Problem: How are companies like Sherwin-Williams able to lower their taxes by “renting” or “licensing” their own brands to themselves?
- What is a “name or brand” in tax law?
- A brand or name in tax law is essentially “intellectual property” (“IP”) or an intangible asset that could be amortized or expensed as a royalty or interest expense. Thus, companies will often transfer trademarks, copyrights, patents and other forms of intangible assets into holding companies or other legal structures.
- How does intellectual property or intangible assets lower your taxes?
- Major companies will transfer the IP to holding companies incorporated in different states. Usually, the most popular state is Delaware due to their royalty income exception for holding companies or Nevada.
- Transferring the IP allows the company to create an expense to itself and shift income to a lower tax bracket. Example: ABC, Inc. pays 35% in taxes, but DEF, Inc. pays 15% in taxes because it has a less income. Thus, the company would save 20% in taxes by transferring the income to the IP holding company.
- The expense that is created is generally royalty income for using a trademark or patent by the parent or original company. Thus, the company is able to deduct an expense equal to the royalty.
- How is this legal?
- Related transactions are viewed with a strict eye to whether or not it has a “valid business purpose.” But, the federal and local governments cannot deem related transactions invalid wholesale because it was be unconstitutional. Thus, related party transactions are valid and binding as long as the taxpayer can prove that it has a “business purpose” according to the black letter of the law.
- A landmark case in New York State by Sherwin-Williams established precedence that this type of tax planning is both legal and valid if you’re able to meet the burden of proof to justify a “business purpose.”
- Sherwin-Williams justified its business purpose by allowing the public to license their trademarks at market rates. Although, the company comprises more than 90% of the subsidiary’s income the facts still illustrate a business purpose. The public is allowed to purchase the license at will and the price the company paid was “at-arms-length” because they paid the same rates as the public.
- Is it dangerous?
- When the Sherwin-Williams case was decided, New York State quickly passed anti-passive investment company legislation that attempted to close this loophole.
- The law adds additional scrutiny to the transaction, but it fails to close the loophole. The legislation could be viewed as a warning and less as a deterrent to companies.
- Are there alternatives?
- Yes, the alternative is to incorporate a legal entity offshore or at a foreign country and utilize the same theory to entirely remove the income from the country. This would allow a reduction in both federal and state taxes.
We often complain that names don’t mean anything, but they should be respected because it could lead to a variety of tax advantages that you never thought of with the right knowledge.