Use of 80/20 companies. (State & Local Taxes).

If a unitary relationship exists between a group of legal entities, certain states would require the group to file a combined income tax return. Generally, a state presumes a unitary relationship whenever unity of ownership, operation and use exists, as evidenced by centralized management, purchasing, advertising, accounting or other centralized interaction. It also presumes a unitary relationship when business activities or operations among a group of legal entities are integrated with, dependent on or contribute to one another, either individually or as a group.

Due to the elimination of intercorporate transactions, pursuant to a combined income tax filing in a unitary state, the use of traditional state tax planning strategies (such as intercorporate financing and intellectual property management/licensing) generally provide no state tax benefit in unitary states.

80/20 Company Exclusion

To realize the benefits from intercorporate transactions in unitary states, a taxpayer has to exclude its intercorporate financing or intellectual property management/licensing entity (or both) from its combined income tax return.

Generally, in several states (AZ, CO, IL, MN, MT, NH, ND and UT), a combined income tax return explicitly excludes an 80/20 company in part or in whole, if the company has at least 80% of its property and 80% of its payroll (and sales in some states) outside the U.S.

Effectively, a combined income tax return excludes an 80/20 company's income or loss and preserves any deductions taken by unitary group members for services that the company provided.

Illinois 80/20 Company

For an entity to establish that it qualifies as an 80/20 company, it must compute a two-factor apportionment formula based on Illinois' standard property and payroll factors. If a corporation has 80% or more of its property and payroll located outside of the U.S., it cannot be part of an Illinois unitary business group. Thus, if properly structured, an 80/20 company cannot include income or loss in an Illinois combined income tax return, and the Illinois unitary group's members do not have to eliminate any deductions already taken, related to the 80/20 company.

How to Establish an 80/20 Company

Three methods can establish a corporation as an 80/20 company. However, their acceptance varies from state to state. In the first method, a corporation contributes sufficient foreign operations to a U.S. entity to achieve an 80%-or-more property and payroll mix outside of the U.S.

In the second method, a corporation uses a disregarded single-member limited liability company (SMLLC) to achieve 80/20-company status. It ensures that the entity designated to become an 80/20 company wholly owns a disregarded SMLLC, which holds sufficient foreign operations to achieve 80/20-company status.

Lastly, a corporation can use a captive partnership to achieve 80/20-company status in states in which a partnership's apportionment factors flow up to a corporate partner and combine with the corporate partner's apportionment factors. In these states, the foreign partnership's apportionment factors do not lose their foreign identity when they flow up to the corporate partner; thus, the entity can achieve 80/20-company status.

Points to Consider

To minimize a state audit challenge, an 80/20 company must have the proper structure and a valid business purpose. Further, the 80/20 company must maintain appropriate property, payroll or sales levels outside the U.S. at all times. (Caution: Prior to implementation, a corporation should address all material Federal and international tax issues to ensure that the strategy does not result in additional Federal or international taxes.) Finally, the 80/20 company must monitor its operations in 80/20 states to ensure that it does not create nexus in those states, as nexus with such a state can negatively affect the 80/20-company tax benefit.

Planning Opportunities

As mentioned, a corporation can use an 80/20 company for intercorporate financing or to manage/ license intellectual property or both. It can transfer a unitary group's intellectual property to an 80/20 company and the 80/20 company can manage the intellectual property and license it to other members of the unitary group.

Alternatively, a corporation can establish an 80/20 company as an internal financing entity that lends funds to other members of the unitary group. Because a unitary group in an 80/20 state excludes an 80/20 company on its return, the group can use any intercorporate interest or royalty expense attributable to the 80/20 company to reduce its taxable income.

FROM VLADIMIR GARY PERIC, J.D., CPA, OAK BROOK, IL