The term ‘upstream’ actually comes from the annual migration of some fish swimming upstream to lay and fertilize eggs. We’re not talking about that today.
Today, we’re talking about ‘upstreaming’ as a business tax strategy that has been touted for years. Upstreaming generally is associated with Nevada or Wyoming companies. The idea is that if you have a business in a home state that has a high tax, you can avoid some of the state tax by upstreaming.
The way it’s explained (generally by people who are big on ideas, low on follow through) is that you just set up a Nevada corporation or a Wyoming corporation and then bill your home state for some kind of products and services. Voila! You’ve created an expense for your home state and income for your Nevada or Wyoming corporation.
That means you’ll have less taxable income in your home state and more taxable income in a state tax-free state like Nevada or Wyoming.
Everything is fine until your home state cries foul because they don’t see the business purpose for moving income to a state tax free state.
The other way you might have heard about upstreaming is if you’re operating your business in an S Corporation because you’re a professional or other business type that makes a C Corporation impossible. But you still want the tax breaks of a C Corporation, so you set up a C Corporation and run some income from your S Corporation to the C Corporation. The S Corp income flows through to you personally, but it’s been reduced because you have an expense for the payment to the C Corporation. The C Corporation has income, but then you’re able to put a great employee benefit plan in place.
The risk in this case was that you have to provide the same benefits to all employees of all other companies that are in your controlled group. So, if you have a bunch of employees in your S Corporation, you can’t set up the C Corporation and pay benefits just to yourself through the C Corporation.
Those were the problems you used to face. Now there is a bigger one. The IRS has some teeth in the requirement that any tax strategy must have an economic purpose. Not only that, but if it’s something that falls into the category of ‘tax shelter’ or ‘tax scheme’, you have to disclose it to the IRS. Fail to do so and you can face jail time.
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