Author: Peter Harper

Grantor vs. Trustee

When dealing with a grantor trust, given the legal, tax, and financial implications, it is essential to have a clear understanding of the various roles within a trust, as well as the duties and responsibilities of each role. Indeed, you may be surprised to know that good teamwork, even within the confines of a trust, often means the difference between everything going smoothly and, on the other hand, friction and outcomes that are not necessarily desirable.

While this article is not an exhaustive resource, it explains the differences between a grantor, trustee, and beneficiary, and the trustee’s duties. There are multiple types of trusts and many terms bandied about, such as a revocable trust or irrevocable trust (and a grantor trust can be either of these) or a revocable living trust. However, we will only discuss the general aspects of trust roles. In addition, as there are many questions surrounding the concept of probate, and while estate planning is a vital topic on its own (not to mention the implications of estate tax), we will not discuss those in this article. Still, we will hopefully lay the groundwork for a better understanding of these topics in future articles. 

What Is The Definition Of A Grantor?

Also commonly referred to as the owner, settlor, or trustor, this person contributes property (such as real estate), other funds, or even instruments such as life insurance to the trust. The property and the grantor’s funds become part of the trust corpus (in other words, the trust’s assets). It is crucial to note that a trust can have more than one grantor. For instance, if more than one person funded a grantor trust, they will each be treated as a grantor in proportion to the value of the cash or property they transferred to the trust. 

We should also note that the grantor is the person who retains the power to control or direct the trust’s income or assets. This is crucial to understand, especially when dealing with a foreign trust and the income tax treatment surrounding this instrument. Pulling from one of our previous articles, the grantor can also be any person who creates a trust or directly or indirectly makes a gratuitous transfer of property to a trust. If someone creates or funds a trust on behalf of another, they are treated as the trust’s grantors. It’s not only imperative to understand for estate planning but also as it relates to estate tax and, of course, probate, which is a scenario that individuals attempt to avoid by creating an instrument such as a revocable living trust.  

What Is The Definition Of A Trustee?

A trustee is a person or entity appointed to administer assets or property for the benefit of a third party, in this case, for a trust. The grantor must designate a trustee to administer the wishes outlined in the trust that will best exercise said grantor’s wishes and maintain asset protection to completion of the transferral or otherwise. As we will discuss later, the grantor and the trust can be the same person. 

Difference Between Grantor And Trustee

The differences between the grantor vs the trustee are numerous. Still, it is essential to point out that trustees are individuals or companies that will be holding and managing assets for a trust and its beneficiaries when the grantor dies. In contrast, the grantor is the person who owns the trust and who appoints the trustee, who specifies the terms of the trust document. As well as someone who has ideally created the trust for purposes such as appropriate financial and tax planning and avoiding probate (which can be accomplished with a revocable trust or irrevocable trust). 

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There Are Three Elements To The “Trust” Document

While trust documents vary in length and scope, certain elements exist in every basic trust document.

The “Grantor”

As mentioned previously, this is the person who creates the trust. They will contribute assets to the trust and, with the help of an attorney, write up the trust agreement that will govern the administration of the trust.

The “Trustee”

The trustee is the person or entity charged with administering the trust in accordance with the terms of the agreement, as set forth by the grantor. The trustee acts as the legal owner of trust assets and is responsible for handling any assets held in a trust. The trustee also typically handles tax filings for the trust and distributes the assets according to the trust document. Whether or not a trustee is paid for their work, they must act prudently in the management of trust property and trust income. If not, they will be liable for breach of trust for failing to exercise proper care, which can lead to the trust fund suffering a loss due to their negligence. Therefore, it is essential to take great care in appointing a trustee, as this is not something they should do flippantly. If a trustee dies or becomes incapacitated, a successor trustee will generally take over this role. 

Accountability of trustee

Although a trustee has far-reaching powers, they may not simply do whatever they want. The law enforces strict obligations and rules for a trustee to follow, such as accounting for any benefits they might have acquired from a trust, whether directly or indirectly. This goes even beyond fraudulent abuse of position by a trustee. 

Duty of Trustee is to obey trust document for benefit of beneficiaries

Building upon the previous point, we must never forget that a trustee is required to obey the stipulations of the grantor trust document for the specific benefit of the beneficiaries. A trustee’s responsibilities are often disclosed in the trust document, and any power not explicitly given cannot be exercised, with certain narrow exceptions. Again, that the trustee has a duty to carry out the trust following its exact terms.

Fiduciary relationship of trustee

We often hear the term “fiduciary” when discussing estates and trusts. In this case, the role of fiduciary means that one is held to high standards in protecting a trust’s investments and distribution. Specifically, the trustee has to obey the directions of the trust document for the benefit of the beneficiaries. 

The Trustee Can Have No Private Advantage

What do we mean by “private advantage” here? Simply put, a trustee may not derive any advantage, directly or indirectly, from a trust unless expressly permitted by the trust. For instance, in a case where a trustee is a professional trustee, and the trust specifically provides a right to make reasonable charges for services rendered, the trustee may do so. However, fully disclosure of the basis and amount of charges will be required. Another aspect of private advantage is that a trustee is not permitted to use or deal with trust assets for private direct or indirect advantage. Courts have held trustees personally liable to account for breaches of the trustee’s obligations. If appointed as a trustee, they must always remember this crucial point. 

The Trustee Must Have The Best Interests Of The Beneficiaries

It seems very obvious to mention that trustees must exercise all their powers in the best interests of the trust’s beneficiaries. The trustee is obligated to have the highest duty of loyalty to the beneficiaries in order to administer the trust solely with the best of intentions, putting aside their own personal gain. At no point can there be conflicts of interest, and if there are any to arise, it must be fully disclosed immediately.

The Trustee Must Act Prudently And Is Under Fiduciary Duty To Do So

Related to the previous point, the trustee has a duty to protect and preserve the trust property. They must also defend the grantor trust and the beneficiaries against anyone who would challenge the trust’s validity or seek to appropriate the trust’s assets. Something also important to mention, but may not be self-evident, is that the trustee must make the trust’s assets productive. What does this mean? The trustee must act prudently or sensibly when investing, acquiring, selling, and managing the trust’s assets. Therefore, as mentioned previously, the trustee is also generally responsible for handling the tax return for the trust. Therefore, appropriate income tax planning for both the trust and the beneficiaries is one of a trustee’s responsibilities. It is clear that a trustee’s duties are numerous and, given their great importance, should not be taken lightly. 

The “Beneficiaries”

While we have mentioned beneficiaries many times in this article, the general definition of a beneficiary is the individual who will receive distributions from the trust, whether they are a family member or a fellow corporation member of the grantor. 

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Who Is Considered The Grantor Of A Trust?

After everything we’ve learned about this role, the trust grantor will usually be regarded by the IRS as the person who funds and/or possesses control of the trust.

Can A Trust Grantor Be The Trustee?

Note that the grantor can act as the trustee while they are still alive and of sound mind to maintain total control of the resources.

How Do The Trust, Grantor, Trustee and Beneficiary All Work Together?

Like any good sports team, there has to be good communication, cooperation, and a mutual understanding of the shared goals between the grantor, trustee, and beneficiary, for the orders of the trust document to be correctly applied. In this scenario, the grantor designates who the trustee will be, and the trustee, in turn, will manage the trust’s assets per the terms of the trust document. As a beneficiary, while the trustee cannot withhold trust assets from you (unless specified within the trust document), the grantor sets forth the stipulations for distribution and can give the trustee the power to decide when you receive the payments. Therefore, all parties involved must maintain a good relationship with each other and buy into the understanding that the outcomes specified by the trust document can only become a reality if everyone is working together toward the end goal.

 Contact Asena Family Office for a detailed understanding of Single Member LLC Taxes.

Arin Vahanian

Peter Harper

Can You Convert An LLC To A Corporation?

Yes, you can convert your Limited Liability Company (LLC) to a corporation. However, understanding the income tax consequences of such a conversion is essential.

Why Should You Consider Converting Your LLC To A C-Corp?

Some of the reasons to convert an LLC to a C-Corp are listed below:

• Corporations can implement share option agreements making it easier to offer employees equity with share options as incentives; 
• Most investors prefer investing in corporations due to receiving equity in return and thus attractive for potential investors;
• Ownership of shares is more straightforward to transfer than interests held in an LLC; and
• Certain states, such as Delaware, provide corporations with additional tax benefits.

LLCs And Corporations: Similarities And Differences 

LLCs and Corporations both provide their owners with limited liability protection, and each can own assets and take on obligations.

Management Complexity

LLC owners are referred to as “members” and can elect member management, or third parties can be brought in to manage the day-to-day operations. This option provides members with more flexibility. Some states may require the filing of annual reports.

Corporation management is more rules bound and includes appointing a board of directors who must have regular meetings, create minutes, ensure record-keeping and file annual reports. State laws may require filing annual reports, including detailed financial information of the corporation.

Taxes

By default, an LLC is taxed as a pass-through entity, meaning that the owner/s file and pay taxes on the LLC profits in their personal tax returns. Members could choose to be taxed as a corporation; however, such an election is not a common practice due to the double taxation of a C-Corp.

C-Corps are not disregarded for tax purposes; therefore, a taxpayer is separate from its shareholders. The C-Corp pays corporate tax on the business profits made, and if dividends are declared to the shareholders, dividends tax applies. (This double tax may not be applicable for Delaware corporations where the shareholders live outside of Delaware).

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S Corporations vs. C Corporations

Similarities

• Both entities are created by filing Articles of Incorporation with the relevant state agency and provide their owners with limited liability protection. 
• They are owned by shareholders who appoint directors and corporate officers.
• They are required to file annual reports, have annual meetings and pay annual fees.
• Both require bylaws.

Differences

• The pass-through laws apply when taxing an S-Corp, meaning that the shareholders pay tax on business profits in their personal capacity. For a C-Corp, the business profits are subject to corporate tax, while the distributions made to shareholders are further subject to dividends tax. Effectively, corporate profits are double taxed.
• S-Corps have additional restrictions imposed regarding ownership. There may only be a maximum of 100 shareholders, and these individual shareholders must be US persons. 
• S-Corps may only issue one class of shares, while a C-Corp is permitted to issue multiple classes of shares – e.g., ordinary and preferred shares.

Understanding The Different Types Of Conversions

The methods to convert your LLC are briefly described below.

Statutory Conversions

This method is relatively new and is available in most states. 

LLC members must file a few forms with the secretary of state’s office requesting approval for the conversion. 

All assets and liabilities of an LLC are transferred to the newly formed corporation, and the conversion occurs by operation of law rather than through formal agreements and additional filings – a significant difference between this method and others.

Statutory Merger

A statutory merger requires the registration of a new corporation, drafting additional agreements, and filing additional forms.

Non-Statutory Merger

Perhaps the most expensive and complex type of conversion, assets and liabilities of the LLC are not allowed to be automatically transferred to the newly formed corporation. Multiple special agreements may be required to affect this transfer and exchanges.

Advantages Of Converting To A C Corporation

• LLCs cannot issue stock to its members, and therefore c-corps are more attractive investment opportunities for venture capitalists, corporation accelerators, and other investors looking to invest in startups via equity;
• Stocks can be reserved to be issued to employees as performance benefits;
• C-Corps can continuously offer equity to investors when capital injections are required.

Disadvantages Of Converting To A C-Corporation

• Corporate tax and dividends tax;
• Conversion costs could be expensive;
• Corporations may have additional annual filing requirements and fees.

Qualifications Needed For Switching From An LLC To A Corporation

To qualify for the conversion of an LLC to a corporation, the ownership restrictions should be considered. This is especially the case when the LLC elects to be taxed as an S-Corp.

How To Convert An LLC Into A Corporation? 

The following are three major directions to consider when transitioning an LLC into a corporation:

Statutory Conversion

• • LLC members need to prepare and approve a conversion plan;
  • Submission of a certificate of conversion and an LLC certificate along with other legally required documentation

Statutory Merger

• • Form a new corporation with the LLC members as corporation shareholders;
  • The LLC members will vote to approve the merger – both in their capacity as LLC members and corporation shareholders;
  • The LLC members will formally exchange their membership rights for shares in the new corporation;
  • A certificate of merger is filed along with other legally required documentation; and
  • Formally liquidate and dissolve the LLC by submitting the necessary forms

Non-Statutory Conversion

• • Form a new corporation;
  • The assets and liabilities belonging to the LLC are to be formally transferred to the new corporation;
  • Arrange for the formal exchange of the membership interests of the LLC for the shares in the corporation; and
  • Formally liquidate and dissolve the LLC by submitting the necessary forms.
  • The following methods described by the IRS in Revenue Ruling 84-111 need to be considered as well, namely:
    • “Assets-over” conversion: 
      • The LLC assets are transferred to the corporation for all the authorized stock. Terminate the LLC by distributing all the stock in the corporation to the members.
    • “Assets-up” conversion: 
      • The LLC is terminated by distributing all the assets and liabilities to the members. The authorized stock in the new corporation is then transferred to the members in exchange for the assets. 
      • The corporation will also assume all the liabilities previously adopted by the members.
    • “Interest-over” conversion: 
      • The LLC members transfer their interests in the LLC in exchange for all the corporation’s authorized shares. The corporation will then hold the assets and liabilities, and the LLC will be terminated.

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When Should You Convert LLC To C Corp?

The conversion from an LLC to a C-Corp would be most advantageous in the following circumstances:

You are a startup and are interesting in joining an accelerator:

Incorporation is an additional selling point for accelerators or incubators who might purchase equity in the company.

You’d like to attract venture capital:

Venture capitalists and angel investors favor investing in corporations as they will receive equity in exchange for their investment (statistically, venture capitalists prefer Delaware C-Corps).

You want to give your employees some equity:

The ownership structure of LLCs does not permit them to incentivize employees with share options without the employees becoming partners/members – this is possible with a corporation as shares can be reserved for employee share options.

Do You Need A New EIN When Converting LLC To C Corp?

Since an LLC is created utilizing state statute, the IRS has not established an income tax classification for these entities. 

However, you will be required to obtain a new EIN if any of the following statements are true.

• A corporation receives a new charter from the secretary of state.
• You are a subsidiary of a corporation using the parent’s EIN, or you become a subsidiary of a corporation.
• You change to a partnership or a sole proprietorship.
• A new corporation is created after a statutory merger.

You will not be required to obtain a new EIN if any of the following statements are true.

• You are a division of a corporation.
• The surviving corporation uses the existing EIN after a corporate merger.
• The corporate name or location changes.
• A corporation chooses to be taxed as an S corporation.
• The reorganization of a corporation changes only the identity or place.
• Conversion at the state level with business structure remaining unchanged.

Tax Consequences From Changing An LLC To A Corporation

When converting an LLC to a corporation, it is crucial to understand what type of tax status already exists in the LLC. The tax status of the LLC determines how the company will be converted. 

A conversion of an LLC to a corporation can have significant tax consequences based on the transactions deemed to occur due to your conversion.

Suppose an election is made in terms of Form 8832 to change classification from a disregarded entity to a corporation. In that case, it’ll be considered as if the disregarded entity’s owner provided all assets and liabilities to the corporation in exchange for stock.

When a business entity experiences a transition in elective classification status from a disregarded entity to a corporation, the change ought to be treated as a transfer of all assets and liabilities kept by the owner of a former disregarded entity to a newly formed corporation. The disregarded entity’s owner will also be treated as the transferor, potentially resulting in unforeseen tax implications. 

Changing The LLC’s Tax Status

As LLCs are not recognized as taxable entities, single-member LLCs are taxed as sole proprietors, and multimember LLCs are taxed as partnerships by default. 

Members can elect to change the tax status of LLCs by using the “check-the-box” classification. LLCs are eligible entities, and IRS Form 2553 needs to be filed to be taxed as an S-Corporation, while an IRS Form 8832 needs to be filed to be taxed as a C-Corporation.

The instructions on the forms need to be followed, completed, and submitted to the IRS. The election is effective from the date specified on the forms. The effective date cannot be more than 75 days prior, too, and not more than 12 months after the election is filed.

The change in tax status from a multimember LLC can trigger a taxable gain if the liabilities transferred to the corporation exceed the assets. 

New Responsibilities With Incorporation

When considering the conversion of the LLC to a Corporation, the following actions need to be taken to ensure that the newly formed corporation complies with the statutory requirements: 

• Corporate bylaws need to be created;
• The shareholders need to appoint a board of directors and corporate officers;
• Hold an initial board meeting;
• Share certificates need to be issued to each shareholder

FAQ

• When should you convert LLC to C Corp? 
  • You should convert LLC to a C Corp when considering share options as incentives for employees or when there is a need to raise capital.
• Can I switch from an LLC to a corporation? 
  • Yes, it is possible to convert an LLC to a corporation.
• Do you need a new EIN when converting LLC to C Corp? 
  • It depends on the type and method of conversion used. If a new corporation was formed due to a statutory merger, the corporation would need to apply for a new EIN. 
• How does an LLC elect as C Corp? 
  • The LLC can complete Form 8832 and follow the steps on the form. The tax implications of the election need to be considered carefully due to the different tax treatment of a C-Corp.

To find out if this conversion is suitable for you, contact us.

Shaun Eastman

Peter Harper

Quite possibly, the most common business structure is the limited liability company or LLC. Business owners love the flexibility, low cost, and ease of setup an LLC offers. Additionally, with many service providers available to set up an LLC, it is no surprise that many business people consider the first type of business structure is an LLC. And in turn, the most common way of starting an LLC is through sole ownership. In this scenario, we call the structure a single-member LLC (SMLLC).

An LLC is a business structure that exists at the state level. When organizing an LLC with the secretary of state, you do so by registering it in a given state, such as Delaware, California, Wyoming, and so forth. Owners of an LLC are called members, and there is tremendous flexibility in that members may include individuals or even corporations.

What’s The Default Tax Treatment For A Single-Member LLC (SMLLC)?

According to IRS rules, an SMLLC is disregarded for U.S. income tax purposes in terms of the default tax treatment of a limited liability company. 

What does this mean? This means all the income and expenses of the LLC flow through to one’s personal tax return on Schedule C of Form 1040. It also means that no separate federal tax return is needed for the LLC and that the income from the LLC is considered self-employment income, on which the taxpayer will pay federal income and self-employment tax (such as social security and Medicare).

Disregarded Entities and Federal Taxes 

When an entity is disregarded, given that the business income and expenses, and hence, profit, flow through to the individual’s tax return (on Schedule C of Form 1040), the taxpayer is liable for federal income tax on the profits of the entity. However, self-employment tax is also payable on the profits of the business (and reported on Schedule SE of Form 1040). 

Changing Your SMLLC’s Tax Treatment

To change the tax treatment of your LLC, you need to file a Form 8832 to change the default classification of the LLC for tax purposes. This election needs to be made within a year before it becomes effective, or within 75 days after it becomes effective. This means that with a new entity, Form 8832 needs to be filed within 75 days of the start of the entity’s fiscal year. To learn more, visit our blog on Check the Box Elections. There are scenarios, however, where you may be able to make a late election. For guidance on this matter, please get in touch today to discuss your options if you are operating an LLC and wish to change its default classification on a delinquent basis. 

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You Must Pay Tax On All Profit (Whether You Distribute It Or Not)

It is important to note that even if you do not distribute any of the LLC’s profit, given that the LLC is a pass-through entity, you will need to report and pay taxes on all profits of the LLC. This is the case even if you leave the profits in the bank and do not use the funds for any purpose. 

Paying Business Tax As A Single Member LLC

While operating an SMLLC is simpler than running a large corporation, there are still many obligations to fulfill, particularly as it concerns paying business taxes. Below you will find details on the various business taxes you may have to pay when operating your business in this way.

Filing As A Sole Proprietorship

When you treat an SMLLC in its default manner, as a sole proprietorship, you are liable for tax on the profits generated by the business entity, which, as we discussed, are reported on Schedules C and SE of Form 1040. Additionally, depending on the state the LLC is organized in, you may also have to file a separate form for the LLC (such as Form 568 in California) and pay a franchise tax and/or a minimum LLC tax. Further, you may also have to pay an annual fee to a registered agent for receiving mail or legal documents on your LLC’s behalf. 

Filing As A C Corporation

If you decide to elect for your LLC to be taxed as a C Corporation for tax purposes, you will need to report the income and activities of the LLC on a corporation tax return on Form 1120. The federal tax rate for corporations is currently 21%, and state income tax rates (and required forms) vary. 

Filing As An S Corporation

When filing as an S Corporation, you would need to file a separate tax return for the LLC (Form 1120S), but the profits ultimately flow through to you, the individual (on Schedule E of Form 1040). Therefore, the treatment is similar to that which we discussed in the first scenario above. 

How A Single-Member LLC Is Taxed

As mentioned previously, the default treatment is as a disregarded entity, where all income and expenses (and hence, profit) flow through to the individual’s personal federal tax return. However, if you elected for the LLC to be taxed as a C Corporation, the tax treatment will differ. Further, if you elected for the LLC to be taxed as an S Corporation, then the tax treatment would be as a disregarded entity. 

Employment Tax And Certain Excise Tax Requirements

Just because one’s business is structured as an SMLLC does not mean that that sole proprietor does everything. Indeed, you might be operating a business as a sole proprietorship but also have employees. In this scenario, ensuring that you are complying with your employment tax obligations (such as payroll, making federal and state tax withholding payments, and so forth) for your employees is critical. Additionally, depending on the type of business and industry you are in, your LLC may also have excise tax obligations (business taxes imposed on various goods, services, and activities). If you are unsure whether your small business may have excise or employment tax obligations, please get in touch today to ensure that you are running your business in a manner that complies with employment and excise tax requirements. 

Bookkeeping And Accounting For Single-Member LLCs

It is crucial to get the bookkeeping and accounting correct for your small business from the start. Many people erroneously think that just because an LLC has only one member, they can just get started and then handle the bookkeeping later. Nothing could be further from the truth. We must remember that an SMLLC is a business, just as a partnership is a business, a corporation is a business, and so forth. And therefore, it is crucial to take the finances of the LLC very seriously, just as a large corporation such as Microsoft or Walmart would. 

If you are considering organizing an LLC or have already organized an LLC and need guidance on the bookkeeping or an operating agreement, please get in touch with us today. Indeed, one of the biggest strengths of an LLC is its flexibility, but that also means there are plenty of areas where things can go wrong. You don’t want to be scrambling at the last minute before the tax filing deadline because the bookkeeping has not been done beforehand. 

Non-Tax Purposes

In addition to the tax implications and obligations of running an SMLLC, there are other things to consider too, which may not be directly related to taxes. Below are a few frequently asked questions (and answers) that you may be curious about. 

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FAQs

Can A Married Couple Be A Single-Member LLC?

Yes, you actually can. If you live in one of nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin), and you and your spouse jointly own an LLC, then you can elect to treat the entity as an SMLLC. In this scenario, all the income and profits of the LLC flow through to Schedule C of your joint tax return (Form 1040), and there will be no need to file a partnership tax return (Form 1065). 

What Is The Best Way For A Single-Member LLC To File Taxes?

This is a subjective question. As mentioned previously, the default treatment of an SMLLC is that it is a disregarded entity. However, this also leads to a situation in which you are liable for not only federal income tax but also self-employment tax. Thus, you may decide to elect to have the LLC be taxed as a corporation to avoid this situation. However, in this scenario, profits distributed to the LLC owner are taxed, as well as the profits being taxed on a corporate level. Therefore, depending on one’s unique situation, it may or may not be better to go with the default classification of an SMLLC. 

What Can You Write Off On Taxes For Single-Member LLC?

When conducting business as a single-member limited liability company, you may deduct all necessary and allowable business expenses incurred as a result of operating the business. Of course, the exact categories depend on the type of company you are running as well as your operations, but common categories of business expenses include advertising, rent, travel, meals (usually deductible only up to a certain percentage), supplies, repairs, legal fees, insurance, and so forth. Please note that the LLC cannot deduct personal expenses and that doing so may land you in big trouble with the IRS. 

Are LLC Single Taxed?

Yes. Given that the IRS considers SMLLCs as sole proprietorships for tax purposes, the LLC itself does not pay tax. Rather, the profits of the LLC flow to your individual tax return, and you in turn pay tax on the profits of the LLC on your own personal tax return.

Does A Single-Member LLC Need A Separate Bank Account?

Generally speaking, yes, a single member limited liability company would need its own bank account. But why? Because not only does it simplify things from a bookkeeping and accounting perspective to have different accounts for personal and business, but commingling personal and business funds are risky in a legal sense. Mixing personal and business finances may lead to a situation in which if the limited liability company is sued, it may lose its liability protection (a term referred to as “piercing the corporate veil.”).   

 Contact Asena Family Office for a detailed understanding of Single Member LLC Taxes.

Arin Vahanian

Peter Harper

Deliberate estate planning is a pivotal aspect of the continuous growth of your family office for generations to come. If your existing wealth is not planned out in the most optimal way, your children or any other subsidiaries can face problems. 

One of the vehicles for estate planning is an IDGT, an irrevocable trust that is created by a Grantor during his lifetime. A popular strategy for planning is for the grantor to gift assets to the trust and later sell other assets to the trust. The sale is usually structured to include an initial gift to the trust and if the gift is sufficient to secure a portion of the purchase price (valuation of assets is important), the trust can subsequently purchase the assets from the grantor in exchange for the trust’s promissory note (valuation should be same for assets and promissory note. 

What Is An Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) is an irrevocable trust set up by the Grantor, where the trust deed is drafted to trigger grantor trust status intentionally. 

Estate Planning With Intentionally Defective Grantor Trusts

An IDGT is a great estate planning tool because it is owned by the Grantor for federal income tax purposes but treated as separate from the Grantor for purposes of estate and gift tax. This treatment enables the Grantor to pay income taxes on the trust’s income, but the appreciation on the assets in the trust is excluded from the Grantor’s estate and does not form part of their taxable estate. The income tax rate is less than the estate tax rate.

Who Owns Assets In Intentionally Defective Grantor Trust?

Legally it is owned by the trust due to it being an irrevocable trust. For tax purposes, it depends on whether it is for federal income tax or federal gift and estate taxes.

Federal income tax: Due to the trust being created with an intentional mistake to trigger the grantor trust rules, it ensures that the IRS regards you as the owner of the trust’s assets for federal income tax.

Federal gift and estate tax purposes: Due to transferring the assets out of your name and into a trust, the assets are owned by the trust and do not form part of your estate, and they will be regarded as a taxable gift. 

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Does An Intentionally Defective Grantor Trust Get A Step Up In Basis?

No. The Grantor trust rules, as set out in IRC 671-679, deem the Grantor to own the assets and liable for any federal income tax and transfer; therefore, tax-free. 

What Taxes Relate To An IDGT?

There are various types of taxes to consider for a taxpayer. Most notably: 

• Gift and Estate Tax
• Income Taxes, including CGT; 
• Generation-skipping taxes (GST); and 
• Transfer tax

Who Pays Income Tax On The Gains Inside Trust?

The Grantor, while alive, pays income tax on the gains. After his demise, the IDGT will bear its own income tax on gains made.

Tax Liabilities

The Grantor is liable for federal income tax on income generated by the trust, including any gains made in his lifetime. If the Grantor gifts the assets to the trust, they will be liable for tax on the gift and are regarded as trust assets subsequent to the gift. 

An IDGT is the preferred estate planning vehicle when generation-skipping transfer tax is a primary goal of the trust. In this case, an asset’s value is set for GSTT purposes as soon as it is sold to the IDGT. Additionally, asset appreciation will not count against the grantor for GSTT purposes if the trust is structured to repay the asset over 10 years.

Reciprocal Trust Doctrine

The reciprocal trust doctrine applies when two trusts are interrelated, “and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been if they had created trusts naming themselves as life beneficiaries“.

For example – 

Spouses set up reciprocal trusts to take advantage of the tax exemption for gifts between spouses. In this case, the husband gives up to $6,030,000 to a trust for the benefit of his wife and issue, and the wife gives up to $6,030,000 to a trust for the benefit of her husband and issue. 

When applying the “reciprocal trust doctrine,” courts often end up uncrossing the trusts. The doctrine states that if a husband creates a trust for his wife, and the wife creates a nearly identical trust for the husband, then the two trusts may be ‘un-crossed’ and treated for tax purposes as if each spouse had made a trust for themselves.

How To Fund An IDGT

There are two methods to fund an IDGT. Either by making a gift or engaging in an installment sale of the trust. 

Selling Assets To An Intentionally Defective Grantor Trust

If you sell assets to an IDGT, this is usually done via an installment sale. In order for a gift to be permanent and count towards a grantor’s lifetime gift exclusion, the trust must be seeded with a gift that is at least 10% of the asset’s value.

The grantor can then sell the assets to the trust and receive an interest-bearing promissory note from the trust in exchange. An IDGT uses the ‘applicable federal rate’ (AFR), a number published monthly by the IRS for purposes of this interest. The interest accrued on this promissory note is not taxable for federal tax purposes due to the fact that you can’t charge yourself an interest rate (i.e. an IDGT being a grantor trust). No tax is due on any gain from the sale by the Grantor to the trust. If the fair market value of the promissory note is equal to the fair market value of assets sold, there will be no gift tax liability except for the 10% initial gift. 

What’s A “Pot Trust”? Can An IDGT Be A Pot Trust?

A pot trust is a trust set up for multiple trust beneficiaries where distributions can be made to any beneficiaries at the trustee’s discretion. And yes, an IDGT can be a Pot Trust. 

Can An IDGT Be A Spendthrift Trust?

Yes. The Grantor may want to build safeguards into the trust to protect their beneficiaries from creditors and to ensure the assets are not misused by beneficiaries due to substance abuse, for example. 

What’s A SLAT? Can An IDGT Be A SLAT?

A Spousal Lifetime Access Trust or ‘SLAT’ is a trust where the Grantor’s spouse and their descendants are permissible beneficiaries of the trust. 

Yes, an IDGT can be a SLAT. 

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Including A Spouse As An Eligible Beneficiary

The purpose of including the Grantor’s spouse as a beneficiary is that the Grantor can transfer assets to a trust (IDGT) and ensure that the spouse has access to those assets should they need them during their life. This is referred to as a SLAT.

What Makes An IDGT A Dynasty Trust?

An IDGT can be a dynasty trust if it is designed to last for multiple generations without being subject to estate taxes on the death of a beneficiary. 

What Other Considerations Are There?

Using an IDGT should be carefully considered based on your own estate planning needs. This is not a magical estate planning tool that will work or even suit everyone. 

For instance, the IDGT is not even in the tax code, but rather gains its authority through numerous decisions from the tax courts. Every time a trust is challenged in the courts by the IRS, the decision creates new boundaries or allowances for future trusts.

Another issue is when the Grantor dies. In the case of an IDGT, there is no official guidance from the IRS as to how they will treat the trust and its assets. Nearly all tax professionals recognize that upon death, the IDGT loses its grantor status. However, it is not clear when that occurs. The IRS tends to provide guidance on how to proceed after the grantor’s death – which is not conductive to the planning process. This can leave grantors, their beneficiaries, and estate planners without a clear picture of what can be done in the case of a premature death.

Below are some of the factors to consider when looking at the feasibility of an IDGT as part of your estate planning.

Will I Need Access To The Assets I Plan To Put Into The Trust?

No, you don’t need access. However, if you want access to the assets, an IDGT may not be the best tax planning structure for you. 

Do I Expect These Assets To Appreciate Over Time?

The primary purpose of an IDGT is to ‘freeze’ a grantor’s estate. Therefore, it makes sense to transfer appreciating assets to the trust.

How Much Control Do I Wish To Give My Beneficiaries?

The Grantor can retain significant control over the trust property even if it is subsequent to the trust being created. This way, you can manage the power of the beneficiaries. For example, the Grantor can have the right to hire or fire trustees and to make investment decisions. 

Who Will Be My Trustee?

It is crucial to ensure that the trustee or trustees are someone you can trust. Appointing a spouse can have severe tax implications. 

FAQ:

What makes an Intentionally Defective Grantor Trust?

“These trusts are referred to as IDGTs because the Grantor intentionally includes in the trust agreement (trust deed) a right or power (such as the Grantor’s ability to switch out and substitute assets for other assets already in the trust) that causes them to be treated as the owner of the trust for federal income tax.“

Who pays taxes in an Intentionally Defective Grantor Trust?

An IDGT is considered separate from the Grantor for federal estate and gift tax purposes. However, it is treated as owned by the Grantor for federal income tax purposes. The Grantor has the income tax liability and pays income tax on the trust income, but the appreciation that builds up in the trust’s assets is excluded from the Grantor’s estate.

Does an Intentionally Defective Grantor Trust get a step up in basis?

No, due to exemption of CGT. Due to the grantor trust rules being applicable, the historical base cost will roll over, and the Grantor will still be the deemed owner for federal income tax purposes. Therefore 

Who owns assets in Intentionally Defective Grantor Trust?

Legally the intentionally defective grantor trust owns the assets. However, for tax, ownership is as follows:

Federal income tax: Due to the trust being created with an intentional mistake to trigger the grantor trust rules, it ensures that the IRS regards you as the owner of the trust’s assets for federal income tax.

Federal estate tax purposes: Due to transferring the assets out of your name and into a trust, the assets are owned by the trust and do not form part of your estate. 

Federal Gift tax purposes: If you gift your assets to the trust, you will be subject to tax, which is calculated as the asset’s value on the date of transfer. Similar to estate tax, it is regarded as owned by the trust.

Estate planning is a delicate matter and it is pivotal to have it catered to you. If you have any questions about intentionally defective grantor trusts, please reach out to Asena for more in-depth advice. 

Shaun Eastman

Peter Harper

Foreign Personal Holding Company Income

This blog addresses the foreign personal holding company income which is a complex topic for taxpayers that requires a deep background understanding so we will start with some framework regarding CFCs and Subpart F income which is contained in Subchapter N of Title 26 and as promulgated by Treasury Regulations. These are special rules. Please contact us or read other blogs in our Quick Guides series for more in-depth information on each one of these topics.

Corporations are either domestic corporations (i.e. U.S. corporations) or foreign corporations.

What is a Controlled Foreign Corporation (i.e., CFC)?

The purpose of this paragraph is to define CFC. A foreign corporation is a controlled foreign corporation if a United States shareholder (i.e. a U.S. Shareholder) directly, indirectly, or constructively holds more than 50% of the stock in such a corporation. Concerning a corporation in a foreign country, a United States shareholder means a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)) or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. Ownership of a CFC is determined based on direct, indirect, and constructive ownership by United States Shareholders. Section 958 Internal Revenue Code 1986 defines the circumstances when stock owned by persons that are related to United States Shareholders will be relevant to determining whether or not a foreign corporation is a CFC. To learn more about CFCs, visit our blog What is Controlled Foreign Corporation?. 

A related person is defined in Treasury regulation 1.958-2 Internal Revenue Code. A person is considered a “related person” if – 

(1) They are partners or partnerships described in section 707(b)(1) of the Code; or

(2) They are related within the meaning of sections 267 (b), (c), and (f) of the Code, except that –

(i) “10 percent or more” shall be substituted for “more than 50 percent” each place it appears; and 

(ii) Section 1563 shall apply (for purposes of section 267(d)), without regard to section 1563(b)(2). 

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What is Subpart F Income of a CFC?

The purpose of this paragraph is to define Subpart F Income of a CFC. To combat overseas tax deferral, Congress enacted the Revenue Act of 1962. This enactment added Subpart F to the IRC in order to allow U.S. taxation of specific undistributed amounts earned by the CFC. Before the introduction of Subpart F, if a foreign corporation derived income unrelated to a U.S. trade or business, that corporation could simply retain the profit within the company and not pay any income tax within the U.S.

Subpart F attributes so much of the foreign-sourced gross income in a taxable year of a Controlled Foreign Corporation (also known as a CFC) that is allocable to a U.S. Shareholder that owns stock in such corporation on the last day of the taxable year. As outlined above, a U.S. Shareholder is a United States Person that owns more than 10% of the stock in a foreign corporation. The foreign corporation is the payor.

What is the Foreign Base Company Income of a CFC?

The purpose of this paragraph is to define Foreign Base Company Income of a CFC. Subpart F is separated into several definitions that categorize certain types of transactions. Most foriegn countries that have CFC regimes similarly categorize income. In the U.S., the income of a CFC is broadly divided into two buckets, the first being related party income that relates to services and sales of a corporate group and the second being income that is widely thought of as passive income. The definitions are pretty intertwined and breakdown as follows. 

Foreign Base Company Income Income is defined to include the Foreign Base Company Income of a CFC. The Foreign Base Company Income of a CFC in a taxable year includes Foreign Personal Holding Company Income of a CFC, Foreign Base Company Sales Income of a CFC, and Foreign Base Company Services Income of a CFC.

As outlined above, the Foreign Base Company Sales Income of a CFC correlates to related party sales income where a foreign corporation sells to a related domestic corporation, and the Foreign Base Company Services Income of a CFC is where a foreign corporation provides related party services income to a domestic corporation.

So, What is Foreign Personal Holding Company Income?

The purpose of this paragraph is to define Foreign Personal Holding Company Income of a CFC. It is a portion of gross income that is thought of as passive income. Income derived from dividends, rents, royalties, etc. The list is far longer than that, and you can see what it covers here: dividends, interests, royalties, and rents; certain property transactions; certain commodity transactions; certain foreign currency transactions; interest income; income from notional principal contracts; payments instead of dividends; and personal services contracts.

Is Foreign Personal Holding Company Income Subpart F?

Yes, Foreign Personal Holding Company Income is Subpart Income. It indirectly forms part of that definition as it is included in the description of Foreign Base Company Income of a CFC.

Computation Of Foreign Personal Holding Company Income of a CFC.

The computation of Foreign Personal Holding Company Income includes dividends, royalties, rents; certain property transactions; income equivalent to interest; income from notional principal contracts; payments in place of dividends; and personal services contracts. In general, if the gross income of a CFC is Foreign Personal Holding Company Income and any portion of the income is from more than one category, that income is treated as income from the category with the highest priority. 

The computation of this income can be complex and very specific to a taxpayers’ assets and situations. 

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Dividends, Interest, Rents, Royalties, And Annuities

In a taxable year:

• Dividends are the dividends derived by the CFC paid from another corporation in the same taxable year. 
• Interest is interest income derived by the CFC on cash or cash equivalents. 
• Rents are derived by the CFC on real estate it owns. 
• Annuities are earnings the CFC derives from fixed income products it holds.

Certain Property Transactions

The purpose of this paragraph is to define certain property transactions of a CFC. Foreign Personal Holding Company Income of a CFC includes Certain Property Transactions, which are the sale of assets that produce income that would otherwise produce foreign personal holding income. This includes:

1. Property that gives rise to dividends, interest, rents, royalties, or annuities; 
2. Property that is an interest in a partnership, trust, or REMIC; 
3. and property that does not give rise to income.

The most basic example of certain property transactions is the sale of real estate, deriving rent, or intellectual property that is paying a royalty. This is a catch-all provision that ensures that regardless of the characteristic of the payment made with respect to this property, it is still subject to Subpart F.

Commodities Transactions

In a taxable year, the Foreign Personal Holding Company Income of a CFC includes gains derived from commodities transactions. Commodities transactions include the sale of any commodity, which would consist of something like coal, and some form of derivative or contract for the sale of commodities.

Foreign Currency Gain or Loss

Foreign Personal Holding Company Income of a CFC in a taxable year includes Foreign Currency Gains Or Losses, the gains or losses realized on a multi-currency transaction. By way of example, if a foreign corporation that was a CFC bought and sold coal in Australian dollars, the Australian dollar appreciated against the U.S. dollar, it would have a foreign currency gain on the sale of the coal to a third party.

Income Equivalent To Interest

The term income equivalent to interest includes income that is derived from- (A) A transaction or series of related transactions in which the payments, net payments, cash flows, or return predominantly reflect the time value of money; (B) Transactions in which the payments (or a predominant portion thereof) are, in substance, for the use or forbearance of money; (C) Notional principal contracts; (D) Factoring; (E) Conversion transactions; (F) The performance of services; (G) The commitment by a lender to provide financing; (H) Transfers of debt securities subject to section 1058; (I) Any guaranteed payments for the use of capital under section 707(c); and (J) Other transactions, as provided by the Commissioner in published guidance.

This is any form of synthetic instrument (like one that would govern factoring) and as outlined above, that generates income equivalent to interest, which is essential since a loan-bearing interest would otherwise be captured under other parts of this section. Without this provision, clever financiers would simply structure around Subpart F.

What Is Excluded From Foreign Personal Holding Company Income?

Certain facets of rents and royalties are excluded from the Foreign Personal Holding Company Income classification:

Excluded Rents:

Rents are considered excluded if they are paid by a related person who is a corporation or delivered to a CFC for the use of property in the country where the CFC is incorporated. This phenomenon is otherwise known as the related entity exception. 

Excluded Royalties:

Royalties are for the use of property in the country where the CFC was incorporated.

Do any Exceptions to Foreign Personal Holding Company Income exist? 

Yes, two notable exceptions are the same country exception and the related party exception. The same country exception provides that sales to property manufactured, grown, or extracted from the country in which the foreign corporation was incorporated is not foreign personal holding company income. This means that if mine coal and generate royalties in Australia the royalties would not be foreign personal holding company income. 

The related party exception is where the payor pays dividends, interest rents, or royalties to a related CFC. This means that if a CFC owns real estate in a country and generates rents from real estate it owns in that country the income is not Foreign Personal Holding Company Income. 

The exceptions to Foreign Personal Holding Company Income focus on the payor of the income rather than the recipient.

Special Rule for Certain Branch Income

954(d)(2) has a special rule for certain branch income to escape a 50% tax on manufacturing and sales income.

For any more information on Foreign Personal Holding Company Income or CFCs, contact Asena Advisors.

Peter Harper

What is a Single Member LLC?

A Single-Member Limited Liability Company is a style of entity classification that has one owner (member) who has complete control over the company. Unique to other types, the LLC itself is considered a separate entity, independent of its owner.

How Single Member LLCs Work

The default classification for federal tax purposes is a disregarded entity; thus, tax flows through to the member. This also provides liability protection for the member.

Are Single-Member LLCs similar to Sole Proprietorships?

The taxation is similar; however, the legal natures differ significantly. 

LLC:

• • Personal liability is limited 
  • Needs to be registered in the relevant state
  • Regarded as a legal entity 

Sole Proprietorships:

• • Has full liability 
  • Does not get registered
  • Not regarded as a legal entity

Single Member LLCs vs. Multi-Member LLCs

Ownership

Single-Member LLC Ownership

An SMLLC has one owner (member) who has complete control over the company. The SMLLC is its own legal entity, independent of its owner.

Multi-member LLC Ownership

This LLC has two or more owners (members) that share control of the company. Unless it elects S Corporation tax treatment, there may be an unlimited number of members in a multi-member. The LLC may decide on how (what percentage of) profits and losses will be distributed among its members.

Management

An SMLLC has one member who is also considered the manager. 

However, a Multi-member LLC must decide if they would like the business to be member-managed or manager-managed.

Member-managed LLC

In a member-managed LLC, the members participate in the work of the business. The company requires the majority approval of all of its members when making significant decisions, such as entering into contracts.  

Manager-managed LLC

In a manager-managed LLC, the members agree on a manager, either a particular member or members of the LLC or a third party, to whom they give authority to manage the day-to-day operations and decisions of the business.  

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Personal Asset Protection

Both types of LLCs protect the owners’ personal assets due to their being separate legal structures.   

Owners may, however, be held personally responsible in certain situations. 

Income Tax Treatment

SMLLC Default Tax Treatment

The income tax treatment of an LLC is that the owner reports the business’s profits and losses on Schedule C of Form 1040, and the company does not report or pay taxes independently. The LLC owner also pays self-employment tax using their Social Security number and Medicare) on all taxable income from the business and reports it on their personal tax return. 

Formation

The formations of the types of LLCs are similar:

• • Choose a business name 
  • Apply for an EIN (Employer Identification Number) 
  • Designate a registered agent
  • File Articles of Organization with the state in terms of the applicable state law
  • Complete the Entity Classification Election Form (IRS Form 8832).
  • Create an LLC operating agreement 
  • Open a business bank account
  • Obtain the necessary business licenses and permits
  • Know and abide by the relevant employment laws
  • Learn the requirements to remain in good standing 

Read our blog – Can you Change a Single Member LLC to a Multi Member LLC? – Asena Advisors for more information

Compliance

A Single-member LLC usually has less-complex requirements to fulfill than a Multi-member one. 

Who Needs a Single Member LLC?

There is no right or wrong answer to this, and it will depend on the specific circumstances of the business and individual. However, a single-member LLC is a prevalent structure for small business owners and entrepreneurs. 

How to Form a Single-Member LLC

1. Step 1: Name Your LLC

   1. Once you have decided on the specific state where you will form the LLC, you will need to register a unique name and not yet used or registered in that state. 

2. Step 2: Choose an LLC Registered Agent

   1. It is important to choose a registered agent for your LLC who acts as the representative of the LLC in the state of formation. Some of the responsibilities of the registered agent are to accept legal documents on behalf of your LLC and, if needed (which most LLC owners would rather want to avoid), lawsuits. 

3. Step 3: File Your LLC’s Articles of Organization

   1. You will need to draft and complete the LLC’s Articles of Incorporation on the secretary of state’s website. 

4. Step 4: Create an LLC Operating Agreement

   1. It is wise to create an operating agreement for the LLC in order to set out the rules of the business entity whenever it is requested by either a financial institution or a potential buyer. The contract will stipulate how these types of transactions should be dealt with. 

5. Step 5: Get an EIN

   1. Even if the LLC does not hire employees or start trading immediately, you will need an employer identification number (EIN). The LLC needs to have an EIN because if you apply for finance at a bank, they will need the LLC’s EIN, and it is required to complete your return. Applying for an EIN can be done on the IRS’s website.

How To Pay Yourself As A Single Member LLC

You don’t get paid a salary as the owner of a single-member LLC. Instead, you pay yourself by withdrawing the profits made by the LLC as and when needed. It’s also referred to as an owner’s draw. 

Hiring Employees As A Single Member LLC

First and foremost, a single-member LLC can hire employees. You need to ensure that you adhere to payroll requirements. So make sure you withhold payroll taxes when paying employees and paying it over to the IRS. 

Tips For Setting Up An Single-Member LLC

Make sure you understand your state’s specific requirements to remain compliant. For example, you should understand the state’s renewal filing requirements, annual reports, and filing fees. Some states levy fines if you fail to maintain the LLC’s compliance.  

When A Single Member LLC Might Be Wrong For You

There is no one shoe fits all answer to this question, but we can point out certain factors to consider when making this decision.

• If you are operating as a sole proprietor without any issues, why burden yourself with additional paperwork and compliance required for an LLC.
• You can’t afford the ongoing maintenance fees.
• If there is more than one member, it will then be a multi-member LLC, and depending on the members and business, an alternative structure might be more feasible and advantageous. 

The Pros And Cons Of A Single Member LLC

Pros:

• • Flexibility in terms of how you want the LLC to be taxed
  • Very little paperwork and can form an LLC with one person
  • Flow-through of income taxation simplifies your tax returns. 
  • Liability Protection if the LLC has legal issues. 

Cons:

• • The owner is not allowed to pay themselves wages.
  • Depending on the state, renewal fees could be expensive.
  • Many states levy capital values or franchise tax.
  • Investors are more prone to invest in a corporation which could be an issue if you want to raise capital.

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FAQs

1. How Much Does It Cost To Form A Single-Member LLC?
   1. It depends on the state where the LLC is formed.
2. How Are Single-Member LLCs Taxed?
   1. The default classification of a single-member LLC is taxed as a sole proprietorship, and therefore the LLC is treated as a disregarded entity for federal purposes. 
   2. You can also elect to be taxed as either a C corporation or an S corporation. This would require the LLC to complete a separate corporate income tax return. 
3. Do I Need A Lawyer To Form A Single-Member LLC?
   1. No. This is not a requirement. 
4. How Are Single-Member LLC Members Paid?
   1. By making withdrawals from the LLC’s profits. This is referred to as an owner’s draw.
5. Does An SMLLC Need An Operating Agreement?
   1. It is generally not required but highly recommendable. 
6. Does An SMLLC Need An Employer Identification Number?
   1. Yes
7. What is the difference between an LLC and a single-member LLC?
   1. There is no difference. An LLC is a type of business structure regarded as a hybrid structure that combines features of both a corporation and a partnership. And a single-member LLC means the LLC has only one member. 
8. What is the point of a single-member LLC?
   1. Single-member LLCs are considered separate legal entity because of how liabilities are treated and therefore protects the owner’s personal assets from being seized to pay for business debts.
9. Is it better to be a single-member LLC?
   1. It depends and should be dealt with on a case-to-case basis. It is, however, a standard structure for small startups. Contact an advisor for an in-depth analysis of your case.
10. What is the difference between a sole proprietor and single-member LLC?
    1. The significant differences are:
       1. Every liability of a sole proprietorship is the responsibility of the owner. On the contrary, this is not the case in a single-member LLC, where the member is shielded from liability.
       2. Raising capital is more difficult for a sole proprietor than for a single-member LLC. 

For more information on Subpart F, please contact one of our specialists at Asena Advisors. We make sure that your specific needs are catered for.

Shaun Eastman

Peter Harper

The world of U.S. taxation is fraught with rules, Internal Revenue Service (IRS) and Treasury Department regulations, and laws, not to mention potentially massive pitfalls for not complying with your tax liability. This risk is especially the case when it comes to international income tax. Adding to the complexity are acronyms such as CFC, FBAR, FATCA, and, now, the mother of all acronyms, GILTI. But what is GILTI, or global intangible low-taxed income? More importantly, what is the impact of the GILTI rules, does GILTI apply to you, and what are the planning considerations for global individuals and business owners, whether U.S.-based or non-U.S.?

What is Global Intangible Low-Taxed Income (GILTI)?

The Internal Revenue Code (IRC), enforced by the IRS, sets out a complex approach to tax specific income of certain non-U.S. entities owned by U.S. shareholders under the global intangible low-taxed income or GILTI regime. The Tax Cuts and Jobs Act of 2017 (TCJA) is a tax policy that had few but significant elements to contradict the territorial tax approach, and one of them was promulgated as the GILTI regime. 

Previously excluded under the subpart F regime, certain earnings of controlled foreign corporations (CFC) have become taxable income thanks to the TCJA, and specifically, under the GILTI regime.  

But before we discuss GILTI, we should specify what constitutes subpart F income. Enacted in the year 1962, IRC §952 defines subpart F income in relation to a CFC as the sum of insurance income, foreign base company income, international boycott income, illegal bribes, kickbacks, or other illegal payments made by the CFC, or income derived from certain disfavored countries. It does not include any income effectively connected to a U.S. trade or business. It is important to note that income that is not categorized as foreign base company income and insurance income, if taxable in a foreign jurisdiction at an effective tax rate of more than 90% of the top U.S. corporate tax rate (high-tax exclusion), would be considered income subject to GILTI. Therefore, a CFC’s subpart F income would not include an income effectively taxed at more than 18.9% (i.e., 90% of 21%) in a foreign country. Stated another way, GILTI income is any income that is not considered subpart F income. The impact here is that GILTI often results in double taxation of a CFC’s earnings. Learn more about Subpart F in our blog _____

Structure and Purpose of GILTI

Before the TCJA, U.S. shareholders and owners could defer income tax on the active earnings of foreign entities until those earnings were repatriated to the U.S. in the form of dividends. 

IRC §951A, which contains the GILTI rules, was added to the tax code by the TCJA. One of the features of the TCJA was to provide corporate shareholders a 100% dividends received deduction (DRD) on dividends from foreign corporations. However, to prevent taxpayers from shifting income offshore to low- or no-tax jurisdictions, Congress passed tax reform via the GILTI rules. These require U.S. shareholders of CFCs to include GILTI in gross income each year. 

Specifically, GILTI is a 10.5% percent minimum tax enacted on this income to dissuade U.S. taxpayers from engaging in profit-shifting.

And although the TCJA lowered the top corporate income tax rate in the U.S. to 21% from 35%, many countries still have a corporate tax rate lower than that in the U.S. 

Who Does it Impact?

Do GILTI Rules Apply To Your Organization?

The GILTI rules impact both U.S. individual shareholders and U.S. corporate owners. “In this scenario, a U.S. shareholder is a person who owns directly, indirectly, or constructively 10% or more of the vote or value of a foreign corporation. A U.S. person includes a U.S. citizen or resident, a domestic partnership, a domestic corporation, any estate (that is not foreign), and any trust if a U.S. court has jurisdiction over its administration and one or more U.S. persons have the authority to control all substantial decisions of the trust.” A CFC is any foreign corporation in which U.S. shareholders own more than 50% of the vote or value directly, indirectly, or constructively.

Applicability to U.S. Taxpayers

It is important to note that the GILTI rules do not impact non-U.S. corporate owners and taxpayers. However, constructive rules of ownership may be looked into to determine whether a U.S. subsidiary of a non-U.S. holding company should make an election. It should also be noted that U.S. companies that have no foreign operations are not impacted by these rules. On the other hand, it is safe to say that multinationals generally would be impacted by these rules. Finally, one should avoid being bamboozled by the acronym GILTI, because as we will explain in the next section, it impacts a lot more than just intangible assets or taxable income.

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How the Tax on GILTI Works

While it will be difficult, if not impossible, to demonstrate an entire understanding of GILTI taxation in this limited space, we can share various concepts here to provide an overview. We recommend contacting us for a more specific analysis of your case.

A U.S. shareholder’s GILTI inclusion is the excess of their pro-rata share of net CFC tested income over their net deemed tangible income return (net DTIR). 

But what is tested income? It is the aggregate pro-rata share of income minus the aggregate pro-rata share of loss (but not less than zero). Net DTIR is defined as 10% of the U.S. shareholder’s pro-rata share of aggregate qualified business asset investment (QBAI), less specified interest expense. 

But what is QBAI? It is the CFC’s average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income. Stated another way, GILTI, with respect to any U.S. shareholder, is net CFC tested income less net DTIR.

Does GILTI Really Work as Intended?

For all intents and purposes, GILTI is, in essence, a form of minimum tax on the profits of CFCs. This calculation generally equals the CFC’s total income in excess of its net deemed tangible income return, which equals 10% of the CFC’s investment in depreciable, tangible business assets minus certain interest expenses.

The income tax on GILTI is particularly significant for CFCs whose profits are high with respect to their investment in tangible or fixed assets, such as those providing software and services. Therefore, this presents a potentially significant problem for taxpayers in specific industries, but it is certainly not limited to these taxpayers.  

Further, GILTI is reported on U.S. tax forms such as Form 5471 (and its various schedules), Form 8992, and Form 1040 (for individual taxpayers). Given the complexity of the GILTI inclusion and calculations, not to mention the IRS’ numerous filing requirements, it is highly advisable to enlist the services of a qualified international tax advisor and preparer to ensure that one is appropriately filing the correct forms and in such a way as to minimize income tax and eliminate risk exposure.

What Should Companies Do?

For U.S. corporate owners, a CFC’s earnings excluded under the ‘high-tax exclusion’ election are not treated as ‘previously taxed profits.’ Accordingly, foreign tax credit paid for such prior earnings would not be eligible for adjustment and may not be eligible to claim dividend deduction (unless conditions of IRC §245A are satisfied). The possible tax cost of CFC’s earnings excluded pursuant to the ‘high-tax exclusion’ election should be evaluated against the possible foreign tax credit to decide the situation that is more beneficial to U.S. shareholders.

A corporate U.S. shareholder can claim a 50% deduction of the GILTI and is eligible for 80% of foreign tax credit that was either accrued or paid by a CFC. In comparison, an individual U.S. shareholder is not eligible for it unless they make an election under IRC §962 to be treated as a corporate U.S. shareholder for U.S. federal tax purposes with respect to taxation of a CFC’s earnings.

Opportunities and Risks

For U.S. individual shareholders, the burden of GILTI is more than a corporate U.S. shareholder. To be at par with a corporate shareholder, an individual taxpayer may make an election to be treated as a corporate shareholder. This would allow GILTI deduction and foreign tax credit within permissible limits. Structural reforms in the business concerning individual ownership in the U.S. should be revisited where global owners propose to become U.S. residents. The cost of compliance should be weighed against the election for ‘high-tax exclusion.’ Additionally, the tax consideration at the time of accrued and actual distribution might result in double taxation.

Further, a proposed regulation published in June 2019 was issued covering IRC §§951, 951A, 954, 956, 958, and 1502. The 2020 Regulations have finalized aspects covered under IRC §951A and §954 related to GILTI’ high-tax exclusion’, but other provisions are still pending.  

The 2020 Regulations cover the below items concerning GILTI’ high-tax exclusion’:

• Conform to implement a unitary approach towards ‘high-tax exclusion’ for subpart F and GILTI: The unitary approach towards ‘high-tax exclusion’ would provide relief to a U.S. shareholder whose CFC’s earnings have already been taxable at an effective tax rate higher than 18.9% and no more part of GILTI inclusion.   
• Redefine ‘tested unit’: A ‘tested unit’ now includes a CFC, an interest in a pass-through entity held by a CFC (which is not treated as a flow-through entity under a foreign country’s law) certain branches of a CFC.
• Consolidated group: The manner of computing ‘tested income’ for the consolidated CFC group is consistent with that of a single CFC.
• Annual election: U.S. shareholders owning more than 50% of the shares (directly or indirectly) may elect for high-tax exclusion annually. They should, however, weigh the cost of compliance as the election continues to apply unless revoked. The election could be made or revoked on an amended federal income return subject to specific requirements.
• Applicability: The ‘high-tax exclusion’ applies on or after July 23, 2020. But U.S. shareholders may apply for a period after December 31, 2017, to July 22, 2020, under the 2020 Regulations.

GILTI: A Classic Misdirection

While the U.S. Congress no doubt had many goals when it came to passing the TCJA, in particular, to address issues with international profit-shifting and repatriating foreign income, what actually ended up happening is that the tax code became even more complex, rather than simple or streamlined, which was probably not the intended goal of this tax policy. Further, the GILTI rules made the U.S. tax system even more global than before, and as a result, made tax reform more complicated. Therefore, taxpayers must carefully manage their international operations or risk facing the wrath of these new regulations.

Expense Apportionment

GILTI requires taxpayers to potentially apportion interest expenses as well as general and administrative expenses. This allocation of expenses may reduce the GILTI inclusion below the amount of the foreign income on which the CFC paid at least a 13.125% foreign effective tax rate. Due to this, a U.S. shareholder may have foreign taxes that exceed the U.S. tax on GILTI. This foreign tax credit limitation results in excess foreign tax credits. In other words, these would be tax credits that the taxpayer cannot claim to the extent the tax credits exceed the pre-credit U.S. tax on GILTI.

However, the opposite will occur in some cases, and taxpayers will pay additional U.S. tax on their GILTI income because the number of foreign tax credits associated with a GILTI inclusion will not cover the full amount of U.S. tax. One way around this is to treat a portion of the taxpayer’s CFC stock as an exempt asset, which would reduce the expense apportionment to the GILTI inclusion and will help the taxpayer claim foreign tax credits. Most taxpayers will likely pay some U.S. tax on their GILTI inclusions since the foreign tax credit is limited to 80% of the taxes associated with a GILTI inclusion. 

QBAI: The Cliff Effect

As discussed previously, net DTIR is defined as 10% of the U.S. shareholder’s pro-rata share of aggregate qualified business asset investment (QBAI), less specified interest expense. To the extent a U.S. shareholder’s pro-rata share of CFC net tested income exceeds net DTIR, there will be a GILTI inclusion. Stated another way, the U.S. shareholder is allowed a 10% rate of return on assets as exempt income before being subject to GILTI.

It is important to note that CFCs with a tested loss are considered to have zero QBAI. Therefore, taxpayers should be careful of this QBAI cliff, a situation in which it is all-or-nothing.

Calling All Intangibles

While it appears that the U.S. Congress attempted a formulaic approach when writing the GILTI rules, what actually ended up happening was that due to the general nature of the GILTI rules (in that anything not subpart F income is GILTI income), nearly every U.S. multinational would be affected by these rules, even if they do not have any foreign-derived intangible income, thus apparently defeating the purpose of the regulations.  

GILTI: NOL?

A discussion of net operating losses (NOL) should be considered when we discuss GILTI, as this is a common topic when considering business taxes. However, in this scenario, it is not clear whether a tested loss carryover can be used for GILTI purposes. We know that domestic corporations may generally carry over an NOL to subsequent years. Therefore, it is reasonable to extend this treatment to CFCs. However, that does not appear to be the case here, and a U.S. shareholder who has a profit in one year and a loss in the next, would receive no benefit from the loss in the second year and would be subject to GILTI tax in the first tax year. 

Coordinated Global Tax Planning

The taxpayer’s exposure to being treated as a U.S. shareholder in a CFC results in additional U.S. income tax under subpart F and GILTI regimes. A timely discussion with your tax advisor to evaluate the different parameters to determine the global effective tax rate could assist you in deciding the impact and addressing income tax leakages, not to mention ensuring that you are compliant with IRS tax filing requirements and pay the necessary tax liability. Indeed, as more and more taxpayers look to take advantage of technology and mobility to benefit from international arbitrage, it is crucial to consider the impact that GILTI may have on you and your business before embarking on such a move. 

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A Time for Reexamination

It goes without saying that the GILTI rules introduced many changes in the world of international business. This requires taxpayers, directors, shareholders, and tax advisors to remain vigilant and reexamine their methods when it comes to tax planning and preparation. Further, it is unlikely that the GILTI rules will go away, and therefore, it has become even more important than ever to stay up-to-date with international tax law and regulations, especially in light of the possibility that treasury departments across the world may try to capture any shortfalls with similar tax legislation, under the guise of tax reform. Therefore, given that this sort of tax policy may become increasingly ubiquitous worldwide, multinationals need a good offense and a good defense, and that involves engaging the services of a firm specialized in dealing with guiding clients through the complexity in order to avoid needless tax liability. 

For more information on GILTI, please contact one of our specialists at Asena Advisors. We make sure that your specific needs are catered for.

Arin Vahanian

Janpriya Rooprai

Peter Harper

What Is Schedule M Form 5471

This schedule is different from many of the Form 5471 Schedules that are required for the different categories of filers or taxpayers. 

This schedule is not an income tax return to report foreign tax, but rather an information return of U.S. persons designed to measure Controlled Foreign Corporation (“CFC”) intercompany payments. This Schedule requires the majority U.S. owner to provide information on transactions between the Controlled Foreign Corporation and its shareholders or other related persons. So this needs to be filed irrespective of income generated that foreign tax was paid on and or tax credit application. 

Who Must Complete Schedule M

Any U.S. citizen, corporation, partnership, trust, or estate who has at least 10% ownership in a foreign corporation, needs to file Form 5471.

Form 5471 and its accompanying schedules must be completed and filed by the following categories of persons or taxpayers:

Category 1 Filer

Officers, directors, or ten percent (or greater) shareholders in a CFC who are US persons. Category 1 includes U.S. shareholders of Section 965 “specified foreign corporation” at any tax year of the foreign corporation, and where that taxpayer-owned that stock on the last day of that year.

A category 1 filer does not need to complete form 5471 M. However they do need to file form 5471 schedule J. 

Category 2 Filer

U.S. persons who are in relation to the foreign corporation a director or officer, where since the last time Form 5471 was filed by a taxpayer, a US shareholder or person has acquired at least 10% or acquired an additional 10% or more in the foreign company.

Category 2 filers do not need to file form 5471 schedule M.

Category 3 Filer

U.S person who 

• • Has acquired a cumulative 10% or greater ownership in the outstanding stock of the foreign corporation;
  • Since the last filing the US person has acquired an additional 10% or more or ownership in such stock;
  • Owns 10% or greater of the value of the outstanding stock of the foreign corporation when it is reorganized, or 
  • Disposes his stock in the foreign corporation to reduce the value of the person’s ownership to less than 10%, or who becomes a U.S. person while owning 10% or more in value of the outstanding stock of the foreign corporation.

Category 4 Filer

Category 4 filers are U.S. persons who had “control” of a foreign corporation for an uninterrupted period of at least 30 days during the foreign corporation’s accounting period. 

Control is defined as more than 50% of voting power or value, with Section 958 of the Internal Revenue Code attribution rules applying. 

The M schedule to 5471 must be completed by Category 4 filers to report the transactions that occurred during the CFC’s accounting period ending with or within the U.S. person’s tax year to the Internal Rev Services.

Category 4 filers also need to complete 5471 schedule J. 

Category 5 Filer

U.S. persons who are 10% or more shareholders in a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of its annual accounting period.

They don’t need to file the M schedule for the current year and therefore form 5471 instructions for the M schedule can be ignored. They do however need to file schedule J of the 5471 and take note of the respective instructions. 

What Category of Filer Must File Attach a Schedule M to their IRS Form 5471

Category 4 filers, as explained above, are the only one out of the 5 categories that need to complete Schedule M.

Transactions of Foreign Corporations

There are various types of different transactions that are included and reportable to the Internal revenue service on this Schedule in the current year. We recommend you refer to the instructions on Form 5471 for further details, especially in respect of a tax credit for purposes of your income tax return. 

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Transactions that Must be Disclosed on Schedule M

This Schedule requires the CFC shareholder or related party to disclose a number of different transactions to the IRS. Anyone completing this Schedule should understand that the IRS will utilize certain information disclosed on this informational return to ensure that the CFC shareholders and related parties report and pay tax on their actual share of income arising from so-called controlled transactions. The IRS, therefore, adopts the regulations under the IRC to adopt an arm’s length standard for evaluating the appropriateness of each transaction under the transfer pricing rules. 

Reporting Transactions on Schedule M

Every U.S. (Category 4 filer) must file this Schedule to report the transactions that occurred during the foreign corporation’s annual accounting period ending with or within the U.S. person’s tax year to the IRS. If a U.S. corporation has stock ownership in a foreign corporation and is a member of a consolidated group, list the common parent as the U.S. person filing this Schedule with the IRS. 

Examples:

• Distributions by way of Dividends received (exclude hybrid dividends, deemed distributions under subpart F income, and distributions of previously taxed income. 
• Distributions of Hybrid dividends 
• Distributions of Dividends paid (exclude hybrid dividends paid)
• Disposition of its stock in trade
• Premiums received for insurance or reinsurance

Columns of Schedule M

This Schedule contains six columns.

The preparer of this Schedule should enter the totals in part I for each type of translation listed under column (a) that occurred during the prior year’s annual accounting period being disclosed on the Form 5471 by the CFC and the persons listed in columns (b) through (f). 

All amounts must be stated in U.S. dollars translated from functional currency (functional currency refers to the main currency used by a business or unit of a business) at the average exchange rate for the foreign corporation.
Columns (b) through (f) are broken down as follows:

(b) U.S. person filing this return

If the CFC entered into a transaction or transactions with the U.S. person filing the Form 5471, the transactions must be listed under this column.

(c) Any domestic corporation or partnership controlled by a U.S. person filing this return

If the CFC entered into a transaction or transactions with a domestic corporation or partnership controlled by a U.S. person, the transactions must be listed under this column.

(d) Any other foreign corporation or partnership controlled by a U.S. person filing this return

If the CFC entered into a transaction or transactions with a foreign corporation or partnership controlled by a U.S. person, the transactions must be listed under this column.

(e) A U.S. shareholder with 10% or more of a CFC (other than the U.S. person filing Form 5471)

If the CFC entered into a transaction or transactions with a 10% or more U.S. shareholders of a CFC (domestic corporation for example) with an individual who is a 10% shareholder, but not a U.S. person, the transactions must be reported under this column.

(f) The 10%-or-more U.S. shareholder of any corporation controlled the foreign corporation

If the CFC entered into a transaction or transactions with a 10% or more U.S. shareholder of a CFC, the transactions must be reported under this column.  

Methods for Estimating an Arm’s Length Charge for Transfers of Tangible Property

Comparable Uncontrolled Price Method

The first method is characterized as the “comparable uncontrolled price method,” referred to as the “CUP” method. The basic approach is to examine comparable sales where the parties are unrelated. 

Resale Method

The second is the “resale price method.” In terms of this method, the price for the controlled transaction is equal to the resale price to an uncontrolled buyer less an “appropriate gross profit.” The appropriate gross profit is determined by multiplying the applicable resale price by the “gross profit margin” (expressed as a percentage of total revenue (rev) derived from sales) earned in comparable uncontrolled transactions. 

Cost Plus Method

The third method is the “cost-plus method.” In terms of this method, the transfer price is generally equal to the cost of production plus an amount determined by the application of a “gross profit markup” to that cost.

The Comparable Profits Method

The fourth is the “comparable profits method” (“CPM”). This method determines an arm’s length result based on profit level indicators derived from similarly situated uncontrolled taxpayers. 

Profit Split Method

The fifth is the “profit split method.” This method evaluates whether the allocation of the combined operating profit attributable to a controlled transaction is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined profit.  

The Unspecified Method

The sixth is the “unspecified method,” described in Treasury Regulation Section 1.482-3(e)(1). The method selected is to be applied in accordance with Treasury Regulation Section 1.482-1 and should take into account the general principle that all of the “realistic alternatives” should be considered when valuing these transactions.

Comparable Uncontrolled Transaction Method

The comparable uncontrolled method (“CUT”) is similar to the CUP method used for transfers of tangible property. Therefore, under the CUT method, the arm’s length charge for the transfer of an intangible is the amount charged for comparable intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. 

Comparable Profits Method

The same comparable profits methods used to determine arm’s length prices for transfers of tangible property can be used to determine arm’s length sales prices or royalty/rent rates for transfers of intangible property. 

Schedule M Reporting Requirements

This schedule requires the Controlled Foreign Corporation shareholder or related party to disclose a number of different transactions to the IRS. 

Additional Schedule M Form 5471 Instructions Tips

• Every U.S. person described in Category 4 must file Schedule M to report the transactions that occurred during the foreign corporation’s annual accounting period ending with or within the U.S. person’s tax year.
• If a U.S. corporation that owns stock in a foreign corporation is a member of a consolidated group, list the common parent as the U.S. person filing Schedule M. It is important to note that you translate the amounts from functional currency to U.S. dollars, by using the average exchange rate for the foreign corporation’s tax year. See IRC section 989(b).
• Report the exchange rate in the entry space provided at the top of Schedule M using the “divide-by convention” specified under Reporting exchange rates on Form 5471, earlier.