Tax upstreaming is a money-saving practice in which a C-corporation based in one state “upstreams” its earnings to a subsidiary based in another state. The corporation can avoid paying state income tax in its home state if everything is done correctly. When upstreaming to a company in a state with no income tax, such as Nevada, the strategy is most effective.
Let’s imagine you live in a state (such as California) with a maximum income tax rate of 13.3%. In that state, $100,000 in business income is taxed at $13,300. If you move that money to a state that doesn’t tax it (i.e. Alaska, Florida, Nevada, South Dakota, Texas, Washington, etc), that is where you can see the simple math that shows substantial money back to you- $13,300 – $0 = $13,300 in savings.
However, it isn’t as straightforward as simply moving funds. It isn’t that simple but there’s more than one method to go about it. For example, you can separate active and passive revenue streams, but it isn’t appropriate in all circumstances. However, regardless of how it’s done, it must be meticulously recorded so that an audit can confirm the strategy’s authenticity.
by Dominique Molina, AITCP
Upstreaming is a tried-and-true method of saving on taxes by skillfully moving income from one subsidiary to its parent. Things are rarely simple when it comes to taxes, but there are various scenarios where upstreaming can produce substantial tax savings. Of course, in a business situation, you will need to show there was a business reason for your actions beyond just saving on taxes, and you will need to document your actions in preparation for any future audit.
Upstream to a Company in Another State
If a business is in a state with high state income tax such as California, it’s possible to reduce that high state tax by upstreaming to a company that is domiciled and has nexus in a state with lower income tax or to avoid state income tax completely by upstreaming to a company in a state with no income tax. You will not have to pay tax in the home state if you are dealing with C corporations. These are states without income tax:
- South Dakota.
The requirement for showing a company has nexus varies across all 50 states. However, some factors that commonly are considered are
- Physical presence such as offices, warehouses, showrooms, etc.
- Representatives operating within the state such as employees, salespeople or other agents
- State-specified number of transactions or sales
Upstream to a Company with Another Tax Structure
“Upstreaming” may also refer to moving income to a company with a more beneficial tax structure. You may have multiple companies with different tax set-ups. One might be a corporation, and another might be a partnership, for example. You may want to upstream where one offers a tax advantage over the other.
Upstream C with a Drop: Moving Assets in Related Entities Through Reorganization
Using the method of “upstream C with a drop” you can move assets within related entities without being taxed on it. The parent company acquires the subsidiary’s assets through a reorganization of the subsidiary’s assets under 26 U.S. Code § 368(a)(1)(C). The parent company then contributes some of the subsidiary’s assets to the new corporation (this is the drop) and may keep part of the subsidiary’s assets under its own control. In this manner, some of the subsidiary’s assets are shifted to the parent corporation tax-free under 26 U.S. Code § 355.
The subsidiary need not be legally liquidated but can be “deemed” to have been liquidated for federal income tax purposes. This can be done by changing the type of entity, such as converting a corporation to an LLC or by making an election by checking the appropriate box on IRS Form 8832 to change the subsidiary’s tax classification under 26 CFR 301.7701-3.
Upstream Gifts to a Relative
There are tax advantages to upstreaming gifts to a parent, so the same property will be included in the estate you will inherit. The purpose of this is so you can get the fair market value of the property at the time of your parent’s death rather than the FMV at the time you first acquired the property. This new FMV passes to you even if your parents pay no estate tax.
There are several ways to reduce your clients’ taxes through upstreaming. Once you introduce the concept to them, you may be able to help your clients in multiple ways using various upstreaming methods. Learn more here about the best tax strategies.
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