Avoiding Tax Issues for LLCs Contracting with Group 2 Simplified Tax Sole Proprietors

Prostir Accounting Services Company provides accounting services for Ukrainian and international companies, representative offices, non-profit organizations and foundations, and individual entrepreneurs (FOP).

Case Study from Accounting Services Practice

An LLC on the general taxation system paid an advance payment to an individual entrepreneur (FOP) on the simplified taxation system, Group 2, under a service agreement.

In 2020, a client (an LLC on the general taxation system), which is under our accounting service, entered into a service agreement with an individual entrepreneur (FOP on the simplified taxation system, Group 2). When the agreement was concluded, no one on the client's side paid attention to a significant fact, namely, that transactions with an individual entrepreneur (FOP on the simplified taxation system, Group 2) constitute a violation of legislation. The LLC successfully transferred the advance payment to the entrepreneur, and when we saw the documents, we "sounded the alarm" and informed the management about a potential problem. What to do in such a case, and is there an opportunity for the LLC and the FOP to avoid penalties and financial risks? What consequences could this situation have led to if tax authorities had noticed it during a tax audit of our client LLC?

What tax risks may arise for the LLC?

If the FOP provided the LLC's management with "a copy of the document confirming their state registration as a business entity," there should actually be no consequences for the LLC (basis - sub-clause 165.1.36 and clause 177.8 of the Tax Code of Ukraine).

However, we do not rule out that tax authorities may attempt to accuse the LLC of failing to perform the functions of a tax agent when paying such funds to the FOP based on sub-clause 177.6 of the Tax Code of Ukraine.

What may be additionally assessed for the LLC in such a case?

• personal income tax liability (18% of the amount of funds transferred to the FOP, increased by the "in-kind coefficient")
• military levy liability (1.5% of the amount of funds transferred to the FOP)
• penalties ranging from 25% to 75% of the additionally assessed tax liabilities (in accordance with Article 125-1 of the Tax Code of Ukraine) and late payment interest (in accordance with Article 129 of the Tax Code of Ukraine).

One should also not forget about liability for incorrect reporting of these operations in Form 1DF and about the administrative liability of LLC officials (Article 163-4 of the Code of Administrative Offenses).

What tax risks may arise for a Group 2 FOP?

• the necessity to pay a single tax at 15% of the advance payment received from the LLC (basis - paragraph 5) sub-clause 293.4 of the Tax Code of Ukraine)
• in accordance with paragraph 9) sub-clause 298.2.3 of the Tax Code of Ukraine, from 01.04.2021, the FOP must switch to the general taxation system – i.e., lose the right to pay the single tax altogether (regardless of the rate/group).

What happens if the FOP does not independently change the taxation system and does not pay the 15% single tax?

If tax authorities discover this violation during a future tax audit, then in accordance with clause 299.11 of the Tax Code of Ukraine, they will forcibly annul the FOP's registration as a single tax payer (regardless of which group they are in at the moment the tax authorities discover such an offense) starting from the quarter following the quarter in which the FOP committed such a violation, i.e., effectively "retroactively."

Such "forced" annulment of the FOP's registration as a single tax payer will lead to the following:

• all income received by such FOP from their business activities for the entire specified period and until the tax authorities annul the FOP's registration as a single tax payer, will be the basis for additionally assessing personal income tax (at a rate of 18%) and military levy (at a rate of 1.5%)
• the FOP will be assessed penalties (from 25% to 50% of the amount of additionally assessed personal income tax and military levy liabilities) in accordance with Article 123 of the Tax Code of Ukraine and late payment interest in accordance with Article 129 of the Tax Code of Ukraine.

On our YouTube channel "Biznesuy" (meaning "Do Business"), you can watch a useful video about the specifics of using RROs by FOPs in 2022 and possible penalties. And it will only take 7 minutes.

How did we resolve this situation?

Fortunately for our client, the FOP had not yet started providing the service. We recommended our client terminate the service agreement with the FOP and ask for the advance payment to be returned. Additionally, we suggested that the LLC's management propose to the FOP to switch to the simplified taxation system and become a Group 3 single tax payer (with a single tax rate of 5%). The FOP agreed to these terms, and they signed a service agreement under the new conditions.

Prostir Accounting Services Company provides comprehensive services for accounting, tax, and management reporting for companies and private entrepreneurs. On the Accounting Services page, you can review our package offers for accounting services, and also calculate the individual cost of services for your company using our Accounting Services Cost Calculator.

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