Frequently Asked Tax Questions --January 9, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, January 9, 1996


Dollars & Sense


Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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Individual Tax Questions

Question: I have heard there is a little-known form called an Extension of Time to File for Payment of Taxes, a Form 1127. What do you know of it?

Answer: The Form 1127 is called an Application For Extension of Time for Payment of Tax. In order for the Application to be granted, the taxpayer must show that he or she has an "undue hardship" that prevents the payment of tax, that the taxpayer has no other sources of income from which to pay the tax and cannot borrow the funds, and the taxpayer must provide security for the payment of the tax (unless the taxpayer has no assets). Extensions are usually granted for 6 months and interest accrues on the unpaid tax. The application must be filed before the tax is due. For amounts of less than $10,000 (this amount could be expanded to $25,000 in 1996), it is suggested that one explore using an Installment Agreement Request, Form 9465, since there is less paperwork and fewer legal requirements involved.

Question: In March of 1995, I received a lump-sum payment from my employer in full settlement of a lawsuit I brought. The claims were based on wrongful termination, fraud, emotional distress, and other claims. The agreement does not specifically allocate damages, but contained an indemnity agreement under which I agree to indemnify my employer for any action against my employer arising from the tax characterization by my employer of the payment of the settlement to me as damages for personal injuries and not as wages. Are the damages paid to me under the settlement agreement taxable as gross income or can they be excluded from gross income as personal injury damages?

Answer: Although the settlement agreement does not fall within the effective date of the new legislation modifying the exclusion of damages received on account of personal injuries, the Schleier case may limit the scope of the exclusion of personal injuries from gross income. The law in this area is now in flux because of the Schleier case.

Typically, the parties must agree as to what portion of the damages are taxable and nontaxable by specifying the amounts awarded for specific damages. Damages awarded for cases involving employment discrimination may be tax free under current law. However, the Supreme Court recently held that damages received based on a claim under the Age Discrimination in Employment Act could not be excluded from income, Schleier v. Commissioner, 115 S. Ct. 2159 (1995), which has created uncertainty as to whether damages awarded for personal injuries that do not relate to a physical injury or sickness can be excluded from gross income.

In response to the Supreme Court decision, the Internal Revenue Service has suspended guidance on the tax treatment of damages received on account of other forms of employment discrimination, and Congress has passed legislation (which has not been signed by the President at this date) stating that only damages attributable to a physical injury or physical sickness are nontaxable . [House Bill sec. 13611, effective with respect to amounts received after December 31, 1995, but not to amounts received under a written binding agreement in effect on (or issued on or before) September 13, 1995. Conference Report, H.R. 2491].

The taxpayer should determine whether his employer will be issuing him a form 1099 for some or all of the damages, then he should characterize the payments accordingly. Although it is risky, the taxpayer should consider damages attributable to employment discrimination as non-taxable. He should have a reportable position with respect to the treatment of employment discrimination damages as non-taxable if there is an allocation of a specific amount to that portion of his claim under the settlement agreement. Perhaps the parties can amend the settlement agreement to specifically state how much of the damage award should be allocated to the taxpayer's claims of employment discrimination.

Foreign Taxpayers

Question: A father (who is a non-resident alien for U.S. income tax purposes) owns shares in a U.S. corporation along with his children (who are U.S. residents). The father has made a loan to the corporation which is subject to a 30% withholding requirement on the interest paid to him. Because of this withholding requirement, the father wants a foreign bank to refinance the original loan and he will pledge certain assets for the repayment of the loan. Will such a plan work?

Answer: No. You have inquired about the tax consequences arising from a foreign shareholder's loan to a U.S. corporation which owns U.S. real property. Generally, the interest on such loans is subject to a 30% withholding obligation by the debtor (unless there is an applicable treaty rate that is lower). There is an exception to this rule called the "portfolio interest" exception. To qualify for this exception, the lender must own, directly or indirectly, less than 10% of the borrower corporation. Parents are considered owning the stock of their children; therefore, a parent cannot own any stock in the corporation if he makes a direct loan (or if his property is used as collateral for the loan) and his children own 10% or more of the stock. Pledging property owned by a shareholder for a loan from a foreign bank is treated the same as a direct loan from the shareholder.

Alternatively, the parent's brother or sister can make the loan, or provide the collateral for the loan, since there is no attribution of ownership between brothers and sisters for portfolio loan purposes. The brother or sister, however, cannot own 10% or more of the corporation.

Remember: For U.S. estate tax purposes, the stock of the U.S. corporation should be owned by a foreign corporation. Also, the U.S. corporation should be filing tax returns with respect to its holdings. The transfer of the stock to a foreign corporation is considered a taxable event; consequently, the fair market value of the U.S. real estate and its adjusted basis (its tax basis) must be determined in order to decide whether such a transfer will cause a taxable gain and the potential size thereof.

Question: When is a foreign corporation liable for a "branch profits" tax upon the sale of U.S. real property?

Answer: The branch profits tax enacted in 1986 as IRC Sec. 884, in general, subjects foreign corporations engaged in a trade or business in the U.S. through a branch office to a flat 30% tax. The purpose of this tax is to burden a foreign corporation's U.S. business profits with roughly the same taxes whether the business is conducted through a domestic corporate subsidiary or an unincorporated branch in the United States.

The business profits are potentially taxed twice; once at regular U.S. corporate income tax rates, and then again at a flat 30% rate as though the after-tax income were transferred to the parent corporation as a dividend. The flat 30% rate may be reduced by applicable treaty, or if the U.S. branch stops doing business in the year of sale. Also, the sale of stock in a U.S. real property holding company under FIRPTA (IRC Sec. 897) is exempt from the branch profits tax under IRC Sec. 884(d)(2).

For example, if a foreign corporation operates a branch in the U.S. which owns stock in a U.S. corporation which owns U.S. real property, the sale of the stock in the U.S. corporation is not subject to the branch profits tax. If, however, a foreign corporation owns U.S. real property directly, the sale of the real property will be subject to both an income tax at regular corporate tax rates, and a branch profits tax.

To avoid the branch profits tax, a foreign corporation should hold stock in a U.S. corporation which then holds the real estate. Please note that when the U.S. corporation makes a dividend payment to the foreign corporation of the proceeds from the sale of U.S. property, there will be a 30% flat tax on the dividend, unless: (1) there is a treaty provision that lowers the tax on the dividend; or (2) the U.S. corporation liquidates (ceases to conduct business in the U.S.) in the year of sale.

The withholding requirements under FIRPTA merely secure a fund from which the U.S. can collect any taxes due. A foreign corporation that sells U.S. real property calculates its tax under regular corporate tax rates, and then adds the branch profits tax, if applicable. If the amount withheld is greater than the tax due, then the foreign corporation is entitled to a refund. For example, if a corporation sells a property in which it had a $950,000 basis for $1,000,000, its gain would be $50,000, but the withholding under FIRPTA would be $100,000 (10% of the amount realized). The corporation's tax (assuming no other income or deductions) would be $7,500 and its branch profits tax would be $12,750. The corporation would either file to reduce the FIRPTA withholding to the amount of the actual tax due, or would file for a refund of $79,750 ($100,000 withheld, less $20,250 in taxes owed.

Challenges to the Payment of Taxes

Preamble: I receive a lot of tax protestor-type questions and suggestions of magical solutions for the avoidance of the payment of federal and state income taxes, and I have the following observations with respect to these types of arguments:

Note: The following question is usually asked with "attitude" and is typical of the tax protestor-type arguments found on the Internet.

Question: As an individual U.S. citizen, is there any authority in the Internal Revenue Code that specifically obligates me to pay income taxes to the federal government?

Answer: IRC Code Section 1 and the regulations thereto make it crystal clear that an individual U.S. resident or citizen is subject to federal income tax. Any conclusion to the clear language cited in the regulations is merely word games played by people who have never won a case or ruling in any court. That speaks volumes for the tax protester's so-called argument. One needs to read the words of the code sections and regulation in context and not claim that the word "individual" is not defined. It does not have to be defined because it is used in its common language usage. You and I are individuals and are liable for federal taxes.

Follow-up question: Does not the Hooven Case define a U.S. citizen and a state citizen and does not Hooven determine who is liable for the payment of taxes?

Answer: The Hooven case (which was subsequently overruled in part) was decided before the Internal Revenue Code of 1954 was enacted and has nothing whatsoever to do with an individual's liability for federal income tax cases. Hooven & Allison Co. v. Evatt, 324 U.S. 652, 65 S. Ct. 870 (1945) (Hooven I). Hooven I dealt with whether state taxation of imports violates the Import-Export clause of the United States Constitution, Art. I, Sec. 10, cl .2. The Court concluded that imported merchandise is exempt from state taxation until it is removed from the package in which it is imported, or when used for the purpose for which it is imported. Hooven I, 324 U.S. 665-669. The Court, noting that the term "United States" may be used in any one of several senses, also concluded that although the Philippines is a territory belonging to the United States, it is not constitutionally united with it, and goods brought from the Philippines constitute "imports" within the meaning of the constitutional provision. Hooven I, 324 U.S. 671,673.

Limbach v. Hooven & Allison Co., 466 U.S. 353, 104 S.Ct. 1837 (1984) (Hooven II) overruled Hooven I to the extent that a state personal property tax could not be imposed until the goods are removed from the original packaging, the court stating that nondiscriminatory ad valorem property taxes are not prohibited by the Import- Export Clause. Hooven II, 466 U.S. 358, 361. Thus, Hooven I and Hooven II are irrelevant to tax protestor arguments. These cases are not legal authority for individual federal income tax liability cases and should not be cited as precedent.

Question: I have a personal service business in California. I heard that incorporating in Nevada will save me taxes and provide security against creditors?

Answer: From the materials that I have read provided by Nevada companies attempting to entice California taxpayers to incorporate there, such a plan is usually a recipe for disaster. Incorporating in Nevada will produce no tax real benefits and will only cost you money. Becoming a C corporation (as the Nevada company recommends) will place you in the highest income tax bracket. One cannot upstream income from California to Nevada and escape California income taxes. California uses a unitary theory of taxation which means it taxes a corporation's business that is performed in California, regardless of the state of incorporation. Also, a Nevada corporation would have to register as a foreign corporation in California and would have to pay the same costs as any corporation that is incorporated in California.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**