But let’s quickly get into the details. Because not only is the case groundbreaking, it produces actionable insights both for small business owners and individual taxpayers.

Issue #1: Due Process Violations

The Moores’ case, if you’re a layperson and you read their petition, brings up three issues related to a tax that appeared in 2017, the Section 965 transition tax. One of the easiest to understand is the “Due Process” clause in the U.S. Constitution.

You can read the Wikipedia definition here, but a quick analogy comparing your own taxes with the Moores’ makes the point clearest.

You probably have saved a bit of money using a 401(k) account. Or a traditional or Roth Individual Retirement Account. Hopefully you’ve been doing that for years. Maybe decades. And partly you’ve done that because tax law says (and has said for decades) you don’t pay income taxes on your profits until you withdraw the money.

That was the deal, right? And so, it would be really crummy, and pretty unfair, if Congress retroactively decided at this point to change the rules. In other words, to now say you need to pay—today—income taxes on the money earned inside your IRA or 401(k) account in the 1990s or the 2000s using a new tax law we cooked up last month.

And yet, that’s basically what the Section 965 transition tax did. It retroactively changed the tax law and rules. And it made previously earned income from earlier years and decades taxable in 2017.

The Moores explain the situation in their petition. They invested $40,000 in a friend’s small business in India. That decision reflected the fact that any income earned by the corporation would not be taxed as earned. But only later as it was distributed. Or when they sold shares. And then on December 22, 2017, President Trump signed the new law which said, ”Okay. Change of rules. Now we want to tax the income as far back as 1986.” The Moores’ resulting tax, apparently paid in 2018, but for an earlier decade’s worth of earnings, equaled $14,729.

Anyway, that’s the first issue—and one that’s largely been missed or ignored or misunderstood by journalists discussing the Moores’ case: Was this retroactive tax law a violation of due process?

Issue #2: Measurement of Income

A second issue the Moore v. United States case examines? When and how a taxpayer measures income.

This bit of the argument gets a little more complicated. As the news coverage of the case shows.

The common-sense income measurement method used for centuries looks at transactions summarized in income statements. That’s been the approach in the Western world since at least the Renaissance (as documented by the Italian monk, Luca Paccioli). And Indian and Arabic cultures have similar accounting traditions that predate the Europeans.

To illustrate how this works for investors, take the example of you owning stock in some U.S. corporation. Like Microsoft. Or Apple Computer.

You don’t owe taxes on the money the Microsoft or Apple shows on their income statements. And on which they pay taxes. You only owe taxes on dividend income you receive from Microsoft or Apple. Or on the capital gain you enjoy if you sell shares of Microsoft or Apple Computer. In other words, the income shown on your income statement. That’s the way the accounting works. Or always used to.

What the Section 965 “transition” tax, and then a related chunk of tax law the Section 951A “global intangible low-taxed income” tax, do? They say you pay taxes on a chunk of the income earned by a foreign corporation you’ve invested in. Even though you haven’t received, or realized, any income. Even though you wouldn’t show that income on your personal income statement. And even if you really don’t have a clean way to measure the income.

Note: Congress and IRS refer to the Section 951A “Global Intangible Low-Taxed Income” tax as the GILTI tax. And, yes, they pronounce it “guilty.”

A quick sidebar for any tax professionals in the audience. Because I want to make two technical points. First, GILTI and other sections of Subpart F do work similarly to how U.S. partnership accounting works. But one noteworthy difference between typical partnership accounting and the Section 965 transition tax is, with a partnership, the income attributed to the partners is earned in the same year the income is attributed—and notably, the attributed partnership income is earned after Congress enacted the law imposing the tax.

A second technical point: Some critics of the Moores’ petition say Subchapter S corporations already force shareholders to report and pay income taxes on corporation income. Thus, Sections 965 and 951A aren’t really a new way of doing the tax accounting. What those folks miss though? With an S corporation, shareholders unanimously consent to this tax accounting treatment before it occurs. Often because the tax accounting both simplifies a small business’s accounting and saves tax.

Summing up, the measurement issue seems more complicated to me. Presumably the Court will consider a bunch of issues as they look closely at how the mechanics need to work. Furthermore, the issue raises more unanswered questions than casual analysis might predict. One issue connected to the complexity, in fact, I discuss next.

Issue #3: Compliance Costs of the Section 965 and 951A Taxes

A third issue is missed in most of the reporting I’ve seen or read: The compliance costs. So let me explain.

In their petition, the Moores note that the Section 965 transition tax equaled, as noted, $14,729. That was the tax per their petition on a $40,000 investment made a decade or so earlier.

The Moores didn’t disclose what the tax accounting costs for determining this tax bill were. Mr. Moore said in an interview said the accountants were costly.

But know this: The costs to calculate Section 965 and 951A taxes in general? Astronomical for a small business investor.

The IRS Form 5471 forms used to calculate these taxes, for example, take roughly a week to prepare according to the IRS. That’s not counting the time to learn the law. Or the time to collect the needed data.

Furthermore, the preparer? She or he needs to be a tax specialist who understands both the federal tax laws for international taxpayers. And she or he needs to understand generally accepted accounting principles since the form incorporates GAAP financial statements.

Rough numbers, you’re probably talking $300 or $400 an hour for roughly 40 hours. That’s $12,000 to $16,000 for just a part of the annual 1040 tax return.

People haven’t thought or talked much about this issue. But it’s an important part of the story. And one small business owners and managers should understand.

Three Closing Comments

Our CPA firm publishes this blog to share actionable insights for small business entrepreneurs and investors. So, let me try to do that regarding the Moore v. United States tax law case.

First, a specific tactical insight. If you’ve invested in a small corporation or LLC in another country? Maybe a family business where your people came from? Or some friend’s foreign venture? Or, heaven forbid, you used a corporation or LLC  to hold some foreign rental property? Oh my gosh. You need to see if you should have been filing 5471s. And then if you should have been but haven’t? You want to get with a CPA firm who handles this to see how to bring yourself into compliance. The penalties for bungling the Section 965 and 951A taxes are brutal. (In general, the penalties are assessed in $10,000 increments.)

A second, more general insight. Whatever you or I may think of these sorts of increased regulatory burdens and compliance costs? The increases appear to reflect a trend or pattern entrepreneurs should plan for. And stay alert to.

As just another example, next year the Financial Crimes Enforcement Network (aka “FinCEN”) will require 30 to 40 million small businesses to file “Business Ownership Information” or BOI reports. Failing to file potentially triggers financial penalties that rise as high as $10,000 and, in a worst-case, results in up to two years in prison. (We blog on this topic next month, by the way.) The only practical response to this sort of stuff? Plan ahead. And budget time and dollars.

Finally, a third important takeaway from the Moores’ case for taxpayers. We all want to allow for the possibility that tax law changes—possibly even retroactive changes—may upset carefully laid plans.

Some Related Resources

We’ve got quite a bit of information about international taxes available here at the blog. And you might find other posts useful. For example, if you need to understand the basics of how one handles foreign business tax reporting? Check out this earlier blog post: Reporting Foreign Business Investment

And this related comment: The Section 965 transition tax is what the Moores’ case looks at but a companion tax is the Section 951A GILTI tax. Small businesses facing or dealing with that tax might be interested in either of these two posts too: Section 951A GILTI Tax Avoidance: Ten Tricks and Section 962 Election: An Answer to GILTI?.

The post A CPA Explains Moore v. United States appeared first on Evergreen Small Business.

The IRS processes millions of tax returns each year that are never subject to additional examination or audit. Obviously, it is in your best interest to report things accurately and hope to stay off the IRS’s radar. Unfortunately, that isn’t always possible. Being selected for an audit does not inherently imply guilt or deception, and can happen to anyone that files a tax return.

I thought this would be a good topic of discussion as we go into the 2023 tax year. The IRS announced they are hiring 5,000 new agents in 2023, so this is especially relevant. Therefore, I will discuss how audits work, how returns are selected for audit, different types of audits, and ways to keep yourself protected if you are audited.

First, let’s go over some interesting statistics found in the 2021 IRS Service Data Book.

Statistics

The chances of being audited are pretty low. The IRS had 78,661 full time employees in 2021, and IRS employees dedicated to enforcement are only around 45%. Contrast this with the 167,915,264 individual 1040 tax returns filed in 2021. Consequently, the IRS has an estimated one IRS enforcement agent for every 4,800 individual 1040 returns filed, an extremely low ratio of agents to returns.

These enforcement agents don’t just look at 1040’s, either. Let’s add the 12,209,623 business entity returns filed in 2021 to our numerator. That equals roughly one IRS enforcement agent for every 5,200 returns. I won’t bother factoring estate, excise, payroll, tax exempt, and trust tax returns into the calculation, you get the idea.

Return Selection 

Most tax returns go through an automated, electronic system called the “Discriminant Function,” or “DIF” for short. The IRS calculates the DIF score by weighting and adding together return characteristics. The higher the DIF score, the higher the potential for audit. Every 1040 return gets a DIF score. Additionally, S Corp and C Corp returns with assets less than $10,000,000 get DIF scores. The IRS uses other techniques to select returns for audits as well.

The IRS matches information in their files to information reported on your tax return. For example, a taxpayer receives a 1099-INT after cashing in a savings bond. If the taxpayer fails to report the interest or reports a different amount than what the 1099-INT shows, chances are this return will get selected for an audit.

Confidential informants can tip off the IRS, resulting in return selection. So can related party transactions with a taxpayer already under examination.

Certain schedules are high risk and can trigger scrutiny from the IRS. Form 8283 Non-cash Contributions, Form 8275 Disclosure statement, and Form 8082 Notice of Inconsistent Treatment are a few examples that can trigger a closer look at your return.

Per the 2021 IRS Data Book, here are some current trends the IRS is looking closely into:

• Too many round numbers and deductions that offset large income items
• FBAR reporting issues related to perceived under-reporting of foreign income
• Virtual currency
• Passive vs. non-passive flow through income
• Real estate professional positions on rental real estate
• Worker classification – employee vs. contractor
• Matching source documents to returns, as mentioned above

But not all audits are equal. The intensity varies. So lets discuss the different types and cover some details of how IRS audits work.

Correspondence Examination/Audit

Correspondence audits are the most common, and there is a good chance you may have already had one. Have you ever received an IRS notice for your tax return? Maybe you failed to make estimated tax payments and received a notice asking you to pay interest. That is a correspondence audit, and usually not a big deal.

The IRS conducts these audits entirely through the mail. The IRS will make an adjustment or correction to a return, indicate the change, and calculate additional tax or refund due. Then, the taxpayer can either pay the additional tax or collect their additional refund if they agree with the adjustment.

Taxpayers can request more information or disagree with the change or correction and propose their own. The taxpayer should support their position with additional supporting documentation in their IRS response letter.

Sometimes taxpayers avoid these letters and take no action; not a recommended strategy. The IRS will send a second notice of deficiency letter, often referred to as a 30 day letter, requesting payment, when no action is taken by the taxpayer.

If no response is sent within 30 days, the IRS issues a Statutory Notice of Deficiency, and if the taxpayer still disagrees, they can file an appeal with the tax court.

Office Examination/Audit

A Tax Compliance Officer (TCO) conducts this type of audit in person at an IRS office to resolve issues too complex to resolve by mail. Typical issues include large itemized deductions, travel expenses, and misclassified income from rents and royalties.

The TCO will send the taxpayer a letter requesting an appointment and the type of documentation they need to bring to substantiate data reported on the tax return.

At the appointment, the TCO will collect oral testimony and physical documentation and will make one of three determinations; 1.) No change 2.) Deficiency 3.) Over-assessment.

Finally, lets discuss the third type of audit, the Field Audit.

Field Examination/Audit

A TCO conducts this type of audit at the location where the original books, records, and source documents are maintained, generally the taxpayer’s home or place of business. As you can probably guess, they are the least common type of audit. 21% of 2021 audits were field audits, per the 2021 IRS Service Data Book.

Spending the day in an office with an IRS agent is nobody’s idea of fun, however, these audits can produce more favorable results for the taxpayer than the other audit types.

Markedly, here are a few tips if you find yourself in a field audit:

• Be polite and friendly
• Know your taxpayer rights
• Avoid offering more information than needed
• Be honest
• Have your records organized and easily accessible
• Never leave the examiner alone
• Negotiate your positions

Appeals

A taxpayer can appeal if no agreement is reached. You must submit a formal written protest if the total amount owed exceeds $25,000, or the appeal is for a partnership, S Corp, or tax exempt organization.

There is no IRS form for a written appeal, but, it needs to include the following information:

• Statement the taxpayer wants to appeal the examiner’s findings to the appeals office
• Taxpayer’s name, address, and phone number
• A copy of the letter showing the proposed changes
• Tax periods involved
• Schedule of adjustments the taxpayer disagrees with
• Statement of fact supporting the taxpayer’s position
• Statement outlining the law the taxpayer relies on
• Declaration under penalties of perjury attesting the statement of facts as true and accurate

Protection

Now lets discuss some different expenses and how to ensure they are substantiated.

Trade or Business Expenses

Before taking a deduction, you want to ensure your activity rises to the level of a trade or business.  26 U.S. Code § 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.  A taxpayer must continuously and regularly be involved in the activity for the primary purpose of making a profit.

The regulations provide a list of relevant factors when considering if the activity rises to the level of a trade or business, including:

• Expertise of the taxpayer
• Time and effort expended on the activity
• History of income and losses with respect to the activity
• Whether elements of personal pleasure or recreation are involved in the activity
• Manner in which the taxpayer carried on the activity

Example

Lets explore this a bit more and use myself as an example.  I like fixing up cars, which inevitably ends up with me having more money in them than I can sell them for.  I also have a job as a CPA and know this car hobby is not a money making endeavor.  There is no profit motive, no history of success, and is done purely for personal pleasure.  It surely does not rise to the level of a trade or business, therefore I cannot report the activity on my 1040 tax return and claim a loss that offsets my CPA income.

The scenario is probably different if I am working on other people’s cars for money on the side.  I would need to report the income, and I would certainly have expenses (tools, supplies, etc.) that are legitimate business deductions.

In summary, be careful not to take losses and deductions on an activity the IRS would classify as a hobby and not a business.

Travel Expenses

You need to substantiate business expenses, clearly, but this is especially true with travel expenses. Travel expenses aren’t as straight forward as say, a rent payment to the landlord of a retail store, so extra diligence must be used when deducting travel.

To qualify for a deduction, travel expenses must be:

• Reasonable and necessary
• Incurred while traveling “away from home”
• Directly related to the conduct of the taxpayer’s trade or business

Three factors are used to determine a taxpayer’s “tax home:”

1. Whether there existed a business connection to the location of the home
2. Were duplicate living expenses incurred while traveling and while maintaining the tax home?
3. Whether personal connections exist to the tax home

Commuting to the office is not a qualified travel expense. And if your place of employment is somewhere other than your residence, and you decide not to move your residence to your work location, living and travel expenses getting to your job are not deductible either.

Mixed purpose travel gets murky too. It must be primarily related to the taxpayer’s trade or business to be deductible, with time spent on business being the most relevant factor. If you have business seminars in Hawaii for four days, and you stay for two additional vacation days, that probably counts. Reverse the business and personal time, that probably doesn’t count.  And there must be a bona-fide business purpose for a spouse’s travel expenses to be deductible.

Charitable Contributions

If you generally have enough deductions to itemize, chances are you have probably taken a charitable contribution deduction.  And you want to have very good records to substantiation the contribution.

For cash contributions of $250 or less, you need to have one of the following:

• Canceled check
• Bank or credit card statement
• Receipt from the organization
• Paystub if contributed through a payroll deduction

Cash contributions greater than $250 should, ideally, be substantiated with a receipt from the organization detailing the dollar amount, date, and whether any goods or services were provided to the donor.

Worker Classification Audits

The last topic I want to discuss is worker classification audits. Employers have a financial incentive to misclassify employees as independent contractors because costs and record keeping is lower.  Workers have an incentive to be classified as independent contractors because they can deduct expenses not available to employees.

The IRS uses a three-factor test to determine if a person is an employee or a contractor:

1. Behavior Control – Does the employer provide training to the worker? The more training provided, the more control the employer exerts over the worker.
2. Financial Control – Key factors include the workers investment in the services they provide, other services they make available to the market, and the opportunity for their own profit with respect to their services.
3. Relationship of Parties – Relationship factors include the extent to which either party can terminate the relationship, the party’s contractual relationship, and the employer providing, or not providing, benefits typically provided to an employee.

Misclassification of a worker as an independent contractor can have large consequences to the employer.  The employer may end up liable for payroll taxes on all open tax years, federal income tax that should have been withheld from the workers paychecks, and any state income taxes that should have been paid on the worker.  Consequently, only one or two worker misclassifications could lead to thousands of dollars of tax owed.

Final Thoughts

The goal of this blogpost was to (hopefully) relieve some anxiety by covering how IRS audits work and what you can expect if you ever find yourself in an audit situation. You should not feel bad if it happens to you. But, you want to be smart and methodical on how your respond to and deal with the IRS.

Good record keeping, honesty, and a little bit of knowledge will go along way on keeping yourself protected.

We have some additional posts on IRS audit prevention tips, real estate professional audit troubles, and surviving short term rental audits that contain great information if you want even more detail.

The post How IRS Audits Work appeared first on Evergreen Small Business.

For some small businesses and individuals, the new Section 951A GILTI tax creates a huge planning challenge and compliance burden.

And what’s worse? Many of these folks don’t even know yet that they have to deal with a new tax.

No kidding, this could get ugly. Fast.

Section 951A GILTI Tax in a Nutshell

The Section 951A GILTI tax—GILTI stands for “global intangible low-taxed income”—requires these U.S. taxpayers to pay taxes on a proportional share of all or some of the income earned inside a foreign corporation.

Example: A small business owns 100 percent of a small foreign corporate subsidiary making $100,000 a year. This small business needs to calculate the Section 951A GILTI tax on the $100,000, report those calculations on its 5471 form, and then pay any taxes owed.

Example: An individual invests in a foreign small family business earning $1,000,000 annually. If the individual’s ownership percentage equals 20 percent, she first needs to determine whether the Section 951A tax applies to the $200,000 “share” of income she indirectly earns (20 percent of the $1,000,000). If Section 951A does apply, she then needs to calculate the GILTI tax, report those calculations on her 5471 form, and finally pay any taxes owed.

GILTI for Small Businesses and Individuals

Large, sophisticated businesses served by big accounting firms already know (and surely have planned for) Section 951A. But we’re finding that scary numbers of smaller businesses and individual investors seem oblivious to the new law.

Any small business or individual with international investments, however, needs to deal with the GILTI tax issue.

Tax practitioners, therefore, can provide enormous value to clients by helping them either avoid the Section 951A tax completely or by minimizing the actual taxes paid. And fortunately, a rich set of planning tactics exist.

Trick #1: Reduce Ownership Percentage Below Threshold

A first tactic to look at? Can a taxpayer reduce shareholdings below the threshold that triggers the Section 951A tax?

The Section 951A GILTI tax hits U.S. taxpayers who own 10% or more of a controlled foreign corporation.

Accordingly, a taxpayer who owns just over that 10 percent threshold may want to look at dialing down her or his ownership percentage. Dropping from 10 percent to 9 percent, for example, “solves” the GILTI problem.

One important wrinkle to consider, however: In determining percentages, tax law requires taxpayers to include stock owned through foreign entities. And it also requires taxpayers to use the Section 318 constructive ownership rules. For Section 318, an individual counts shares owned by a spouse, children, grandchildren, and parents as her or his own shares. And an individual counts shares owned directly or indirectly through a corporation he controls, a partnership he owns an interest in, or a trust he’s a beneficiary of—and vice versa.

A taxpayer could not, therefore, get around the GILTI rules by giving or selling his stock to a spouse, his parents, children, or grandchildren. Nor could a taxpayer get around GILTI by splitting his interest in a foreign corporation among a bunch of different entities he controls. The constructive ownership rules count those shareholdings, too.

Trick #2: Fail the Controlled Foreign Corporation Test

The Section 957 controlled foreign corporation definition suggests another gambit for avoiding GILTI in some situations: A U.S. taxpayer may want to orchestrate failing the controlled foreign corporation test.

Tax law defines a controlled foreign corporation as a foreign corporation where U.S. shareholders owning at least 10 percent of the corporation collectively own more than 50 percent of the corporation. In some situations, failing this “test” may make sense.

Example: A foreign corporation with five unrelated U.S. taxpayer shareholders who each own 11 percent shares counts as a controlled foreign corporation. If the U.S. taxpayers reconfigure their ownership so these five shareholders each own 10 percent shares, that change should mean the foreign corporation no longer counts as “controlled.”

The one wrinkle with this gambit? Tax law is clever, and defines “control” as not just owning more than 50% of the shares by value, but also more than 50% of the shares by voting power. So a scheme where U.S. shareholders only own 50% or less of the corporation, but still get more than 50% of the votes on major shareholder decisions, almost certainly won’t work.

Trick #3: Elect Disregarded Entity or Partnership Status

Our office’s “favorite” trick for avoiding Section 951A GILTI tax? Elect to have the foreign entity treated as a disregarded entity or partnership.

Often, this choice is available to a taxpayer. (One needs to check the Section 301.7701-2 regulations for entity classification choices available to a particular entity.) And when the choice exists, making an election moots Section 951A.

Two reminders about this approach: First, if a taxpayer elects to treat a foreign corporation as a disregarded entity or partnership, the taxpayer reports the foreign entity’s income on the U.S. taxpayer’s U.S. tax return. (This is bad.) But if the taxpayer elects, then the taxpayer also reports the foreign income taxes as credits on the U.S. taxpayer’s U.S. tax return. (This is good.) In many cases, the taxes and the credits offset each other—or nearly so.

A second reminder: Electing disregarded entity or partnership status for a foreign entity previously treated as a corporation triggers a deemed liquidation of the foreign corporation. That deemed liquidation in turn triggers income taxes, potentially, on the taxpayer’s U.S. tax return. Accordingly, these taxes may need to be considered.

Trick #4: Make a Section 962 Election

An old statute, Section 962, provides a last-minute gambit for mostly avoiding the Section 951A GILTI tax: A taxpayer may elect to treat any interests in controlled foreign corporations as if they are owned not directly, but indirectly through a “virtual” U.S. corporation.

The Section 962 election results in two benefits for individuals. First, the Section 951A GILTI tax calculations use the taxpayer’s marginal tax rate on the GILTI income. Regular corporations, as compared to individuals, pay a pretty low 21 percent flat income tax rate. That means the taxpayer uses that 21 percent rate of the “virtual corporation” for the GILTI calculations.

The Section 962 election also produces a second benefit for individuals. With a Section 962 election in place, the taxpayer gets deemed-paid foreign tax credits for the foreign taxes paid by the controlled foreign corporation. The credits reduce the virtual corporation’s GILTI tax.

Example: Before the Section 962 election, a high-income taxpayer with $100,000 of GILTI income might pay a 37 percent tax, or $37,000 in GILTI taxes. However, with the Section 962 election, the taxpayer would pay a 21 percent tax tentatively, or $21,000 in GILTI taxes. In addition, the taxpayer potentially would get a tax credit for 80 percent of the foreign taxes paid on the $100,000 of GILTI income. If the foreign corporation pays $25,000 in foreign taxes, the deemed-paid foreign tax credits might equal $20,000, thereby reducing the net taxes paid to just $1,000.

Tax practitioners and taxpayers late to planning for the Section 951A GILTI tax probably want to consider a Section 962 election for the 2018 year.

Keep in mind, however, a predictable downside to creating that “virtual” corporation: That corporation triggers the traditional double-taxation inherent in a regular corporation on any dividends from the foreign corporation. And here’s one subtle nuance of the Section 962 election that tripped up a taxpayer in the recent Smith v. Commissioner (151 T.C. 5) case: That dividend often isn’t eligible for qualified dividend treatment.

Trick #5: Hold GILTI Income Source in a Real Corporation

The Section 962 election just described provides two of the benefits of holding an interest in controlled foreign corporation through a real U.S. corporation. But looking forward to 2019 and beyond, some taxpayers may want to actually set up a corporation and then contribute their controlled foreign corporation interest to that corporation.

Why? Holding a controlled foreign corporation interest through a real domestic corporation gives the U.S. taxpayer two additional benefits compared to a Section 962 election.

The first benefit is that when the U.S. corporation pays a dividend to its owners, those dividends will be qualified dividends under U.S. tax law.

The second benefit is the Section 250 foreign-derived intangible income deduction. This deduction essentially halves GILTI tax for U.S. C corporation taxpayers.

Note: Holding interests in controlled foreign corporations through a real corporation, then, delivers four benefits: the 21 percent tax rate, the deemed-paid foreign tax credits, certainty of qualified dividend income treatment, and then the foreign-derived intangible income deduction.

Tax practitioners who make a Section 962 election for 2018 may want to move quickly to set up a real U.S. corporation for 2019 to take advantage of the Section 250 deduction starting in 2019.

Trick #6: Revoke Subchapter S Status

A related trick: If someone owns an S corporation which in turn owns a controlled foreign corporation interest, the S corporation’s shareholders may want to revoke the Subchapter S status.

That revocation, which can be made for 2019 anytime before March 15^th, 2019, means the controlled foreign corporation interest would held by a regular corporation starting in 2019.

That regular corporation, of course, means a 21 percent flat tax rate, deemed-paid foreign tax credits, certain qualified dividend income treatment, and foreign-derived intangible income deductions.

Trick #7: Reduce Controlled Foreign Corporation Income

A simple but powerful trick needs to mentioned somewhere in this discussion: Reducing the income of the controlled foreign corporation.

For example, adding legitimate deductions to the controlled foreign corporation’s tax return (such as expenses for growing the business) should reduce the controlled foreign corporation’s income and will therefore reduce any GILTI tax.

As another example, adjusting transfer pricing so the U.S. parent corporation makes more and the foreign corporation makes less may reduce the controlled foreign corporation’s income and the related GILTI tax.

The above techniques don’t work as long-term solutions. They may, however, work as stop-gap measures for 2018.

Trick #8: Reduce Taxpayer’s Taxable Income

Individual taxpayers should also look the possibility they can reduce GILTI taxes by reducing their U.S. tax return taxable income.

For an individual taxpayer, as noted earlier, the GILTI tax formula in effect uses a taxpayer’s marginal tax rate. A low marginal tax rate means a lower GILTI tax.

If someone does something to dramatically lower their U.S. tax return taxable income—use big bonus depreciation deductions in 2018, for example—that reduction minimizes the GILTI tax.

Trick #9: Exit the Controlled Foreign Corporation

Some individuals and at least a few businesses should probably consider a crude, if effective, tax planning gambit: Terminating their ownership interest in a controlled foreign corporation that triggers the GILTI tax.

Here’s why termination sometimes makes sense to consider: Unfortunately, a taxpayer with low GILTI income and a low GILTI tax still needs to prepare the time-consuming 5471 forms.

Furthermore, these forms are not just expensive, they are risky to prepare. (The penalty for failing to file a 5471 form, or for filing a 5471 that isn’t substantially complete, starts at $10,000. And word on the street is, the IRS more regularly assesses this penalty these days than it has in the past.)

Someone with a very small, strategically insignificant foreign business interest, therefore, may want to look at just dumping that investment and removing that complexity from their return.

Trick #10: Ignore the Section 951A GILTI Tax

One final “response” to the burden of the Section 951A tax accounting bears mentioning.

Taxpayers in a few small business and investment situations may simply want to ignore the tax and its complexity.

No, no, don’t misunderstand us. These taxpayer’s accountants will still need to deal with the Section 951A calculations, the 5471 forms and then any resulting income taxes.

But high-income taxpayers with small controlled foreign corporation investments may want to focus their tax planning on other more significant opportunities.

Example: A taxpayer with $5 million of taxable income and $100,000 of GILTI income may just want to accept paying the 37 percent GILTI tax on the $100,000.

Final Comments

Four closing comments: First, tax practitioners and taxpayers who don’t work regularly on international tax planning issues need to be careful using any of the tricks discussed above. Review the relevant regulations carefully before you pull the trigger on some tactic. (People probably also want to wait for final regulations whenever possible.)

Second, if you’re a tax practitioner with clients impacted by Section 951A, you possibly should have been filing 5471 forms in past. You will, accordingly, want to check out whether you need to go back and file these late returns. (By the way, filing late 5471s counts as another activity you need to be really careful about.)

Third, if you need to deal with the Section 951A GILTI tax for some client, you probably want to make sure the Section 965 transition tax was correctly handled on the 2017 tax return and 5471. The Section 965 transition tax probably should have been paid by any taxpayers who need to deal with the Section 951A GILTI tax. We think a number of taxpayers and tax practitioners missed this requirement due largely to the crazy timing the transition tax required.

And fourth, note that when Congress passed the new GILTI rules, it included a provision authorizing the Treasury to create regulations to prevent avoidance of the GILTI tax, as the Treasury determines appropriate [Section 951A(d)(4)]. The Treasury has released proposed regulations that include anti-abuse rules, but no regulations have been finalized on this topic yet. Accordingly, as you plan around GILTI you’ll want to stay on top of this evolving area of tax law.

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The post Section 951A GILTI Tax Avoidance: Ten Tricks appeared first on Evergreen Small Business.

The Section 951A GILTI tax hits imputed income from controlled foreign corporations. And at a high level, GILTI works simply.

How the Section 951A GILTI Tax Works

Say you own 10% of a controlled foreign corporation (“CFC”) with no fixed assets that makes $1,000,000 a year before foreign income taxes. In this case, you may owe U.S. income taxes on 10% of the CFC’s profit, or $100,000.

Let’s say this CFC’s foreign corporate income tax rate is 25%. Since the CFC has no fixed assets, all of its income ($1,000,000 – $250,000 of tax = $750,000) is GILTI income. If your marginal tax rate before GILTI equals 37%, the GILTI rules make you pay 37% of regular tax on your $75,000 share of the profit, or $27,250. In many cases, this GILTI income is also subject to net investment income tax, in which case you would pay an additional 3.8% tax on top of the first 37%, or $75,000 × 40.8% = $30,600.

As an individual taxpayer, you can’t claim a foreign tax credit against this tax (only C corporations can do that), so the total tax burden you’ll end up paying on this $100,000 of pre-tax income is $25,000 of foreign taxes + $30,600 of U.S. income taxes = $55,600 of total income taxes.

And this important clarification: You owe the GILTI taxes even though you haven’t actually received any of the $100,000.

Note: If you don’t know yet whether you or your business owes GILTI or want more information, we’ve got a longer discussion here: Will Your Small Business Owe GILTI Tax?

This imputed income and the resulting taxes have some investors and entrepreneurs tax scrambling. People want—and need—ways to dial down this new surprise tax.

We continue to think that for many small businesses, the cleanest and simplest way to avoid GILTI is to elect to have their foreign subsidiaries treated as disregarded entities or partnerships (as discussed in the above-linked article). However, the Section 962 election deserves consideration.

How the Section 962 Election Works

When a taxpayer makes a Section 962 election, the tax accounting changes for an individual or pass-through entity.

That change? Well, think of the 962 election as basically inserting a “pretend” domestic C corporation between the foreign corporation and the individual owner.

In other words, if Steve owns a controlled foreign corporation but makes a Section 962 election, Steve calculates the tax he owes on Subpart F and GILTI income of the CFC using C corporation tax rates. For 2018 the corporate tax rate is only 21% (and no NIIT or AMT to worry about), compared to a top marginal rate of 37% for individuals (plus NIIT and AMT to potentially worry about).

A taxpayer who tallies $100,000 of GILTI income (after grossing up for the deemed-paid FTC), therefore, would potentially pay $21,000 of income taxes.

A second wrinkle appears in the Section 962 election too. The taxpayer’s virtual corporation can use deemed-paid foreign tax credits paid by the controlled foreign corporation to reduce the GILTI tax.

Deemed-paid foreign tax credits get a little complicated. But suppose for sake of illustration that the controlled foreign corporation pays a 25% local income tax. In this case, the foreign tax credit might equal 80% of that 25%, or 20% (in effect).

That 20% credit would then cut the 21% GILTI tax rate to effectively 1%: The 21% GILTI tax – the 20% deemed foreign tax credit equals 1%.

In the final accounting, therefore, a Section 962 election means some investor or entrepreneur might pay a very low tax rate on the imputed GILTI income.

But this election doesn’t work as cleanly as one might hope or expect.

The Section 962 Election GILTI Gotcha

The Section 962 election comes with a downside. That downside?

When you make this election you don’t just get the benefit of the 21% corporate tax rate and the deemed paid foreign tax credit; you also get the double-taxation that comes with C corporations if the taxpayer ever gets a dividend from the controlled foreign corporation.

For example, suppose that the next year, the controlled foreign corporation pays the taxpayer a $75,000 dividend from the money already recognized as GILTI income and on which she or he has already paid U.S. income tax.

Note: I calculate the $75,000 by subtracting the $25,000 of local or “foreign” income taxes from the $100,000 of controlled foreign corporation profits.

On that $75,000 dividend, the taxpayer again pays income taxes—though only to the extent the dividend exceeds the “corporate income tax” you already paid on the money once before, or $74,000.

If the local country and the U.S. have a comprehensive tax treaty in place, the taxpayer probably treats the $74,000 payment as a qualified dividend. But that may still mean a 20% qualified dividend rate plus 3.8% net investment income tax, or $17,612 in total. And many countries don’t have such treaties in place, so dividends paid out of many CFCs are actually ordinary dividends, not qualified dividends.

Note: You don’t treat this dividend paid by the foreign corporation as paid by a faux domestic C corporation, but as paid directly out of the foreign corporation. So, this is where that analogy starts to fall apart a bit.

In the end, then, the taxpayer may net $56,388 of after-tax cash flow. Out of a $100,000 of controlled foreign corporation profits, the U.S. taxpayer pays $25,000 in foreign taxes, $1,000 of GILTI tax, and $17,612 in individual income taxes for a total of $43,612.

On $100,000 of income, that $43,612 of income taxes equates to a 43.612% tax rate. $43,612 is better than $55,600. But not by as much as some taxpayers may have hoped.

Note, too, what happens if the dividends aren’t qualified: the taxpayer instead likely pays $74,000 × 40.8% = $30,192 on the dividend, for a total of $25,000 + $1,000 + $30,192 = $56,192. So in that situation, the election actually costs tax.

One Other Wrinkle Worth Mentioning: An Actual C Corporation

One other note: If a taxpayer holds a controlled foreign corporation through an actual U.S. C corporation, as compared to just making a 962 election (which creates a sort of temporary “virtual” corporation, and only for some parts of the tax code), the taxpayer enjoys an additional benefit: the foreign-derived intangible income deduction.

The foreign-derived intangible income deduction counts as a big benefit. It essentially halves GILTI for U.S. C corporation taxpayers.

The 962 election doesn’t get you the foreign-derived intangible income deduction, though. And note, too, as we mentioned above, that a 962 election doesn’t guarantee qualified dividend treatment for the dividends paid out of the “pretend domestic C corporation.” So in effect, the Section 962 election compares unfavorably to the option of actually, truly holding controlled foreign corporation interests through a U.S. C corporation.

A Final Comment about Section 962 Election GILTI Tactic

The upshot of all this? Don’t rush too quickly to make choose a Section 962 election as the way you avoid GILTI.

You may need to use the Section 962 election as a temporary “patch.”

But in the long run, probably options like treating the foreign controlled corporation as a pass-through or disregarded entity or owning a controlled foreign corporation through a real U.S. C corporation make more sense.

Interested in More Small Business Tax Information?

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In addition, certain aspects of the tax don’t quite line up with Congress’ stated intention for enacting the new rules. So, it would be understandable for practitioners to not realize, in the chaos of tax season, that § 965 tax applied to their clients—particularly their non-C-corporation clients.

Accordingly, this post exists to warn practitioners about the nature of the § 965 tax and provide some actionable insight on what to do about it.

Who Owed Section 965 Transition Tax

The 965 tax hit U.S. shareholders owning a “deferred foreign income corporation.” The new statute defines a “deferred foreign income corporation” as any “specified foreign corporation” with post-1986 E&P which the U.S. hasn’t yet taxed.

Probably most specified foreign corporations are “controlled foreign corporations” (“CFCs”). As a refresher for those who don’t work with foreign investment reporting all that much, a CFC is a foreign corporation where U.S. shareholders owning individually at least 10 percent of the foreign corporation stock collectively own more than 50% of the foreign corporation’s stock. These are the foreign corporations we’ve been reporting on 5471s for years.

However, one important thing to realize about the new § 965 is that the definition of “specified foreign corporation” is broader than that of a CFC. A specified foreign corporation (often abbreviated “SFC”) can be a controlled foreign corporation. But it can also be any foreign corporation with at least one U.S. corporation as a shareholder. So, some clients of yours who own foreign corporations may have needed to file a 5471 for the first time last year because their foreign corporation counted as an SFC.

In addition, it would be understandable if a taxpayer assumed that § 965 transition tax only applied to C corporations. The idea behind the transition tax, after all, was to tax pre-2018 earnings held inside foreign subsidiaries before C corporation parent companies transitioned to a new territorial tax system. However, § 965 applies to all U.S. shareholders, not just U.S. C corporations. And there’s no special “small taxpayer” exception to help the little businesses get around the complexity.

Examples of Foreign Corporations Triggering a Section 965 Transition Tax

Two examples show how easily U.S. taxpayers with small corporations overseas fall into the Section 965 tax trap.

Example 1: Your small business wholly owns a foreign subsidiary. Maybe a small Irish brewery operating (predictably) as an Irish corporation. Your small business formed the subsidiary ten years ago and most years the brewery makes a small profit. In this case, that Irish corporation counts as a deferred foreign income corporation (because the Irish corporation is a CFC.) Your 2017 tax return should have reported the earnings accumulated over the last ten years as taxable income.

Example 2: For three decades, you and five college friends have individually owned 10.2% shares of a foreign corporation that operates a small hotel for surfers in Costa Rica. (Local, foreign investors hold the remaining shares and manage the property.) The Costa Rican corporation counts as a deferred foreign income corporation (because the Costa Rican corporation is a CFC.) The 2017 tax returns of each of the individual U.S. taxpayers owning shares should have reported the earnings accumulated over the last ten years as taxable income.

Calculating the Section 965 Transition Tax

The one bit of good news in all of this? The Section 965 transition tax isn’t terribly expensive if you know how to calculate it correctly.

The tax is approximately either 15.5% or 8% of any foreign income previously untaxed by the US. (Compare that to 2017 top marginal tax rates of 35% or 39.6%). And taxpayers can often claim a foreign tax credit for foreign income taxes paid in prior years—if the tax preparer is careful and knows what they’re doing.

Note: For taxpayers who owe the tax in 2017, to calculate the actual Section 965 income amounts and then the deductions the law allows, you need to read IRS Publication 5292 and use its worksheets. For taxpayers who owe the tax in 2018, you’ll use future Form 965 and its supporting schedules (currently still in draft).

Section 965 Transition Tax Elections

Furthermore, the Section 965 statute provides some special elections that taxpayers can make to delay paying the tax.

A Section 965(h) election, for example, lets a taxpayer pay the tax in eight payments over the next eight years.

Another election, the 965(i) election, lets an S corporation delay paying the transition tax until a triggering event. “Triggering events” include stuff like the S corporation revoking its election or liquidating.

Alternative Minimum Tax and Net Investment Income Tax

One bad surprise about the Section 965 tax? The income the Section 965 tax “taxes” seems to be subject to both AMT and net investment income tax. The law is a little murky about this. (Probably the statute was poorly written.)

What If You Flubbed This?

If your 2017 tax return should have included the Section 965 transition tax, you’re going to need to amend the tax return, calculate the tax, and then pay what you owe.

Omitting this tax from your tax return is a big deal. It’s like “omitting” the AMT tax, the self-employment tax, or the net investment income tax from a return.

But you have another serious issue if you bungled the Section 965 transition tax.

If you owed a Section 965 transition tax for 2017, you also owed the IRS a Form 5471 for either 2017 or 2018—even if the foreign corporation triggering the tax wasn’t a CFC.

A caution: The penalties for filing late 5471 forms can be severe. You probably want an experienced tax accountant to help with this.

Interested in More Small Business International Tax Information?

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Many small business owners with foreign corporations have grown accustomed to not paying tax on the corporation’s earnings until the corporation pays them a dividend. But because of the new tax reform bill, for many small businesses those old rules no longer apply.

Who Needs to Worry About GILTI

GILTI stands for “global intangible low-taxed income.” However, the GILTI tax doesn’t just hit taxpayers, investors, and small businesses operating in jurisdictions that lightly tax income.

Rather, the GILTI tax tags U.S. shareholders who own just about any controlled foreign corporation (or “CFC”) that doesn’t have much in the way of fixed assets.

GILTI forces people who own more than ten percent of a foreign corporation to pay US taxes on their proportional share of the corporation’s profit, even if the corporation doesn’t distribute that profit to the shareholders.

Note: If you or your small business paid (or should have paid) the Section 965 transition tax on a foreign investment, you likely owe GILTI tax starting in 2018.

How GILTI Works: The $0.10 Explanation

For most individual and small business taxpayers, here are the new GILTI rules in a nutshell: U.S. taxpayers need to recognize any income earned inside a foreign corporation that exceeds 10% of the foreign corporation’s fixed assets.

C corporation taxpayers get a special, lower tax rate on this income. But individual small business owners won’t get a special tax rate. Instead, they’ll just add this income to all the other income they’re paying taxes on, and then calculate income tax on GILTI just like it’s Subpart F income.

In addition, unlike C corporation taxpayers, individual taxpayers won’t get to claim what’s called an “indirect foreign tax credit” on GILTI. This also applies to individuals who own their foreign corporation through a past-through entity, such as a partnership or S corporation.

Example: Let’s say an individual small business owner owns 100% of a U.K. corporation with no fixed assets. This corporation earns $100,000 in 2018, none of which is Subpart F income. It pays no dividends to its owners. Before tax reform, the business owner didn’t have to worry about paying U.S. income taxes on the $100,000. But post-tax reform, the business owner will need to include the $100,000 on their 2018 1040 and pay tax on it. And this individual won’t even get to claim a foreign tax credit for any income taxes the corporation paid to the U.K. on this income.

Avoiding GILTI Tax

Some individuals and small businesses do, however, have a way to avoid GILTI. They can elect to treat their foreign business as a partnership or disregarded entity.

This, of course, means that the taxpayer will recognize taxable income inside the foreign entity as it’s earned. And this may be a disappointment for some. But remember that the GILTI rules mean the IRS now taxes that income currently anyway. However, note that pass-through or disregarded entity status means the foreign income taxes probably work as a foreign tax credit.

Foreign Partnership Tax Classifications

By default, U.S. tax law usually treats foreign entities that limit the liability of their owners as C corporations.

However, some foreign limited liability entities may elect to be treated as partnerships or disregarded entities. And a taxpayer isn’t stuck with the tax treatment they chose when the foreign entity was formed. A taxpayer subject to the GILTI rules could elect to have their foreign business entity treated as a partnership or a disregarded entity going forward.

What’s more, revenue procedures often allow taxpayers to make late entity classifications. This means that, even at this late date, some U.S. taxpayers could elect a new tax treatment for their foreign entities for 2018.

Note: We believe the correct revenue procedure to invoke in order to make a late entity classification is Rev. Proc. 2009-41.

Making Late Partnership Classifications

To convert a foreign corporation to a foreign partnership, you would file a late Form 8832 “entity classification” election.

Note: Some foreign limited liability entities cannot elect to be treated as partnerships. Check Treasury Regulation 301.7701-2 if you have questions.

Partnership Reclassification Triggers Gain

Note that the change in status from corporation to partnership would mean that you need to report, in essence, foreign corporation stock being “sold” for a foreign partnership interest. So, a taxable transaction.

But that might be a very low-tax transaction. Your “basis” in your foreign corporation’s stock doesn’t just include the money you originally invested. It also includes your share of the “Section 965 income” dealt with on the 2017 return. (This was the Section 965 transition tax you paid, started paying, or elected to pay sometime in the future.)

Further, keep in mind that many small businesses have very modest valuations. A multiple of two or three or four times earnings is common.

The upshot for some individuals and small businesses invested in foreign corporations? A change in entity classification may be the cleanest way to avoid GILTI.

If you’re a tax accountant who needs to learn the Section 965 transition tax stuff in detail, you may be interested in looking at our Preparing International Tax Returns of U.S. Taxpayers monograph.

Like our other monographs for CPAs and attorneys, it provides practitioners with a way to get up to speed in few hours—rather than spend days or longer reading the statutes, regulations, and case law.

Interested in More International Tax Information?

We regularly blog about issues related to small business taxation, including international taxes. You may want to consider subscribing to our free monthly-ish newsletter. You can subscribe anytime.

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Most of the time, this blog addresses subjects of general interest to most small business owners. But this week, I want to talk about the Section 965 Transition Tax and about how tax accountants can use the IRS Pub 5292 worksheets to develop the information taxpayers need to report on their 2017 tax return.

We are, in other words, way out into the weeds.

Before I supply the link to the Excel workbook that makes the IRS Pub 5292 calculations along with some brief instructions, let me provide some background information.

Section 965 Transition Tax Background

A CPA friend of ours, Moses Mann, did a great guest blog post about key features of the new international tax stuff, including the Section 965 transition tax. If you’re still getting up to speed on how any of this works, refer to that post: International Tax Reform: Key Changes from Tax Cuts and Jobs Act.

To give you a birds-eye view, however, U.S. taxpayers who own what’s called a “deferred foreign income corporation” (aka a “DFIC”) need to recognize as 2017 income the cumulative undistributed earnings of the foreign corporation on which U.S. income tax has been, up until now, deferred.

If you’re surprised by this—say because you own an interest in a controlled foreign corporation—know you’re not alone. In the past, a small business or an individual who owned an interest in a controlled foreign corporation usually wouldn’t need to pay U.S. income taxes on the foreign corporation’s income until that income was distributed.

Note: A controlled foreign corporation is a foreign corporation where U.S. shareholders who each own more than 10% ownership interests collectively own at least 50% of the stock in the foreign corporation.

The new Section 965 transition tax says different, however. It says, “Hey, um, you know those retained earnings that have accumulated in that foreign corporation you own a slice of?… Yeah, well, we’re just going to pretend, or ‘deem,’ your share of those earnings was repatriated in 2017. And then we will make you pay a repatriation tax.”

This stuff, if you own an interest in a controlled foreign corporation or any other type of DFIC, should have been dealt with on your 2017 tax return.

But quite possibly it wasn’t.

The Section 965 Transition Tax Conundrum

The problem here? The actual tax law was enacted much too late to make this something the Internal Revenue Service, tax accountants and their clients could deal with during the 2017 tax season.

Accordingly, neither the tax software companies nor the Internal Revenue Service were able to provide rich guidance or robust tools to make the calculations.

The Internal Revenue Service, for example, published its guide, IRS Pub 5292, on April 6^th, 2018. And it originally published these FAQs in March 2018, but has been updating them since, with some parts added as recently as June.

Even as I write this, the U.S. Treasury’s eftps.gov system can’t at this point accept payments of the Section 965 transition tax—which tells you something (see Question 10 of the IRS FAQs linked above).

The proposed regulations for Sec. 965 only came out today (August 1, 2018).

And, big surprise, tax software preparation companies haven’t had time to add to their products all functionalities that really deal with the Section 965 transition tax.

To be honest, it’s a little bit of a goat rodeo.

Excel Versions of Pub 5292 Worksheets

Accordingly, what many tax practitioners have had to resort to is constructing Excel workbooks that mimic the worksheets from IRS Pub 5292. Only then can they can calculate the stuff that needs to be reported in order to (a) comply with the Section 965 transition tax reporting and (b) to calculate the Section 965 transition tax.

We supply our firm’s version of this Excel workbook via the link below:

IRS Pub 5292 Worksheets for Sec. 965 Tax

Please treat this like you would “beta software.” In other words, we’ve tested it (as we continue to test it). But be careful. And a request? If you have questions or spot issues, for heaven’s sake, post a comment here. We thank you in advance for that. And so will all of your professional brothers and sisters.

And three quick notes to close: First, the worksheet cells that show in orange accept the input values.

Second, you want to have the IRS Pub 5292 in your hand (or on your screen) as you work through the calculations. That publication provides the instructions for “filling in the blanks.”

Third, Pub 5292 does contain rather obvious errors. Watch for those as you read. And remember the attorneys and accountants at the Internal Revenue Service were just trying to do the best job they could… at the last minute… with a confusing, probably incorrectly written bit of tax law.

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This blog post highlights the key changes in international tax laws under the Tax Cuts and Jobs Act.

I highlight four provisions which I think will have the most impact on small multinational businesses and I also provide a quick summary of the remaining changes.

International Tax Reform #1: Section 245A Participation Exemption

IRC Section 245A allows a US corporate shareholder to receive a 100% dividend received deduction for dividends received from a foreign corporation.

Section 245A sets three main requirements:

• Dividends must relate to foreign earnings (i.e. dividends attributable to a US trade or business do not qualify)
• A shareholder receiving the dividend must own at least 10% in vote or value of the foreign corporation
• A shareholder must be a domestic corporation

As you can see from the requirements, only corporate shareholders benefit from the 100% dividend received deduction. Individuals, partnerships, and S-Corporations don’t.

Note: Small businesses ownerships often include individuals or flow-through entities as shareholders of foreign corporations.  These types of shareholders do miss the benefit of the participation exemption.

International Tax Reform #2: Section 965 Transition Tax

As a way to transition to the participation exemption system, IRC Section 965 requires the recognition of income, as subpart F income, for all undistributed earnings of a foreign corporation.

This provision applies to the last taxable year “which begins before January 1, 2018”, which therefore includes foreign corporations with 12/31/2017 year-ends.

If a US shareholder of a foreign corporation files a calendar year tax return ending 12/31/2017, for example, the transition tax applies to the US shareholder’s tax return due April 17, 2018.

At a very high level, the transition tax formula looks at the greater of earnings and profits (E&P) amounts on either 11/2/2017 or on 12/31/2017.   Then the formula taxes the earnings and profits related to cash positions and liquid assets using a 15.5% rate and the remaining earnings and profit using an 8% rate.

The transition tax applies to a US shareholder of a specified foreign corporation (“SFC”).

A US shareholder includes domestic corporations, partnerships, and individuals that own directly, indirectly, or constructively more than 10% vote or value of the foreign corporation.

The new law defines a specified foreign corporation as any controlled foreign corporation (“CFC”) or any foreign corporation with at least one domestic corporation as a US shareholder.

As you can see, the transition tax can apply to minority individual US shareholders of CFCs.   Therefore, it is important to review your existing business structure to assess the potential impact of the transition tax on the 2017 tax return.

If you are a CPA, additional budget should be incorporated to the tax return to factor in:

• E&P calculations on 11/2 and 12/31
• Review of liquid assets
• Calculation of the transition tax

International Tax Reform #3: Section 951A  Global Intangible Low-Taxed Income

The Tax Cuts and Jobs Act introduces a new form of subpart F income:  Global Intangible Low-Taxed Income, or GILTI.  The term “intangible” can be misleading, as the scope of GILTI covers a broad spectrum of income.

In general, IRC Section 951A requires a US shareholder of any CFC to include GILTI in the shareholder’s gross income during the current year.

At a very high level, GILTI is defined as:  CFC’s net tested income less shareholder’s net deemed tangible income return.

• Net tested income – With a very limited amount of exceptions, net tested income is any gross income of the CFC
• Net deemed tangible income return – 10% of the CFC’s depreciable assets

In contrast to the Section 245A dividends received deduction discussed in the first paragraphs of this post, GILTI applies to all US shareholders.  Therefore, an individual US shareholder in a CFC may be subject to GILTI.

Currently, US corporate shareholders are eligible for a deduction equal to 50% of GILTI, thus US corporate shareholders are able to achieve an effective tax rate of 10.5% on GILTI.  However, this deduction is only available to US corporate shareholders.

Furthermore, since GILTI is a form of subpart F income, GILTI will be taxed at the individual shareholder’s ordinary tax rate.   Note, however, an individual may make an election under Section 962 to be treated as a corporation for subpart F purposes.

I expect most CFCs that are operating in the consulting and IT industries to be impacted by GILTI due to the minimal amount of fixed assets required to operate the business (i.e. minimal net deemed tangible income return).

Therefore, tax planning conversations should include the potential US tax impact of the CFC’s operations on going forward and should explore ways to eliminate or minimize GILTI (i.e. making a check-the-box election).   In addition, GILTI should also be considered when calculating estimated tax payments.

International Tax Reform #4: Changes in Attribution Rules

The Tax Cuts and Jobs Act eliminated IRC Section 958(b)(4).  As a result, a foreign corporation’s ownership in an affiliated foreign corporation may be attributed to a US shareholder.

For example, if a domestic corporation owns 5% of a foreign corporation (F Sub), and the remaining shares of F Sub is owned by the domestic corporation’s foreign parent (FP), then F Sub would be considered a SFC for purposes of the transition tax and also a CFC for purposes of GILTI.

Prior to the TCJA, F Sub likely went unnoticed during US Sub tax preparation.  F Sub now plays a more vital role as US Sub needs to consider whether GILTI, the transition tax, and subpart F income from F Sub impact US Sub’s US tax liability.

The repeal of IRC Section 958(b)(4) impacts inbound businesses, too.  I recommend reviewing existing structures to see if any of the US shareholders who own a minority stake in a foreign corporation can potentially be exposed to subpart F, GILTI, and the transition tax.

Other Notable International Tax Law Changes

With regard to the Subpart F rules, the new law repeals the foreign base company oil-related income rule. Furthermore, the US Shareholder definition now includes 10% vote OR value (previously it was only vote). And the new law eliminates the 30-day minimum holding period for CFC.

The new law creates BEAT, an acronym for “Based Erosion and Anti-abuse Tax.” This tax applies to corporations with average annual gross receipts of at least $500 million for the three-year period ending.  This tax prevents US corporations from making deductible payments to foreign affiliates.

With regard to the foreign tax credit, the law repeals the Section 902 indirect credit. It creates a new separate basket for foreign branch income. And it changes the sourcing rules from sales of inventory. (Income from the sale of inventory produced partly in, and partly outside of the US, must be sourced based on where the inventory was produced, thus eliminating the 50/50 rule.)

About the author:

Moses Man is the CEO of M Squared Tax PLLC which helps individuals and small businesses navigate the complexity of US international tax laws and provides international tax consulting services to CPA firms across the Pacific Northwest.

A practicing CPA and adjunct tax professor at Seattle University and the University of Washington, Moses also currently serves as a board member at the Washington Society of Certified Public Accountants.

Other Related Posts

Primer on the FBAR and FATCA Rules & Penalties

Reporting a Foreign Business Investment

Excluding Foreign Income from Taxes

Do You Have a Foreign Trust to Report?

The post International Tax Reform: Key Changes from the Tax Cuts and Jobs Act appeared first on Evergreen Small Business.

The first thing we need to say is that if you’re an entrepreneur or business owner operating internationally, you need to be really careful about reporting your activities to the U.S. government—really careful. The IRS has an extreme interest in your foreign business investment.

The second thing we need to say is that the rules for reporting interests in foreign business entities depend on the type of entity the business is classified as under U.S. tax law.

The good news? You can generally figure out what the classification of a particular type of foreign entity is by consulting Treasury Regulations 301.7701-2 and 301.7701-3. Once you’ve determined the correct classification of the foreign business entity you’ve invested in, you’re ready to determine your reporting obligations.

Corporations

If you’ve acquired an interest in a foreign corporation, you likely have to file Form 5471, a time-consuming document to fill out (even for a skilled tax accountant working with high-end tax software).

Specifically, the requirement to report an interest in a foreign corporation on a Form 5471 kicks in for the following situations:

• You own, directly or indirectly, a controlling interest (more than 50% of the stock or the voting power) of a foreign corporation (IRC § 6038). Controlled foreign corporations are sometimes referred to as CFCs.
• You organize, reorganize, or acquire 10% or more of the stock in a foreign corporation (IRC § 6046), or you become a U.S. person while owning 10% or more of the stock in a foreign corporation.
• You are an officer or director of a foreign corporation with more than 10% U.S. owners (IRC § 6046).
• You are considered a shareholder of a foreign corporation under IRC § 953(c) (IRC § 6046).

You might wonder how big a deal this requirement even is, but here are some facts you’ll want to keep in mind.

First, the minimum penalty for failure to file Form 5471 for a CFC is $10,000 per missing form [see Treas. Reg. § 1.6038-2(k)]. And you can be assessed more than one $10,000 penalty for failing to file the form. So you do not want to goof this up or blow this off.

Second, you can’t prepare the Form 5471 using popular consumer tax software programs such as TurboTax nor, as a practical matter, with most of the modest-cost professional tax software programs either. This is a high-complexity task that requires a skilled tax accountant. (A full-blown 5471 amounts to a corporate tax return with GAAP financial statements prepared in both the functional currency used by the foreign corporation and also U.S. dollars.)

Third, up-front planning can dramatically reduce the work of disclosure because of a quirk in the regulations related to foreign entities.

This gets complicated but briefly, here’s the deal: By default, U.S. limited liability entities (other than true corporations) get treated as disregarded entities or partnerships by tax laws. And this default treatment keeps things easy—or at least easier.

The rules for non-U.S. limited liability entities work differently, however. By default, non-U.S. limited liability entities get treated as corporations, which means these entities by default do require a 5471 form. However, if you act quickly (by filing a Form 8832), you may be able to elect to have the default rules for entity classification overridden and not be burdened by the requirement to file a 5471.

Disregarded entities and partnerships, however, do have their own reporting requirements, as discussed next.

Partnerships

If you’ve acquired an interest in a foreign partnership, you likely have to file Form 8865, which is essentially a miniature partnership tax return.

But here again the rules are a little tricky. The requirement to report kicks in for the following situations:

• You own a controlling interest (more than 50%) in a foreign partnership (IRC § 6038). Controlled foreign partnerships are sometimes referred to as CFPs.
• You make a Section 721 contribution to a foreign partnership in return for an interest of at least 10% of the partnership, or you make a Section 721 contribution to a foreign partnership that exceeds $100,000 (IRC § 6038B). (A Section 721 contribution is a contribution of property in exchange for an interest in a partnership.)
• You acquired an interest in a foreign partnership, you disposed of an interest in a foreign partnership, or your proportional interest in the partnership changed substantially (IRC § 6046A).

The minimum penalty for failure to file Form 8865 for a CFP is $10,000 per missing form [see Treas. Reg. § 1.6038-3(k)].

Disregarded Entities

If you’ve acquired an interest, either directly or indirectly, in a foreign disregarded entity (often abbreviated as FDE), you likely have to file Form 8858 for each FDE you own (IRC § 6038). The requirement to report kicks in for the following situations:

• You are the “tax owner” of the FDE at any time during your tax year.
• You are required to file Form 5471 because you own an interest in a CFC (see above), and the CFC is the “tax owner” of the FDE.
• You are required to file Form 8865 because you own an interest in a CFP (see above), and the CFP is the “tax owner” of the FDE.

How must I report the income of a foreign corporation I own stock in?

The default rule

Generally U.S. taxpayers owe U.S. tax on the earnings of their foreign subsidiaries when the income is repatriated. Under this default rule, the earnings are taxed as dividends (and also net investment income) to the U.S. taxpayer. These dividends are sometimes taxable as qualified dividends. However, under the default rule, the U.S. taxpayer cannot claim the foreign tax credit for foreign income taxes paid by the subsidiary.

The optional rule

A U.S. taxpayer that owns a foreign subsidiary can make what’s called a “check-the-box” election. By making this election, the taxpayer forgoes the deferral of income from the foreign corporation and dividend tax rates, but it becomes eligible to claim the foreign tax credit for income taxes paid by the foreign subsidiary.

The loophole-closing rule

U.S. taxpayers must include their pro rata share of a CFC’s “Subpart F” income in their taxable income. Note, however, that there is a de minimis rule in IRC § 954(b)(3)(A) which exempts many small businesses from having to worry about Subpart F income. See IRC §§ 951-965 (Subpart F) for more details.

My business is a U.S. partnership, but it has a foreign partner. What are my reporting obligations?

You must file Forms 8804, 8805, and 8813.

In addition, you must withhold U.S. income tax from the partner’s distribution (IRC § 1446).

By the way, not to be grumpy, but often the worst part of having to fiddle with the foreign partnership forms and withholding is getting a non-U.S. taxpayer identification number for the partner—something you do using with Form SS-4 (for entities) or Form W-7 (for humans).

My business is a U.S. corporation, but it has foreign shareholders. What are my reporting obligations?

If your U.S. corporation is more than 25% foreign owned, then you must report so on Form 5472 (IRC § 6038A).

Are You a Small-Business Owner Paying Too Much Tax?

Small-business owners often don’t do a good job maximizing their legitimate tax deductions. They don’t, for example, structure their operations to protect legitimate deductions. They frequently don’t do enough to create new deductions. And rarely do they understand how to recycle, or double-deduct, amounts that can be used more than once.

Which is all a financial tragedy. Getting smarter about tax deductions can save business owners a bundle.

If you’re thinking after reading this that maybe you can do a better job with your tax deductions, consider our $40 ebook Small Businesses Tax Deduction Secrets.

This 70-page ebook provides detailed instructions about how you can annually save thousands of dollars in income and related taxes simply by more effectively using legitimate small-business tax deductions. Interested in more detailed information? Click here.

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Tip: If you are a client of our CPA firm, don’t purchase this ebook—or any of our other ebooks. Just email us and ask for your complimentary copy.

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The post Reporting a Foreign Business Investment appeared first on Evergreen Small Business.

We get a lot of questions from people who earn money outside the United States and wonder how, and if, U.S. income taxes can be avoided.

For this reason, we’ll try to answer here the common questions we get with good “general” answers. (If you need more specific answers, you want to contact a local tax accountant and  give him or her the details of your situation.)

Do I have to pay U.S. taxes on income I’ve earned from other countries?

Generally speaking, yes.

U.S. citizens and permanent residents owe U.S. income tax on their worldwide income, not just on income they earn in the United States. The one exception to this rule is if the income in question can be excluded due to the foreign earned income exclusion. In addition, taxpayers can often take a credit for the amount they pay in foreign income taxes.

How does the foreign earned income exclusion work?

Under IRC § 911, U.S. taxpayers who spend most of the year abroad can opt to exclude up to about $100,000 of foreign earned income from their U.S. taxable income. (The exact amount adjusts for inflation every year, and in 2014 was $99,200 per individual.) Foreign earned income includes things such as salaries, wages, and self-employment income.

You qualify for the foreign earned income exclusion if your tax home is in a foreign country and you meet one of two tests: either the bona fide residence test or the physical presence test. You meet the bona fide residence test if you are a resident of a foreign country for an uninterrupted period that lasts an entire tax year. You meet the physical presence test if you are physically present in a foreign country or countries for at least 330 days during a consecutive 12-month period.

Sometimes you can qualify for the foreign earned income exclusion—even if you don’t meet the two tests described above—because you were forced out of the foreign country due to war, civil unrest, or something similar.

In addition, if you work abroad, you may be able to claim a tax benefit for your housing costs. You may be able to exclude from income housing costs your employer pays. For any housing costs you pay, you may be entitled to a deduction.

I work for a supranational entity (e.g., the UN, the IMF). How do I report my earnings?

You report your earnings from a supranational entity on line 7 of your 1040 just like any other wages, but you must pay self-employment tax on the money you’ve earned inside the United States. (Our experience is that these supranational entities will tell you what portion of your income you can exclude from self-employment taxes because you earned that money outside the United States.)

This is because even though payments from your employer are wages, the International Organization Immunities Act exempts these organizations from withholding Social Security or Medicare tax from your wages. Accordingly, these organizations don’t file a W-2 for your wages.

Note that some supranational employers reimburse their employees for any U.S. income taxes they must pay on their earnings in an attempt to equalize things with employees of other nations who do not owe income taxes on their earnings. Inquire with your employer to check if they will provide you with such a reimbursement.

Am I getting taxed twice, then?

Probably not. If you’ve earned money offshore and some other country has already taxed you, you do need to report the income to the United States. And you may pay taxes on the money. But in general, any taxes you’ve paid to some foreign country on the income can be deducted from the U.S. taxes you owe on the income.

The precise calculations can sometimes be a little bit tricky, though, as I describe next.

How does the foreign tax credit work?

If you have foreign-source income and pay foreign income taxes on it, you can claim a tax credit for the amount of foreign tax you paid against any U.S. income taxes you owe on that same income. However, your credit is limited to the amount of U.S. income taxes you owe on the income. You generally claim the credit by filing Form 1116.

It’s easier to explain this by illustrating it with an example. (Though fair warning, this has been a bit oversimplified to illustrate conceptually how the foreign tax credit is supposed to work.)

Suppose Bob has $1,000 of dividend income that’s properly sourced to the country of Freedonia. Freedonia withholds 30% of this dividend, or $300, for income taxes. Bob owes U.S. taxes on the dividend income at a rate of 15%. On his U.S. income tax return, Bob reports that he owes $150 of income tax due to the dividends, which he includes on line 44 of his 1040. Then he goes on to figure how much of a foreign tax credit he can claim to offset this $150 of tax. He compares how much income tax he paid to Freedonia ($300) to how much U.S. income tax he owes ($150), and claims the smaller of the two as his credit.

How can my business claim the foreign tax credit?

If your business has foreign-source income and pays foreign income taxes on it, you can generally claim a tax credit for the amount of foreign tax the business paid.

For pass-through entities (partnerships and S corporations), the business’s owners will receive foreign tax credit information on their Schedules K-1. These individuals claim the foreign tax credit by filing Form 1116. For C corporations, the credit is counted against the business’s corporate income tax and is reported on Form 1118.

Small-Business Owners Often Pay Too Much Tax

It is common for small-business owners to do a poor job maximizing their legitimate tax deductions. They don’t, for example, structure their operations to protect legitimate deductions. They usually don’t do enough to create new deductions. And rarely do they understand how to recycle, or double-deduct, amounts that can be used more than once.

That is all a financial tragedy! Getting smarter about tax deductions can save you a bundle.

If you’re thinking after reading this that maybe you can do a better job with your tax deductions, consider our $40 ebook Small Businesses Tax Deduction Secrets.

This 70-page ebook provides detailed instructions about how you can annually save thousands of dollars in income and related taxes simply by more effectively using legitimate small-business tax deductions. Interested in more detailed information? Click here.

View Cart

Tip: If you are one of our clients, don’t purchase this ebook—or any of our others. Just email us and ask for your complimentary copy.

Immediately Downloadable & Money-Back Guarantee

The book is instantly downloadable upon purchase.

Also, we provide a money-back guarantee. If you don’t get the information you need or want, just email us and request your refund.

The post Excluding Foreign Income from U.S. Taxes appeared first on Evergreen Small Business.