IRS Further Relaxes Deadline for Transition Tax on Foreign Company Owners
To further ease the pain of the transition tax on foreign company owners, the IRS has amended its FAQs page to include more relaxed deadline rules for both filing and paying the tax in installments.
In this blog, we provide a brief overview of the transition tax and its relevant provisions for U.S. expats owning foreign companies, and we describe the taxpayer-friendly amendments to the deadline rules.
The Transition Tax – How Does It Work?
As part of the transition to a so-called participation exemption system (which we describe more fully here), new Section 965 of the Internal Revenue Code uses the mechanics under Subpart F to impose on U.S. shareholders owning at least 10% of a foreign subsidiary a one-time mandatory “repatriation tax” or “transition tax” on the undistributed, non-previously taxed post-1986 foreign earnings and profits (“E&P”) of a “specified foreign corporation.” A specified foreign corporation is defined as (i) any CFC, and (ii) any foreign corporation with respect to which one or more domestic corporations is a 10% United States shareholder. The portion of the E&P comprising cash or cash equivalents is taxed at the rate of 15.5%, while any remaining E&P is taxed at the rate of 8%.
Section 965 does not distinguish U.S. corporate shareholders from other U.S. shareholders, so the transition tax potentially applies to any U.S. person (including an individual) owning at least 10% of a foreign subsidiary. The transition tax rates can be slightly higher for U.S. individual shareholders whose effective tax rate was higher than 35% for the 2017 tax year.
Section 965 specifies, importantly, that the transition tax applies to the greater of the accumulated post-1986 deferred foreign income (essentially the previously untaxed earnings and profits) of the foreign corporation determined as of November 2, 2017 or as of December 31, 2017. In order to prevent pre-transition tax avoidance planning, the section adds that E&P is determined by essentially ignoring dividends distributed during the 2017 taxable year (other than dividends distributed to another specified foreign corporation).
To lessen the harshness of the transition tax, the following beneficial provisions apply:
- U.S. shareholders can elect to pay the transition tax in installments over a period of up to eight years.
- Deferred earnings of a U.S. shareholder are reduced (but not below zero) by the shareholder’s share of deficits from other specified foreign corporations.
- The transition tax does not apply to previously-taxed earnings and profits.
- The portion of earnings subject to the transition tax does not include E&P that were accumulated by a foreign company prior to attaining its status as a specified foreign corporation.
- Owners of foreign companies that are fiscal year taxpayers may not have a payment obligation until next year (although the transition tax rate may be higher at that point).
- An election is available for an individual to be treated as a corporate taxpayer for purposes of the transition tax in order to claim a credit for foreign taxes paid at the corporate level (although we note that such an election has potential drawbacks that require consideration and analysis).
IRS Relaxes the Transition Tax Deadline
The first good news for expats regarding the transition tax deadline came back in April in Notice 2018-26, which explained that in the case of a taxpayer who otherwise qualifies for the automatic June 15 extension (including U.S. citizens or residents whose tax homes and abodes, in a real and substantial sense, are outside the United States), the date of June 15 (and not April 15) is the general deadline for the transition tax. It further clarified that June 15 (and not April 15) is the deadline for the first payment for those who elect to pay the transition tax in annual installments.
On June 4, the IRS amended its FAQs page to further help out taxpayers by adding the following:
- If an individual elects to pay the transition tax in installments, then no penalty will be assessed if the first installment payment is made by the second installment due date (June 15, 2019 for citizens living abroad), but only if: (i) the individual has timely made the election by the return due date, including extensions; and (ii) the transition tax liability is less than $1 million. Paying the first installment by the second installment due date also does not nullify the taxpayer’s ability to continue paying the rest of the transition tax in the remaining installments.
- If an individual has already filed his or her tax return and did not make an election to pay in installments, such individual can make the election by filing a Form 1040X that complies with the transition tax procedures on or before the due date of the individual’s 2017 return, taking into account any additional time that would have been granted if the individual had made an extension request.
Further Guidance from the IRS
For further guidance, the IRS page dedicated to the transition tax and other provisions of the tax reform can be found here:
Due to the complexity of Trump’s reform legislation, we expect that we’ll be writing a number of additional blogs that analyze the tax reform. For the latest news and in-depth coverage of the tax reform provisions, including further analysis of accompanying regulations and IRS publications, stay tuned throughout the year!
By Ephraim Moss, Esq. & Joshua Ashman, CPA