Module 8
Multijurisdictional Taxation and Transfer Taxes
A. State and Local Taxes
While businesses deal with a single federal tax code, there are different tax codes
for each state in which they are required to pay taxes. This makes state tax research
particularly challenging. State tax agencies (such as the California Franchise Tax Board
and the New#York Department of Finance and Taxation) administer the law and
promulgate regulations for their particular states.3 State and federal courts interpret the
law when a state’s tax authority and businesses cannot agree on its interpretation or
constitutionality. Because of constitutionality questions, judicial law plays a significantly
more important role in state tax law than in federal tax law.
The most important question Wild West, or any other business, must answer is
whether it is subject to a state’s taxing regime. The answer depends on the business’s
state of commercial domicile and whether the business has nexus in that
state.#Commercial domicile is the state where a business is headquartered and directs its
operations; this location may be different from the place of incorporation.4 A business
must always collect and remit sales tax from its customers and pay income tax in the state
where it is domiciled. Nondomiciliary businesses—businesses not domiciled or
headquartered in a state—are subject to taxing authorities only where they have nexus.
Nexus is the sufficient (or minimum) connection between a business and a state that
subjects the business to the state’s tax system. As we discuss below, the standard for sales
tax nexus is different than the standard for income tax nexus. The nexus standard varies
because the financial and administrative burdens vary across taxes. Sellers collect and
remit sales tax for administrative convenience, but the sales tax burden belongs to the
buyer in most states. In contrast, income tax is both owed and paid by the business
earning the income.
Businesses engaged in interstate commerce must also deal with income-tax
related issues. If a business meets certain requirements creating income tax nexus, it may
be required to remit income tax to that state. The general process of determining a
business’s state income tax liability is highlighted in Exhibit 23-3. We compute the state
tax base by making adjustments to federal taxable income. The adjustments are necessary
to account for differences between federal income tax laws and state income tax laws.
Then we divide the state tax base into business income and nonbusiness income. Business
income (income from business activities) is subject to apportionment among states where
income tax nexus exists, based on the extent of the business’s activities and property in
various states. Nonbusiness income (all income except business income—generally
investment income) is subject to allocation#or assignment directly to the business’s state
of commercial domicile. For states in which the business has income tax nexus, state
taxable income is the sum of the business income apportioned to that state plus the
nonbusiness income allocated to that state. The business computes its state tax liability
for that particular state by multiplying state taxable income by the state’s tax rate.
B. Sales and Use Taxes
Forty-five states and the District of Columbia impose sales taxes; Alaska,
Delaware, Montana, New Hampshire, and Oregon do not. Sales tax must be collected on
the state’s sales tax base. Generally, sales of tangible personal property are subject to the
tax. Most states also tax restaurant meals, rental car usage, hotel room rentals (often at
higher tax rates than general sales), and some services (which vary by state). Purchases of
inventory for resale are exempt from the sales tax.7 For example, Wild West’s rafting
equipment purchases for resale are exempt from sales tax because inventory is taxed
when sold, but its office furniture purchased for use in the business are taxable because
they represent final sales. Taxable items that are included in the sales tax base vary from
state to state. Many states exempt food (except prepared restaurant food) because taxing
food is considered to be regressive; that is, it imposes a proportionally higher tax burden
on lower-income taxpayers, who spend a greater proportion of their income on food and
other necessities. Most states also exempt sales of real property, intangible property, and
services. However, many states are expanding the types of services subject to sales tax in
order to increase their sales tax revenue.
Have you ever wondered why sometimes you pay sales tax on goods purchased
over the Internet and sometimes you don’t? The answer is it depends on whether the
seller has sales tax nexus. A business is required to collect sales tax from customers in a
state only if it has sales tax nexus in that state. For example, if you purchase a book from
a local bookstore you paid sales tax, but if you purchased the book from an online seller
you didn’t pay sales tax (unless you live in a state where the seller has sales tax nexus).
While Amazon now collects sales taxes in all states having sales taxes, Exhibit 23-4
explains how Amazon’s prior position on sales tax collection could result in a substantial
sales tax liability if a state successfully asserts that Amazon’s position was wrong.
Businesses that establish sales tax nexus with a state but fail to properly collect sales tax
can create significant liabilities that may need to be disclosed for financial reporting
purposes.9 As a result, understanding when a business has sales tax nexus can be
extremely important for profitability, business modeling, and compliance.
The physical presence requirement is a judicial interpretation of the Commerce
Clause of the U.S. Constitution. Designed to encourage interstate commerce, this clause
gives Congress power “to regulate Commerce with foreign Nations, and among the
several States, and with the Indian Tribes.” Because Congress has never exercised its
right, the courts have determined the sales tax nexus threshold. In National Bellas Hess,
the U.S. Supreme Court held that an out-of-state mail-order company did not have a sales
tax collection responsibility because it lacked physical presence (even though it mailed
catalogs and advertised in the state).11 The mail-order industry used this decision as a
competitive advantage for several decades. In Quill, the U.S. Supreme Court reaffirmed
that out-of-state (nondomiciliary) businesses must have a physical presence in the state
before the state may require a business to collect sales tax from in-state customers.
Typically, sellers with sales tax nexus collect customers’ sales tax liabilities. For
example, Wild West collects sales tax on river rafting equipment it sells from its retail
store but not on river guiding services it provides. If the seller doesn’t have sales tax
nexus, then the customer is responsible for remitting a use tax (at the same tax rate as
sales tax) to the state in which the property is used. If the buyer is charged a sales tax in
another state, the buyer will have a use tax liability for an incremental amount if the state
where the property is used has a higher sales tax rate.
C. Income Taxes
Forty-six states impose an income tax on corporations; only Nevada, South
Dakota, Washington, and Wyoming do not.15 Forty-three states tax income from
partnerships and S corporations. This chapter focuses on C corporations, but the same
principles apply to flow-through entities.16 Most states imposing income-based taxes
conform to an entity’s federal tax status. For example, an S corporation is treated by the
state as a flow-through entity. However, a few states impose minimum taxes on these
entities. For example, California imposes a minimum tax of $800 or 1.5 percent tax on
the income of all flowthrough entities: S corporations and LLCs taxed as partnerships.
Businesses must pay income tax in their state of commercial domicile (where they are
headquartered). For example, Wild West is both incorporated and domiciled in Idaho and
is therefore subject to Idaho’s income tax regime. Until a few decades ago, many
businesses believed they were virtually exempt from state income taxes in states other
than their state of commercial domicile.
Businesses must file income tax returns in states where they have income tax
nexus. However, the determination of whether the business has established income tax
nexus within a state depends on the nature of its activities in the state. Thus, the rules for
determining income tax nexus are not necessarily the same as those for determining sales
tax nexus. Physical presence creates income tax nexus for service providers, sellers of
real property, and businesses licensing intangibles. However, physical presence does not
necessarily create income tax nexus for sellers of tangible personal property if their
activities within a state are limited to certain “protected” activities as described by Public
Law 86-272.
Businesses wishing to avoid income tax nexus based on net income must sell only
tangible personal property within the state.20 Providing services along with property
violates the criteria and creates income tax nexus. For example, providing installation
services with tangible personal property exceeds solicitation and creates income tax
nexus. Businesses selling services, real property, or licensing intangibles are not
protected by Public Law 86-272. Income tax nexus for these nonprotected activities
simply requires a physical presence similar to establishing sales tax nexus. Only
nondomiciliary companies engaging in interstate commerce are protected. Orders taken
or received instate must be sent out of state—say to regional sales offices or headquarters
—for approval. The acceptance of orders in the state, or even the power to accept orders,
exceeds the protection of Public Law 86-272 and results in the business being subject to
an income tax. Accepted orders must be delivered by common carrier. Delivery using the
seller’s truck violates the criteria and creates income tax nexus, except as permitted by
state law (New Jersey, Rhode Island, and South Carolina are among the states that list
delivery by private vehicles as a protected activity).
As we have discussed, businesses must have a physical presence in a state to
establish income tax nexus with that state (Public Law 86-272 is the exception).
However, many states currently assert economic income tax nexus, without physical
presence, on businesses that have an economic presence in the state.22 South Carolina
was the first state to pursue economic income tax nexus. South Carolina disallowed the
royalty expenses of Toys ‘R’ Us South Carolina to Geoffrey (a related Delaware holding
company) rather than subject Geoffrey to the South Carolina income tax. States asserting
economic income tax nexus claim they provide an infrastructure of phone and Internet
connections to consumers (an economic base) that nonresident companies use to solicit
business (in the same way states provide roads for salespeople to visit the state’s
customers). For example, West Virginia asserted an income tax liability on a business
(MBNA Bank) that merely solicited credit card customers through advertising and phone
calls without having physical presence (employees or property) in the state. The West
Virginia Supreme Court upheld the assertion, and the U.S. Supreme Court denied
MBNA’s writ of certiorari. However, most experts believe West Virginia’s law to be
unconstitutional, and that the U.S. Supreme Court’s refusal to hear the case was designed
to urge Congress to resolve the uncertainty surrounding income tax nexus issues.
While separate tax returns are simple, the income reported on separate tax returns
can be manipulated through related-entity transactions (through transfer pricing, for
example). Another important planning technique is the use of passive investment
companies (PICs), in which a company simply creates a subsidiary and transfers
ownership of its trademarks and patents to an entity within a state that does not tax
royalties, interest, and other similar types of intangible income (such as Delaware or
Nevada). The new PIC then charges a royalty for use of the intangible, which generates a
deductible business expense in the state used and creates income in a little- or no-tax state
like Delaware or Nevada. States have implemented laws to fight this type of planning,
and ten states have responded by adopting unitary filing requirements. Such “tax
planning” opportunities are not available if the related entities are required to file a
unitary tax return.
The important concept here is that companies filing a federal consolidated tax
return can be separated, and companies not filing a federal consolidated tax return can
become a unitary group.26 A unitary tax return group includes all members meeting the
unitary criteria—whether they have income tax nexus or not.27 Unitary businesses
usually have a flow of value between the various businesses. For example, raw materials
or components can flow between businesses or one entity may borrow funds from
another. The unitary concept pervades activities in the entire income tax system,
including computing taxable income, computing apportionment percentages (discussed
later in the chapter), and identifying income tax return filing requirements. The primary
difference between separate and unitary states is that separate-return states tax the entire
apportioned income of each separate business unit with income tax nexus while unitary-
return states tax the entire unitary group using a smaller apportioned percentage.
Several states have nonincome-based taxes. Washington has the Business &
Occupation Tax, which is a gross receipts tax. Texas has the Margin Tax, the lesser of a
gross margin tax or gross receipts tax (many states are treating the Texas Margin Tax as a
tax based on net income). Some states imposing nonincome-based taxes treat all
businesses as taxable entities. For example, Texas imposes the Margin Tax on C
corporations, S corporations, partnerships, and sole proprietorships that have limited
liability. As we discussed earlier, Public Law 86-272 doesn’t apply to nexus for
nonincome-based taxes such as gross receipts taxes or property taxes; these are
deductible for calculating taxable income for net income-based taxes.
D. The U.S. Framework for Taxing Multinational Transactions
When a U.S. person engages in a transaction that involves a country outside the
United States, there arises the issue as to which tax authority or authorities have
jurisdiction (i.e., the legal right) to tax that transaction. All governments (national, state,
and local) must adopt a basis on which to claim the right to tax income. The criteria they
choose to assert their right to tax a person or transaction is called nexus. At the national
level, governments most often determine nexus by either the geographic source of the
income, called source-based jurisdiction, or by the taxpayer’s citizenship or residence,
called residence-based jurisdiction. Once nexus has been established, a government must
decide how to allocate and apportion a person’s income and expenses to its tax
jurisdiction. Under a residence-based approach, a country taxes the worldwide income of
the person earning the income. Under a source-based approach, a country taxes only the
income earned within its boundaries. When applying a source-based approach, a
government must develop source rules to allocate and apportion income and expenses to
its jurisdiction.
The United States applies both residence-based jurisdiction and source-based
jurisdiction in asserting its right to tax income. The U.S. government taxes citizens and
residents on their worldwide income, regardless of source (residence-based jurisdiction).7
In the Tax Cuts and Jobs Act, enacted on December 22, 2017, Congress replaced the
worldwide approach with a territorial approach for certain U.S. corporations earning
foreignsource income through specified 10 percent-or-more owned foreign corporations.
The Act establishes a participation exemption system for foreign income, under which
there is allowed a 100 percent deduction for the foreign-source portion of dividends
received by domestic corporations that are U.S. shareholders of those foreign
corporations. In contrast, the U.S. government only taxes nonresidents on income that is
“U.S. source” or is connected with the operation of a U.S. trade or business (source-based
jurisdiction).
U.S. source income earned by a nonresident is classified into two categories for
U.S. tax purposes: (1) effectively connected income (ECI) and (2) fixed and
determinable, annual or periodic income (FDAP). Income that is effectively connected
with a U.S. trade or business is subject to net taxation (i.e., gross income minus
deductions) at the U.S. tax rate. A nonresident reports such income and related
deductions on a U.S. tax return, either a Form 1120F for a nonresident corporation or a
Form 1040NR for a nonresident individual. FDAP income, which generally is passive
income such as dividends, interest, rents, or royalties, is subject to a withholding tax
regime applied to gross income. The payor of the FDAP income withholds the tax at the
statutory rate (30 percent under U.S. tax law) or less under a treaty arrangement and
remits it to the government. The recipient of the FDAP income usually does not have to
file a tax return and does not reduce the FDAP income by any deductions. Most
countries, including Canada, apply a similar tax regime to U.S. persons earning income
within their jurisdiction.
An individual who is not a U.S. citizen is characterized for U.S. tax purposes as
either a resident alien or a nonresident alien. An individual becomes a U.S. resident by
satisfying one of two tests found in the IRC.11 Under the first test, sometimes referred to
as the green card test, an individual is treated as a resident if he or she possesses a
permanent resident visa (“green card”) at any time during the calendar year. Under the
second test, sometimes referred to as the substantial presence test, an individual becomes
a U.S. resident when he or she is physically present in the United States for 31 days or
more during the current calendar year and the number of days of physical presence during
the current calendar year, plus one-third times the number of days of physical presence
during the first preceding year, plus one-sixth times the number of days of physical
presence during the second preceding year, equals or exceeds 183 days.12 As we will
discuss later in the chapter, these rules often are modified by treaties between the United
States and other countries to limit instances in which an individual might be taxed as a
resident by more than one country.
E. U.S. Source Rules for Gross Income and Deductions
Many of the U.S. tax rules that apply to multinational transactions require
taxpayers to determine the jurisdictional (geographic) source (U.S. or foreign) of their
gross income.15 The source rules determine whether income and related deductions are
from sources within or without the United States. All developed countries have source-
ofincome rules, although most practitioners consider the U.S. rules to be the most
complex in the world. The U.S. source-of-income rules are important to non-U.S. persons
because they limit the scope of U.S. taxation to only their U.S. source income. For U.S.
persons, the primary purpose of the U.S. source-of-income rules is to calculate foreign
source taxable income in the numerator of the foreign tax credit limitation. Except in the
case of dividends eligible for the 100 percent dividends received deduction, the United
States imposes a tax on the worldwide income of U.S. persons, regardless of its source or
the U.S. person’s residence.
U.S. persons must understand the source-of-income rules in other situations. For
example, U.S. citizens and residents employed outside the United States may be eligible
to exclude a portion of their foreign source earned income from U.S. taxation under
§911.16 In addition, U.S. persons who pay U.S.-source FDAP income to foreign payees
(e.g., interest or dividends) usually are required to withhold U.S. taxes on such
payments.17 U.S. corporations earning “foreign-derived intangible income” (FDII)
receive a 37.5 percent deduction on such income that reduces the effective tax rate on
such income to 13.125 percent. U.S. corporations receive a 100 percent DRD on the
“foreign-source portion” of dividends received from 10 percent-or-more owned foreign
corporations. (These later two situations were added by the Tax Cuts and Jobs Acts and
will be discussed later in the chapter.) The source-of-income rules are definitional in
nature; they do not impose a tax liability, create income, or allow a deduction. Although
the primary focus of the source rules is on where the economic activity that generates
income takes place, the U.S. government also uses the source rules to advance a variety
of international tax policy objectives.
As a general rule, the taxpayer looks to the residence of the party paying the
interest (the borrower) to determine the geographic source of interest received. A
borrower’s residence is established at the time the interest is paid. Factors that determine
an individual’s residence include the location of the individual’s family; whether the
person buys a home, pays foreign taxes, and engages in social and community affairs;
and the length of time spent in a country. Under these general rules, interest income is
U.S. source if it is paid by the United States or the District of Columbia, a noncorporate
U.S. resident, or a U.S. corporation. Although interest income paid by a U.S. bank to a
nonresident (e.g., an international student attending a U.S. university) is U.S.-source
income, such interest is exempt from U.S. withholding or other income taxation.20 This
exception is designed to attract foreign capital to U.S. banks.
The United States frequently alters the limitations on length of stay and
compensation through treaty agreements. In most cases, the 90-day limit is extended to
183 days, and no dollar limit is put on the amount of compensation received.
Compensation for services performed within and outside of the United States must be
allocated between U.S. and foreign sources. An individual who receives compensation,
other than compensation in the form of fringe benefits, as an employee for labor or
personal services performed partly within and partly outside the United States is required
to source such compensation on a time basis. An individual who receives compensation
as an employee for labor or personal services performed partly within and partly outside
the United States in the form of fringe benefits (e.g., additional amounts paid for housing
or education) is required to source such compensation on a geographic basis; that is,
determined by the employee’s principal place of work.
After determining the source of gross income as being from U.S. or foreign
sources, a taxpayer may be required to allocate and apportion allowable deductions to
gross income from each geographical source to compute taxable income from U.S. and
foreign sources. For a U.S. taxpayer, this allocation and apportionment process identifies
the foreign source deductions that are subtracted from foreign source gross income in
computing foreign source taxable income in the numerator of the FTC limitation
computation. A non-U.S. taxpayer with gross income that is effectively connected with a
U.S.#trade or business must identify the U.S. source deductions that are subtracted from
U.S. gross income to compute U.S. taxable income.
Special apportionment rules apply to nine categories of deductions, most notably
interest, research and experimentation, state and local income taxes, losses on property
disposition, and charitable contributions.25 These special apportionment rules are very
complicated, and the details are beyond the scope of this text. The basic rules for interest
expense and research and experimentation are discussed below. Interest expense is
allocated to all gross income using as a basis the assets that generated such income.
Interest is apportioned based on average tax book value for the year. Assets are attributed
to income based on the source and type of income they generate, have generated, or may
reasonably be expected to generate. A taxpayer using the tax book value method can elect
to use the alternative depreciation system on U.S. assets solely for purposes of
apportioning interest expense.
Research and experimentation (R&E) expenditures must be apportioned between
U.S. and foreign source income using either a sales method or a gross income method.
Taxpayers can apportion a percentage of R&E expenditures based on where the research
is conducted. The amount that can be sourced under this exclusive apportionment method
is 50 percent if the sales method is elected and 25 percent if the gross income method is
elected. State and local income taxes are allocated to the gross income with respect to
which such state income taxes are imposed. Charitable contributions and the dividends
received deductions generally are allocated to U.S. source income. The allocation and
apportionment rules of these deductions are complex and beyond the scope of this text.
The foreign tax credit limitation is computed on Form 1118 (corporations) or Form 1116
(individuals). Exhibit 24-1 presents a completed Form 1118 for the cumulative facts in
Examples 24-8 and 24-9. Note that the Form 1118 is for tax year 2017 because the
revised form for the Tax Cuts and Jobs Act changes was not available when this chapter
went to press. The 2017 form does not include the new FTC basket for foreign branch
income. The branch income was put in the general limitation basket for this exhibit.
F. Operating Abroad through a Foreign Corporation
The Tax Cuts and Jobs Act made significant changes to the taxation of foreign
source income earned through foreign corporations owned 10 percent or more by
domestic corporations that meet the definition of a U.S. shareholder. U.S. shareholders
for this purpose are U.S. corporations owning 10 percent or more of the voting power and
value of the foreign corporation. Such foreign source income, to the extent it is not
subject to the deemed dividend rules of subpart F (to be discussed later), is eligible for a
100 percent dividends received deduction (participation exemption) when distributed to a
domestic corporation that meets the definition of a U.S. shareholder.26 Any foreign
income taxes paid on income eligible for the exemption are not creditable or deductible
on the U.S. shareholder’s U.S. tax return. The enactment of this participation exemption
moves the United States toward a territorial tax system, and puts the United States in line
with most other countries in the taxation of foreign source active trade or business
income.
The Tax Cuts and Jobs Act gave U.S. producers of goods and services an
incentive to manufacture such products in or provide such services from the United
States, and to hold intellectual property in the United States. For tax years beginning after
December 31, 2017, gross profit derived from certain export sales or services, referred to
as foreign-derived intangible income (FDII), is eligible for a deduction equal to 37.5
percent of FDII, which reduces the effective tax rate imposed on such income to 13.125
percent (21 percent × 62.5 percent).27 The computation of FDII is extremely complex, as
are many of the international tax provisions enacted in the new tax law. In general terms,
the deduction applies to income from sales of property intended for foreign use or
services provided to any person or with respect to property not located in the United
States in excess of a “normal return” on U.S. assets used in the production of the product
or services. A normal return is defined as 10#percent of qualified business asset
investment (QBAI), which is defined as the tax basis of depreciable property used in the
production of the products sold (both to U.S. and foreign customers), assuming straight-
line depreciation.
A tax treaty is a bilateral agreement between two contracting countries in which
each#agrees to modify its own tax laws to achieve reciprocal benefits. The general
purpose of an income tax treaty is to eliminate or reduce the impact of double taxation so
that residents paying taxes to one country will not have the full burden of taxes in the
other country. The United States signed its first income tax treaty with France in 1939.
The United States now has income tax treaties with 67 countries. Exhibit 24-2 provides a
list of the countries with which the United States has income tax treaties. U.S. treaties
generally do not affect the U.S. taxation of U.S. citizens, residents, and domestic
corporations because such taxpayers are taxed on a worldwide#basis.
Treaties reduce or eliminate the tax on income earned in one contracting country
by a resident of the other contracting country. For example, most U.S. treaties provide a
low withholding tax rate or an exemption from tax on various types of investment income
(interest, dividends, gains from sale of stock, and royalties) that otherwise would be
subject to a high withholding tax.28 For individuals, U.S. treaties often provide
exemption from taxation by the host country on wages or self-employment income
earned in the treaty country, provided the individual does not spend more than 183 days
in that other country. U.S. businesses generally are not taxed on business profits earned in
the host treaty country unless they conduct that business through a permanent
establishment. A permanent establishment generally is a fixed place of business such as
an office or factory, although employees acting as agents can create a permanent
establishment. Treaties also provide “tiebreaker” rules for determining the country in
which an individual will be considered a resident for treaty purposes.
G. Foreign Tax Credits
The United States taxes the worldwide income of U.S. partnerships, trusts and
estates, U.S. citizens, and resident aliens. U.S. corporations continue to be taxed on all
income other than dividends received from foreign corporations eligible for the 100
percent dividends received deduction. As we have discussed, U.S. persons earning
foreign source income may be subject to multiple taxation on such income by the United
States and the country in which the individual resides or where the income is earned. For
example, a U.S. citizen who earns income in France may be subject to taxation by both
governments. Without any relief from such multiple taxation, U.S. taxpayers would have
little incentive to do business outside the United States.
As a policy matter, the U.S. government must decide whether, and to what extent,
U.S. taxpayers should segregate foreign source income subject to different tax rates and
compute a separate FTC limitation for each category of income. Since 1976, the United
States has required persons claiming the foreign tax credit to segregate foreign source
income by category of income. Practitioners often refer to each income category as an
FTC basket. Prior to the Tax Cuts and Jobs Act, there were two primary categories of
FTC income, passive category income and general category income.30 The Tax Cuts and
Jobs Act added two more categories for foreign branch income and global intangible low-
taxed income (GILTI), a new category of subpart F income to be discussed later in the
chapter. The “basket” approach is intended to limit blending opportunities (high-tax
foreign source income and low-tax foreign source income) to income that is of the same
character.
The foreign tax credit is available only for foreign taxes the United States
considers to be income taxes “in the U.S. sense.” In general, a tax “resembles” the U.S.
concept of an income tax when it is applied to net income.31 Taxes that do not qualify as
income taxes include property taxes, customs taxes, sales taxes, and value-added taxes.
U.S. taxpayers can deduct noncreditable foreign taxes. On an annual basis, U.S. taxpayers
also can elect to deduct foreign income taxes in lieu of claiming the credit. This election
might make sense if the taxpayer does not expect to be able to use the credit during the
10-year carryforward period. Foreign taxes generally are translated into U.S. dollars
using the average exchange rate for the year, regardless of when the tax is actually
paid.32 U.S. taxpayers can elect to translate withholding taxes using the exchange rate on
the day the tax is withheld. This election makes translation of the withholding tax
consistent with the translation of the payment (dividend, interest, royalty) into U.S.
dollars, which is done using the exchange rate on the date of payment, which is referred
to as the spot rate.
H. Planning for International Operations
The organizational form through which a U.S. person does business or invests
outside the United States affects the timing and scope of U.S. taxation of foreign source
income or loss reported by the business or investment. U.S. corporations conducting
international operations directly (e.g., through a branch) or through a flow-through entity
(such as a partnership) are subject to U.S. tax or receive a U.S. tax benefit currently on
income or loss from those operations. Foreign source income earned by a foreign
corporation owned by U.S. persons (e.g., a Canadian subsidiary of a U.S. corporation)
generally is not subject to U.S. taxation until such income is repatriated to the U.S.
shareholder as interest, rent, royalty, or a management fee (i.e., U.S. taxation of such
income is deferred to a future period). Dividends paid to domestic corporations from 10-
percent-or-more owned foreign corporations are exempt from U.S. taxation because they
are eligible for a 100% dividends received deduction.
Each organizational form offers a U.S. person investing abroad with advantages
and disadvantages. Most U.S. businesses operate abroad through either a subsidiary or
hybrid entity. Corporation status provides the U.S. investor with protection against
liabilities of the subsidiary, entitles the subsidiary to treaty benefits in its dealings outside
the country of incorporation, and insulates the subsidiary’s business income from U.S.
taxation until such income is repatriated back to the United States. Conversely, losses
incurred in the subsidiary are not currently deductible on the investor’s U.S. tax return.
Through regulations, the U.S. Treasury allows U.S. taxpayers to elect the U.S. tax
status of eligible entities by checking the box on Form 8832. Where the U.S. person owns
100#percent of the entity, he or she can choose corporation status or branch status; the
latter often is referred to as a disregarded entity because it is disregarded for U.S. tax
purposes. Where more than one U.S. person owns the entity, the taxpayers can choose
corporation status or partnership status. Such an entity is referred to as a hybrid entity. A
multiple-person-owned hybrid entity for which corporation status is elected is referred to
as a reverse hybrid entity. Certain designated “per se” foreign entities are not eligible for
this elective treatment. These ineligible entities tend to be entities that can be publicly
traded in their host countries (e.g., a German A.G., Dutch N.V., U.K. PLC, Spanish S.A.,
or Canadian corporation). The entire list is printed in the Instructions to Form 8832. In
Canada, a U.S. corporation or individual must operate through an unlimited liability
company (ULC) organized under the laws of Nova Scotia, Alberta, or British Columbia
to achieve the benefits of operating through a hybrid entity.
Hybrid entities offer U.S. investors much flexibility in avoiding the U.S. anti-
deferral rules found in subpart F, which we discuss in the next section. However, there
are drawbacks to operating through a hybrid entity. In particular, a hybrid entity
organized outside the United States may not be eligible for treaty benefits because it is
not recognized as a resident of the United States by the host country. For example, the
U.S.–Canada treaty does not extend treaty benefits to distributions from a ULC to its U.S.
investors. Distributions from a Nova Scotia ULC to its U.S. parent company in the form
of dividends or royalties will be subject to a 25 percent withholding tax instead of a 5
percent or 10 percent withholding tax, respectively, under the U.S.–Canada treaty.
Exhibit 24-3 lists the advantages and disadvantages of operating outside the United States
through different organizational forms.
I. U.S. Anti-Deferral Rules
Deferral of U.S. taxation on all foreign source income earned through a foreign
subsidiary would invite tax-planning strategies that shift income to low-tax countries to
minimize worldwide taxation. U.S. individuals and corporations could transfer
investment assets to subsidiaries located in low- or no-tax countries, called tax havens,
and earn low-tax or tax-exempt income until such time as the money was repatriated to
the United States. The United States has debated whether to allow full deferral on all
foreign earnings since 1937, when the U.S. government enacted its first “anti-deferral”
rules applying to foreign personal holding companies. Congress, with urging from
President Kennedy, enacted more expansive anti-deferral rules in subpart F of subchapter
N of the Internal Revenue Code in 1962.
In a nutshell, subpart F requires certain U.S. shareholders in a controlled foreign
corporation (CFC) to include in their gross income their pro rata share of specified
categories of “tainted” income earned by the CFC during the current year—called subpart
F income—regardless of whether such income is repatriated as a dividend (the income is
treated as if it were paid out to the shareholders as a deemed dividend at the end of the
CFC’s taxable year). The deemed dividend is translated into U.S. dollars using the
average exchange rate for the year. The technical rules that determine the amount of the
deemed dividend to be included in income are among the most complex provisions in the
Internal Revenue Code.
A controlled foreign corporation (CFC) is defined as any foreign corporation in
which U.S. shareholders collectively own more than 50 percent of the total combined
voting power of all classes of stock entitled to vote or the total value of the corporation’s
stock on any day during the CFC’s tax year.36 For purposes of subpart F, a U.S.
shareholder is any U.S. person who owns or is deemed to own 10 percent or more of the
voting power or value of the corporation’s stock.37 The term United States person means
a citizen or resident of the United States, a domestic partnership, a domestic corporation,
or any U.S. estate or trust, but it excludes certain residents of U.S. possessions.
Constructive ownership rules are used in the calculation of both the 50 percent test for
determining CFC status and the 10 percent test for determining who is a U.S.
shareholder.38 These rules are similar to the constructive ownership rules found in
section 318 (see the Corporate Taxation: Nonliquidating Distributions chapter) and
include family attribution (spouse, children, grandchildren, and parents), entity-to-owner
attribution, and owner-to-entity attribution. A detailed discussion of the other attribution
rules is beyond the scope of this text.
Subpart F income generally can be characterized as low-taxed passive income or
as “portable” income earned by a CFC. Passive income, otherwise referred to as foreign
personal holding company income, includes interest, dividends, rents, royalties, annuities,
gains from the sale of certain foreign property, foreign currency exchange rate gains, net
income from certain commodities transactions, and income equivalent to interest. There
are complex exceptions involving payments between CFCs in the same country, export
financing interest, and rents and royalties derived in the active conduct of a trade or
business. Subpart F income does not include dividends, interest, rents, and royalties
received by one CFC from a related CFC to the extent the payment is attributable to non-
subpart F income of the payor (the taxpayer “looks through” the payment to the income
from which it was paid).
Also included in subpart F income is foreign base company sales income, which
is defined as income derived by a CFC from the sale or purchase of personal property
(e.g., inventory) to or from a related person, (a U.S. shareholder owning more than 50%
of the CFC or a corporation owned more than 50% by the CFC) when the property is
manufactured and sold outside the CFC’s country of incorporation.40 Similar rules apply
to foreign base company services income. This category of subpart F income was added
because many countries offer incentives to multinational corporations to locate holding
companies or sales companies within their borders by imposing no or a low tax on
investment income or export sales. These companies are referred to as base companies
because they operate primarily as profit centers and are located in a different country than
where the economic activity (manufacture, sales, or service) takes place.
The computation of the deemed dividend under subpart F is exceptionally
complicated and requires the CFC to allocate both deductions and taxes paid to subpart F
gross income. The formula for this computation can be found in worksheets in the
Instructions to Form 5471. In addition, the U.S. shareholder receives a foreign tax credit
for income taxes paid on the subpart F income.41 Earnings of the CFC treated as a
deemed dividend under subpart F become previously taxed income and subsequently can
be distributed to the shareholders without being included in the recipient’s gross income a
second time. A foreign currency gain or loss on repatriation of such income is included in
(deducted from) the shareholders’ income. Non-subpart F income (that is, income
otherwise eligible for deferral) that is invested in U.S. property (for example, a loan from
the CFC to its U.S. shareholder or stock in the U.S. parent) can be treated as a deemed
dividend under the subpart F rules. This rule is intended to prevent U.S. corporations
from borrowing money from their foreign subsidiaries on an indefinite basis, which
would take the form of a disguised dividend.
U.S. multinational corporations expanding outside the United States often use
hybrid entities as a tax-efficient means to avoid the subpart F rules. Tax aligning a U.S.
corporation’s international supply chain has become a frequent objective in international
tax planning. Accomplishing this goal requires the formation of a foreign holding
company (Foreign HoldCo) treated as a corporation for U.S. tax purposes (and thus
eligible for deferral from U.S. taxation). The holding company owns the stock of hybrid
entities set up to conduct each of the components of the company’s foreign operations:
financing (FinanceCo), manufacturing (OpCo), distribution (DistribCo), and intellectual
property (IPCo). The holding company is strategically located in a country that lightly
taxes dividend income paid by the hybrid entities. The hybrid entities also are
strategically located in countries that tax the income from such operations (e.g., interest
or royalties paid by the operating company to the finance company or intellectual
property company) at a low tax rate.
For instance, Ireland taxes manufacturing and intellectual property income at 12.5
percent. Because these operations are conducted through hybrid entities, transactions
between the entities (e.g., payments of interest, rents, or royalties from one entity to
another), which otherwise would create subpart F income, are ignored for U.S. tax
purposes but respected for foreign tax purposes, because the hybrid entity is treated as a
corporation in the country in which it is organized. This allows for the free flow of cash
between foreign operations without the intrusion of the U.S. tax laws and the reduction of
taxes in high-tax countries through cross-border payments that are deductible in the
country in which the hybrid entity is located. Exhibit 24-5 illustrates a template for such
an international operation.
J. Base Erosion and Profit Shifting Initiatives around the World
The Organization for Economic Cooperation and Development (OECD) has
embarked on a “base erosion and profit shifting” (BEPS) initiative that has, as its goal, to
provide “governments with solutions for closing the gaps in existing international rules
that allow corporate profits to ‘disappear’ or be artificially shifted to low/no tax
environments, where little or no economic activity takes place.” This initiative, which
began in 2013, was prompted by estimates that governments around the world were
losing between $100 and $240 billion per year in tax revenues due to aggressive tax
planning by multinational corporations. The OECD issued 15 “actions” in October 2015
that focused on transfer pricing, harmful tax practices, and treaty shopping and urged
more transparent reporting (“country-by-country reporting” of income and taxes paid).
Adoption of these actions by governments around the world will dramatically change the
way multinational corporations plan their international operations and develop their
information systems, as well as the way taxing agencies audit the tax returns filed by
these corporations.
Consistent with the BEPS objectives, Congress added a Base Erosion and Anti-
Abuse Tax (BEAT) minimum tax in the Tax Cuts and Jobs Act. Corporations with annual
average gross receipts of at least $500 million for the three tax-year periods ending with
the preceding tax year are required to pay a minimum tax amount (10% (5% in the case
of taxable years beginning in calendar year 2018 and 12.5 percent for tax years beginning
after December 31, 2025) of the corporation’s modified taxable income over the
corporation’s regular tax liability) on cross-border outbound payments such as interest,
royalties, and rents.43 The BEAT serves as a minimum tax on outbound payments made
by U.S. corporations to related foreign parties that reduce the U.S. tax base. The BEAT
only applies when the “base erosion” deductions exceed three percent of total deductions.
The details of this new tax are beyond the scope of this text.
In addition, the European Union has aggressively gone after U.S. multinational
companies for special arrangements with low-tax countries such as Ireland and
Luxembourg that lowered the tax paid in these countries through transfer pricing. The
European Commission ruled in September 2016 that Apple, Inc., had received more than
$14.5 billion of “illegal” tax benefit from Ireland and demanded that the Irish government
recoup these lost taxes. While Apple, Inc., said it would look to overturn the decision, the
company noted in its fiscal 2017 Form 10-K that it expected to get a foreign tax credit on
its U.S. tax return if it had to pay the tax. The real loser in this ruling could very well be
the U.S. Treasury!
K. Federal Transfer Taxes
In 1916 Congress imposed an estate tax on transfers of property at death.
Transfers at death are dictated by the last will and testament of the deceased and such
transfers are called testamentary transfers. The transfer tax system was expanded in 1924
to include a gift tax on lifetime transfers called inter vivos transfers (inter vivos is from
the Latin meaning “during the life of”). Eventually, a generation-skipping tax was also
added to prevent people from avoiding taxes by transferring assets to younger generations
(making transfers to grandchildren rather than to children).1 Together, this trio of taxes
represents one way of reducing the potential wealth society’s richest families might
accumulate over several generations. (Recall that neither gifts nor inheritances are
included in recipients’ gross income.)
The two primary federal transfer taxes, the gift tax and the estate tax, were
originally enacted separately and operated independently. In 1976 they were unified into
a transfer tax scheme that applies a progressive tax rate schedule to cumulative transfers.
In other words, the gift and estate taxes now are integrated into a common formula. This
integrated formula takes into account the cumulative effect of transfers in previous
periods when calculating the tax on a (gift) transfer in a current period. Likewise, it takes
lifetime transfers into account to compute the tax on assets transferred at death. As you’ll
see in the tax formulas, we add the taxable transfers in prior years to the currentyear
transfers and compute the tax on total (cumulative) transfers. Then we subtract the tax on
the prior-year transfers from the total tax, to avoid taxing them twice. This calculation
ensures that the current transfers will be taxed at a marginal tax rate as high or higher
than the rate applicable to the prior-year transfers.#Exhibit 25-1 presents the unified
transfer tax rate schedule for estate and gift taxes that has been in effect since 2013.
The second common feature of the integrated transfer taxes is the applicable
credit. This credit, previously known as the unified credit, was enacted in 1977, and it
applies to both the gift tax and the estate tax. The credit is designed to prevent the
application of transfer tax to taxpayers who either would not accumulate a relatively large
amount of property transfers during their lifetime and/or would not have a relatively large
transfer passing to heirs upon their death. The value of cumulative taxable transfers a
person can make without exceeding the applicable credit is called the exemption
equivalent or, alternately, the#applicable exclusion amount.
A third common feature of the unified tax system is the application of two
common deductions. Each transfer tax provides an unlimited deduction for charitable
contributions and a generous marital deduction for transfers to a spouse. The marital
deduction allows almost unfettered transfers between spouses, treating a married couple
as virtually a single taxpayer. A final important feature of the transfer taxes is the
valuation of transferred property. Property transferred via gift or at death is valued at fair
market value. While fair market value is simple in concept, it is very complicated to
apply.
L. The Federal Gift and Estate Tax
The gift tax is levied on individual taxpayers for all taxable gifts made during a
calendar year. As explained shortly, each individual (married couples cannot elect joint
filing for gift tax returns) who makes a gift in excess of the annual exclusion amount
must file a gift tax return (Form 709) by April 15 of the following year.2 Exhibit 25-3
presents the complete formula for the federal gift tax in two parts. In the first part, taxable
gifts are calculated for each donee, and in the second, the gift tax is calculated using
aggregate taxable gifts to all donees.
The gift tax is imposed on lifetime transfers of property for less than adequate
consideration. Typically, a gift is made in a personal context such as between family
members. The satisfaction of an obligation is not considered a gift. For example, tuition
payments for a child’s education satisfy a support obligation. On the other hand, transfers
motivated by affection or other personal motives, including transfers associated with
marriage, are gratuitous and potentially subject to the tax. The gift tax is imposed once a
gift has been completed, and this occurs when the donor relinquishes control of the
property and the donee accepts the gift.3 For example, deposits made to a joint bank
account are not complete gifts because the donor (depositor) can withdraw the deposit at
any time. The gift will be complete at the time the donee withdraws cash from the
account.
There are several important exceptions to the taxation of complete gifts. For
example, political contributions are not gifts. Also, the payment of medical or educational
expenses on behalf of another individual is not considered a gift if the payments are made
directly to the health care provider or to the educational institution. To avoid confusing a
division of property with a gift, a transfer of property in conjunction with a divorce is not
considered to be a gift (it is treated as a transfer for adequate consideration) if the
property is transferred within three years of the divorce under a written property
settlement. In addition, special rules apply to transfers of certain types of property. To
make a complete gift of a life insurance policy, the donor must give the donee all the
incidents of ownership, including the power to designate beneficiaries. An individual
who creates a joint tenancy—either a tenancy in common or joint tenancy with right of
survivorship— with someone who does not provide adequate consideration for their
interest in the property is deemed to make a gift at that time. The gift is the amount
necessary to pay for the other party’s interest in the property. For example, suppose the
donor pays $80,000 toward the purchase of $100,000 in realty held as equal tenants in
common with the donee (i.e., the donee provides only $20,000 of the purchase price).
The donor is deemed to make a gift of $30,000 to the donee, the difference between the
value of the joint interest ($100,000 ÷ 2 = $50,000) and the consideration provided by the
donee ($20,000).
Assigning value to unique property is difficult enough, but sometimes we must
also assign a value to a stream of payments over time or a payment to be made in the
future. The right to currently enjoy property or receive income payments from property is
called a present interest. In contrast, the right to receive income or property in the future
is called a future interest. A present right to possess and/or collect income from property
may not be permanent; if granted for a specific period of time or until the occurrence of a
specific event, it is a terminable interest. For example, the right to receive income
payments from property for 10 years is a terminable interest. A right to possess property
and/or receive income for the duration of someone’s life is called a life estate. The person
whose life determines the duration of the life estate is called the life tenant.
At the end of a terminable interest, the property will pass to another owner, the
person holding the future interest. In a reversion, it returns to the original owner. If it
goes to a new owner, the right to the property is called a remainder and the owner is
called a remainderman. For example, the right to own property after a 10-year income
interest has ended is a future interest held by the remainderman. The right to property
after the termination of a life estate is also called a remainder. Future interests are
common when property is placed in a trust. Trusts are legal entities established by a
person called the grantor. Trusts are administered by a trustee and generally contain
property called the trust corpus. The trustee has a fiduciary duty to manage the property
in the trust for the benefit of a beneficiary or beneficiaries. This duty requires the trustee
to administer the trust in an objective and impartial manner and not favor one beneficiary
over another.
One of the most important aspects of the gift tax is the annual exclusion, which
operates to eliminate “small” gifts from the gift tax base. The amount of the exclusion has
been revised upwards periodically over the years and is now indexed for inflation.7 In
2018, the annual exclusion amount is $15,000. The annual exclusion is available to offset
gifts made to each donee regardless of the number of donees in any particular year. For
example, a donor could give $15,000 in cash to each of 10 donees every year without
exceeding the annual exclusion. One important limitation to the annual exclusion is that it
applies only to gifts of present interests; that is, a gift of a future interest is not eligible for
an annual exclusion.
In part 1 of the formula in Exhibit 25-3, current gifts are accumulated for each
donee, and this amount includes all gifts completed during the calendar year for each
individual. Current gifts do not include transfers exempted from the tax, such as political
contributions. Several adjustments are made to calculate current taxable gifts for each
donee. As we’ve seen, each taxpayer is allowed an annual exclusion applied to the
cumulative gifts of present interests made during the year to each donee. Next, if a
married couple elects to split gifts (discussed below), half of each gift is included in the
current gifts of each spouse. The marital deduction for gifts to spouses and the charitable
deduction for gifts to charity are the last adjustments to calculate taxable gifts for each
donee. We discuss each in turn.
Besides increasing the application of the annual exclusion, a gift-splitting election
also increases the likelihood that taxable gifts will be taxed at lower tax rates or any gift
tax will be offset by applicable credits. To utilize gift-splitting, each spouse must be a
citizen or resident of the United States, be married at the time of the gift, and not remarry
during the remainder of the calendar year. Both spouses must consent to the election by
filing a timely gift tax return. Taxpayers make this election annually and can apply it to
all gifts completed by either spouse during the calendar year. As a result of the election,
both spouses share a joint and several liability for any gift tax due.
The marital deduction was originally enacted to equalize the treatment of spouses
residing in common-law states. In community-property states, the ownership of most
property acquired during a marriage is automatically divided between the spouses. In
common-law states, one spouse can own a disproportionate amount of property if he or
she earns most of the income. Absent the marital deduction, in a common-law state, a
transfer between the spouses to equalize the ownership of property would be treated as a
taxable gift. However, because transfers to spouses are eligible for a marital deduction,
no taxable gift results from such a transfer. The marital deduction is subject to two limits.
First, the amount is limited to the value of the gift after the annual exclusion. Second,
transfers of nondeductible terminable interests do not qualify for a marital deduction. A
nondeductible terminable interest is a property interest transferred to the spouse that
terminates when some event occurs or after a specified amount of time, when the
property is transferred to another.
The amount of the charitable deduction is also limited to the value of the gift after
subtracting the annual exclusion. Requirements for an organization to qualify as a charity
for purposes of the gift tax charitable deduction are quite similar to those for the income
tax deduction (the entity must be organized for religious, charitable, scientific,
educational, or other public purposes, including governmental entities). Unlike the
income tax deduction, however, the charitable deduction has no percentage limitation. In
addition, as long as the qualifying charity receives the donor’s entire interest in the
property, no gift tax return need be filed (assuming the donor has no other taxable gifts).
Finally, a transfer to a charity also qualifies for an income tax deduction (subject to the
AGI limits on the income tax charitable deduction).
The last adjustment in the formula is the unused portion of the applicable credit.
Recall that the applicable credit is determined by the current tax on the exemption
equivalent ($11.18 million for 2018) and the exemption equivalent can change over time
because it is indexed for inflation. Hence, rather than track the unused portion of the
applicable credit, it is far easier to track the unused portion of the exemption equivalent
and then convert that into the applicable credit using current rates. Tracking the unused
portion of the exemption equivalent makes sense because the exemption equivalent is
ignored in calculating the tax on prior taxable gifts.#
To recap, the gift tax requires donors to keep track of the portion of the exemption
equivalent they used to generate an applicable credit to offset prior taxable gifts. This
prevents multiple applications of the same exemption. The gift tax on previous gifts is
computed using the current tax rate schedule, but this amount does not represent the
amount of gift tax paid—just the gifts previously subject to tax. The unused portion of the
applicable credit then reduces the total gift tax to reach the gift tax due. The gift tax is
calculated using the current rate schedule and ignores the amount of gift tax actually paid
in prior periods. Exhibit 25-5 presents the first page of the 2017 gift tax return Form 709
for Harry Smith (Form 709 for 2018 was not available from the IRS as of press date).
Property possessed by or owned (titled) by a decedent at the time of death is
generally referred to as the probate estate, because the transfer of this property is carried
out by a probate court. The person appointed by the court to carry out the will is called
the executor. Probate is the process of gathering property possessed by or titled in the
name of a decedent at the time of death, paying the debts of the decedent, and transferring
the ownership of any remaining property to the decedent’s heirs. Property in the probate
estate can include cash, stocks, jewelry, clothing, and realty owned by or titled in the
name of the deceased at the time of death.
Besides property in the probate estate, the gross estate also includes property
transferred automatically at the decedent’s death. These automatic transfers can occur
without the help of a probate court because the ownership transfers by law at the time of
death. Certain automatic property transfers are specifically included in the gross estate
because, while the decedent didn’t own the property at death, Congress deemed that the
decedent controlled the ultimate disposition of the property. That is, the decedent
effectively determined who would receive the property at the time of death. A common
example is property held in joint tenancy with right of survivorship, which legally
transfers to the surviving tenant upon the joint tenant’s death. Joint bank accounts are
commonly owned in joint ownership with right of survivorship. In contrast, tenants in
common hold divided rights to property and have the ability to transfer these rights
during their life or upon death. Property held by tenants in common, such as real estate,
does not automatically transfer at death and thus must be transferred via probate.
Although the decedent’s interest in jointly owned property (with the right of
survivorship) ceases at death, the value of the interest the decedent held in this property is
still included in the gross estate.
The proportion of the value of jointly owned property included in the gross estate
depends upon the type of ownership. When a decedent’s interest is a tenancy in common
(there is no right of survivorship), a proportion of the value of the property is included in
the gross estate that matches the decedent’s ownership interest. For example, consider a
decedent who owned a one-third interest in property as a tenant in common. If the entire
property is worth $120,000 at the decedent’s death, then $40,000 is included in his gross
estate. The amount includable for property held as joint tenancy with the right of
survivorship depends upon the marital status of the owners. When property is jointly
owned by a husband and wife with the right of survivorship, half the value of the
property is automatically included in the estate of the first spouse to die.15 For unmarried
co-owners, the value included in the decedent’s gross estate is determined by the
decedent’s contribution to the total cost of the property. For example, consider a decedent
who provided twothirds of the total cost of property held as joint tenants with the right of
survivorship. If the entire property is worth $240,000 at the decedent’s death, then two-
thirds ($160,000) is included in his gross estate.
Certain transfers, such as transfers of life insurance policies, made within three
years of the decedent’s death are also included in the decedent’s gross estate, valued as of
the time of death. Without this provision, a simple but effective estate tax planning
technique would be to transfer ownership in a life insurance policy just prior to the
decedent’s death. This strategy, called a deathbed gift, would reduce the decedent’s
transfer taxes on the life insurance by the difference between its proceeds from the policy
(the value at death) and its value on the date transferred. Only certain transfers are
specifically included under this provision, and they are often difficult to identify.#
Referring to the federal estate tax formula in Exhibit 25-6, we calculate the
taxable estate in two steps. The first consists of subtracting from the gross estate the
deductions allowed for administrative expenses, debts of the decedent, and losses
incurred during the administration of the estate. These deductions are allowed because
Congress intends to tax the amount transferred to beneficiaries. This step results in the
adjusted gross estate. In the second step, the adjusted gross estate is reduced for transfers
to a decedent’s spouse (the marital deduction) and to charities (the charitable deduction).
These deductions result in the taxable estate. We discuss each type of deduction next.
Debts included in or incurred by the estate, such as mortgages and accrued taxes,
are deductible. Expenses incurred in administering the estate are also deductible, such as
executor fees, attorney fees, and the like. Funeral expenses are deductible if reasonable in
amount. Likewise, casualty and theft losses are deductible. These losses must be incurred
during the administration of the estate, otherwise any deductions belong to the new owner
of the property. Finally, death taxes imposed by the state are also deductible.
To avoid taxing a married couple’s estate twice, Congress provides a deduction
for bequests to a surviving spouse. To qualify for the marital deduction, the transferred
property must be included in the estate of the deceased spouse. That is, the surviving
spouse must receive the property from the decedent and control its ultimate disposition.
For example, property that passes to the surviving spouse as a result of joint tenancy with
the right of survivorship qualifies for the marital deduction, as would a direct bequest
from the decedent. In contrast, transfers of property rights that are terminable do not
generally qualify for the estate marital deduction (as discussed earlier, terminable
interests are treated similarly for gift tax purposes). For example, suppose the decedent
bequeaths the surviving spouse the right to occupy the decedent’s residence until such
time as the spouse remarries. The value of the right to possess the residence is a
terminable interest and is not eligible for the marital deduction.18 In general, the estate
tax marital deduction is unlimited in amount. Hence, no tax would be imposed on a
decedent who leaves her entire estate to a spouse.
Three additional steps are necessary to calculate the estate tax liability from the
taxable estate. First, the taxable estate is increased by adjusted taxable gifts to compute
cumulative lifetime transfers (the estate tax base). Next, the tax on cumulative lifetime
transfers is computed and reduced by the tax payable on adjusted taxable gifts (computed
using the current tax rates). This tentative tax is reduced by the applicable credit. In
contrast to the gift tax formula, the estate tax formula allows a reduction only for taxes
payable on adjusted taxable gifts. Taxes payable are a hypothetical amount computed
using the past amount of applicable credit but the current tax rate schedule. Another
difference with the gift tax formula is that the entire applicable credit (not just the unused
portion) reduces the tentative tax (because all prior transfers are included in the tax base).
Besides subtracting the credit for tax on adjusted taxable gifts, we reduce the
gross estate tax by several other credits.20 The most important is the applicable credit,
because it eliminates the estate tax on cumulative transfers up to the exemption
equivalent (currently $11.18 million). Hence, estate taxes are imposed only on relatively
large estates. The objective of the applicable credit is to prevent the application of
transfer tax to taxpayers who either would not accumulate a relatively large amount of
property transfers during their lifetime and/or would not have a relatively large value of
assets to pass to heirs upon their death. The applicable credit for a surviving spouse is
increased by the amount of the#deceased spousal unused exclusion (DSUE). For example,
in 2018 a spouse whose spouse died without using any applicable credit would be entitled
to an exemption equivalent of $22.36 million.
M. Wealth Planning Concepts
The generation-skipping tax (GST) is a supplemental tax designed to prevent the
avoidance of transfer taxes (both estate and gift tax) through transfers that skip a
generation of recipients. For example, a grandparent could give a life estate in property to
a child, with the remainder to a grandchild. When the child dies and the grandchild
inherits the property, no transfer tax is imposed because nothing remains in the child’s
estate (the life estate terminates at death). In this way, the grandparent pays one transfer
tax (on the initial gift) to transfer the property down two generations. The GST is
triggered by the transfer of property to someone more than one generation younger than
the donor or decedent—a grandchild rather than a child. A transfer to a grandchild is not
subject to GST, however, if the grandchild’s parents are dead. The GST is very complex
and can be triggered directly by transfers or indirectly by a termination of an interest.
Fortunately, the GST is not widely applicable because it does not generally apply to
transfers that qualify for an annual gift tax exclusion, and each donor/decedent is entitled
to a relatively generous aggregate exemption ($11.18 million in 2018).
A fiduciary entity is a legal entity that takes possession of property for the benefit
of a person. An estate is a legal entity that comes into existence upon a person’s death to
transfer the decedent’s real and personal property. Likewise, a trust is also a legal entity
whose purpose is to hold and administer the corpus for other persons (beneficiaries).
While an estate exists only temporarily (until the assets of the decedent are distributed), a
trust may have a prolonged or even indefinite existence. Because these entities can exist
for many years, special rules govern the taxation of income realized on property they
hold. These rules are complex and relate to how fiduciaries account for income under
state law. A detailed discussion is beyond the scope of this text, but we provide an
overview below.
To better understand how taxable income is divided between a trust or estate and
its#beneficiaries, it is helpful to first summarize the formula for determining taxable
income.23 With few exceptions, the formula for calculating taxable income for a trust or
an estate is analogous to the individual income tax formula. Gross income for the entity is
determined in the same manner as gross income for an individual. For example, trusts are
generally taxed on realized income, but they can exclude certain items from gross
income, such as municipal interest, and make elections to defer certain items, such as
installment gains. Trusts and estates can also deduct expenses similar to an individual.
For example, trade or business expenses, interest, taxes, and charitable contributions.
Lastly, trusts and estates are allowed a deduction for distributions of income to
beneficiaries. It is this distribution deduction that operates to eliminate the potential for
double taxation of income.
Transfer tax planning strategies are the same as those employed for income tax
planning: timing, shifting, and conversion. Like income tax planning, wealth planning is
primarily concerned with accomplishing the client’s goals in the most efficient and
effective manner after considering both tax and nontax costs. For the most part, wealth
planning is directed to maximizing after-tax wealth to be transferred from an older
generation to a younger generation. A critical constraint in this process, however, is
determining how tax strategies can achieve the client’s ultimate (nontax) goals. Before
attempting to integrate tax and nontax considerations, let’s survey a few basic techniques
for transfer tax planning.
Timing is an important component in tax planning. Generally, a good tax strategy
delays payment of tax, thereby reducing the present value of the tax paid. While deferral
is important, transfer tax planning must also consider the potential appreciation of assets
transferred, and the effect of the income tax that could apply if and when the appreciation
is realized. Gifted property generally retains the donor’s basis in the property, meaning
the donee takes a carryover basis, whereas inherited property takes a tax basis of fair
market value. The advantage of gifting property is that the donor eliminates the transfer
tax on any additional future appreciation on the gifted property. The disadvantage is that
the unrealized appreciation of the gifted property will eventually be taxed (although at the
donee’s income tax rate). Thus, gifting appreciating property reduces future transfer taxes
but at the cost of additional future income taxes imposed on the donee. In contrast, for
inherited property, past appreciation (up to the date of death) will never be subject to
income tax but instead is subject to transfer tax at the time of the transfer.
Donors often use partnerships to transfer assets and for the control of a business in
a systematic manner that also provides them with income and security. One specific form
of partnership, the family limited partnership, divides a family business into various
ownership interests, representing control of operations and future income and
appreciation of the assets. Prior to restrictions enacted by Congress, these limited
partnerships were sometimes used to transfer appreciation to members of a younger
generation while allowing the older generation to effectively retain control of the
business. Obviously, the intent of estate and gift taxes is to recognize transfers of assets
that also represent control of the assets. Hence, it is not surprising that Congress revised
the law to restrict the ability of family limited partnerships to effectively transfer
appreciation in business assets and operations to younger generations without also
transferring control.
