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?.

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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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