In December 2017, the IRS enacted Section 965, which places a transition tax on post-1986 earnings from specified foreign corporations in which U.S. shareholders hold at least 10% interest. The goal of Section 965 is to impose a one-time transition tax on accumulated foreign earnings prior to January 2018 as if they had been returned to the United States. The inclusion of accumulated earnings and profits (E&P) can be reduced by a deduction of 15.5% for cash and cash equivalents and 8% for any remaining earnings. Taxpayers who are subject to Section 965 can make the election to pay the total tax in installments over an eight-year period.
On August 1, 2018, the IRS released proposed regulations for Section 965 of the Internal Revenue Code. These regulations provided additional guidance for taxpayers who are affected by the transition tax, by specifically tackling the frequently asked questions of this new IRS code. The proposed regulations clarified the rules for calculating the total transition tax under Section 965. In addition, they addressed confusion in determining accumulated E&P that are subject to the transition tax, how to treat previously taxed E&P, as well as an election to defer payment of the transition tax.
Payment and Deferral
There are various options available to alleviate the effects of the substantial transition tax that numerous individuals will be facing. As previously mentioned, taxpayers may elect to pay the transition tax in installments over an eight-year period. The taxpayer would be responsible for paying 8% of the tax during each of the first five years, followed by 15% in the sixth, 20% in the seventh and lastly, 25% in the eighth. The second option is the election to defer payment of the transition tax until a triggering event. An example of a triggering event is the sale of the U.S. shareholders’ assets. For the purpose of electing to defer the transition tax, U.S. shareholders of a consolidated entity are viewed as a single corporation. Lastly, a net operating loss during the current year may be used to offset the total transition tax liability.
Individuals and Partnerships
If a U.S. pass-through entity holds an interest in a specified foreign corporation, the shareholders of the domestic pass-through are subject to Section 965, regardless of whether they are U.S. shareholders. However, U.S. shareholders can make the Section 962 election to have Subpart F income from the controlled foreign corporation (CFC) taxed at the corporate tax rate, if favorable. In addition, shareholders are able to minimize the total transition tax owed by aggregating accumulated earnings and deficits between two or more controlled foreign corporations. So, if accumulated deficits from one CFC exceed the accumulated earnings from another, that individual taxpayer will not be subject to transition tax.
If, however, an individual has income under Section 965, he or she is required to include an IRC 965 Transition Tax Statement with his or her individual tax return. This form requires the following information to be included:
- Total income included under 965(a) of IRS code
- The individual’s aggregate cash position
- The individual’s total deduction under 965(c)
- The individual’s total allowed and disallowed deemed paid foreign taxes in comparison to total required to be included in income
- The individual’s total net transition tax liability under Section 965
- The individual’s net tax liability- paid in installments under Section 965(h) – if applicable
- The individual’s net tax liability deferred under 965(i) – if elected
- The individual’s elections made under 965
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