tax tips

Inbound Investor U.S. Tax Playbook, Part 3: Operating and Repatriating Profits

Nick Eusanio, Esq., LL.M. Leave a comment

Overview:

Once a U.S. structure is established, it’s important to manage day-to-day compliance, withholding obligations, and cash repatriation in a way that aligns commercial objectives and tax efficiency.

This is where many inbound investors run into trouble. Overlooked filings, employee visits, or intercompany payments can inadvertently create additional tax exposure.

This article outlines some key operational compliance considerations for inbound investors — including how to manage U.S. trade or business (USTB) risk, how to comply with withholding and reporting rules, and how to repatriate profits efficiently under U.S. and treaty frameworks.

This article summarizes considerations for entity selection, including notation of federal, treaty, and state regimes, and practical planning points.

1. Core Federal Compliance Framework

Once an inbound structure is live, foreign investors must quickly identify original and extended due dates (and filings necessary to obtain extension), and establish a compliance calendar to track federal, state, and local tax compliance obligations.

Key federal tax filings to note include:

  • Form 1040-NR – For foreign individuals with U.S. income.
  • Form 1120-F – For foreign corporations with U.S. income, even if limited to effectively connected income (ECI) or protective filings.
  • Form 1120 – For investments held through a U.S. C corporation (or LLC taxed as a C corporation).
  • Form 1065 – For investments held through a U.S. partnership (or LLC taxed as a partnership).
  • Form 5472 – For U.S. entities that are at least 25% foreign-owned, reporting related-party transactions.
  • Form 1042 and 1042-S – For withholding on payments to foreign persons (interest, dividends, royalties, services)

Failure to file or report properly can lead to disallowance of deductions, interest, penalties, and loss of treaty benefits.

2. Understanding U.S. Trade or Business (USTB) and Effectively Connected Income (ECI)

A foundational question for any inbound operation is whether the foreign investor itself — or one of its affiliates — has become engaged in a U.S. trade or business.

Once a USTB exists, U.S.-source income that is effectively connected with that business becomes ECI, taxable on a net basis (income minus deductions) through Form 1120-F.

A. When USTB Exposure Arises

A USTB exists where a foreign person conducts regular, substantial, and continuous commercial (profit seeking) activity in the U.S. — either directly or through dependent agents. Examples include:

  • Operating or managing a U.S. branch, office, or fixed place of business.
  • Having employees or dependent agents who habitually conclude contracts in the U.S.
  • Providing services or technical work in the U.S. for U.S. clients.
  • Participating in U.S. real property development or leasing.

In contrast, passive investment (holding stock, notes, or real estate for appreciation) generally does not create a USTB, provided contracting, management and decision-making occur offshore.

B. Treaty Overlay and Permanent Establishment (PE)

Under most U.S. income tax treaties, a nonresident is taxed on business profits only if attributable to a permanent establishment (PE) — generally a fixed place of business or a dependent agent with contracting authority. This overlay provides important protection but can be lost through day-to-day activities by foreign executives or employees.

3. Managing Executive Travel, Employee Presence, and Secondments

One of the most common ways a foreign investor unintentionally creates a USTB or PE is through foreign executives or employees performing services in the U.S.

Even short-term visits can be enough to shift the tax profile of the entire structure if those individuals perform core operational or revenue-generating functions while in the U.S

Risk scenarios include:

  • Executives negotiating or signing contracts during U.S. visits.
  • Technical staff providing services to U.S. customers on-site.
  • Management personnel directing local operations or overseeing projects.\

These activities can create a U.S. fixed place of business or a dependent agent PE, exposing the foreign parent to U.S. net income tax, Branch Profits Tax (IRC §884), and potential treaty complications.

Mitigating Exposure Through Secondment and Intercompany Structures

Inbound groups can mitigate this risk through:

  • Secondment arrangements, where the U.S. affiliate formally “borrows” employees and assumes day-to-day control, paying costs on a reimbursed (no markup) basis.
  • Intercompany service agreements, where cross-border support is formalized with arm’s-length pricing and defined scope under IRC §482.

Properly structured, these arrangements can:

  • Prevent the foreign parent from being viewed as conducting business directly in the U.S. or mitigate the associated amount of income.
  • Preserve treaty protection by keeping activities within the U.S. entity’s control.
  • Support transfer pricing compliance and deduction eligibility.

4. Withholding Obligations and Cross-Border Payments

Even when a foreign investor avoids direct USTB/ECI exposure, U.S. withholding tax applies to certain payments to foreign persons.

Key categories include:

  • FDAP (Fixed, Determinable, Annual, or Periodical) Income: Interest, dividends, rents, royalties, and similar payments are subject to 30% withholding, unless reduced by treaty.
  • Service Fees: Fees for services performed outside the U.S. are generally exempt, but services performed in the U.S. can become ECI.
  • Dividend Equivalent Amounts (DEA): Amounts subject to the Branch Profits Tax (IRC §884) and payments under equity-linked instruments that replicate U.S. stock dividends (IRC §871(m)) can be treated as dividend equivalents and subject to withholding.

U.S. payors must report and remit these withholdings on Forms 1042 and 1042-S, other than for a DEA subject to Branch Profits Tax which is reported on Form 1120-F.
For a reporting corporation (either a 25% foreign-owned U.S. corporation or U.S. disregarded entity, or a foreign corporation engaged in a USTB), Form 5472 remains the key disclosure for any payments to related foreign parties, including royalties, management fees, or cost allocations.

5. State and Local Considerations

Inbound investors often underestimate the complexity of state-level tax exposure.

Key Concepts:

Even absent a federal USTB, a foreign company (or its U.S. affiliate) may face state income or franchise tax based on economic nexus — often triggered by as little as $100,000 of in-state sales or 100,000 in-state transactions. Some state economic nexus thresholds are more favorably based on both the amount of sales and the number of transactions in state for the year.

Some states, such as California, require multinational groups to file combined reports, which can pull in global income under:

  • Worldwide combined reporting, or
  • A water’s-edge election, limiting inclusion to U.S. entities and their CFCs, foreign partnerships and foreign branches.

The water’s-edge election (e.g., California Form 100-WE) can be a significant planning tool for inbound investors, reducing compliance complexity and exposure to foreign-source income inclusion.

6. Repatriation and the Branch Profits Tax

When a foreign corporation earns ECI, it faces not only regular U.S. corporate income tax but also a Branch Profits Tax (BPT) under IRC §884.

The BPT, generally at 30% (potentially treaty-reduced to between 0% and 15%), applies to deemed remittances of after-tax earnings from the U.S. branch to its foreign parent.
Conceptually, it mirrors the dividend withholding tax that would apply if operations were conducted through a U.S. subsidiary instead of a branch.

Practical planning often favors operating through a U.S. subsidiary to simplify compliance and provide clearer control over repatriation timing. Dividends, interest or royalties from a U.S. subsidiary are typically subject to withholding at 30%, potentially reduced by treaty to between 0% and 15%.

7. Practical Compliance and Strategic Takeaways

  • File protective Form 1120-F returns when there’s potential USTB exposure — to preserve deductions and refund rights.
  • Maintain intercompany documentation (service, cost-sharing, royalty, and loan agreements) under IRC §482.
  • Review treaty applicability and PE thresholds before executives or employees travel to the U.S. Consider potential secondment or intercompany service agreements to manage as necessary. Consider documenting treaty positions in a tax-technical opinion, supporting expected rates and treatment of covered income streams or payments.
  • Monitor withholding and information reporting on all cross-border payments.
  • Evaluate annually: state nexus and water’s-edge election options, and state tax credits and incentives compliance and opportunities.
  • Plan repatriation to manage Branch Profits Tax or dividend / interest / royalty / service fee payment withholding efficiently.

In Conclusion

Running a U.S. operation successfully requires implementing the right structure, plus ongoing attention to compliance, withholding, and cross-border activity.

Inbound investors who proactively manage USTB risk, withholding compliance, and repatriation planning can operate confidently and minimize problematic surprises from both the IRS and state tax authorities.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Inbound Investor U.S. Tax Playbook, Part 2

Nick Eusanio, Esq., LL.M. Leave a comment

Structuring the Investment — Entity Choice & Tax-Efficiency

The United States is one of the most attractive places for foreign capital — deep markets, relative stability, and strong investor Once an inbound investor decides to enter the U.S. market, the next decision — how to structure the investment — can drive the ultimate tax result significantly. The U.S. system taxes differently depending on the type of entity, its ownership, and whether treaty benefits apply.. But the U.S. also has a uniquely complex tax environment.

This article summarizes considerations for entity selection, including notation of federal, treaty, and state regimes, and practical planning points.

1. Balancing Tax Efficiency, Liability Protection & Compliance

Every inbound structure should balance three objectives:

  1. Liability protection — containing business legal risk within the U.S. entity.
  2. Tax efficiency — minimizing both U.S. and home-country tax leakage.
  3. Administrative manageability — minimizing annual administrative tasks and costs.

While the right structure depends on the investor’s facts — activity and income type, treaty position, and cash planning — there are key guardrails to consider.

2. Basic Options: Direct or U.S. Blocker, Foreign Holding Company Considerations

A. Direct Investment by the Non-Resident

This is the simplest on paper — the investor (either a foreign individual or foreign holding company) directly holds the U.S. asset, partnership interest, or LLC (treated as a partnership or disregarded for tax purposes) interest.

  • Tax result: The investor is directly subject to:
    • U.S. tax on ECI and FDAP (with related withholding)
    • Branch Profits Tax (if foreign corporation owner)
    • FIRPTA (if any disposition of USRPI or USRPHC)
    • U.S. estate tax on U.S.-situs assets (if foreign individual owner)
    • Annual filing requirements for Form 1040-NR (individuals) or Form 1120-F (foreign corporations).
      • May require additional U.S. filings at entity level (e.g., U.S. partnership or LLC treated as partnership required to file Form 1065, related Schedules K-1 and Forms 8804 / 8805 / 8813 (withholding statements) issued).
    • Pros: No interposed entity unless desired (e.g., partnership, LLC); may reduce foreign-country complications.
    • Cons: Exposed to above-noted U.S. filing obligations and taxes and potentially no legal liability protections that would exist with a corporate structure (unless using U.S. LLC).
    • Potential use case: Small passive investments or treaty-protected portfolio holdings.U.S. “Blocker” Corporation (or LLC treated as a corporation for tax purposes)

B. U.S. “Blocker” Corporation (or LLC treated as a corporation for tax purposes)

A common approach for institutional or fund investors. The foreign investor capitalizes a U.S. C-corporation to hold the operating business, real estate, partnership or disregarded LLC interest.

  • Tax result / Pros:
    • The Blocker “absorbs” ECI, paying 21% corporate income tax.
    • When profits are distributed, they are dividends subject to 30% withholding under IRC §881 (often reduced by treaty).
    • Avoids the Branch Profits Tax that would otherwise apply to a foreign corporation’s U.S. branch.
    • Potential insulation from FIRPTA (or ability for same with additional tiered structuring).
    • Simplifies compliance — the foreign owner does not file Form 1120-F or 1040-NR; only the U.S. corporation files Form 1120 (and partnership files Form 1065 if there is a U.S. partnership in the structure).
  • Con: “Double” taxation — once at the corporate level and again on distribution — though effective rates can be moderated by treaty reductions or reinvestment strategies.

3. Withholding Tax & Using Treaties Strategically (Without Over-Engineering)

The U.S. imposes withholding tax on most payments to foreign persons, such as: dividends, interest, royalties, rent, service fees, and deemed branch remittances (DEA). This withholding tax is generally levied at a statutory rate of 30%, unless reduced by treaty. U.S. payors are responsible for withholding and reporting this tax via Form 1042 / 1042-S. Failure to withhold properly can shift liability for the original tax, plus penalties and interest, to the payor as withholding agent.

Treaties can dramatically reduce withholding and sometimes exempt outbound payments or business profits from U.S. taxation altogether.

Checklist for claiming treaty benefits:

  1. Confirm investor’s residency certificate from home jurisdiction.
  2. Evaluate specific treaty qualification articles (residency, dividends, interest, royalties, business profits, etc.).
  3. Evaluate Limitation on Benefits (LOB) treaty article — are applicable requirements (such ownership and / or activity tests) satisfied?
  4. Issue Form W-8BEN or W-8BEN-E to payor(s).
  5. Disclose treaty position on Form 8833 if taking a treaty-based return position required to be reported.

4. Financing the U.S. Operation: Debt vs. Equity

Foreign investors often capitalize U.S. ventures through related-party debt, seeking to deduct interest while repatriating profits as interest payments (often subject to lower withholding than dividends).

Consideration:

  • Debt / equity analysis (common law, and IRC §385 if applicable): Debt can be reclassified as equity, disallowing deductions and potentially creating other unintended tax impacts in certain structures.
  • IRC §163(j) (generally applicable to taxpayers with average annual gross receipts of $30 million+) limits interest deductions to 30% of adjusted taxable income.
  • IRC § 267 loss disallowance and matching rules regarding timing of deduction and income recognition for accrued but unpaid interest between related parties.
  • IRC § 267A deduction disallowance for interest (and royalty) payments to related parties in hybrid transactions or with hybrid entities if the payment isn’t included int eh recipient’s income under foreign tax law.
  • Withholding: 30% on interest, unless reduced by treaty or portfolio interest exemption applies.
    • Branch context: If the foreign corporation operates a U.S. branch, adjustments under Treas. Reg. §1.884-4 apply to determine the portion of deemed interest also subject to BPT at 30% (unless reduced by treaty), if any (i.e., the amount of excess interest not apportioned to ECI taxed at 21%).
  • Base Erosion and Anti-Abuse Tax (BEAT) under §59A, which targets large corporations (generally those with $500 million+ in average annual gross receipts) making base-eroding payments like interest to related foreign parties.
  • Documentation: Written loan agreements, arm’s-length terms and pricing / interest rates, contemporaneous intercompany pricing support.

5. State Tax Structuring Overlay

States have their own tax bases, nexus thresholds, and combination rules. Depending on the investment type and amount, and the state or states involved, state tax can be a material consideration.

Key Concepts:

  • Nexus: Physical presence (property, payroll) or economic nexus from sales into a state.
  • Separate vs. Combined Filing:
    • Some states tax entities separately.
    • Others (e.g., California, New York, Illinois) require or permit combined/unitary reporting for related entities.
  • Water’s-Edge Elections:
    • Limit the combined group to U.S. members (and certain CFCs).
    • Usually binding for 7 years (Cal. Rev. & Tax Code §25113).
    • Must be modeled carefully — including impacts on foreign tax credit planning and apportionment.

Practical tips:

  • Where possible, isolate U.S. operations in one entity (or the fewest otherwise necessary entities) per state nexus profile.
  • Consider flexibility in deployment of property / assets, debt, and people in context of state credits and incentives, state apportionment, net worth tax, and separate vs. combined or unitary reporting rules.
  • Evaluate broader U.S. legal entity structure in multi-state operating structures (e.g., corporate holding company with use of wholly-owned disregarded / flow through LLCs or subsidiary corporations) for potential state tax planning or simplification.

6. Key Takeaways

  • Start with cash return in mind. Structure for efficient repatriation.
  • Contain ECI. Blockers or treaty planning can reduce compliance and tax cost.
  • Limit BPT exposure. It’s often the hidden double tax.
  • Remember FIRPTA. Structure real estate holdings to avoid FIRPTA.
  • Treaty benefits aren’t automatic. Evaluate, document, and claim them properly.
  • Don’t ignore state rules. Multiple states with differing rules can complicate matters, determine materiality and perform tax impact diligence and identify opportunities accordingly.

A well-planned structure can provide legal protections and tax efficiencies.

Coming Next

Part 3: Operating and Repatriating Profits: In our next article, we’ll explore what happens once the investment is operational: withholding regimes, filing obligations, profit distributions, and how to repatriate capital without triggering unnecessary tax.

Missed Part 1? Read it here.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Inbound Investor U.S. Tax Playbook, Part 1

Nick Eusanio, Esq., LL.M. Leave a comment

U.S. Tax Basics for Non-Resident Investors

The United States is one of the most attractive places for foreign capital — deep markets, relative stability, and strong investor protections. But the U.S. also has a uniquely complex tax environment.

For inbound investors (non-U.S. individuals or entities investing in the U.S.), understanding the basic tax framework at the start is essential. This first post in our Inbound Investor U.S. Tax Playbook series outlines how the U.S. taxes inbound investors, some of the key filings required, and how federal and state systems interact in sometimes unexpected ways.

1. Who’s a “Non-Resident” for U.S. Tax Purposes?

The U.S. distinguishes between resident and non-resident taxpayers using two tests for individuals and one for entities.

A. Individuals

  • Green Card Test: If you hold a green card, you are a U.S. tax resident regardless of where you live or how long you spend in the U.S.
  • Substantial Presence Test (SPT): You’re a resident if you are physically present in the U.S. for at least 31 days in the current year and 183 days over a three-year period, counting:
    • All days in the current year,
    • ⅓ of days in the prior year,
    • ⅙ of days in the year before that.

The SPT often surprises executives or investors with recurring business trips. Certain exceptions (teachers or students on certain visa programs, diplomats on certain visa programs, professional athletes participating in charitable sporting events) may apply.

Those who fail both tests are non-resident aliens (NRAs) — taxed only on U.S.-source income.

B. Entities

  • Formed under U.S. law → U.S. tax resident.
  • Formed under foreign law → non-resident entity, unless it has a U.S. trade or business.
  • Note: Check-the-box regulations under Treas. Reg. §301.7701 allow certain foreign entities to elect U.S. classification (corporation, partnership, or disregarded entity)

2. Three Buckets of Income: ECI, FDAP, and DEA

The U.S. system divides taxable income for non-residents into three broad categories:

A. Effectively Connected Income (ECI)

Income that is effectively connected with the conduct of a U.S. trade or business (USTB).

Typical examples:

  • Operating income from a U.S. business.
  • Rents or gains from real estate when the investor has elected to treat them as ECI under IRC §871(d) or §882(d).
  • Income from partnerships or other flow-through entities engaged in a USTB.

Tax treatment:

  • Taxed on a net basis at applicable rates (graduated rate scale for individuals (top rate 37%), flat 21% for corporations; subject to potential treaty reduction).
  • Foreign companies report this income on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation).
  • Non-resident individuals report on Form 1040-NR.
  • Deductions are allowed for related expenses (assuming a return, or protective return, is filed; failure to file a return can result in denial of deductions).

A key concept is the “force of attraction” rule — once a non-resident is engaged in a U.S. trade or business, all U.S.-source income connected to that business can be treated as ECI.

B. Fixed, Determinable, Annual, or Periodical (FDAP) Income

Passive U.S.-source income — dividends, interest, royalties, and certain rents.

  • Taxed on a gross basis at 30% withholding, unless reduced by a tax treaty.
  • No deductions permitted (gross basis tax).
  • Reporting generally handled by the U.S. payor via Form 1042 (annual withholding return) and Form 1042-S (statement to the foreign payee).

C. DEA / The Branch Profits Tax

When a foreign corporation operates a U.S. business directly (without a U.S. subsidiary corporation or LLC taxed as a corporation “blocker”), it may face an additional Branch Profits Tax (BPT) under IRC §884.

  • This tax approximates the dividend withholding that would apply if the U.S. operation were conducted through a domestic corporation.
  • The BPT is imposed at a 30% rate (often reduced by treaty) on the corporation’s “dividend equivalent amount” (DEA) — essentially, the after-tax earnings deemed repatriated out of the U.S. branch during the year.
  • The calculation starts with the U.S. branch’s effectively connected earnings and profits (ECE&P), adjusted for increases or decreases in U.S. net equity.

Many investors assume that forming a “U.S. branch” is simpler than establishing a domestic corporation, but the BPT can make it significantly more expensive from an after-tax standpoint. This is because the BPT applies in addition to the 21% tax on ECI.

Treaty Note: Most modern U.S. tax treaties reduce or eliminate the Branch Profits Tax (e.g., 5% under the U.S.–U.K. treaty), but only if the foreign corporation qualifies under the treaty’s limitation on benefits (LOB) provisions.

3. Tax Treaties: Analyze & Document Relief

The U.S. has income tax treaties with about 60 countries. Key potential benefits common in treaties are:

  • Reduced withholding rates (e.g., sometimes 0% but commonly between 5%–15% on dividends, interest or royalties, instead of 30%).
  • Exemption for business profits if the foreign investor has no permanent establishment (PE) in the U.S.
  • Relief from double taxation through foreign tax credits or exemptions.
  • Legal and dispute resolution mechanisms such as the mutual agreement procedure (MAP) to resolve disputes between the U.S. and treaty partners.

Treaty benefits are claimed via applicable reporting which includes, based on the facts and circumstances, one or more of the following: Form W-8BEN (individuals) or W-8BEN-E (entities), Form 1120-F, Form 8833 Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and Forms 1042 and 1042-S, provided the investor is a resident of a treaty country and satisfies the limitation on benefits (LOB) clause.

Avoid treaty shopping: intermediate holding companies without substantive activity may fail LOB tests, precluding treaty relief. The IRS increasingly reviews substance, management location, and beneficial ownership.

Consider obtaining a tax opinion to document the expected comfort level of treaty applicability and associated U.S. tax impact.

4. Structuring the Investment

Choosing an entry structure has long-term tax and compliance implications. The below chart offers a high-level overview of key considerations in structural options for nonresident investment in the U.S.

StructureProsCons
Direct ownership
(individual)		(individual) Simple, transparentExposed to ECI, FIRPTA, U.S. estate tax for U.S. stock holdings, and personal filing obligations (Form 1040-NR, others as applicable), no corporate liability limits.
U.S. corporation or
LLC taxed as
corporation (C-corp
“blocker”)		Generally shielded from ECI and Branch Profits Tax, potentially limits FIRPTA, simplifies compliance, corporate liability limitations for shareholders / membersDouble taxation (21% corporate + dividend withholding)
U.S. LLC (treated as
partnership or
disregarded)		Flow-through taxation, flexibility, corporate liability limitations for membersForeign owner becomes directly taxable and must file Form 1040-NR/Form 1120-F, exposed to FIRPTA
Foreign corporation
holding U.S. assets
(including LLC treated
as disregarded or
partnership)		Potential treaty benefits, estate tax protection, corporate liability limitations for shareholders / membersBranch Profits Tax, 30% withholding on certain payments, complex reporting (Forms 1120-F, 5472, 8833)

5. FIRPTA: The Real Estate Trap

The Foreign Investment in Real Property Tax Act (FIRPTA) taxes foreign persons on gain from the sale of U.S. real property interests (USRPI) (which includes interest in a U.S. real property holding company (USRPHC), very basically, a U.S. real-property rich – at least 50% FMV of its assets – holding company)) as if it were ECI.

  • Withholding: Buyers must withhold 15% of the gross sale price, unless the seller obtains a reduced-withholding certificate on Form 8288-B.
  • Reporting: Withholding submitted on Form 8288; seller receives Form 8288-A as credit evidence.
  • Election: Foreign investors in rental real estate may elect to treat rental income as ECI (thus deductible) under IRC §871(d)/§882(d) — often made by attaching a statement to Form 1040-NR or 1120-F.

6. Key Federal Tax Filings for Inbound Investors

FormDescriptionGeneral Filing Requirements / Purpose
1040-NRNon-resident individual U.S. income tax returnDirect investor or member of U.S. LLC (if disregarded for tax purposes)
1120-FU.S. income tax return for foreign corporationsForeign corporation with ECI or U.S. branch
5472Information return of a 25% foreign-owned U.S. corporation or a foreign corporation engaged in a U.S. trade or businessReporting corporation required to disclose reportable transactions with foreign or domestic related parties
8833Treaty-based return position disclosureClaiming treaty benefits to override domestic law
1042 /
1042-S		Annual withholding return / statement for FDAP incomeU.S. payor with foreign recipient
8288 /
8288-A /
8288-		FIRPTA withholding formsNon-U.S. party disposition of real property interest / interest in U.S. real property holding company
8804 / 8805
/ 8813		Partnership withholding on foreign partnersU.S. partnership with foreign investors

Failure to file can result in steep penalties and the loss of treaty benefits.

7. State Tax Considerations: The Overlooked Layer

Federal planning alone isn’t enough. States operate semi-autonomously, and foreign investors can create state “nexus” — a taxable presence — much more easily than they realize.

A. Key Triggers for State Nexus

  • Owning or leasing property in the state.
  • Having employees, agents, or contractors there.
  • Exceeding sales thresholds under economic nexus standards (post-Wayfair).
  • Holding a partnership interest in an entity operating in that state.

B. Filing Implications

  • Corporate income/franchise tax: Many states follow federal taxable income but have unique state tax addback or deductions based on whether the state conforms to or decouples from federal tax law. Income is also apportioned with state-specific income apportionment formulas.
  • Partnership or pass-through entity tax: Some states impose entity-level taxes or mandatory withholding on non-resident partners.
  • Sales/use tax: Separate compliance system — nexus rules differ from income tax nexus.
  • Net Worth tax: Some states impose taxes on net worth (generally, total assets less total liabilities) in the state as well.

C. Combined Reporting and Water’s-Edge Elections

For foreign corporate groups with U.S. subsidiaries:

  • Worldwide combined reporting: Some states (e.g., California) require or allow combination of worldwide income, including foreign affiliates.
  • Water’s-edge election: Available in certain states (notably California) to limit combined reporting to U.S. entities and controlled foreign corporations (CFCs) meeting specific ownership thresholds.
  • These elections are often binding for 7 years and must be carefully modeled before election — they can dramatically change state tax bases.

D. Apportionment

Most states use a single-sales factor or three-factor formula (sales, property, payroll) to determine what portion of income is taxable. The rules vary widely — meaning two states may tax the same income differently.

8. Common Pitfalls

1. Accidental U.S. Trade or Business: Taking an active role in management, hiring U.S. agents, or signing contracts in the U.S. can trigger ECI.

2. Overlooking FIRPTA: U.S. real estate is always within U.S. tax jurisdiction.

3. Neglecting State Taxes: Many foreign investors assume federal treaties cover states — they don’t necessarily as states may follow or not follow federal tax treaties, so a state-specific review is necessary.

4. Missing or Late Filings: Non-filing penalties can exceed the tax itself and be imposed on information-reporting only (no tax-due) filings that are missed or filed late.

5. Treaty Misuse: Claiming treaty benefits without satisfying LOB tests invites IRS scrutiny.

6. Improper Entity Selection: Legal entity form and tax treatment can differ (e.g., LLC treated as a corporation, partnership, or disregarded entity for tax purposes). These differences can have varying tax implications for inbound investors, so it is important to structure carefully.

9. Getting Started — A Practical Checklist

Before your first investment:

1. Confirm tax residency of all investors and entities.

2. Identify expected income types (ECI vs FDAP).

3. Review potentially applicable treaty benefits, document applicability with a tax opinion.

4. Model federal and state tax exposure, including combined reporting effects.

5. Select optimal entity structure and make elections early.

6. Implement withholding and filing procedures.

7. Keep contemporaneous records to support treaty positions and LOB compliance.

Coming Next

Part 2: Structuring the Investment — Entity Choice & Tax-Efficient Entry Point: In our next article, we’ll examine entity options for inbound investors, how to manage Branch Profits Tax, treaty planning, and how different structures affect ongoing operations and repatriation strategies.

Thinking about investing in the U.S.? Start with a consultation to evaluate your company’s readiness and identify strategies for success. Connect with Nick Eusanio, Tax Planning & Compliance Partner at DBL Law, to learn how proper tax planning and investment structure can help you achieve the best possible outcome.

Business Sale Basics, Part 4: Close & Integrate or Transition

Nick Eusanio, Esq., LL.M. Leave a comment

Closing a business sale is just the beginning. Learn how to manage integration or transition effectively to protect and drive value in Part 4 of our Business Sale Basics series.

Closing the sale is a major milestone, but it’s not the end of the journey. Proper planning for integration or transition ensures long-term success for both you as the seller and the buyer. Again, due consideration for these matters has already been given in Part 2 of our series (Structure the Sale).

Post-Closing Considerations

1. Integration / Transition Planning

Clear documentation in one or more appropriate agreement(s) is key to ensuring the intended transition mechanics. Consider the following factors when drafting appropriate documentation.

  • How and when the buyer will assume operations.
  • How and when will the owner / seller notify existing employees, customers and vendors / suppliers of the sale? What steps are necessary to ensure business continuity for these groups?
  • Whether and what level of involvement the owner / seller will continue to have in the company and for what time period.
    • If the owner / seller remains involved:
      • What type and level of pay and benefits will be continuing?
      • Will the owner / seller retain any percentage ownership in the equity of the company (i.e., a rollover interest)?
    • If the owner / seller is exiting:
      • Address any interim transition period / consulting arrangement, earn-out, or other phased exit plan.

2. Tax and Regulatory Compliance

Post-closing reporting is just as important as pre-closing planning. Consider the following compliance items after closing.

  • Required tax filings for the transaction.
  • Required industry / regulatory filings for the transaction.
  • Tracking for installment sale payments or deferred compensation.

3. Avoiding Post-Closing Disputes

A seller who has successfully navigated the process following our Business Sale Basics: 1. Prepare the Pieces, 2. Structure the Sale (Legal & Tax), 3. Align Team, Finance, & Industry Factors can expect to be in good position to avoid post-closing disputes. Below are some key factors expected to be in place and continuing to achieve that goal.

  • Keep documentation clear to reduce claims risk.
  • Follow through on representations and warranties.
  • Maintain open communication with the buyer during transition.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome.

Business Sale Basics, Part 3: Align Team, Finance, & Industry Factors

Nick Eusanio, Esq., LL.M. Leave a comment

Employees, financing, and industry / regulatory factors can make or break a business sale. Learn how to address these critical elements in Part 3 of our Business Sale Basics series on Aligning these Factors.

Business sales are more than numbers on a balance sheet. Employees, financing, and industry-specific regulatory considerations play a critical role in the success of a transaction. Well-prepared sellers project credibility and value by aligning these items in the deal. This article serves as a continuation of Part 2 of our series (Structure the Sale), as each of these factors is important in structuring the transaction.

1. Employee & Management Factors

Retaining key employees and ensuring the business isn’t overly tied to the selling owner are often key factors for buyer confidence and demonstrating value. A thoughtful seller should align these factors in the deal by considering the items below.

  • Invest the necessary training time and resources to improve management team business / technical capabilities and integration with operations personnel and customers to reduce dependency on the owner.
  • Document steps to accomplish the above and ideally matching metrics to substantiate the value retained or created, for sharing with the buyer team.
  • Ensure key management and operations team members are valued in the deal by negotiating appropriate provisions for continuing employment including roles and levels of salary, benefits and bonuses. Don’t forget to provide for any special items like remote versus on-site work, parking, company phones and cars, or similar benefits.

2. Financing the Transaction

Understanding the buyer’s funding method for the deal is important to both timing and negotiations. Below are some key points to consider with respect to financing, timing and related negotiations.

  • Bank / 3rd party financing versus seller financing.
  • For seller financing, a well-crafted promissory note and security agreement with appropriate collateral are key considerations.
  • Be aware of potential covenants or guarantees, particularly any ‘earn-out’ provisions.

3. Industry and Regulatory Factors

Various industries have unique licensing, permitting, regulatory or other compliance requirements that can impact a sale. Heavily regulated industries like health care, financial services / banking, or insurance may require specific disclosures or approvals. Below are some key items to consider from an industry / regulatory perspective.

  • Review licensing, permits, and regulatory compliance requirements for your industry.
  • Understand other regulatory frameworks that may apply based on the type (e.g., cross-border transaction, involvement of sensitive information or data, etc.) or value of the transaction (for instance, anti-trust, securities, cybersecurity and infrastructure security, export control system, foreign investments, etc.).
  • Ensure necessary additional documents or agreements are prepared and negotiated as part of the sale based on applicable regulatory regimes.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome.

Business Sale Basics, Part 2: Structure the Sale (Legal & Tax)

Nick Eusanio, Esq., LL.M. Leave a comment

Avoid costly mistakes in selling your business. Learn the key legal and tax tips and traps to avoid in Part 2 of our Business Sale Basics series: Structure the Sale.

Selling a business comes with both opportunities and potential pitfalls. The structure of your sale can dramatically influence both your liability exposure and tax outcome. Choosing the right approach and understanding common issues can protect your proceeds and mitigate future risk.

1. Legal Considerations

Structuring the deal as an asset sale versus a stock sale is first a legal consideration (as well as tax, to follow) affecting liability and risk allocation. Buyers often prefer an asset sale to limit liability exposure, while sellers tend to prefer a stock sale for the same reason (as well as for tax purposes, to follow). The deal landscape is a balancing act, especially concerning risk allocation. A wise seller should consider the following items in structuring the sale.

  • Understand the difference between asset and stock sales from a risk / liability allocation standpoint.
  • Review the pieces that should have been prepared in initial seller due diligence (see our prior article: Prepare the Pieces, the first in this series).
  • Carefully evaluate representations, warranties, indemnification, and mandatory dispute resolution clauses.
  • Consider representations and warranties insurance if financially prudent.

2. Tax Considerations

Tax planning is central to structuring the sale. In an asset sale (or stock sale treated as an asset sale for tax purposes), how the purchase price is allocated—between tangible assets, intangible assets, goodwill, and inventory—affects the type and amount of tax you pay. In a stock sale, generally expect capital gains tax treatment assuming appropriate holding requirements are met. Consult with your tax advisor on the following to structure the sale to achieve the intended tax impact.

  • Asset, Stock, or Stock (treated as Asset for tax purposes) sale tax impacts.
    • For an Asset or Stock (treated as Asset for tax purposes), purchase price allocation and related tax implications (e.g., amount subject to ordinary tax / rate treatment vs. capital gains tax / rate treatment).
    • IRS §§ 338(h)(10) or 336(e) elections.
    • Tax gross-up provision in the purchase agreement.
  • Tax compliance considerations (short and final year returns, additional required transactional reporting forms and statements, etc.).
  • State and local tax considerations (are the impacts aligned to federal income tax outcomes / conformity? Or are there significant differences?).

3. Common Traps to Avoid

Certain oversights can erode buyer trust and reduce the purchase price, destroy the deal, or trigger post-closing disputes and liabilities. Smart sellers should anticipate and consider the below items to improve transparency and trust in the process (most of which should be caught in the Prepare the Pieces stage).

  • Deferred compensation or bonuses.
  • Ongoing liabilities, like employee benefits.
  • Proper due diligence documentation and clearly and accurately stating facts.

4. Build Your Professional Advisory Team for a Smooth Sale

Engaging the right professional advisory team early (ideally in the Prepare the Pieces diligence phase, but certainly no later than the Structuring phase) is vital to a smooth, clean deal. Below are some considerations for structuring your deal-team and related processes.

  • Engage legal, business, financial, and tax advisors early (e.g., attorneys, accountants / CPAs, valuations professionals, investment bankers, and wealth advisors).
  • Identify and communicate your key goals and objectives, and chief ‘deal-killer’ items, to your professional advisory team.
  • Communicate clearly with buyers.
  • Follow standardized processes to streamline due diligence.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome

Business Sale Basics, Part 1: Prepare the Pieces

Nick Eusanio, Esq., LL.M. Leave a comment

Learn the essential steps to get your business ready for sale, from organizing financials to planning for taxes, in this first installment of our Business Sale Basics series: Prepare the Pieces.

Preparation is the foundation of any successful business sale. Owners who take the time to get their company “deal-ready” often sell faster, for more money, and with fewer surprises and snags. This post covers key steps to prepare your business before putting it on the market.

Key Steps to Prepare

1. Organize Financials & Records

Accurate and well-organized financials are critical. Buyers generally want to review at least three years of statements, so savvy sellers should review and organize the following items (ideally in a centralized digital data room or diligence binder).

  • Accounting records (P&L, Balance Sheet, etc.) in current, accurate, and reconciled form (preferably with assistance of a professional accountant / CPA).
  • Corporate documents: articles, bylaws, operating agreements, meeting minutes and resolutions.
  • Contracts, leases, permits, licenses and intellectual property documentation in a centralized file.

2. Identify & Address Risks & Liabilities

Buyers are highly sensitive to hidden liabilities and risks. A smart seller should conduct a fresh risk assessment for potential yet-uncovered issues, as well as identifying and listing known disputes, litigation, and liabilities. Below are some key areas for review and assessment. Once identified, a prepared seller should form a plan to resolve or address each item of risk or liability.

  • Confirm company and asset (real estate, operating assets, intellectual property, permits, licenses, etc.) ownership records reflect reality.
  • Resolve disputes with minority owners.
  • Review buy-sell agreements and stock restrictions, as well as employment agreements and restrictive covenant (nondisclosure / noncompetition / non-solicitation) agreements for key personnel.
  • Evaluate tax accounts (federal, state and local).
  • Consider any zoning, environmental, or other industry-specific regulatory issues.

4. Optimize Operations & Team Readiness

Buyers are often acquiring more than the business – they may also be taking the team that’s in place. As with all team-based pursuits, performance and value is heavily dependent on each team member and the process in place. A strong seller should take the steps below to improve the company’s team and methods prior to sale.

  • Invest in management team business / technical capabilities and integration with operations personnel and customers to reduce dependency on the owner.
  • Review key customer and vendor contracts to align the proper internal personnel and processes for continued success.
  • Identify (and improve, where necessary) and document processes and systems to demonstrate stability.

5. Plan for Taxes Early

The tax structure of a sale can significantly impact a seller’s net proceeds. Early planning allows you to evaluate whether an asset sale, stock sale, or other structure is most favorable. A savvy seller should begin by considering the following tax matters.

  • Alternative deal structures and impacts on taxes (asset sale, stock sale, or stock sale treated as an asset sale for tax purposes?)
  • Evaluate potential tax elections as relevant (e.g., IRC §§ 338(h)(10) or 336(e)).
  • Consult with a tax advisor to identify potential tax issues and opportunities, and improve tax efficiency of the deal.

Thinking about selling your business? Start with a pre-sale consultation to evaluate your company’s readiness and identify strategies to preserve and maximize value. Connect with Nick Eusanio, Tax & Compliance Partner at DBL Law, to learn how proper tax planning and deal structure can help you achieve the best possible outcome.

Common Tax Traps for Entrepreneurs, Startups & Small Businesses

Nick Eusanio, Esq., LL.M. Leave a comment

Federal tax audits or examinations don’t just happen to big corporations. Founders and small businesses are often hit the hardest. This is sometimes because growth outpaces compliance, and sometimes because the rules themselves are complex. Here are some key areas where trouble tends to strike, and what you can do to mitigate risk.

1. Worker Classification: Independent Contractors vs. Employees

Issue: Misclassifying workers can lead to payroll tax assessments, penalties, and even personal liability for owners.

Consider: The IRS applies a multi-factor test focused on control. If you dictate hours, tools, and how the work is done, odds are the worker is an employee.

Action: Use written contracts with contractors. Review relationships annually. Consider preparing and filing IRS Form SS-8 if classification is unclear.

2. Payroll Tax Compliance

Issue: The IRS treats unpaid payroll taxes as one of the most serious violations. Missed deposits, late filings (Form 940 and Form 941), or failure to remit tax withholdings can trigger the Trust Fund Recovery Penalty (TFRP). Under the TFRP, the IRS can collect directly from “responsible persons”—owners, officers, or even bookkeepers.

Consider: Red flags like:

  • Borrowing from payroll tax withholdings to cover operating expenses.
  • Repeated late deposits.
  • Incomplete or inaccurate Forms 940 or Forms 941.

Action: Use an outside payroll provider if you don’t have in-house talent. Always confirm deposits are made, even if a third-party processor is used.

3. Deductibility of Expenses

Issue: The IRS often challenges whether claimed deductions are truly “ordinary and necessary” under IRC § 162. Startups and entrepreneurs are particularly at risk because personal and business expenses sometimes blur together.

Consider:

  • Startup vs. operating expenses: Generally, pre-opening costs must be capitalized and amortized under IRC § 195. There is a limited first-year immediate deduction of $5,000 in startup costs and another $5,000 in organizational costs. But this deduction is subject to limitations and phase-out.
  • Meals, travel, and vehicles: Require strict substantiation with logs and receipts. Note applicable limitations like 50% of meals. Identify clear business purpose.
  • Home office deductions: Often challenged unless the space is used exclusively and regularly for business. Evaluate applicable safe harbor rules and remember deduction recapture rules on sale of your home.

Action: Keep meticulous records. A clean ledger with contemporaneous notes, mileage logs, and calendar entries are key in audit defense.

4. Entity Structure & Elections

Issue: The choice of entity—and whether elections are properly filed—drives tax mechanics and impact, reporting compliance, and controversy.

Consider:

  • Entity Classification Election (Form 8832): What is the default tax classification of the entity? Is the entity eligible to elect a different tax classification? Options are: association taxable as a corporation, partnership, or entity disregarded from its owner for federal income tax purposes. A late or erroneous election can have significant consequences. These mistakes can impact applicable tax mechanics and rate(s) and reporting obligations. Often, an election mistake leads to other incorrect or missed filings and more tax, interest and penalties.
  • S Corporation Election (Form 2553): If filed late or incorrectly, the IRS treats the company as a C corporation. This creates unintended double taxation. As above, impacts can also include other incorrect or missed filings, more tax, interest and penalties.
  • Reasonable Compensation: S Corp shareholders who underpay themselves and take most income as “distributions” risk IRS reclassification. This reclassification often triggers more payroll tax liabilities.
  • Conversions and Reorganizations: Changing from an LLC with partnership or disregarded entity tax classification to a corporation (or vice versa) can trigger unanticipated tax consequences. As before, this often leads to more tax, interest, and penalties if not carefully planned.

Action: Confirm your entity elections are on time, appropriate, and as intended. Keep written records of salary determinations and supporting research. Consult tax counsel before making any structural changes or elections.

5. Qualified Business Income (QBI) Deduction (IRC § 199A) Complexities

Issue: The 20% deduction can be huge—but the rules are highly technical. The IRS closely examines whether a business is a “specified service trade or business” (SSTB), how wages are calculated, and whether property is properly classified.

Consider:

  • Is your business type listed as a SSTB?
  • How are wages and property allocated?
  • Do income thresholds limit your deduction?

Action: Model the deduction annually to confirm eligibility, and document how wages and property are allocated. Careful planning around compensation, entity choice, and property ownership can preserve or improve the benefit.

6. Sale, Exit & Mixed-Character Transactions

Issue: When it’s time to sell, how you structure the deal often impacts whether proceeds are taxed as ordinary income or capital gain.

Consider: Impact to character (ordinary or capital gain) of gain, tax rate, and timing from:

  • Stock / equity sale (legal) treated the same for tax purposes,
  • Asset sale (legal) treated the same for tax purposes OR Stock / equity sale (legal) treated as an asset sale for tax purposes (available elections / requirements)
    • Allocation of purchase price to asset classifications (e.g., accounts receivable, inventory, goodwill, etc.)
  • Installment sale treatment
  • Foreign Investment in Real Property Tax Act (FIRPTA) for foreign investors selling an interest real property or a real-property rich entity.

Action: Get tax advice before signing the letter of intent. Once the framework structure is agreed upon, the tax impact of the final deal is often limited unless flexibility was built in.

7. Recordkeeping & Documentation – IRS Audit

Issue: The IRS doesn’t always take your books at face value. If records are thin, the IRS can use indirect methods to recreate your P&L. This can include bank deposit analysis, percentage markup analysis, or lifestyle audits (looking at cash and credit card expenditures and assets).

Consider / Action: Keep separate business and personal accounts and reconcile monthly. Save receipts and invoices. Prepare clear schedules for deductions. Save other relevant supporting documentation from third parties.

8. Penalties & Interest

Issue: The tax bill is only part of the pain. Late filing, late payment, and accuracy-related penalties can quickly snowball.

Consider:

  • IRC § 6651 penalties for failure to file/pay.
  • IRC § 6662 accuracy-related penalties for negligence or substantial understatement.
  • Other IRC provisions imposing penalties for failure to file related to certain informational returns.

Action: Keep a tax compliance calendar with entries and recurring reminders for all tax filing and payment due dates and amounts. Task a responsible employee (or a third-party consultant) with monitoring and managing all tax obligations to ensure timely reporting and payment.

Final Word

For entrepreneurs and small businesses, tax controversies often arise not from intent but from oversight, rapid growth, or technical missteps. Minding entity classification elections and payroll tax obligations, documenting deductions, and involving tax counsel early in transaction planning, can help small businesses avoid many of the most common IRS challenges.

Often a short consultation with a tax attorney can save you from years of penalties, interest, and costly disputes. If you’re facing an IRS notice of audit or examination, notice of proposed adjustment, or IRS collection action, don’t delay. Now is the time to contact tax counsel with experience in tax controversy matters. Prompt action with a tax attorney in your corner can improve results. Potential benefits can include avoiding or releasing tax liens and levies, reducing tax, interest and penalties, or settling tax debts for less than the amount owed.

Are Personal Injury Settlements Taxable in Kentucky or Ohio?

Nick Eusanio, Esq., LL.M. Leave a comment

When it comes to personal injury settlement proceeds, the U.S. federal and state income tax treatment can significantly affect how much of your recovery you keep. Whether you’re a personal injury plaintiff, attorney, or tax advisor, thoughtful structuring and characterization of a settlement is essential.

Here’s a high-level summary of how federal, Ohio, and Kentucky income tax law treats personal injury settlement proceeds, and how to structure a settlement agreement for tax efficiency.

💡Personal Injury Settlements Can Be Tax-Free

Under Internal Revenue Code (IRC) § 104(a)(2), certain damages received on account of personal physical injuries or physical sickness are not taxable. So, these proceeds aren’t included in federal gross income under IRC § 61, which otherwise broadly includes “all income from whatever source derived.”

To support tax-free payments, especially for Kentucky or Ohio taxpayers, attention to the relevant legal framework and aligning structuring and documentation of the settlement are critical.

🔍 The Federal Income Tax Framework: IRC and Treasury Regulations

Under federal income tax law:

  • IRC § 61 is the starting point, which states that gross income includes all income of a taxpayer unless a specific exclusion applies.
  • IRC § 104(a)(2) excludes from gross income damages received (other than punitive damages) on account of personal physical injuries or physical sickness.
  • Treas. Reg. § 1.104-1(a), (c) confirms that the exclusion applies to both lump-sum and periodic payments and clarifies the scope of injuries that qualify.
    • For instance, it is also possible to exclude settlement amounts attributable to emotional distress, but that emotional distress 🧠 must be directly related to the personal physical injury sustained, unless the amount is for reimbursement of actual medical expenses related to the emotional distress and such amount wasn’t previously deducted under IRC § 213.
    • 💭 Note: Punitive damages and damages unrelated to physical injury—like reputational harm or contract claims—are taxable.

🏛️ State Income Tax Law: Ohio and Kentucky Generally Follow Federal Law

  • Ohio Revised Code § 5747.01(A) and Kentucky Revised Statutes §§ 141.010 and 141.019 state that both Ohio and Kentucky generally conform to the federal definition of gross income, with certain state-specific adjustments.
  • So, if your settlement proceeds are excluded under IRC § 104(a)(2), they are also excluded from Ohio and Kentucky state income tax, unless a specific modification exists (which does not in Ohio or Kentucky income tax law).

📝 How to Structure the Settlement Agreement

The tax characterization of a settlement isn’t solely based on what the payment is called—it depends on what the payment is actually for. Still, clear language in the agreement helps support favorable tax treatment.

Recommended provisions to include:

  1. Purpose – Clearly state that the agreement is a settlement instead of pursuing a potential or existing claim or legal action under statutory or common law involving personal physical injuries or physical sickness.
  2. Characterize Settlement Proceeds into Appropriate Buckets –  
    State amounts of any payments attributable to personal physical injuries or sickness and affirm that the parties intend those payments to be excluded from gross income under IRC § 104(a)(2) and Treas. Reg. § 1.104-1(a), (c). Specifically allocate any settlement proceeds to other buckets if relevant, like punitive damages which are taxable.

⚖️ Final Word

Not every settlement dollar is tax-free. But with smart planning and a well-structured agreement, plaintiffs in Kentucky and Ohio can often shield personal injury settlements from both federal and state income taxes.

Tax advice should always be tailored to the specific facts of the case—so if you’re drafting a settlement agreement or receiving a payout, consult with a tax attorney who knows how to structure these arrangements properly.

Tax Implications of Employer Gifts to Employees

Nick Eusanio, Esq., LL.M. Leave a comment

Corporate gifting is a thoughtful way to reward and recognize employees. But, as with all transactions, tax is an important consideration. The Internal Revenue Code (IRC) treats gifts from employers differently than personal gifts. Even seemingly small offerings like holiday bonuses or gift cards can trigger tax and withholding obligations. This post summarizes how the general rules apply to both the employer and the employee.

1. What is a “Gift”?

Under IRC § 61, almost anything paid by an employer to an employee is income, unless a specific exception applies. IRC § 102(a) allows taxpayers to exclude value from a gift in the personal context, but not when it comes from an employer (see IRC § 102(c)). Following are some general taxability rules for certain items “gifted” by an employer to an employee.

2. Cash & Cash‑Equivalent Gifts = Taxable Compensation

Below are the general rules regarding cash and cash equivalent gifts from an employer to an employee.

Employee side:

  • It’s treated like wages. Employees must report the full amount as income on their Form 1040.

Employer side:

  • Employers must withhold regular income tax, Social Security, and Medicare, and report the gift as wages on Form W-2.
  • Deductible as ordinary business expenses under IRC § 162—just like salaries and bonuses.
  • Subject to payroll taxes (employer match for FICA, FUTA, SUTA) because this is wage income.

3. Non‑Cash, Nominal Gifts can = “Gifts”

Gifts of tangible personal property—think mugs, plaques, small gift baskets—are typically exempt as de minimis fringe benefits under IRC § 132(e), if they are all of the following:

  1. Not cash or cash equivalent;
  2. Infrequent;
  3. “Nominal” in value (commonly considered $100 or less per gift) and administratively impractical to track; and
  4. For business purposes.

It is important to note that there are specific rules for certain other types of employee fringe benefit which are not covered by this article. Those other employee fringe benefits include the following: qualified transportation fringe, no-additional cost service, working condition fringe, qualified employee discount, qualified moving expense reimbursement, qualified retirement planning services, or qualified military base realignment and closure fringe.

Employee side de minimis fringe benefits:

  • These are not taxable if they meet those criteria—no income or withholding.

Employer side de minimis fringe benefits:

  • Fully deductible as ordinary business expenses.

4. Achievement & Retirement Awards Get Special Treatment

If your gifts are used as achievement awards (e.g., length of service, safety milestones), there’s a separate set of rules under IRC §§ 74(c) and 274(j). These may allow up to $1,600 per employee per year (non‑cash or cash equivalent; clearly certified program required). But, the rules here are detailed and have specific requirements, so it is important to consult with a tax professional when planning to structure achievement awards intended to be treated as non-taxable employee gifts.

Summary & Employer Tips

For both employers and employees, cash and cash-equivalents = taxable compensation.
When using infrequent, non-cash, nominal gifts, it can be a win-win: tax break for employers, tax-free perk for employees.

So, employers:

  • Think twice before handing out gift cards—automatically treated as cash.
  • Outside of qualified achievement or retirement awards (which should be planned with a tax professional) stick to infrequent, low value (not the proverbial gold watch!), tangible gifts to recognize employees.
  • Document purpose, amount, date, and recipient to support deductions.

As always, it’s important to have an experienced tax attorney evaluate the specific facts, circumstances, and applicable law when considering employee gifts that may not fit neatly within the above general rules, such as other fringe benefits (besides the de minimis fringe benefit rule discussed above) or qualified achievement or retirement awards.