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Profit Shifting to Reduce Taxes

How Businesses and Wealthy Individuals Shelter Their Income

By Robert J. Mintz, J.D., LL.M (taxation)

Businesses and wealthy individuals often reduce their overall tax burden by holding assets or conducting business operations in low or no tax jurisdictions. This may be done through overseas transactions or domestically by taking advantage of tax laws in low or no tax states.

Shifting Business Income 

To minimize federal income tax companies often attribute a large share of their income to overseas subsidiaries in tax haven countries. Under U.S. tax rules, income earned from activities and sources outside the U.S. are generally not taxed until the income is repatriated. Technology companies have a particular advantage since intellectual property such as patents can be owned, and royalties paid, to an affiliated company in a location that does not tax royalty income or license fees.  The result is that U.S. tax is effectively deferred for many years or indefinitely into the future.  The current estimate is that approximately $1.5 trillion in profits are sitting on the books of foreign subsidiaries of U.S. based companies.  Apple alone holds $74 billion in offshore profits and according to a recent story in the New York Times (“How Apple Sidesteps Billions in Taxes”) aggressively routes over 70 percent of its profits through foreign affiliates in no or low tax jurisdictions which provide substantial tax breaks for royalty income, manufacturing and sales activities.

It’s not just foreign profits which are sheltered in this manner.  Profits generated in the U.S. can be shifted from high tax states to those with a lower corporate tax rate. According to the Times story, although Apples worldwide headquarters are in Cupertino, California, the company is able to move substantial profits to Nevada which has no corporate or personal income tax.  By transferring its’ investment activities to a minimally staffed office in Reno, Nevada, Apple is able to save billions of dollars in tax on its investment income each year by avoiding the California 8.84% corporate tax rate. Companies which are able to segregate business functions to some degree use similar tax strategies to shift profits from state to state, seeking the most attractive tax treatment.

Trusts for Wealthy Individuals

Wealthy individuals often employ similar income shifting strategies between high and low tax states to shelter investment income and capital gains. These techniques are increasingly popular, as a new wave of IPO’s create millions and billions in profit for shareholders in successful technology companies, primarily based in California’s Silicon Valley.

Here’s an example of how this strategy is used. A California resident may own company shares which have appreciated from zero to $10 Million. If those shares were held and then sold by a California Trust, the state capital gains tax would be roughly $930,000.

To avoid recognizing the gain in California, the most popular technique involves transferring the ownership of the shares to a Delaware trust. Delaware law does not tax trust income accumulated for a non-resident beneficiary so a resident of a high tax state such as California or New York can dispose of highly appreciated assets through a Delaware trust without state income tax on the sale proceeds or the subsequent earnings on the funds.

In addition to the tax savings, the trust laws in Delaware are designed to allow a high level of asset protection and flexibility in accomplishing a wide variety of wealth management objectives.

As might be expected, the high tax states attempt to prevent their residents from using low or no tax states to achieve these tax benefits. Just as the U.S. Government attempts to limit revenue loss to the offshore countries, the high tax states fight against these profit shifting strategies with varying degrees of success.

Again, using California to illustrate, the law provides that if a California resident is a beneficiary of an out of state trust, that beneficiary is subject to California tax on the income of the trust.  Conversely, if the beneficiary’s interest in the trust is “contingent” rather than fully vested than the trust income is not taxed in California. If the goal is to avoid California tax then the Delaware trust must be carefully drafted to make sure that a beneficiary’s interest is contingent and subject to various conditions within the trust agreement.

Depending on the specific law of the state and the goals of the trust grantor, Delaware Trusts or trusts formed in other low tax jurisdictions may be a useful income tax planning vehicle for reducing home state taxes on capital gains, investment income and some types of business income. In all cases, knowledge of the tax provisions of relevant state and federal law and proper trust drafting is essential.

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