GLOBAL
Unclaimed Value-Added Tax Refunds Add Up to Money Lost for U.S. Taxpayers

With commerce becoming an increasingly global activity in most industries, many companies may be incurring a liability that is not readily apparent on their financial statements. The culprit is the value-added tax (VAT) that most countries outside the U.S. impose on transactions involving goods and services in lieu of the sales tax system used in this country. The recent addition of 10 nations to the European Union and the subsequent growth of international trade opportunities make this a more important issue for U.S. companies—and individual taxpayers who travel extensively—than ever before.

While VAT rates average about 19% in Europe, according to the Federation of International Trade Associations (FITA), they can range from a low of 3% to as much as 25%. They also vary by the type of product or service being purchased within individual countries. Sweden’s VAT rate is 6% on taxi rides and car rentals, 12% on business meals and entertainment and 25% on trade shows and conferences. Germany’s standard VAT rate is 16% with a reduced rate of 7% for items such as artwork.

Companies that have incurred business expenses in European countries (and some non-European nations, as well) are often entitled to reclaim VAT paid on specific business expenses, including most goods and services. FITA estimates that U.S. companies currently are reclaiming only 20% of the more than $1 billion they pay in European VAT annually. Other estimates place the total paid higher and the percentage reclaimed lower. Add in the money left on the table by individual U.S. citizens traveling abroad, whether for business or pleasure, and the stakes are even greater.

Claiming a VAT Refund
Each country has its own rules on what types of VAT can be reclaimed, as well as its own procedures for doing so. For example, UK VAT on travel expenses may be reclaimed “if your company is registered for business purposes outside the European Union, your company has no place of business or other residence in the EU and your company does not make any supplies in the UK,” according to HM Customs & Excise, the agency that administers VAT in the United Kingdom.

Among expenses that may qualify for VAT refunds in the UK are hotel accommodations, meals, car hire, conference and exhibition facilities, telecommunications and secretarial services. Claims must be made no later than six months after the end of the year (from July 1st to June 30th) in which the VAT is incurred pursuant to the European Community 13th Directive. Thus claims must be submitted by December 31st of that year. A specific form—VAT 65A—must be used to claim a refund. Additional documentation is also required, including a certificate (generally Form 6166, US Residency Certification Letter, is sufficient to meet the documentation requirement) from an official authority in the U.S. indicating that your business is registered there and original invoices, vouchers or receipts (not copies) for all transactions on which a VAT refund is claimed.

Although the amount of money involved can be significant, the complexity of the VAT refund process—which is exacerbated for companies doing business in multiple countries and/or when many expenditures are made by individuals traveling on the company’s behalf—too often results in businesses not recouping funds to which they are legally entitled.

FEDERAL
Avoiding Tax Pitfalls in S Corporations

There are many legitimate reasons why S corporation status has long been a popular choice among small business owners. However, S corporation shareholders who provide services to the company must exercise caution when choosing how to receive the earnings of the company. They should pay particular attention to the allocation between wages and dividends, because missteps in this area have the potential to trigger significant penalties related to employment taxes.

S corporations can offer business owners some protection against personal liability for the company’s debts, as long as the corporation is properly structured and strict separation is maintained between the financial affairs of the company and the owner. Unlike C corporations, S corporations allow corporate income and subject to certain limitations, losses to pass through to shareholders.

Shareholders in an S corporation who provide services to the company must receive compensation for those services in the form of salary, and they may receive profits in the form of dividends.

The FICA Factor
A sole proprietor or active member of a partnership must pay self-employment taxes covering Social Security and Medicare (FICA) of 15.3% on the first $87,900 of earnings in 2004, plus 2.9% on all self-employment earnings above this level. Shareholder employees of an S corporation pay FICA only on salary actually paid; they do not pay FICA on profits (whether distributed as dividends or retained by the company). Accordingly, the temptation exists to distribute more of the company’s earnings as dividends and less as salary. Succumbing to that temptation, however, carries significant risks.

“The immediate effect of shifting income from salary to dividends is a reduction in liability for FICA payments, but choosing S corporation status for this reason is not a legitimate tax-planning strategy,” says Charles Pomo of Geller & Company ^{www.gellerco.com/tax.html/taxview/archives/PositionA">1}. “ IRS auditors are becoming increasingly aggressive about going after shareholders in S corporations it suspects of receiving, as dividends, income that should be classified as salary.”

Protection Through Reasonable Salary
The best way for S corporation shareholders to avoid this pitfall and be protected in case of an audit is to pay themselves a salary that the IRS would deem “reasonable” for the services they perform and the positions they hold, relative to the industry in which their company does business.

The IRS does not provide an exact definition of what constitutes a “reasonable salary.” However, Pomo suggests several rules of thumb and advises that the shareholder’s salary should reflect:

• The company’s level of profitability.
• The nature of the services performed on behalf of the company and the amount of time spent providing them.
• Salaries being paid to executives with similar duties at other companies in the S corporation’s industry.
• What the S corporation would expect to pay a non-shareholder to do the same job.

Possible sources for information on comparable salary levels include salary.com, Watson Wyatt, Hay Group, trade associations in the S corporation’s industry and surveys conducted by the Bureau of Labor Statistics. Whatever salary level is chosen, it will be more supportable in an audit situation if it is set through a specific process, if a rationale for calculating the salary is provided, and if it is approved by members of the S corporation’s board of directors.

Steep Penalties
The penalties for failing to adhere to justifiable salary guidelines can be steep. If the IRS examines an S corporation’s tax return and determines that revenues that should have been paid as salary were instead disbursed as dividends or other types of profit distributions, it can reclassify the amounts involved as salary, assess payroll taxes on the distributions and impose stiff penalties and interest on the unpaid taxes.

For more information, please contact Charles Pomo at cpomo@gellerco.com.

¹ Geller & Company is a leader in finance, accounting and tax outsourcing services, as well as a provider of tax consulting services to corporations, individuals and private equity firms.

INDIVIDUAL
A GRAT-ifying Technique with Potential Tax Advantages

A grantor retained annuity trust (GRAT) can provide a low risk vehicle to transfer wealth from one generation to the next, typically with little or no gift tax liability incurred. It can be a particularly useful vehicle for transferring an asset that is expected to increase significantly in value (such as a closely held business interest) while retaining an income interest for the grantor for a fixed period of time. Lack of marketability and minority discounts may also be available to further reduce the value of the gift in the case of a closely held business interest.

The usefulness of a GRAT is not solely limited to individuals with closely held business interests, however. Grantors can also contribute other types of assets, including stocks, bonds, notes, cash and partnership interests. The primary consideration in deciding whether an asset is appropriate for inclusion in a GRAT is its projected appreciation relative to the “hurdle rate” dictated by Internal Revenue Code section 7520. The hurdle rate is equal to 120% of the applicable federal rate. For example, the June 2004 GRAT hurdle rate is 4.6%. As such, today’s low interest rate environment makes GRATs a particularly attractive estate planning vehicle. To the extent that a GRAT’s assets appreciate at a rate greater than the hurdle rate, grantors generally are able to make tax-free gifts to their beneficiaries.

How GRATs Work
A GRAT is an irrevocable trust in which the grantor retains an annuity interest. That allows for a reduction in the value of the assets transferred for gift tax purposes and provides the grantor with an income stream from those assets for a predetermined period of time. The amount that must be paid to the grantor each year is calculated as a percentage of the fair market value of the assets contributed to the GRAT. At the end of the term, the GRAT terminates. Any assets remaining in the trust at that time are transferred to the GRAT’s beneficiaries or trusts for their benefit. Thus, the assets have passed to the beneficiary and will not be included in the estate of the grantor.

While the grantor is permitted to set the term of the GRAT, it must be for a period of no less than two years. Factors such as the grantor’s age and health should be taken into consideration because maximum tax benefits depend on the grantor outliving the term of the GRAT. The term should also be calculated to cover the period of maximum appreciation of the assets within the GRAT and to terminate as soon as possible after the appreciation.

If the grantor does not outlive the annuity period, a significant portion—if not all—of the value of the trust assets will be included in the grantor’s estate for estate tax purposes.

Two other considerations related to establishing a GRAT are income taxation and gift tax treatment. Grantors who create a GRAT will continue to be taxed on all activity within the trust during the term of the GRAT. This is an important consideration from a cash-flow perspective if there is a possibility that the income tax liability will greatly exceed the annuity payment. At its creation, a GRAT is a completed gift, and a gift tax return must be filed for the transaction.

In summary, a GRAT can provide a low risk vehicle to transfer wealth from one generation to the next, and the very low interest rates that have recently characterized the economy often make it possible to effect large transfers of wealth with little or no gift tax liability incurred. Currently, the estate tax is in a state of flux with a great amount of uncertainty as to its future. Thus, any significant modification of the estate tax could affect the benefits of a GRAT or other estate planning strategy.

For more information, please contact Tate Elliott at telliott@gellerco.com.

Click here to unsubscribe> | Visit the Geller & Company website>

The information contained in TaxView is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Geller & Company to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors.