Blogger Diane Kennedy, a CPA who graduated from the University of Nevada, Reno wrote a recent post on her website, TaxLoopholes.com, about legally upstreaming income. Diane points out several legitimate strategic uses of upstreaming strategies. I will use her four stated uses, and add my own commentary:
1. To upstream the income of a C corporation in your home state for the purpose of reducing state income tax. For this have any benefit, the corporation must be generating sufficient “upstreamable” profits that justify the costs associated with making the strategy work. It has to make sense financially. We use a rule-of-thumb of 12:1 – for every $1 that the strategy costs you, you need to be able to upstream $12 to a state-tax-free jurisdiction to justify the expense.
2. To divide out multiple streams of income within a company to separate active income from passive income. This is particularly effective if your company has some active income that would be taxed at a lower rate, but where the more than 60% of income is passive, subjecting it to Personal Holding Company taxation on all income.
3. To legitimize an asset protection plan. In this scenario, the amount of “upstreamable” profits that exist are not really the deciding factor. What DOES matter, is the value of the assets you are trying to protect. When upstreaming to legitimize an asset protection plan, it is critical that the goods, services, or financing that is the basis of the commercial relationship between the two companies is REAL. In other words, everything needs to be arm’s-length, and the services need to be provided; the products need to be real; or the loan must actually be funded – and repaid according to the terms of the agreement.
4. To flunk controlled group issues for the purpose of implementing nondiscriminatory benefits. This can be a sticky issue, and probably needs an attorney’s review before you run with it.
No matter what the strategy is, it won’t hold up unless it is completely verifiable, legitimate and documented. And, the company that receives upstreamed funds must have a defensible nexus of operations in the target state. Upstreaming demands crossing all your “t’s”.