FJV – Boston CPA Firm and Tax Advisor

Payroll Tax Credits Provide Cash Flow Benefits For Technology Start-Ups With Research Activities

January 14, 2020 by Frank Vari, JD. MTax, CPA

Our practice serves a number of early and mid-stage technology clients and many have significant research and development (“R&D”) activities and expenses but have not generated taxable income either due to tax planning or net operating losses. Conventional wisdom has been that these companies cannot claim any tax benefits related to their R&D related expenses because they have no taxable income. However, these same clients often pay significant payroll taxes and they are often unaware that they can reduce their annual payroll taxes, and improve cash flow, by as much as $250,000 per year by taking advantage of the United States (“US”) R&D payroll tax credit.

Let us explain here how we help our qualifying clients claim these important benefits.

As noted, US businesses historically have not been able to use the traditional US R&D income tax credit in tax years where there was no regular US income tax liability. However, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made very favorable changes to the research credit that help mitigate the impact of this limitation. In particular, PATH allows certain small businesses to offset their alternative minimum tax (“AMT”) or payroll tax liability with a research credit. As a result, small businesses in an AMT or net operating loss (“NOL”) position that cannot claim the traditional R&D credit can now claim tax and cash flow benefits.

The R&D Credit

The R&D credit was enacted back in 1981 to stimulate US R&D activities by helping businesses offset some of the costs associated with their qualified R&D activities. Quite basically, a qualified R&D activity expense qualifying for the credit is one where:

The expense is incurred in a trade or business which represent R&D costs in the experimental or laboratory sense;
The research is technical in nature including bioscience engineering, computer science including software, chemical/polymer design, manufacturing processes, and other similar activities;
The research contains aspects of experimentation related to a new or improved design, function, or performance; and
The research is intended to result in a new or improved product or business element for the taxpayer.

Today, there is a regular R&D credit and an alternative R&D simplified credit (“ASC”) option to calculate the benefits. Qualifying businesses can compare the two methods and choose the more favorable one by making an annual election on a timely filed federal return. Businesses that have not claimed a regular credit in a prior year may make the election on an amended return for that year.

PATH significantly expanded the R&D credit by allowing certain businesses to claim R&D tax benefits in years when they had no regular US income tax liability. In other words, before 2015, if a business didn’t have US taxable income, there was no way to claim an R&D credit. Now, the R&D credit can be used to reduce AMT or payroll tax liabilities.

Although AMT liabilities may also be reduced, our discussion here will focus on the payroll tax R&D credit.

Learn More About Our Tax Planning Practice

Which Businesses Qualify For Payroll Tax R&D Credits

In order for a business to offset its payroll tax liability with the R&D credit, the taxpayer must be a Qualified Small Business (“QSB”). A QSB may be a corporation, partnership, or even an individual with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year.

Example: For the first five years of its existence, Corporation A had gross receipts of $1,000,000, $7,000,000, $4,000,000, $3,000,000, and $4,000,000. Corporation A is a QSB for year 5 because its gross receipts are less than $5,000,000, even though its gross receipts exceeded the limitation for a prior year. However, Corporation A is not a QSB in year 6 due to having gross receipts in year 1.

Gross receipts here are reduced by returns and allowances but also include non-sales related items such as interest, dividends, rents, royalties. These receipts must also be adjusted to account for predecessor entities meaning that past mergers and acquisitions are relevant to this calculation. One must also adjust for any entities or individuals treated as a single taxpayer meaning that gross receipts must be aggregated for a controlled group of corporations or for trades or businesses under common control.

Claiming Benefits

A QSB may elect to claim the R&D credit against the Old Age, Survivors, and Disability Insurance (“OASDI”) portion of the employer’s Federal Insurance Contributions Act (“FICA”) payroll tax liability for up to five tax years. The election to claim the payroll R&D credit must be made on a timely filed US tax return including extensions (please note this differs from the regular R&D credit which can be claimed on an amended return). The election is reported in Section D of Form 6765 as part of the aforementioned return. Special rules apply for partnerships and S corporations.

The election must indicate the amount of the research credit that the QSB intends to apply to the expected payroll tax liability. This amount is the smaller of:

A $250,000 cap;
The amount of the research credit for the tax year (without regard to the election); or
The amount of any business credit carryforward under IRC §39 carried from the tax year of the election, without regard to the election, but only for QSBs that are not partnerships or S corporations.

A QSB that files quarterly payroll tax returns may apply the credit on its payroll tax return for the first quarter beginning after it files the federal return appropriately reflecting the election. For these quarterly payroll taxpayers, a QSB seeking benefits related to 2019 R&D activities that files that timely files their US income tax return by April 15, 2020 will be able to claim these benefits beginning in the second quarter of 2020 but not before. If the return is extended, then the timing of the benefits extends as well. Accordingly, a QSB that files annual payroll tax returns may apply the credit on the first quarter beginning after the date on which the business files its US income tax return containing the election.

When filing the payroll tax return, Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must be completed and attached to the payroll tax return to ensure that the amount of the previously elected credit is limited to the employer portion of the Social Security tax for the period. Any excess may be carried forward pursuant to future periods. The credit does not reduce the QSB’s deduction for payroll taxes which provides an additional benefit.

Next Steps

The best next steps for any start-up with R&D activities is to take the following steps along with a qualified tax adviser:

Determine qualification as a QSB;
Identify qualifying research activities;
Calculate the amount of the R&D credit and the corresponding payroll tax offset;
Make the appropriate elections and file the requisite income tax and payroll tax forms using the most beneficial methodologies; and
Organize supporting documentation in case of a tax authority examination.

In summary, any tech start-up not claiming these cash flow benefits should be paying attention.

Please let us know how we can help you plan for your tax planning and compliance needs. Learn more about our business tax practice or our firm by contacting us at FJVTAX.com.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

October 17, 2019 by Frank Vari, JD. MTax, CPA

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

Frank J. Vari, JD, MTax, CPA

Passive Foreign Investment Company (PFIC) is a term that many U.S. taxpayers and practitioners do not understand or recognize but it stands as one of the most significant risk exposures to any US taxpayers with foreign investments of any sort. Many U.S. taxpayers, primarily individual investors, and practitioners are too quick to conclude that they do not own a PFIC interest. In our experience, this is because they either don’t understand what a PFIC is or they are daunted by the complicated PFIC rules and reporting requirements. The common results on audit are unexpected severe tax consequences to unsuspecting and unprepared taxpayers. When one considers that a PFIC could be anything from a small interest in a foreign corporation to a Bitcoin investment it is easy to see how easy it is to come into contact with the complex and punitive PFIC rules. This article is intended to provide some basic guidance on the PFIC regime and to address some basic issues.

The PFIC rules were enacted in 1986 as a counterpart to the anti-deferral regime of Subpart F with an intended target of U.S. owners of foreign corporations with primarily passive income or assets. The PFIC rules, unlike the rules in Subpart F, aim to remove the economic benefit of deferral with respect to any and all U.S. PFIC investors and not just those with significant ownership interests. Extremely broad and complex, the PFIC rules discourage U.S. taxpayers from investing in PFICs assuming that they can identify whether their foreign investment is a PFIC in the first place.

The PFIC rules are primarily contained within IRC §§1291, 1297, 1298 and related authority. Primary technical guidance has historically been provided by IRS Notice 88-22 which continues to provide significant guidance to this day.

Generally defined, a PFIC is a foreign corporation that has, during the tax year, at least 75% passive income (“Income Test”) or at least 50% of assets that produce passive income (“Asset Test”). Passive income is any income that would be Foreign Personal Holding Company Income (“FPHCI”) as defined by the Subpart F provisions in IRC §954(c). Many conclude that unless the investment is considered a Controlled Foreign Corporation (“CFC) there is no PFIC exposure. This is an incorrect and false analysis that confuses PFIC with Subpart F. This is an especially dangerous conclusion when one recognizes that the PFIC rules don’t apply to a CFC after 1997 as part of the PFIC/CFC overlap rule of IRC §1297(d) exempting CFC shareholders from the PFIC regime.

Here for example, are common PFIC investments that we regularly see in our international tax practice. In any of these or similar situations PFIC testing is required:

Foreign Mutual Funds

The primary investments of a mutual fund are most often passive or generate passive income qualifying the mutual fund itself as a PFIC.

Foreign Holding Companies

Many foreign holding company investments by U.S. shareholders are tailored to avoid CFC rules due to passive share investments. However, there is often PFIC exposure which often goes untested. This is a very common PFIC scenario.

Foreign Hedge Funds

Like a mutual fund, a hedge fund is an entity often engaging in passive investment activity. We work with a number of foreign hedge funds and any U.S. investor in a foreign hedge fund has potential PFIC exposure.

Foreign Trusts

A foreign trust is most often a foreign entity consisting of passive investments generating passive income. We often see U.S. beneficiaries of foreign trusts, many of which are family trusts established many years ago, that qualify as PFICs and carry significant past tax liabilities with them.

Foreign Bank Accounts

A bank account might also be a PFIC if that account is a money market type investment rather than simply a deposit account as many money market investments are equivalent to fixed income mutual funds.

Foreign Pension Funds

PFIC rules can and do apply to passive investments held inside foreign pension funds unless those pension plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country.

Bitcoin / Cryptocurrency

If cryptocurrency is held in via a foreign fund or it is held via a foreign entity maybe a PFIC investment. The passive nature of these investments always require PFIC testing.

Learn More About Our International Tax Practice Here

As noted above, the PFIC regime is essentially an anti-deferral regime intended to remove any advantage of income deferral provided by a non-CFC offshore investment. PFIC taxation falls into three elective categories. First, income can be currently taxed as a Qualified Electing Fund (“QEF”) under IRC §1293 where a U.S. shareholder elects to have their PFIC income taxed annually. Second, the IRC §1291 “interest on deferral” regime allows annual U.S. taxes on PFIC income to be deferred but requires the U.S. shareholder to pay any tax plus interest on the deferred PFIC income when the shareholder ultimately receives their PFIC income via distribution or disposition. Third, there is the IRC §1296 mark-to-market regime where the shareholder recognize gains and losses from marketable stock on an annual basis. The most common taxing regime chosen is a QEF election if PFIC treatment cannot be avoided altogether.

One notable rule around PFICS is the “once a PFIC always a PFIC” rule. This rule states that if stock in a foreign investment meets the PFIC definition at any time during the shareholder’s holding period it continues to be treated as a PFIC forever even after it no longer meets the PFIC definition. This requires a lookback for many taxpayers to see if their investment has been tainted as a PFIC at some point in the past even if it clearly no longer qualifies as a PFIC today. This is not an uncommon event.

This article is not intended to be and should not be treated as a complete description of the PFIC testing and treatment rules. There is much more to this regime including complex Foreign Account Tax Compliance Act (FATCA) reporting rules which include filing Form 8621 for each PFIC investment.

The bottom line to any U.S. taxpayer or practitioner who believes that a foreign investment is or was a PFIC should immediately research or seek out an experienced international tax practitioner with PFIC experience to help them navigate and limit their PFIC tax exposure.

Please let us know how we can help you plan for your international investments. Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

How Does the US Tax UK Pension Lump-Sum Payments to US Citizens?

July 23, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our international tax practice gets a large number of questions from United Kingdom (UK) citizens that are also United States (US) citizens and residents regarding their UK pensions. There are a number of complex issues around both UK private and public pensions that need to be addressed and each question requires separate research and analysis. Further complicating matters are issues for dual citizens that are trying to navigate not only both US and UK tax laws but also the US/UK Income Tax Treaty. These are certainly difficult waters to navigate even for experienced tax professionals.

One very common and complex question is the US tax treatment on a 25% lump-sum distribution from a UK pension. As many know, the UK government will not tax the 25% lump-sum payment as a matter of UK law. The tricky question is how does the US treat it?

There is a lot of information out there on the internet and much of it is either wrong or misleading. Many “advisers” claim that the 25% lump-sum payment is tax free both in the US and the UK. These folks claim that in the UK it is tax exempt by statute/law and that it is also tax free in the US by virtue of the US/UK Tax Treaty. They advise that the Treaty will allow you to escape US tax on this payment. Treaty questions are usually rather complex and difficult to understand especially if you’re not used to the language they use meaning things like “savings clause”, etc. I’ll try to explain below both what we’ve seen and what the rule is on this issue.

One thing that seems to be clear is that all of a US citizen’s income from any source is subject to US tax under IRC §61. Further, a dual citizen of the US and UK is entitled to rely on the aforementioned tax Treaty between the two countries by virtue of Article 23(2)(A).

The basic position we’ve seen out there is as such:

There is a “reciprocal pension exemption” in Article 17(1)(b) that requires the US to respect the UK exemption on the 25% lump-sum payment when paid to a US citizen and resident. This is False.
There is something in many tax treaties, including this one, that is called a “savings clause”. Basically, what this says is that if income received by a resident of country #1 is not taxed by county #2, country #1 can tax it. It almost serves as a soak-up clause to make sure all income is taxed by someone. This is true and is contained in many income tax treaties.
An exemption from a savings clause would mean that income received by a treaty country resident – like a dual citizen of the UK and the US residing in the US – is not taxed on that exempted income in either the UK or US. True if it applies.
The position to avoid tax here relies on the Article 1(4) savings clause – citing Article 1(5)(A) – to say that Article 17(1)(B) is not covered by the savings clause meaning, if read in conjunction with the earlier point, that the 25% lump-sum payment is not taxed by the US under Article 17(1)(b) and is exempt from the Treaty’s savings clause. This is false as the savings clause does apply as enumerated below.
Stated alternatively, these advisers are saying that the Treaty binds the US to recognize the UK exemption on the 25% payment and the savings clause does not operate to “soak it up” or otherwise tax it. Thus, you escape both US and UK tax on the 25% lump-sum distribution.

There are some big problems with this. The first is that, if you read the Treaty, this is not what it says. The second is that the IRS has publicly stated that this is not what the Treaty says. Please read the latter as the IRS explains its position on this very specific issue.

Please allow me to explain what the Treaty says on this issue:

Article 17(1)(B) provides us with a reciprocal pension exemption but not at all in the way described above. Treaty Article 17(1)(B) says no such thing. Also, Article 17(1)(B) does not address lump-sum payments which are clearly addressed in Article 17(2).
Article 17(2), covering lump-sum pension payments like this one, tells us that a lump-sum payment that is tax-free in one state shall also be tax-free when received by a resident of the other state. That’s a great answer if you stop there.
The Treaty’s savings clause specifically cites Article 1(5)(A). A reading of that article shows that it exempts Articles 17(3) – dealing with periodic payments of a social security scheme – and 17(5) – dealing with divorce and support payments – from the savings clause. Article 17(2) – dealing with lump-sum payments – is not mentioned or exempted in any way from the Treaty’s savings clause.
As such, the savings clause will require that the lump-sum payment be picked up in the taxpayer’s US tax as neither US tax law nor the US/UK Tax Treaty offers any exemption.

The IRS has specifically said what is clearly in the Treaty:

Article 1(5) of the Treaty provides a number of exceptions to the saving clause, but there is no exception for Article 17(2). Therefore, the saving clause overrides Article 17(2) and allows the United States to tax a lump-sum payment received by a U.S. resident from a U.K. pension plan.

That is sufficiently clear regarding the US tax authority’s position on the issue.

In summary, a UK 25% lump-sum pension distribution is fully taxable to a US citizen and resident and the US tax authorities have specifically stated that the Treaty language agrees. Any other position on this issue contradicts the IRS’s position and, quite frankly, has no basis either in US tax law or the Treaty itself. One taking an alternative position on this issue should be aware that it will likely require a substantive audit defense. Further, any practitioner taking this position should be mindful of IRS Circular 230’s requirements for tax return positions.

This is surely a complex subject as any Treaty based analysis usually is and any slight change in facts could derive a completely different answer. Each taxpayer situation is slightly different and that is why an experienced international tax practitioners should always weigh in on these questions. We do a considerable amount of work in this area and we hope that this note clears up a situation with considerable confusion around it.

International Tax Planning Tools for US Individuals with Foreign Investments

February 4, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

There is no question that Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act (“Act”), changed the rules governing all US individuals and corporations with foreign businesses and investments. The Act was advertised to reduce taxes and compliance costs for both individuals and corporations and for most parties it has accomplished that goal. However, some of these new rules have had a decidedly negative impact on individual or non-corporate US shareholders of controlled foreign corporations (“CFC”) compared with corporate shareholders. Many non-corporate CFC shareholders actually face an expensive tax increase as well as increased compliance costs.

It is not clear whether the negative impact of these new rules was intended or simply the result of constructing very complicated tax legislation in a somewhat short time period. Whatever the cause, where care was taken in domestic legislation to place individual and corporate shareholders on a somewhat equal footing, e.g., new IRC §199A tax benefits offered along with reduced corporate tax rates, the same efforts were not made in the context of international shareholdings.

US individuals with foreign investments must immediately explore their international tax planning options to avoid these negative US income tax effects. We are actively engaged with a number of US based individuals on their individual international tax planning and we hope this article sheds some light on these important issues and related planning opportunities for you or your clients.

CFC Ownership

A CFC is generally defined as any foreign corporation where US persons own 50% or more (directly, indirectly, or constructively) of the foreign corporation’s stock (measured by vote or value) taking into account only those US persons who own at least 10% of the aforementioned stock. These shareholders are each referred to as a United States Shareholder (“USS”).

US individual ownership of CFC shares was always disadvantaged compared to corporate shareholders primarily due to the inability of individuals to use IRC §902 to credit indirect foreign taxes paid by the CFC. US individual shareholders can only use IRC §901 foreign tax credits which are basically limited to withholding taxes associated with the CFC dividend. Where the CFC’s local income taxes are high, the US individual shareholder’s effective tax rate on their CFC income is effectively equivalent to their US individual rate plus the CFC’s effective rate. It’s not uncommon for us to see an individual effective rate exceed 70% in these cases.

The benefit that US individual CFC shareholders did receive was deferral. In other words, unless an anti-deferral regime such as Subpart F was in play, the US individual did not have to recognize the CFC income until it was actually dispersed to them via dividend or otherwise. Further, if the CFC’s local income tax was a low amount, the increase in their overall effective tax rate for taxes not creditable under IRC §901 may have been worth it if deferral had true economic value to them.

Tax Reform Changes

The aforementioned CFC tax regime has significantly changed under the Act. Here are the major changes affecting individuals:

No Transition Tax Relief

IRC §965 requires the inclusion in income for all CFC shareholders of the CFC’s previously untaxed earnings and profits (“E&P”). The Act offered corporate CFC shareholders a reduced transition tax rate to cushion the blow of this unanticipated income inclusion but no such rate forbearance was offered to individual CFC shareholders. They took their inclusion at their regular individual tax rates.

No Participation Exemption

IRC §245A provides a full participation exemption, also referred to as dividends received deduction (“DRD”), for certain dividends received by a US C corporation from a CFC. However, US individuals who own CFC shares are not eligible for this participation exemption. CFC dividends received by individuals remain taxable either as qualified or non-qualified dividends at higher individual rates.

No GILTI Tax Reduction

The Act added IRC §951A which requires a USS to include in their US taxable income their pro-rata share of the CFC’s Global Intangible Low-Taxed Income (“GILTI”) which is treated, basically, as Subpart F income.

The GILTI calculation is complex by any measure. Quite basically, GILTI is the excess of a USS’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property. US corporate CFC shareholders are given a 50% deduction via newly enacted IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

Individual shareholders of CFCs are not eligible for either of these benefits afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions without any foreign tax credit offsets. It is certainly a bitter pill for US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions.

The following example illustrates the disparate impact of the GILTI regime on an individual CFC shareholder who is also a USS. Assume a CFC operates an active services business in a jurisdiction that imposes a 30% income tax rate. The CFC has no tangible depreciable assets and generates $100 of net taxable income annually that is not otherwise classified as Subpart F income. The following graphic compares the tax consequences to a US corporate shareholder to those of an US individual shareholder:

	C Corporation USS of a CFC	Individual USS of a CFC
GILTI inclusion (IRC §951A)	$100	$100
50% Deduction (IRC §250)	$50	N/A
US Taxable Income	$50	$100
Foreign Income Tax (30%)	$30	$30
US Pre-Credit Tax	$10.5 (21% x $50)	$25.9 (37% x $70)
US Foreign Tax Credit	$24 IRC §960(d) 80% FTC limit	$0 No IRC §902 Credits
US Tax Liability	$0	$25.9
GILTI Effective Tax Rate	30% No GILTI FTC Carryforward	55.9%

Corporate CFC shareholders who utilize foreign tax credits to offset their GILTI tax expense are not only limited by the 80% IRC §960(d) limitation but also the inability to carryforward or carryback GILTI basket foreign tax credits. However, the IRC §78 gross-up still applies to 100% of the foreign tax expense. Even with these limitations, corporate shareholders get a much better deal than individual shareholders under the GILTI rules as a whole.

No FDII Benefits

The Act introduced, via IRC §250(a), the Foreign Derived Intangible Income (“FDII”) regime which provides C corporations with export sales important new tax benefits. These export benefits provide a reduced US tax rate on income attributable to intangible assets owned within the US in a similar manner to how the GILTI rules create income inclusions for the same activities conducted offshore. For a detailed description of the FDII rules, please see this recent article we authored on this topic.

The FDII rules were theoretically intended to provide tax benefits to offset the impact of GILTI inclusions. The result is a new benefit to US C corporations for using US based intangible property that they’ve owned all along. Even better, they don’t have to patent, copyright, or even identify the intangible property as the benefit is derived from a deemed return on assets calculation. It’s all good but it does not apply to individuals, S Corps, or partnerships. As a result, individuals take a harder hit from the GILTI rules with no corresponding relief from the FDII regime.

Learn More About Our International Tax Practice By Clicking Here

Planning Options

For a US individual with existing or planned CFC ownership, there are various options available to mitigate some of these new provisions but each involves different steps with different side effects. We continue to see new options arise depending on the facts and circumstances of each particular taxpayer but here are some of the most common planning options we’ve been using thus far:

Contribute CFC Shares to a C Corporation

The logic here is easy enough to understand. Once the CFC shares are held by the C corporation, the corporation can utilize IRC §902 credits for taxes paid by the CFC, use offsets to the GILTI provisions provided under IRC §250 and elsewhere, and utilize the FDII regime. However, double taxation still occurs to the individual shareholder and there can be considerable complexity and costs in restructuring the CFC’s ownership chain.

Making an Annual IRC §962 Election

An IRC §962 election is a rarely utilized election employed to ensure that an individual taxpayer is not subject to a higher rate of tax on the earnings of a foreign corporation than if he or she had owned it through a US C corporation. This is an annual election with respect to all CFCs for which the individual is a USS including those owned through a pass-through entity.

The primary benefits of this election are that it provides a 21% corporate tax rate on any GILTI or Subpart F inclusion as well as allowing the use of IRC §902 credits. The individual taxpayer also does not have to endure the administrative burden of actually creating a C corporation holding structure for the CFC(s). However, in addition to having to make an annual election, the election does not allow the taxpayer to take the GILTI IRC §250 deduction or utilize the FDII export incentive regime.

Check-The-Box / Disregarded Entity Election

The taxpayer may also solve many of the problems created by the Act by using the now commonly exercised tool of a CFC check-the-box or disregarded entity election. This changes the CFC into a disregarded entity or foreign branch for US tax purposes while leaving it unchanged for local country purposes.

This has long been an instrument for individuals invested either directly or indirectly, via S corporations or partnerships, in a CFC. The primary benefits have been to allow individuals to benefit foreign tax losses in the US and to convert IRC §902 taxes into creditable IRC §901 taxes thus significantly reducing their individual tax burden on foreign earnings. Now, however, a disregarded entity election also allows the US individual shareholder to escape both GILTI and Subpart F inclusions

Prior to the Act, the main downside of a disregarded entity election by an individual was that it eliminated foreign deferral via the CFC. The conversion of a CFC to a disregarded entity could also be very expensive due to rules around CFC conversion. Most of the expense and complexity are due to a disregarded entity election being treated the same as a CFC liquidation.

US individuals may not use IRC §332 to effectuate a tax-free CFC liquidation. Instead, they must rely on IRC §331 where a liquidating distribution is considered to be full payment in exchange for the shareholder’s stock rather than a deemed dividend distribution. These shareholders generally recognize gain or loss in an amount equal to the difference between the fair market value (“FMV”) of the assets received, whether they are cash, other property, or both, and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholder’s hands, the transaction qualifies for capital gain or loss treatment. The detailed tax effects of an IRC §331 CFC liquidation are outside the scope of this document but they are important and must be addressed thoroughly as part of any related analysis.

For a corporate USS, IRC §332 will generally apply to provide tax-free treatment but IRC §367(b) steps in and requires that the liquidating corporate USS include, as a deemed dividend, the CFC’s “all earnings and profits” amount (“All E&P Amount”) with respect to the CFC. The All E&P Amount generally is the corporate USS’s pro rata share of the CFC’s E&P accumulated during the USS’s holding period.

What’s important to note here is that the corporate USS’s All E&P Amount is reduced by E&P attributable to previously taxed income (“PTI”). The CFC’s E&P subject to the IRC §965 transition tax distribution, which is likely now in the past, becomes PTI. A corporate USS’s PTI amount resulting from the transition tax will likely equal the shareholder’s All E&P Amount and therefore reduce the required All E&P Amount inclusion to $0. If the All E&P Amount is $0, the disregarded entity election will not trigger any incremental US income tax to the electing corporate shareholder.

Here, we may actually have an instance where the IRC §965 transition tax, likely already incurred by the corporate shareholder, will serve to greatly reduce the cost of a disregarded entity election by making the deemed liquidation much less expensive. It’s an unusual situation for sure but one that allows a low-tax way for corporate USS’s to escape GILTI and Subpart F inclusions.

Here again we have another distinct advantage provided to corporate CFC shareholders but not individuals.

Here is a basic example of how CFC earnings are taxed to corporate, individual, and individual assuming the CFC is now treated as a disregarded entity:

	C Corporation USS of a CFC	Individual USS of a CFC	Individual Shareholder of a Disregarded Entity
Foreign Entity Income	$100 Dividend	$100 Dividend	$100 Pass-Through Earnings
Foreign Income Tax (assumed 30%)	$30	$30	$30
US Pre-Credit Tax	$21 (21% x $100)	$25.9 (37% x $70)	$37 (37% x $100)
US Foreign Tax Credit	$30	$0 No IRC §902 Credits	$30
US Tax Liability	$0	$25.9	$7
Effective Tax Rate	30% Possible FTC Carryforward	55.9%	37%
Tax on $70 Corporate Dividend to Individual Shareholder	$16.7 (23.8% x $70)	$0	$0
Post- Distribution Effective Tax Rate	46.7%	55.9%	37%

Conclusion

The US tax reform rules are certainly not advantaged to individuals as originally enacted. There is certainly the possibility that the Act will be amended to balance the negative effect on individual CFC shareholders but there is no guarantee. In the interim, there are some planning tools that the taxpayer can utilize to offset the negative impact of these new rules. This is not and is not intended to be an exhaustive list of each planning opportunity that we see or that we will see. What each shareholder should do depends upon a detailed analysis of the taxpayer’s unique facts coupled with sophisticated modeling to confirm the planning benefits. Anything short of that is likely to fail in some regard.

We’ve authored other articles on GILTI that you may find helpful by clicking here.

Please let us know how we can help you plan for your international investments. Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

The Foreign Earned Income Exclusion Dilemma

January 14, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our practice deals with many expatriate US citizens of varying income levels working abroad as well as supporting CPAs and attorneys with their expatriate clients. We find that many clients are directed by their advisers to take advantage of the US Foreign Earned Income Exclusion (“FEIE”) rather than the US Foreign Tax Credit (“FTC”). The problem that we see is that those taking, or many giving, this advice do not understand how these different rules apply or even how they may interact to benefit the taxpayer.

Our advice to any expatriate taxpayer is that there is no one size fits all answer to which method works best. A US citizen working and/or living abroad must pay US tax on their worldwide income so the question of what works best is very important. Each methodology has some rather basic pros and cons that can help the taxpayer or their adviser pick what works best for that taxpayer. Let’s take a basic overview of these rules to outline the issues and recommended approach. This is not meant to be a technical dissertation of these rules but rather a practical approach.

The Foreign Earned Income Exclusion

The most popular method to address US expatriate taxation is the FEIE. It’s relatively easy to apply and understand and most US tax preparation software can do the heavy lifting. Those are all positives for the tax preparer or adviser but not always for the taxpayer.

The FEIE only applies to foreign earned income which is generally defined as salary and wages and related income. The FIEI for 2018 is $104,100. This means that this amount of foreign earned income may be excluded from US taxable income provided it otherwise qualifies. It may not be excluded from local country taxation but the US will allow it to escape US taxation.

The FEIE does not apply to foreign source passive income like, for example, any interest, dividend, or investment income earned outside the US. It also does not shelter foreign self-employment income from US self-employment taxes. Thus, you can have income from self-employment earned outside the US that is excluded from US income tax that is still subject to US self-employment taxes. Determining whether the self-employment tax applies is a separate analysis that depends upon whether the US has what is known as a Totalization Agreement with the country where the self-employment income is earned.

One final point to note regarding the foreign earned income exclusion is that once a taxpayer decides to take the exclusion, and then does not take it in a subsequent year, they are barred from taking it for the following 5 years. The only way to reverse is IRS permission via a US tax ruling which can be complicated and costly to obtain.

Learn More About Our Individual International Tax Practice by Clicking Here

The Foreign Tax Credit

The US FTC is a tax credit that reduces or offsets a US taxpayer’s US income tax liability based on the foreign income taxes that have been paid during the relevant tax period. It sounds simple enough but it can be complex in practice and, sometimes more importantly, most US tax software packages cannot handle the FTC or are unable to properly take into account the many variables impacting a properly prepared FTC calculation. This leads many US tax preparers and advisers to avoid it even when it would provide a better result.

The purpose of the US FTC is to avoid double taxation on US taxpayers. In general, if the taxpayer lives and pays taxes in a country where the income taxes are higher than the US the expected result of utilizing the FTC will usually be that the taxpayer owes zero income tax to the IRS. If the foreign taxes paid are lower than the US tax rate, then there will likely be incremental US taxes due to meet the US tax expense.

If a US taxpayer has unused FTCs from prior years, they are automatically carried forward and can be utilized in future years where the taxpayer may not have paid sufficient foreign income tax credit to offset their US income tax owing. This is a valuable tool for US expatriates moving between high tax and low tax jurisdictions.

It must be noted that foreign social security taxes cannot be used for the US FTC since only income taxes are creditable. This is a common error that is made and it must be noted that if the IRS audits the related personal tax return, they will disallow from the FTC any foreign social security taxes or any other taxes for that matter that are not income taxes including sales taxes, VAT, etc.

Taking Both the FEIE and the FTC?

Most practitioners understand that a US taxpayer can either take the FEIE or the FTC on the same income but not both. This rule is simple enough but it leads to much confusion.

For example, does this mean if the US taxpayer earns over $104,100 in foreign earned income in 2018 that they have to pick one regime over the other? The answer is no. The US taxpayer can actually use the FEIE for the foreign earned income up to the annual limitation and then use the FTC mechanism for the remainder. This blended approach is often the approach for high income taxpayers.

The rules tell us these two regimes can be used in the same tax year but the same foreign income taxes excluded by the FEIE cannot be credited under the FTC. In other words, if a certain amount of foreign earned income was excluded, and there is additional income to be taxed exceeding the FEIE, then the foreign taxes paid on the income that was already excluded cannot be used to offset US income taxes on the remaining income.

Why is this so complicated and misunderstood? As noted above, the US FTC can be very complex. Also, most US tax software packages are not able to handle this blended approach to foreign income taxation and the FTC calculation must be performed offline and typed into the return.

The Bottom Line

The proper taxation of a US taxpayer’s foreign earned income can be very complex especially when that income exceeds the FEIE. However, as this article points out, there are still ways to reduce or entirely avoid US income taxes for these taxpayers. The problem is that many practitioners are not familiar with these methods and most US tax preparation software packages do not help with a blended approach of the FEIE and FTC. As such, practitioners and taxpayers must remain aware that this approach exists and it could save them a considerable amount of current and future US taxes.

Beware of GILTI Basis Adjustments

December 13, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTAx, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime. What has not been widely publicized are the basis adjustment rules for consolidated groups. This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena. The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice. They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group. They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold. The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter. Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all. The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction. When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail. As noted above, the basis adjustments relate to the use of tested losses by the group. The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”. The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock. Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs. In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2. In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2. The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss. The result is a net used tested loss amount of $80 to CFC1 at the end of year two. If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC. Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize. The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex. Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.