July 2010

In this issue:

• A message from Jim Brasher 
• The international tax gap, expatriates and the IRS 
• Increased state tax agency scrutiny of related-party transactions
• Providing relocation assistance to employees
• Announcing Tina Milligan

	A message from Managing Partner of Tax Services Jim Brasher

Hemingway and Fitzgerald wrote about them. Their tales were filled with rich characters living exciting, complicated lives on the streets of Paris and Madrid. I’m talking about Americans who reside abroad. The stories we read were interesting and compelling, but as a tax professional, I sometimes wondered how these individuals managed their tax obligations to the U.S. It is a complex and often intriguing journey that most expatriates – and inpatriates as well – have to make in order to meet the requirements of both their host and home countries.

Dealing with the international tax gap – or the difference between what is paid by U.S. residents with respect to activities like foreign investments, cross-border transactions, and what the government believes is owed – is the subject of much conversation at the IRS and also the subject of the featured article in this issue of this newsletter. The author of this article, Christopher Braun, also led a recent Baker Tilly Tax Webinar on the topic. I encourage you to access the presentation material, which I think you’ll find interesting – whether you are an expatriate, an inpatriate, or decision maker in an organization that sends workers abroad or hires them from other countries.

On the domestic front, sound tax planning is becoming more and more important as many states step up their requirements on related-party and intercompany transactions. Read the article entitled, Increased State Tax Agency Scrutiny of Related-Party Transactions to find out more.

I hope you enjoy this issue of Tax Strategist. If you have comments, questions, or concerns about the newsletter, or any Baker Tilly tax communication you receive, I’d like to hear from you. Please feel free to e-mail me at james.brasher@bakertilly.com.

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The International tax gap, expatriates, and the IRS

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The Internal Revenue Service is giving top strategic priority to the reduction of a very large estimated international tax gap. Its efforts are likely to impact the large and growing population of U.S. expatriates and those moving to the United States, or inpatriates. These expatriates are typically U.S. citizens working or living out of the country for extended periods of time and the inpatriates are typically employees of foreign employers sent to the United States to work for a time period (also called “recently resident" persons). Many members of these two groups will be involved in an expanding effort that the IRS is conducting as part of the activities being undertaken by its newly organized Global High Wealth Task Force (“task force"). At Baker Tilly, we fully support the due administration of the tax laws and the collection of all properly owed taxes. To that end, we are taking the lead in addressing our populations of the “recently resident" and “expatriate groups" in a variety of positive ways to enhance their ability to stay compliant with the U.S. tax law while being able to legitimately conduct their myriad range of foreign activities.

The task force’s mission is to take a closer look at global financial transactions and reporting behaviors of high wealth U.S. citizens and residents living in the United States or overseas. Their scrutiny extends to U.S. citizens moving overseas, investing overseas, having closely-held family investments, or running businesses overseas. While once only wealthy individuals and large corporations had the means to make those types of investments, diminished legal barriers and technological advances have provided opportunities for offshore investments to a broader spectrum of the population, with the same being true of foreign companies and individuals who see the United States as fertile ground for business and personal investments. As companies expand their global reach and engage cross-border employees to manage business activities, their international tax picture becomes increasingly complex and, under increased IRS international scrutiny, companies and their employees can easily run afoul of U.S. tax laws.

Why the increased IRS effort and involvement? There are a number of reasons and one is certainly the potential for legitimately collecting increased tax revenue. International business investments in the United States grew from nearly $188 billion in 1978 to more than $14.5 trillion in 2007. In the same period, U.S. business and investment overseas grew from nearly $368 billion to nearly $15 trillion. The international tax gap mentioned above is defined as taxes owed – but not collected on time, or ever—from a U.S. person or a foreign person whose cross-border transactions are subject to U.S. taxation. The international tax gap encompasses all revenue losses resulting from noncompliance with the U.S. tax laws due to international transactions. These include taxpayer error, conflicting legal interpretations, misinterpretation of the facts, and outright tax evasion. Non-IRS estimates place the total international tax gap at a range of $40 to $123 billion annually.

In addition, in a post 9/11 world there is an increased need to properly report overseas bank account activity. The federal government has a legitimate interest in money coming into the United States as it watches for money-laundering schemes or money being sent to the United States for other criminal purposes. It is monitoring money movement much more closely and the IRS is one of the tools that it is using to help protect U.S. citizens and their interests.

The UBS scandal provided a third reason for enhanced efforts. United States tax law requires that U.S. citizens or residents report annually any foreign based investment, bank, or brokerage accounts on a “Foreign Bank Account Report Form" (form FBAR 90-22.1). The interest and dividends from such accounts also are subject to U.S. income tax. In the UBS scandal, U.S. citizens investing or living abroad created foreign bank accounts with the Swiss bank and did not disclose the existence of these accounts or interest earned on them to the IRS. UBS admitted responsibility in the case and in helping U.S. taxpayers conceal more than $20 billion in offshore accounts from the U.S. government in an effort to avoid paying U.S. income tax. In the agreement reached between the IRS, the U.S. Department of Justice, and the Swiss government, UBS turned over information on thousands of offshore accounts and names of account holders. The IRS offered an amnesty program, which ended last year, to those who came forward to make voluntary disclosures and may criminally prosecute those who did not.

If you’re wondering what all this might have to do with you or your employees then remember that the United States stands alone in taxing its citizens on a global basis, U.S. income tax, as applied to residents, is also global in reach, and unlike many countries around the globe, there are few loopholes for offshore deferral of income under U.S. tax law. Many American expatriates don’t know they need to report accounts held in foreign countries and pay taxes on them and on their worldwide income. And foreign nationals who have become recently resident in the United States do not know that significant reporting is required of foreign employees who come here to work. These people – innocent of wrongdoing – are nonetheless still subject to the IRS’s legitimate scrutiny and investigation efforts.

The United States subscribes to two basic tax law concepts that govern how the IRS tracks employees and income. The first is the concept of citizenship which it borrowed from the Roman Empire: If you are a citizen of the United States, no matter where you reside, you have to pay U.S. tax on your worldwide income. In addition, foreign persons are taxed on their U.S. source income when they are connected to a U.S. trade or business, for instance. The second concept is that of domicile (or extended residency intention) which the United States modeled after the British Empire: Where you are intending to live is where you have to pay taxes. Income tax is governed by the concept of citizenship and residency (e.g., 183 days in the United States in any given year) and estate taxes (which will be effective again in 2011) and gift taxes are governed by citizenship and domicile making individuals subject to estate and gift tax on a global basis. In this way, the United States has a unique global tax perspective that isn’t replicated anywhere else in the world.

This above described uniqueness has a significant impact on recently resident employees in the United States. Here are the top five surprises that typically confront them:

1. United States income tax is globally assessed on residents irrespective of the source of their income or where the resident of the United States lives. This is particularly true for green card holders who are deemed to be residents of the United States for tax purposes even though they may live abroad and have numerous sources of foreign income.
2. The United States has a death tax (again effective in 2011) assessed on domiciles and citizens of the United States and that death tax is assessed on global assets irrespective of where the U.S . citizen or domicile dies. 
3. The United States has a gift tax which is assessed on U.S . citizens or domiciles globally.
4. Our anti-deferral rules, (aka, the controlled foreign corporation or passive foreign investment company rules), apply to many interests in foreign corporations that are privately held and can produce current income to the shareholder even in the absence of actual distributions.
5. Holding a green card for eight of the last fifteen years can result in a global exit tax assessed on all global assets worldwide on a deemed sale basis if one gives up the green card after seven years and moves back to one’s original foreign country of residence. 

In an effort to help clients avoid unexpected penalties, Baker Tilly’s international tax professionals ask a series of questions of recently resident persons in the United States or persons considering a move to the United States for any period of time as an employee or an entrepreneur:

1. Do you have any foreign bank accounts? Failure to report on them annually can lead to a penalty of $10,000 per year per bank account.
2. Do you have interests in any foreign privately-held corporations? Failure to report the presence of such interests, for instance in the case of controlled foreign corporations, can lead to a $10,000 per year penalty for failure to file a Form 5471.
3. Have you received any gifts from abroad in excess of $100,000 in any one year from any one donor or any one estate?
4. Have you received any distributions from any foreign trusts?
5. Have you created or settled any foreign trusts?

A “yes" answer to any of the last three questions requires the filing of IRS Form 3520 to report the transactions or gifts. Though no actual tax may be due, failure to report the transactions or gifts can result in severe penalties. The penalty for failure to report the creation of a foreign trust is 35 percent of the transfer to the trust. Failure to report a distribution from a foreign trust results in a penalty of 35 percent of the value of any distribution. And failure to report a foreign gift can be up to 25 percent of the value of the gift.

U.S. international tax laws address a multitude of potentially taxable transactions that are engaged in by millions of entities worldwide, including large multinational enterprises, U.S.-based companies operating internationally, foreign-based companies operating in the United States, nonresident individual investments in the United States, individual U.S. investors’ international investments, individual U.S. residents residing abroad, and non-resident aliens residing in the United States. That’s a pretty all-encompassing list and Baker Tilly international tax professionals encourage all – individuals or companies, employers or employees, expatriates or the recently resident – to seek the best advice they can to be in compliance with U.S. international tax laws. In an increasingly complex world where borders are indeed vanishing, it is incumbent that U.S. tax advisors understand the unique U.S. tax compliance and planning needs (and world views) of their expatriate and recently resident clients. It is certain that the IRS’s legitimate and good-faith efforts at enhancing the level of compliance from such globally situated individuals will soon directly impact their lives.

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Increased state tax agency scrutiny of related-party transactions

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The fiscal crisis in many states has deepened with most running a significant budget deficit. State governments are looking where they can for new revenue sources. One common response to revenue needs has been to tighten tax rules governing related-party transactions. In an effort to counter perceived tax avoidance, states have focused attention on dealings between owners and their companies and on transactions among affiliated businesses.

Multistate businesses commonly employed aggressive tax planning strategies in the 1990s and 2000s that included the use of related entities to lower their effective state tax rate. Across the country, states have different income tax rates ranging from low to high. Five states impose no corporate income tax at all. Nine states have no broad-based personal income tax.

Many states do not tax certain types of entities, such as partnerships or limited liability companies (LLCs). Over time, a large number of businesses have converted to these non-taxable, flow-through entities, resulting in lower tax revenue from corporate taxpayers.

States have also enacted preferential apportionment methods or filing conventions in an attempt to lure businesses to their state or favor existing companies located there. This diversity and complexity encouraged sophisticated business structures and creative tax planning strategies designed to take advantage of those differences. Usually, these tax planning strategies involved the use of multiple entities and related parties.

The heightened scrutiny of related-party transactions (among family members, between business owners and their companies, and among affiliated entities) targets: Intercompany sales of products and services, loans, leases, licensing and royalty agreements, management fees, and sales or exchanges of fixed assets. An increasing number of states are enacting laws, or implementing rules to disregard or severely discourage such transactions from an income tax or business entity tax perspective. State responses have included:

• Adding back expenses from related-party transactions, e.g., rent, interest, royalty payments
• Requiring related entities to file combined returns (historically required for “C" corporations, but now being required for partnerships, LLCs and S corporations)
• Mandating increased disclosure in tax returns and transparency in reporting

This trend is snowballing among states. For example, in Wisconsin, previous measures to enact tougher state tax legislation had been defeated for many years. In 2009, Wisconsin passed legislation requiring combined reporting in a matter of days. Combined reporting eliminates intercompany transactions and treats all the related entities as one taxpayer. Massachusetts, Michigan, and Texas have also recently joined the ranks of combined reporting states.

Of the 24 states that have enacted related-party reporting and add-back requirements, the majority created those rules between 2000 and 2007. Twenty-three states have mandatory combined reporting, and eight states have both tax add-backs and mandatory combined reporting. According to one estimate, adopting combined reporting will increase a state's corporate tax revenues on average by $95.7 million. It is no wonder states have rushed forward with this type of legislation.

This presents both an issue and an opportunity for individuals and businesses. They must gain an awareness of state statutory and administrative mechanisms aimed at related-party transactions. This is essential to reduce their risk of incomplete tax compliance and to identify possible avenues for tax planning. In some cases, ensuring that a related-party transaction reflects "arm's length" terms will be sufficient to preserve the associated tax benefits. Documenting a "business purpose" other than decreased state taxes is key. Economic substance is also usually required as opposed to "paper" transactions without real changes in assets or liabilities. There are safe harbors in these new tax laws for legitimate business purposes such as legal liability or succession planning.

If related-party transactions are not handled properly, they can result in additional state tax as well as interest and penalties. Risks include:

• Disallowance of expenses
• Audit adjustments to force combined filing
• Missing available “safe harbors” or the ability to petition for relief/alternate reporting
• Penalties for negligence or fraud
• Interest charges on delinquent taxes
• Possible financial impairment under the FIN 48 provisions of FAS 109, or under FAS 5

Our advice to business and individual clients involves taking an approach of compliance that stems from solid information. First, companies should map out all related-party transactions of a material nature. Don’t neglect to look at international affiliates for exposure.

For closely held companies, examine important contracts or large transactions with shareholders or LLC members. In some cases, the activities of an affiliate can create nexus, or a business tax filing requirement for all related entities.

Link this map to states where you have business activity and match the business activity to state compliance requirements. As you determine how to comply with the laws, you may still be able to take advantage of safe harbors and examine transactions for possible planning opportunities. Careful analysis of an affiliated group's facts and a state's tax laws might permit the exclusion or inclusion of companies in a combined return such that the overall state tax result is favorable. You will need to quantify your financial exposure with respect to taxes and FIN 48 and FAS 5 reporting. Don’t forget to factor in additional compliance costs such as return preparation time, possible investments in better software,and potential Internal Revenue Code Section 482 studies. Document the nature of related-party transactions and your support for claiming deductions or not filing combined returns.

State statutory and administrative rulings in this area are nothing less than a minefield for the uninformed or unconcerned. In September 2003, 40 states and the District of Columbia signed a "memorandum of understanding" to partner with the IRS to fight abusive tax-avoidance schemes, including plans to share information regarding both the abusive transactions, as well as the taxpayers who participate in them. Keep in mind, however, that many tax-saving strategies are perfectly legal and simply take advantage of the diversity of laws that govern state taxation. The key is making informed decisions regarding business taxation and understanding your level of comfort with the associated risks. Given their continuing fiscal challenges, states’ scrutiny of related-party transactions and their enactment of new legislative solutions are not likely to cease until they conclude that they have the tools to address aggressive state tax planning and to reach all of the economic profit or value generated by a business enterprise and its owners. 

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Providing relocation assistance to employees

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Employers often offer relocation assistance to attract new employees from other areas or to encourage current employees to relocate. The relocation assistance provided can impact the taxes of the employee and the employer. The following is a look at several common situations.

Moving Expenses
Generally, if an employer reimburses an employee for moving expenses, the reimbursement represents income to the employee. However, reimbursements made through an accountable plan need not be included in an employee’s income if the employee would have been able to deduct the moving expenses had the employer not provided a reimbursement.

Purchase of Residence
If the employer offers to purchase an employee’s old residence at its fair market value, the employee will not be treated as having received any additional compensation. And, the employee will not be taxed on any gain realized on the sale if he or she qualifies for the exclusion from gross income of $250,000 of gain ($500,000 for married persons filing a joint return) on the sale of a principal residence. The exclusion is generally allowed once every two years. It is available if the taxpayer owned the home and used it as a principal residence for periods aggregating at least two years during the five-year period before the sale.

An employee who begins a job in a new location may have to sell his or her old home at a loss. If the employer reimburses the employee for the loss, the reimbursement is taxable as compensation to the employee. If the employer purchases the employee’s home for more than its fair market value, the employer is also considered to have reimbursed the employee for a loss and the employee will have additional compensation income.

Sale Assistance
A common arrangement is for the employer to hire a relocation service company to manage the sale of the employee’s old residence. The relocation service generally pays for the cost of maintaining the residence while finding a third-party buyer and is reimbursed for the expenses by the employer. Depending on the terms of the arrangement, the employee may have to report compensation income.

Your Baker Tilly tax advisor can provide more information about specific tax consequences of relocation assistance based on your current environment, as well as assist with planning considerations. 

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	Baker Tilly welcomes Partner Tina Milligan to the Private Client Group Download a printable version.

Tina Milligan is a partner in the Private Client Group and recently joined Baker Tilly after eight years with financial institutions where she advised high net worth clients regarding tax, wealth transfer, philanthropic, insurance, investment, and other advanced financial planning matters. Prior to her time with financial institutions, Tina worked with business owners, corporate executives, and family offices on their tax planning as part of a national accounting firm. She also has presented and published on a wide range of financial and tax planning topics.

Tina specializes in estate, gift, fiduciary, and individual income tax planning, as well as retirement, corporate executive, business succession, wealth transfer, and charitable planning. She has worked closely with individuals and family offices to:

• Advise on business owner succession planning, executive compensation, and retirement planning,
• Advise on and model estate disposition, wealth transfer, charitable, and other advanced financial planning techniques
• Coordinate implementation of estate, wealth transfer, and charitable planning with clients’ other advisors
• Provide financial modeling to guide cash flow, insurance, retirement, and asset allocation planning
• Research and develop proprietary marketing, presentation, and modeling materials for financial institutions and family offices regarding financial and tax planning topics

Experienced Baker Tilly Private Client Group advisors like Tina collaborate on every aspect of financial planning for individuals, from tax liabilities to charitable giving. As we learn about your interests, we research and recommend solutions that align complex financial options with your personal values and goals. Contact your Baker Tilly Tax Advisor or send an e-mail to tax@bakertilly.com for more information.

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