failure to Comply with Demand (6652(c)(3)(B)(ii)) $105 $10,500

 

© 2020 Davis|Kuelthau, s.c. All Rights Reserved

ARTICLE BY Mark G. Kmiecik of  Davis Kuelthau.
For more IRS Guidance & Regulatory Updates, see the National Law Review Tax Law section.

Redesigned 2020 IRS Form W-4

The IRS has substantially redesigned the Form W-4 to be used beginning in 2020.

New employees first paid wages during 2020 must use the new redesigned Form W-4.  In addition, employees who worked for an employer before 2020 but are rehired during 2020 also must use the redesigned 2020 Form W-4.

Continuing employees who provided a Form W-4 before 2020 do not have to furnish the new Form W-4.  However, if a continuing employee who wants to adjust his/her withholding must use the redesigned Form.

IRS FAQs for Employers

The IRS has issued the following FAQs for employers about the redesigned 2020 Form W-4:

  • Are all employees required to furnish a new Form W-4?

No, employees who have furnished Form W-4 in any year before 2020 do not have to furnish a new form merely because of the redesign. Employers will continue to compute withholding based on the information from the employee’s most recently furnished Form W-4.

  • Are new employees first paid after 2019 required to use the redesigned form?

Yes, all new employees first paid after 2019 must use the redesigned form. Similarly, any other employee who wishes to adjust their withholding must use the redesigned form.

  • How do I treat new employees first paid after 2019 who do not furnish a Form W-4?

New employees first paid after 2019 who fail to furnish a Form W-4 will be treated as a single filer with no other adjustments.  This means that a single filer’s standard deduction with no other entries will be taken into account in determining withholding.  This treatment also generally applies to employees who previously worked for you who were rehired in 2020 and did not furnish a new Form W-4.

  • What about employees paid before 2020 who want to adjust withholding from their pay dated January 1, 2020, or later?

Employees must use the redesigned form.

  • May I ask all of my employees paid before 2020 to furnish new Forms W-4 using the redesigned version of the form?

Yes, you may ask, but as part of the request you should explain:

 »   they do not have to furnish a new Form W-4, and

 »   if they do not furnish a new Form W-4, withholding will continue based on a valid form previously furnished.

For those employees who furnished forms before 2020 and who do not furnish a new one after 2019, you must continue to withhold based on the forms previously furnished.  You may not treat employees as failing to furnish Forms W-4 if they don’t furnish a new Form W-4. Note that special rules apply to Forms W-4 claiming exemption from withholding.

  • Will there still be an adjustment for nonresident aliens?

Yes, the IRS will provide instructions in the 2020 Publication 15-T, Federal Income Tax Withholding Methods, on the additional amounts that should be added to wages to determine withholding for nonresident aliens. And nonresident alien employees should continue to follow the special instructions in Notice 1392 when completing their Forms W-4.

  • When can we start using the new 2020 Form W-4?

The new 2020 Form W-4 can be used with respect to wages to be paid in 2020.

Additional Information

This Publication includes the income tax withholding tables to be used by automated and manual payroll systems beginning in 2020 regarding both (i) Forms W-4 from 2019 or earlier AND (ii) Forms W-4 from 2020 or later.

  • IRS FAQs on the 2020 Form W-4

Jackson Lewis P.C. © 2020

More on IRS Forms & Regulations on the National Law Review Tax Law page.

2019 Year-End Estate Planning: The Question Is Not Whether to Gift, But How to Gift

Federal and Illinois tax laws continue to provide opportunities to transfer significant amounts of wealth free of any federal gift, estate and generation-skipping transfer (GST) taxes. However, because certain beneficial provisions “sunset” on January 1, 2026, now is an ideal time to revisit estate plans to ensure you make full use of this opportunity.

Current Exemption Levels

The federal gift, estate and GST exemptions (i.e., the amount an individual can transfer free of any of these taxes) are currently $11,400,000 for each individual, increasing to $11,580,000 in 2020. For married couples, the exemptions are currently $22,800,000, increasing to $23,160,000 in 2020. However, on January 1, 2026, the federal gift, estate and GST exemptions will be cut in half.

Federal and Illinois estate tax laws allow for a marital deduction for assets passing outright to a spouse or to qualifying trusts for the benefit of a surviving spouse. Thereafter, the federal estate tax rate is 40 percent. Illinois imposes a state estate tax based on a $4,000,000 threshold, which is not adjusted for inflation, at effective rates ranging from 8 percent to approximately 29 percent. (The Illinois estate tax paid is allowable as a deduction for federal estate tax purposes.) The only way to take advantage of the increased federal exemptions is to utilize planning strategies such as gifting in advance of the sunset date.

Gifting Options

Lifetime utilization of transfer tax exemption. A simple and effective planning opportunity involves early and full use of the high exemptions. Lifetime gifts utilizing the exemption amounts will almost always result in overall transfer tax savings, unless the assets that have been transferred decline in value. As with any gifting strategy, all income and future appreciation attributable to the gifted assets escapes future gift and estate taxation.

Assuming that assets appreciate, the sooner a planning strategy is implemented, the greater the estate tax savings will be. On November 22, 2019, the IRS issued final “anti-clawback” regulations expressly acknowledging that, when the exemptions are decreased, gifts made using the current high exemption amounts and which are in excess of the future reduced exemption amounts will not be subject to any additional gift or estate taxation. Thus, now is clearly the time for a “use it or lose it” strategy.

Annual exclusion gifts. Making use of annual exclusion gifts remains one of the most powerful estate planning techniques. The “annual exclusion amount” is the amount that any individual may give to any other individual within a tax year without incurring gift tax consequences. This amount, indexed for inflation, is currently $15,000 per donee.

Married couples can combine their annual exclusion amounts when making gifts, meaning that a married couple can give $30,000 per year to a child without using any transfer tax exemption (although filing a gift tax return may be required in some circumstances). When the spouses of children are included in the annual exclusion gifting, the amount that can be gifted is doubled again, meaning that a married couple can give a total of $60,000 per year to a child and the child’s spouse without using any transfer tax exemption.

Annual exclusion gifts can result in substantial transfer tax savings over time, as they allow the donor to remove the gift amount and any income and growth thereon from the donor’s estate without paying any gift tax or using any transfer tax exemption. Annual exclusion gifts also reduce a family’s overall income tax burden when income-producing property is transferred to family members who are in lower income tax brackets and not subject to the “kiddie tax” or the 3.8 percent net investment income tax.

Tuition and medical gifts. Individuals can make unlimited gifts on behalf of others by paying tuition costs directly to the recipient’s school or paying their medical expenses (including the payment of health insurance premiums) directly to a health care provider.

Gifts to spousal lifetime access trusts. Most people consider $11,400,000 to be a very large gift and either cannot, or do not want to, give away that much, as they may need or want it for themselves. A gift to a properly structured “spousal lifetime access trust” lets an individual make a completed gift now, and use the temporarily increased transfer exemption, but allows the individual’s spouse to be a beneficiary of the trust and have access to trust assets if needed. If the spousal lifetime access trust is implemented properly, the assets of trust (and the growth thereon) will not be subject to estate tax at the death of the grantor or at the death of the grantor’s spouse.

Grantor trusts. When planning with trusts, donors have great flexibility in determining who will be responsible for the payment of income taxes attributable to the assets in a trust. As an enhanced planning technique, trusts can be structured as “grantor trusts,” in which the trust is a disregarded income tax entity and the donor—not the trust or the beneficiaries—is responsible for paying tax on the trust’s income. By structuring a trust as a grantor trust, a donor can make tax-free gifts when paying the tax attributable to the trust’s income. This technique promotes appreciation of the trust assets while simultaneously decreasing the size of the donor’s estate, producing additional estate tax savings.

Combining gifting and selling assets to grantor trusts. Additional estate tax benefits can be obtained by combining gifts to grantor trusts with sales to grantor trusts. Because the grantor is treated as the owner of the trust for income tax purposes, no capital gains tax is imposed on the sale of assets to a grantor trust. The trust can finance the sale with a promissory note payable to the grantor, which provides the grantor with cash flow from the trust. The growth on the assets that are sold would then escape estate taxation at the grantor’s death.

Considerations When Making a Gift

Use of trusts when gifting. As with any gifting strategy, assets may be gifted outright so that the recipient directly controls the assets, thereby exposing the assets to the claims of the beneficiary’s creditors. Alternatively, assets may be gifted in trust, which 1) protects the gifted assets from the beneficiary’s creditors, including the spouses of beneficiaries in the event of divorce, 2) determines the future use and control of the gifted assets, and 3) shelters the gifted assets from future gift, estate and GST taxes through the allocation of the GST exemption.

Valuation discounts and leveraging strategies in the family context. “Minority interest,” “lack of marketability,” “lack of control” and “fractional interest” discounts can still be applied under current law to the valuation of interests in family-controlled entities and of real estate and other assets that are transferred to family members. Such discounting provides for estate and gift tax savings by reducing the value of the transferred interests. Leveraging strategies (e.g., family partnerships, sales to grantor trusts and grantor retained annuity trusts) can also be utilized to advantageously pass tremendous amounts of wealth for the benefit of many generations free of federal and Illinois transfer taxes.

State of Illinois estate tax laws. Illinois continues to tax estates in excess of $4,000,000, which is not adjusted for inflation and not allowed to be “ported” to a surviving spouse. Given the disparity between the $11,400,000 federal estate tax exemption and the $4,000,000 Illinois estate tax exemption, married couples domiciled in Illinois should make certain that their estate plans are structured to take advantage of the Illinois estate tax marital deduction. Otherwise, an estate plan that is designed to fully utilize the federal exemption can inadvertently cause an Illinois estate tax in excess of $1,000,000 upon the death of the first spouse.

The obvious and most direct strategy to address the Illinois estate tax is to simply move to one of the many states that do not currently impose an estate tax. In the event that a change of domicile is not possible or is not desired, all of the traditional planning techniques described above (in addition to others) are available to address this state liability. Because Illinois does not impose a gift tax, enacting gifting strategies will reduce future Illinois estate taxes.

Income tax basis changes. We continue to enjoy an income tax basis adjustment for assets received from a decedent upon his or her death (commonly known as the “step-up in basis,” although if values go down it can also be a “step-down” in basis). With the increase in the federal gift, estate and GST exemptions, and even with Illinois’ $4,000,000 exemption, transfer taxes are no longer a concern in many circumstances, and there is increased emphasis on income tax planning (specifically, planning with the goal of obtaining an income tax basis step-up at death). For many clients, it may be advisable, if possible, to “reverse” prior estate planning techniques, including trusts that were established on the death of a first spouse to die, to allow for a step-up in basis.

Traditional Estate Planning Still Matters

There is no time like the present to make certain that estate planning documents accurately reflect current wishes and make beneficial use of the federal and state transfer tax exemptions (to the extent not utilized during lifetime), federal and/or state marital deductions, and federal GST exemptions. Revisions may also be needed if family circumstances have changed since documents were originally executed.

Your estate planning goals may have changed. Many people no longer have taxable estates for federal estate tax purposes and may be able to adjust their estate plans accordingly, while others have existing plans that automatically adjust to the increased exemptions and do not desire more aggressive planning. Still others may want to take prompt action to aggressively utilize the new exemptions.

The above summary is not intended to enumerate all available estate planning techniques. Non-tax reasons to review and implement estate plans include:

  • Planning for probate avoidance
  • Planning for individuals with special needs (or who otherwise require specialized planning)
  • Implementing advance health care directives (such as living wills and health care powers of attorney)
  • Planning for incapacity
  • Planning for business succession
  • Planning for minor children and designating guardians
  • Planning for charitable giving

New Trust Code for 2020

On January 1, 2020, a new Illinois Trust Code will become effective, making many significant changes with regard to the administration of trusts. Of note:

Notice and designated representatives. Under the new law, for trusts that become irrevocable on or after January 1, 2020 (for example, a revocable trust becomes irrevocable upon a settlor’s death), the trustee is required to provide a copy of the trust agreement to all current and presumptive remainder beneficiaries. However, you can name a designated representative to receive such notice on behalf of any current and remainder beneficiaries.

Accountings. Under current law, a trust can be drafted so that accountings only need to be provided annually to current beneficiaries, not presumptive remainder beneficiaries. Under the new Illinois Trust Code, for trusts that become irrevocable on or after January 1, 2020, a trustee will have to provide annual accountings to current and presumptive remainder beneficiaries.

However, a trust agreement can be drafted to forego the requirement of providing the annual accountings to the remainder beneficiaries or potentially to provide that the accountings be provided to a designated representative for a remainder beneficiary rather than the remainder beneficiary himself or herself (although the remainder beneficiaries will be entitled to accountings when the current beneficiary’s interest terminates). This could mean, for example, that children who are remainder beneficiaries of a marital trust created under their father’s estate plan for their mother’s benefit will receive an annual accounting during their mother’s life unless they waive their right to receive it or the trust provides otherwise.

The Secure Act

Finally, pending in Congress is a bill known as the Secure Act. This legislation, if enacted in its current form, would push back the age of required minimum distributions from 70½ to 72 and eliminate the “stretch IRA.” If the Secure Act becomes law, we will send a supplement to this bulletin.

© 2019 Much Shelist, P.C.

More estate planning considerations on the National Law Review Estates & Trusts law page.

2020 Vision: Protecting Your Hospital’s Tax-Exempt Status

The manner in which medical services are being provided to patients is rapidly changing. Procedures that used to be performed in hospitals and required overnight stays are now being performed at outpatient clinics. Similarly, technological advances have decentralized hospital administration and the way in which treatment is provided. This should not come as a surprise to anyone that has any level of familiarity with the health care system, which includes just about anyone who goes to a doctor on a regular basis.

It should also come as no surprise that the law often lags behind technological advances and is often in a state of playing “catch up.” This trend is readily apparent when it comes to the property tax exemption for Wisconsin hospitals. The good news is that the courts are now taking the advances in hospital care into account when affirming eligibility for property tax exemption, particularly as to clinics and outpatient facilities. That said, hospitals must be vigilant in obtaining and maintaining their exemption.

This Legal Update offers guidance for Wisconsin nonprofit hospitals that may be filing tax exemption applications for calendar year 2020. Later in this Legal Update, we briefly discuss recent developments at the federal level involving hospital exemptions under § 501(c)(3) of the Internal Revenue Code.

Property Tax Exemption for Nonprofit Hospitals

In Wisconsin, all property is subject to taxation unless it is explicitly deemed exempt by statute. The Wisconsin Statutes provide that the following type of property is exempt:

(4m) NONPROFIT HOSPITALS. (a) Real property owned and used and personal property used exclusively for the purposes of any hospital of 10 beds or more devoted primarily to the diagnosis, treatment or care of the sick, injured, or disabled…. This exemption does not apply to property used … as a doctor’s office.

(Wis. Stat. § 70.11(4m)). The legislative intent behind this exemption is to encourage not-for-profit hospitals to provide care for the sick.

Applications for property tax exemption must be filed by March 1. This includes exemption applications for newly constructed property as well as for existing and previously non-exempt property whose use has changed in a way that now makes it eligible for exemption. The property owner bears the burden of proving that the property is exempt and the Wisconsin courts interpret the statutory exemptions narrowly. Hospitals should start analyzing and preparing their exemption applications well in advance of the filing deadline.

All real property is assessed based on its “fair market value” as of January 1 of each year. The Wisconsin Property Assessment Manual (“WPAM”) makes it clear that in the case of partially completed improvements, the assessor must value the improvements as they exist on the assessment date. Accordingly, hospitals with facilities currently under construction need to document the state of building as of January 1, 2020. Key documentation may include photographs and time-lapse construction progress videos. Assessors typically conduct an on-site inspection when there have been significant construction changes, and may also request additional documentation such as construction contracts and blueprints.

Assessors frequently utilize the cost approach when valuing new construction. One way to assess value for an under-construction project is to look at construction draws. This method has the appeal of simplicity but does not always produce accurate results. For example, if there have been construction draws of $12 million as of January 1 on a $30 million dollar project, an assessor might be inclined to give the property a fair market value of $12 million as of that date. It is entirely possible, however, that $1 million of that work was done on grading, soil stabilization, or other site development work that adds no value to the building from a “fair market value” perspective. Accordingly, the owner should be armed with knowledge of the actual condition of the building, including statements from the project manager, showing the value of what is “in the ground” as of the assessment date.

While it is important that new exemption applications document value as of January 1, the most important piece of the application involves documentation of exempt use. Recent litigation has focused on whether outpatient clinics or satellite hospital facilities are being used as a “doctor’s office,” which may disqualify the facility from exemption. The Wisconsin courts have identified the following list of factors that must be considered and evaluated when determining whether real property is used as an exempt hospital or as a doctor’s office:

  1. Do physicians own or lease the facility or equipment or are they hospital owned?
  2. Do physicians at the facility receive “variable compensation,” that is, compensation based on their productivity?
  3. Do physicians at the facility employ or supervise non-physician staff, or receive extra compensation for such duties?
  4. Does the facility and hospital generate separate billing statements or use separate billing software?
  5. Do the physicians in the facility have office space in the facility?
  6. Does the facility provide care on an outpatient, as opposed to inpatient, basis?
  7. Is the facility only open during regular business hours during which time the physicians generally see patients by appointment or is there 24/7 urgent care?

It should also be noted that the exemption for a nonprofit hospital is not an all-or-nothing proposition—partial exemptions are permitted. For example, in a seminal case interpreting the breadth of the nonprofit hospital exemption, Covenant Healthcare System, Inc. v. City of Wauwatosa, the Wisconsin Supreme Court upheld Covenant Healthcare System’s application for an exemption for 3 out of 5 floors in an outpatient clinic. The other floors did not fall within the criteria for the hospital exemption because they were doctors’ offices, among other reasons.

Another use-related issue involves the exempt status of vacant space in newly constructed hospital facilities. The WPAM acknowledges that “hospitals often construct oversize additions to anticipate technological and industrial changes and to reduce the unit cost of construction.” Assessors will generally treat this space as exempt so long as it meets the following conditions:

  • The hospital is exempt.
  • The space is attached to an existing hospital.
  • The projected use of the space is declared in the board minutes, in the general building plans, and in the blueprints and is consistent with exempt hospital use.
  • The building specifications and actual construction-to-date include features appropriate for hospital space.
  • The owner annually declares by affidavit that the space will be used as hospital space that would normally be exempt.

Hospitals intending to seek exemption for vacant space in new construction should ensure that they have appropriate documentation for these elements as of January 1.

Wisconsin law states that property tax exemption claims are strictly construed in favor of taxability. Given today’s climate of tight budgets, assessors are understandably conservative in their exemption determinations as they try to protect their tax base. Vigilance and thorough preparation are the keys to obtaining exemption under § 70.11(4m). Hospitals that are planning to file an exemption application by March 1 of this coming year, particularly for property that might have been taxable in the past as a physician clinic, should begin preparing their exemption applications no later than January 1 with an eye on these requirements.

Finally, note that owners of property exempt under sec. 70.11, Wis. Stats., are required to file a Tax Exemption Report form with the municipal clerk in each even-numbered year. Reports are due March 31, 2020.

Federal Tax Exemption under IRC § 501(c)(3)

Hospitals claiming exemption under IRC § 501(c)(3) have been under the microscope for the past several years; judging from events in 2019, that pattern will continue in 2020.

Senator Charles Grassley (R-Iowa) is back at the helm of the Senate Finance Committee and is once again pushing for increased transparency and oversight, including hospital adherence to community benefit requirements. In February 2019, Senator Grassley asked that IRS Commissioner Charles Rettig provide a briefing on the scope of IRS audits of tax-exempt hospitals on matters including charity care, financial assistance, and billing and collection policies. Senator Grassley called into question hospital compliance with the standards set by Congress and made it clear that he expects IRS enforcement to include all of the tools in its toolbox, including denial of exempt status. He specifically asked for details on how many hospitals have been found to be out of compliance with § 501(c)(3) requirements and how the IRS is dealing with noncompliant hospitals. In October of this year, Senator Grassley wrote to the University of Virginia Health System regarding a news report that the System’s financial assistance and debt-collection practices did not comply with its obligations as a tax-exempt entity, as well as regarding possible issues on overcharging.

Nonprofit hospitals and health systems can expect increasing scrutiny on Schedule H of Form 990. Past analyses of Schedule H reporting have found inaccuracies and inconsistencies in reporting of community benefits and financial assistance policies, including how financial assistance policies are publicized – these areas should receive particular attention when preparing 990 forms in the coming year. Form 990 is due on the 15th day of the 5th month following the end of the organization’s taxable year. Hospitals and health systems with September 30 fiscal years will need to file their 990 forms by February 15, while organizations on a calendar year have a due date of May 15.

Conclusion

Nonprofit hospitals remain under attack regarding their tax-exempt status. It is extremely important—now more than ever—for administrators to have a familiarity with the law and the criteria necessary to maintain their exemptions into the future. Proper planning heading into 2020 is an important key to that success.

©2019 von Briesen & Roper, s.c

For more on hospital administration, please see the National Law Review Health Law & Managed Care page.

The Rise Of Digital Services Taxes

Governments are coming after online businesses. Multinational clients that provide online advertising services, sell consumer data, or run online intermediary platforms should prepare themselves for the imminent arrival of digital services taxes (DSTs) on revenues from digital activities.

IN DEPTH

Having failed to reach an EU-wide unanimous consensus on an earlier EU Commission proposal for a DST Directive, certain EU countries, including Austria, the Czech Republic, France, Italy, Spain and the United Kingdom, decided to go it alone and introduce DSTs unilaterally into their own national tax systems. These decisions were driven primarily by a perception that larger multinationals, many of which have highly digitalised operations, are not paying their “fair share” of taxes globally. In addition, a growing consensus has emerged in recent months that “market jurisdictions” should have the right to tax, because those markets—namely, the countries where the users and consumers are based—ultimately create value for online businesses.

The Organisation for Economic Co-operation and Development (OECD) takes a neutral view on the use of DSTs by its members, in that it neither recommends nor discourages them. Member countries that do decide to adopt a DST should

  • Comply with international obligations
  • Ensure the DST is temporary and narrowly targeted
  • Minimise over-taxation, cost, complexity, and compliance burdens
  • Ensure the DST has a minimal adverse impact on small businesses.

The French DST is already in force. The Italian DST is in draft form, with the government intending for it to enter into force in January 2020, while other DST regimes, including that of the United Kingdom, are expected to come into force some time during 2020. None of these national rules seem to have complied with the OECD guidelines, and there are several practical challenges for businesses that are common across all three regimes.

Identifying Taxable Revenues and Services 

In France, each company belonging to a group that derives gross revenues from digital services exceeding €750 million on a worldwide basis, and €25 million in France, is subject to French DST at a rate of 3 per cent. French DST is assessed at the company level only, based on gross revenues derived from digital services deemed to be provided in France during the previous calendar year. This is calculated as the gross revenues derived from taxable digital services, multiplied by the proportion of French users over the total number of users of the taxable digital services.

As it currently stands, the Italian DST would apply to Italian resident and non-resident companies that, at the individual or group level, earned during a calendar year a total amount of worldwide revenues of over €750 million, and an amount of revenues derived from digital services provided in Italy of over €5.5 million.

Only groups with annual worldwide revenues above £500 million and UK revenues above £25 million would be affected by the UK DST, with the first £25 million of UK revenues being exempt. The UK DST would be calculated on a group-wide basis and apportioned pro rata to each group member. Groups with low operating margins may opt for a “safe harbour” alternative DST calculation, based on the group’s operating margin.

Identifying Taxable Services

The taxable services that fall within the scope of the French, Italian, and UK DSTs are broadly similar and include

  • The provision of a social media platform
  • Search engines
  • Any online marketplace
  • Online advertising business, including those that use or sell individual users’ data

It is noteworthy that digital platforms for the provision of payment services, communication services, crowdfunding services, or digital content, as well as self-operated digital platforms for the direct sale of goods and services, are specifically beyond the scope of the French and UK DST.

The issues that arise are also broadly similar. There are likely to be conflicts regarding dual-purpose platforms, i.e., those that include both taxable and exempt digital services. The fact that the lists are not exhaustive and that the DSTs will apply to all revenues received in connection with a relevant DST activity means that affected businesses will need to analyse the nature of the revenue streams and the activities from which they are generated, and each case will turn on its own facts.  This will entail a substantial administrative burden for affected businesses, as well as a lack of certainty over potential DST filing obligations.

Identifying Users 

Both France and Italy consider the location of users to be based on the location of the electronic device when the user accesses the digital services. The United Kingdom intends to determine that someone is a UK user if, it is reasonable to assume, they are normally located or established in the United Kingdom.

France and Italy will use IP addresses, wi-fi connections, GPS data, etc., plus reference to that user’s personal data and place of residence; while the UK plans to extrapolate user location from data such as delivery addresses, payment details, IP addresses, contractual evidence, or the address of properties for rent or location of goods for sale.

There are many problems with these approaches. At the most basic level, different data sources can provide conflicting evidence of a user’s location, and IP addresses can be easily manipulated. Businesses will, therefore, need to come to a reasonable, evidence-based conclusion on the likelihood of that user’s location, further adding to their administrative burden and broadening the scope to make a mistake. The use of personal data and place of residence are also likely to trigger data protection issues under the EU General Data Protection Regulations.

Potential Double Taxation and Reimbursements

There is a risk of double taxation if another jurisdiction imposes a DST on the same revenues, for example as a result of inconsistencies between one set of national rules and those of another jurisdiction regarding user location or taxing rights. DST is however generally deductible for corporate income tax purposes.

France’s President Macron stated at the 2019 G7 that any excess of French DST over the new international DST being brokered by the OECD would be refunded. He did not, unfortunately, give much detail as to how and under what limitations this refund will take place.

The Italian draft DST provisions do not include any specific rule on this aspect and, although they seem to propose a sunset clause according to which the Italian DST is automatically repealed when the new OECD-agreed corporate income tax enters into force, there does not appear to be scope for a retroactive reimbursement of the difference (if any) between the Italian DST and such future corporate income tax.

The draft UK DST rules disregard 50 per cent of UK revenues from cross-border transactions between a buyer and a seller through an online marketplace where the non-UK party is in another DST jurisdiction. But this does not fully resolve the issue of potential double taxation if the other jurisdiction imposes a DST on the same revenues, for example due to inconsistencies between the UK national rules and those of the other DST jurisdiction regarding user location and/ or taxing rights.

The UK DST will also not be creditable against either corporation tax, income tax under the Offshore Receipts in respect of Intangible Property regime, or diverted profits tax; although it should generally be deductible for corporation tax purposes as a trading expense. Unlike France or Italy, neither the draft legislation nor HMRC guidance mentions the possibility of a retroactive reimbursement of the UK DST once the OECD’s long-term solution for a revised corporate income tax has been agreed and implemented by member countries.

The US Response

The US administration takes a hostile view of DST proposals generally, as evidenced by a recent investigation into whether the French DST discriminates against US businesses. This could lead to retaliatory US tariffs being imposed on imports from France and punitive US tax charges on French companies doing business in the United States.

Other DSTs, including those of the United Kingdom and Italy, can probably expect similar responses from the United States. UK Prime Minister Boris Johnson has indicated his support in principle for a UK DST or a similarly targeted tax. He has also indicated that the structure of this tax would be on the table in any trade negotiations with the United States, and the future of the current draft Finance Bill hinges on the result of the UK general election in December, so there is currently very little certainty as to whether UK DST will take effect at all.

For now, the best course of action for affected businesses is to assume that all DSTs will take effect as planned and prepare accordingly, notwithstanding any current legislative or political uncertainty.

© 2019 McDermott Will & Emery

More on digital taxation on the National Law Review Tax law page.