Tax planning: It doesn’t deserve a yellow card from Washington
The recent FIFA World Cup soccer competition kept many of us glued to the television. For several weeks every four years, the attention of the world is engulfed by this event. It is a combination of national pride and the spirit of competition.
Competition transcends sports. It is present in many aspects of our daily lives including business and, in particular, taxes. Many corporate taxpayers and their shareholders are searching for tax nirvana. What exactly tax nirvana is I don’t know, but it may be similar to a runner’s high.
I commented two months ago on issues in the U.S. tax code that are pushing some companies to consider offshore structures. As I have mentioned in the past, the U.S. corporate tax rate is the highest among our major trading partners and is considered by many to be uncompetitive. Many in Congress realize this fact and have proposed possible corporate tax reforms, but nothing has really gained traction or support of the White House to date.
The attention has been mostly on C corporation situations. These corporations tend to be larger corporations, often publicly owned. The fact of the matter is, most businesses in the U.S. — including business start-ups — are not C corporations. This is, in part, because of the high corporate tax rate and imposition of double tax on the corporation profits when profits are distributed as dividends to shareholders.
Most U.S. businesses operate as sole proprietorships, partnerships, or S corporations. Operating in these formats results in profits being taxed not at the entity level but rather at the individual owner’s marginal tax rate.
In a longstanding tax court case (Gregory v. Helvering) from the Great Depression era, Judge Learned Hand stated, “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.”
We all engage in legal tax planning in some fashion, whether it is making a year-end charitable deduction or financing a home purchase with mortgage debt. It is also legal tax planning for a small business to use an S corporation tax structure rather than C corporation in which to operate.
It is rare to hear someone in Washington criticize a small business for operating as an S corporation or other flow-through format. On the other hand, operating in an international format receives much criticism for accumulating profits offshore or changing the domicile of operations.
States have often engaged in tax competition. Most of us have probably seen the recent advertisements on cable news channels for New York and its tax incentives. For years, state and local governmental units have used various forms of incentives in luring a business from one state to another. Michigan provides incentives for businesses locating here and for existing businesses that create additional jobs and investment in the state. In recent years, Michigan reformed its business tax system to eliminate double taxation on business profits for businesses operating in flow-through structures.
Tax planning is very common in our country. However, it isn’t always obvious. One can’t necessarily determine the tax planning or tax structure of a company by looking at a business or the business assets. One can’t walk into a retailer and know whether it is operating as a C corporation or a flow-through entity. The same applies for the real estate where the retailer is doing business. It may be owned by the retailer, a third party, or even a real estate investment trust, or REIT.
An interesting tax trend is the current use of REIT in tax structuring. The use of REITs has expanded in recent years. They can be public entities or privately owned entities. The use of private REITs has expanded as foreign ownership in U.S. real estate has increased. This is, in part, the result of the single level of taxation at the REIT shareholder level. There are also favorable provisions for foreign investors that apply on the exit of the REIT investment in a publicly owned REIT or one that has majority U.S. ownership.
Most of us likely encounter a REIT every day and don’t realize it. In the U.S., many cell towers, shopping malls and major hotels are owned by REITs. Most recently, two of the country’s major billboard companies announced their plans to convert to REIT status.
REIT status comes with some very technical and intricate rules on qualification and operation. Thus, the tax savings comes with some compliance and administrative burdens and costs.
In past columns I have commented on the use of other tax-efficient structures. These include such tax structures as regulated investment companies, or RICs, which are used for mutual funds, and Interest Charge – Domestic International Sales Corps., or IC-DISCs, which are used for export transactions of U.S. produced products. These structures also use a single layer of taxation at the owner level.
Many of these business operating structures are not as glamorous as the recent press stories of inversion transactions that result in redomiciling a U.S. corporation outside the U.S., but they can provide favorable tax results to a business and its owners in the appropriate fact situation.
Tax planning is largely understanding the business and its transactions and fitting the appropriate solution to the particular facts and circumstances. There is no one-size-fits-all in tax planning. Each situation merits its own solution. Tax planning can enhance commercial transactions that occur in a business’s lifecycle. The planning may center on a capital purchase or expansion into a new market.
Unfortunately, some in Washington are eager to label tax planning as sinister and seek to penalize or publicly flog businesses for their tax planning. Perhaps the solution is updating the tax rules by an overhaul of our tax system and enacting comprehensive tax reform, rather than waving the yellow card in front of law-abiding taxpayers. This will create a win-win situation for business taxpayers and the U.S. Treasury.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are his and not necessarily of BDO. The comments are general in nature and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult their professional advisers before acting on any items discussed herein.