Individual tax

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.

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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.

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.

Can a Partnership With Some Service Activities Claim Section 199A Benefits?

November 16, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

We recently went on the Massachusetts Society of CPAs (“MSCPA”) tax practitioner website, aka the “HUB”, to answer a question regarding the ability of a partnership that has some service type activities to claim Section 199A benefits. We do get a number of questions on this so we felt it would be great to share on our blog.

The basic question presented was whether a partnership that manufactures and sells goods but has some consulting or service type activities may claim Section 199A benefits?

This is a very good Section 199A question that, as noted above, we’re seeing quite a bit in our business practice. It highlights the fact that Section 199A is actually a very complicated piece of legislation lacking solid administrative guidance and detailed understanding among many professionals. Many clients have assumed they qualify for Section 199A benefits when they actually do not.

When Section 199A was enacted and reviewed by the tax community there were more questions than answers to many specific fact situations. In particular, the statute itself left unclear to us the treatment of trades or businesses with both a Qualified Trade or Business (“QTB”) component which is benefit eligible and a Specified Service Trade or Business (“SSTB”) component which is not benefit eligible.

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Section 199A only applies to pass-through businesses. C Corporations received their tax break separately by reduced tax rates. The Proposed Regulations issued in August created the term “relevant pass-through entity” (“RPE”). An RPE is generally a partnership, other than a Publicly Traded Partnership, or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust. In most states, including Massachusetts, partnerships are mostly multi-member LLCs.

Section 199A defines a QTB rather simply as any trade or business except a SSTB or services performed as an employee. A SSTB includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. For practitioners familiar with former Section 199 and the former Extraterritorial Income Exclusion (“EIE”) rules, one could foresee how services besides architecture and engineering were going to be excluded from benefits – and they were but in a complicated fashion.

The Proposed Regulations provide us with our only guidance on our issue of a partnership, i.e., an RPE, with both QBI and SSTB activities. Prop. Reg. 1.199A-5(c)(1) provides a de minimis rule based on trade or business gross receipts and the percentage of gross receipts attributable to a SSTB under which a trade or business will not be considered a SSTB merely because it performs a small amount of services in a SSTB. The Preamble to the Proposed Regulations explains that this rule was created because the Treasury Department and the IRS believe that requiring all taxpayers to evaluate and quantify any amount of specified service activity would create administrative complexity and undue burdens for both taxpayers and the IRS. It is simply an administrative safe harbor.

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Under this rule, a trade or business, determined before application of the aggregation rules, which I’m not addressing here, would not be a SSTB if in a specific tax year it has: (1) gross receipts of $25 million or less, and (2) less than 10% of the gross receipts are attributable to the performance of services in a SSTB. Take note that this includes the performance of activities incidental to the actual performance of services. For a trade or business with gross receipts greater than $25 million, the trade or business qualifies for the de minimis rule if less than 5% of the gross receipts are attributable to the performance of services in a SSTB.

The bottom line is that if the SSTB activities rise above these safe harbor amounts within a single RPE, the entire trade or business is tainted and is considered to be a SSTB. The law does not allow you to otherwise create allocations within a single RPE. It is either a QBI or a SSTB depending upon the results of the test outlined above.

We are assisting many of our clients with both QBI and SSTB activities with restructuring options to qualify for Section 199A benefits. However, any restructuring alternatives are fact dependent. There is no one option that applies to all businesses but restructuring options do exist that allow many taxpayers to claim these important new benefits.

New Tax Benefits for Pass-Through Entities – What’s There to Know?

October 25, 2018 by Frank Vari, JD. MTax, CPA

By FJV Tax Staff

There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about. That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.

This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate. For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.

The motivation for the new deduction is rather simple. It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform. Income earned by a C corporation has always been subject to double taxation. The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend. Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.

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In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level. Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates. Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.

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What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty. What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.

One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction. Service businesses are the real problem. Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”. That definition cast a pretty wide shadow.

Proposed regulations have come to the rescue at least a little bit. The proposed regulations clarified several questions related to specified service businesses. First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above. Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business. These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.

Some of the most complicated areas are services related to health, consulting, and real estate businesses. Here are examples of the application of Section 199A from each of these businesses:

Health and Health Care

A qualifying health care business means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient. It excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient. An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.

Consulting

Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems. However, these services do not disqualify larger businesses that only involve small levels of consulting. Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product. For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.

Real Estate

Brokerage services are specifically excluded from Section 199A benefits. This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers. The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.

As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships. As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution. Many questions still remain.

Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to. To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.