Introduction to the Trump Tax Reform
We summarize below the provisions of the legislation that we believe most significantly impact U.S. citizens living abroad in the realms of both personal taxation and business taxation.
What Did Not Change Under the Trump Tax Reform?
Before we analyze the legislative changes in the Trump Tax Reform, it’s important to first acknowledge that the major features of U.S. taxation affecting expat individuals generally did not change under the new law.
No Change to the Basics of Expat Taxation
Perhaps most fundamentally, the Trump Tax Reform did not change the rule that U.S. expat individuals are subject to citizenship-based taxation on their worldwide income.
While the Trump Tax Reform does change the scope of taxation in this regard for U.S. corporations (discussed further below), it does not affect the overall tax and reporting obligations of U.S. individuals living abroad. For instance, FBAR and FATCA and the other foreign information reporting rules and concepts that U.S. expats have become accustomed to will continue to apply.
The Trump Tax Reform also does not change the major provisions benefiting U.S. expats, such as the foreign earned income exclusion and foreign tax credit for individuals, so U.S. expats can continue to utilize these and other methods to reduce or eliminate their tax obligations (although, as we often point out, these methods do not exempt expats from filing tax returns and FBARs with the IRS on an annual basis).
Notable changes that were proposed in previous versions of the bill, but did not make it into the final version, include:
No Change to the Net Investment Income (Obamacare) Tax
One of the bigger surprises in the final iteration of the Trump Tax Reform was the retention of the Net Investment Income Tax (NIIT), sometimes called the Obamacare Tax, which Trump had pledged a number of times to repeal.
To briefly explain how the tax works – if an individual has income from investments, the individual may be subject to the 3.8 percent NIIT on the lesser of their net investment income (such as interest, dividends, capital gains, rental and royalty income, among others), or the amount by which their modified adjusted gross income exceeds the statutory threshold amount based on their filing status.
Why is no change to the NIIT significant for U.S. expats?
The basic answer is that in accordance with Treasury regulations, the foreign tax credit cannot be used to reduce the tax. Consequently, a U.S. expat who otherwise has 100% foreign source income and sufficient foreign tax or other credits to credit against such income, can still end up paying U.S. federal income taxes by virtue of the NIIT. Depending on the amount of investment income, the 3.8% tax can end up being significant for expat investors. Unfortunately for expats, the exclusion was not repealed by the Trump Tax Reform.
No Change to the Exclusion from Gain on Sale of Principal Residence
A previous version of the tax reform bill would have modified the current “primary residence exclusion” rule, which allows an individual to exclude gain of up to $250,000 realized from the sale of his or her home ($500,000 if married and filing jointly), provided they meet the “ownership” and “use” tests for 2 out of the 5 years leading up to the sale.
The previous version would have increased the required period of ownership from 2 of the previous 5 years to 5 of the previous 8 years, including phase-outs of the exclusion for wealthier individuals. In the end, however, the beneficial exclusion was not changed.
Why is no change to the exclusion from gain on the sale of a principal residence significant for expats?
The principal residence exclusion is often an important tax-saving method for expats because it is not limited to homes in the United States. Since many foreign jurisdictions offer an exemption on the sale of a personal residence (thereby creating no foreign tax credits to utilize), a sale of a personal residence triggers taxable gain only for U.S. tax purposes. However, due to the exclusion, expat sellers only have to pay tax to the extent the gain exceeds the $250,000 or $500,000 amount. Fortunately for expats, the exclusion remains untouched by the Trump Tax Reform.
What Did Change Under the Trump Tax Reform?
The provisions of the Trump Tax Reform legislation can generally be categorized as those specifically related to individual income and those related more specifically to business income.
Changes for Individuals
The following are the provisions of the Trump Tax Reform that we believe will most significantly impact U.S. citizens living abroad in terms of personal (non-business) taxation. The changes generally apply through the year 2026, but many expect that they will be renewed at that time.
Some of the changes that we list are only relevant if the expat taxpayer has at least some U.S. tax due (i.e., taxable income is not completely eliminated by the foreign earned income exclusion or foreign tax credit).
(1) CHANGE TO PERSONAL INCOME TAX RATES
The Trump Tax Reform keeps the seven ordinary income tax brackets but with generally reduced rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%. Capital gains rates remain the same (0/15/20%), but the brackets are adjusted to correspond with the new ordinary income tax brackets.
(2) STANDARD DEDUCTION INCREASED BUT PERSONAL EXEMPTION ELIMINATED
The Trump Tax Reform nearly doubles the standard deduction amounts to $12,000 for individuals, $18,000 for heads of household, and $24,000 for married couples filing jointly (amounts that will increase each year with inflation).
To offset this increase, the personal exemption is eliminated. Interestingly, for the 2018 tax year only, employers can withhold as if the personal exemption is still allowed, allowing taxpayers to pay delay their tax payment, if due, to the time of filing.
(3) MANY ITEMIZED DEDUCTIONS ELIMINATED OR LIMITED
For those taxpayers who think their itemized deductions may exceed the new standard deduction, it should be noted that a number of itemized deductions are eliminated or limited, including, among others:
- Miscellaneous itemized deductions which exceed 2% of adjusted gross income (AGI) (an example includes the deduction for tax preparation services) are eliminated
- The deduction for mortgage interest is limited to an underlying indebtedness of up to $750,000 ($350,000 for married taxpayers filing separately)
- State and local income and property tax deductions are collectively limited to $10,0000 per year (foreign real property taxes may not be deducted)
(4) CHILD TAX CREDIT INCREASED
The Trump Tax Reform doubles the child tax credit to $2,000 per child, which is refundable up to $1,400, subject to higher phase-out thresholds ($400,000 for married taxpayers filing jointly and $200,000 for all other taxpayers). It also includes a temporary $500 nonrefundable credit for other qualifying dependents (for instance, older adults).
This increased credit can be significant for expat parents as it can be used to offset the Net Investment Income (Obamacare) Tax, whereas the foreign tax credit cannot be so utilized (as discussed above).
(5) ESTATE AND GIFT TAX EXEMTPION AMOUNT INCREASED
Following previous iterations of the tax reform that included a repeal of the estate tax and then a phase-out of the estate tax, the final bill keeps the estate tax for U.S. individuals intact but increases the lifetime estate and gift tax exemption from the $5 million base amount, set in 2011, to a new $10 million base amount.
The exemption is adjusted for inflation each year, so in 2019, an individual would be able shelter approximately $11.4 million in assets from the estate and gift tax. Couples who do proper planning can double the estate tax exemption to approximately $22.8 million. (Non-U.S. individuals remain subject to the U.S. estate tax and gift tax with respect to "U.S.-situs property" in excess of $60,000).
The increase in the gift tax exemption could prove very beneficial for wealthier individuals who want to renounce their U.S. citizenship but avoid the dreaded “exit tax.” The exit tax applies to renouncers who, among other things, have a net worth of $2 million or more. The utilization of gift planning in order to fall under the $2 million threshold is made significantly easier with the increase to the lifetime estate and gift tax exemption.
Other Changes for Individuals
For the sake of completeness, the following are some of the other changes for individuals under the Trump Tax Reform that are perhaps less relevant for most of our expat clients, but are still noteworthy:
- New measure of inflation provided
- Alternative minimum tax (AMT) retained with higher exemption amounts
- The moving expenses deduction and exclusion for moving expense reimbursement are eliminated
- Deduction for interest on home equity eliminated
- Charitable contribution deduction limitation increased to 60%
- Kiddie tax modified
- Alimony deduction eliminated
- New deferral election for qualified equity grants
Changes for Businesses
Below we list the business taxation provisions of the Trump Tax Reform legislation that we believe most significantly affect U.S. expats with overseas businesses.
We note that while almost all of the Trump Tax Reform provisions are effective beginning with the 2018 tax year (or sometimes in a later year), there are a few foreign business taxation provisions that already became effective with respect to the 2017 tax year.
Perhaps most importantly, as detailed below, a one-time so-called “transition tax” or “repatriation tax” is imposed on certain U.S. shareholders with respect to the accumulated and previously untaxed earnings and profits generated by certain 10%-held foreign corporations through the 2017 tax year (or more technically speaking, through the last tax year beginning before the Trump Tax Reform enactment date of December 22, 2017).
For ease of understanding, we’ve broken down the Trump Tax Reform provisions, into: (i) those that apply more generally to businesses, and (ii) those that apply more specifically to U.S. expats with businesses operating overseas.
(1) CORPORATE TAX RATE REDUCED DRAMATICALLY
In one of the more dramatic changes to the U.S. tax system under the TJCA, the U.S. federal corporate tax rate is reduced to a flat rate of 21 percent.
(2) AMT FOR CORPORATIONS ELIMINATED
While the alternative minimum tax (AMT) is retained and modified for individuals, it is eliminated for corporations.
(3) MODIFICATION OF NOL DEDUCTION
The two-year carryback of net operating losses (“NOLs”) and accompanying carryback provisions are repealed under the Trump Tax Reform. The deduction can now be carried forward indefinitely, but is limited to 80% of taxable income.
(4) NEW LIMITATION FOR INTEREST DEDUCTIONS
The Trump Tax Reform completely rewrites 163(j), which acted to limit the deductibility of interest by a thinly capitalized corporation where the interest is paid to a related payee that is totally or partially exempt from U.S. tax on the distribution.
The new Section 163(j) limits the deductibility of interest expenses of any business entity (whether or not in corporate form) paid to anyone (not just related parties) to 30 percent of “adjusted taxable income” (defined similarly to “EBITDA” by adding back to taxable income interest, any NOL or pass-thru business deduction, and (until 2022 only) depreciation). Interest in excess of 30 percent is carried forward indefinitely. The new rule does not apply to: (1) taxpayers with average annual gross receipts for the three-year period ending with the prior tax year that do not exceed $25 million; and (2) real property trades or businesses that elect out of the limitation.
(5) NEW DEDUCTION FOR PASS-THRU INCOME
Individuals, trusts, and estates may be eligible for a 20% deduction on so-called “qualified business income” earned through a sole proprietorship (including a wholly-owned disregarded LLC), partnership, or S corporation. The 20% deduction is subject to a number of complex rules, including limitations based on taxpayer wages that phase in at certain taxable income thresholds ($315,000 for married individuals filing jointly and $157,500 for other individuals). The type of income eligible for the deduction is generally U.S. trade or business income, so the deduction is not relevant for expats with income from a foreign trade or business.
(6) STRICTER QUALIFICATION FOR LIKE-KIND EXCHANGES
The Trump Tax Reform makes two significant changes to the rule allowing for the deferral of realized gain on like-kind exchanges. First, the rule is modified to allow for like-kind exchanges only with respect to real property that is not held primarily for sale. Second, real property located in the United States and real property located outside the United States are no longer considered property of a like kind.
International Business Provisions
(1) ESTABLISHMENT OF “PARTICIPATION EXEMPTION” SYSTEM FOR TAXATION OF FOREIGN INCOME
In another of the more dramatic changes to the U.S. tax system, the Trump Tax Reform provides for a complete exemption for active foreign income (or non-Subpart F income) earned by certain U.S. corporate taxpayers via a foreign subsidiary. The exemption is provided for by means of a 100% dividends received deduction (“DRD”) for the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” by domestic corporations that are U.S. 10% shareholders of those foreign corporations. This new rule is intended to encourage companies to repatriate their active income to invest in the U.S. economy.
While this new taxation regime doesn’t negate other important foreign income regimes such as the CFC or PFIC regimes (which continue to apply to passive-type income, such as dividends and interest, earned by foreign corporations), it does have a significant ripple effect on a number of other rules relating to the taxation of foreign income. For instance, foreign tax credits are not allowed for taxes paid or accrued with respect to a dividend that qualifies for the new DRD. Also, as an example, in the case of a sale by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend under Code Sec. 1248 of the Code, is treated as a dividend for purposes of applying the DRD.
(2) THE ONE-TIME REPATRIATION TAX
In another of the more dramatic changes to the U.S. tax system under the new tax reform, the Trump Tax Reform provides for a complete exemption for active foreign income (or non-Subpart F income) earned by certain U.S. corporate taxpayers via a foreign subsidiary. The exemption is provided for by means of a 100% dividends received deduction (“DRD”) for the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” by domestic corporations that are U.S. 10% shareholders of those foreign corporations. This new rule is intended to encourage companies to repatriate their active income to invest in the U.S. economy.
Under revised Internal Revenue Section 965, as part of the transition to the participation exemption system described above, the Trump Tax Reform 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).
Other aspects of Section 965 that could potentially ease the pain of the transition tax including the following:
- U.S. shareholders can elect to pay the transition tax over a period of up to eight years.
- In the case of foreign corporations held via an S corporation, U.S. shareholders can elect to maintain deferral on the deferred foreign income.
- 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.
(3) THE GILTI TAX
Starting with the 2018 tax year, a U.S. shareholder of any CFC will have to include in gross income the CFC’s global intangible low-taxed income (“GILTI”) in a manner generally similar to inclusions of Subpart F income as described above. In general, GILTI is computed as the income of the CFC (aggregated for all the CFCs owned by the U.S. shareholder) that is in excess of a 10% return on certain tangible property of the CFC. GILTI does not include income effectively connected with a U.S. trade or business, Subpart F income, Subpart F income qualifying for the high-tax exception, or certain related party payments.
A U.S. corporate shareholder of a CFC is entitled to a 50% deduction to offset GILTI plus an 80% foreign tax credit for foreign tax paid at the CFC level. As a result, the corporate shareholder will be taxed at a maximum 10.5% rate (50% x 21% corporate tax rate), and there will be no additional tax if the GILTI was subject to foreign tax of at least 13.125%.
A U.S. individual, on the other hand, will be taxed at the ordinary tax rate on such GILTI (37% will be the top rate starting with the 2018 tax year) with no 50% deduction and no foreign tax credit for the foreign tax paid at the CFC level. For this reason, an individual U.S. shareholder who holds at least 10% of the CFC should consider making a so-called “962 election” to be taxed as a corporation on the GILTI (i.e., taxed at the 21% corporate rate with the 80% indirect foreign tax credit and 50% deduction). Such an election can have complex and varied tax consequences, and a tax advisor should be consulted to fully understand its merits.
(4) CHANGES TO THE CONTROLLED FOREIGN CORPORATION (CFC) RULES
The Trump Tax Reform also makes a number of changes to the CFC rules, including:
- Elimination of the 30-day minimum holding period for shareholders of a CFC to be subject to the Subpart F inclusion rules.
- Amendment to the constructive ownership rules so that certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. entity for purposes of determining whether the related U.S. entity is a U.S. shareholder of the foreign corporation (which can determine whether the foreign corporation is a CFC). This change begins with the last tax year of the foreign corporation beginning before January 1, 2018.
- Expansion of the definition of “U.S. shareholder” for CFC purposes to include any U.S. person who owns 10% or more of the total value of shares in the foreign corporation (prior to this change, the CFC rules looked only to the percentage of voting interests). This change also begins with the last tax year of the foreign corporation beginning before January 1, 2018.
Some of the other significant changes for businesses under the Trump Tax Reform that are perhaps less relevant for most of our expat clients, but are still noteworthy include:
- A 3-year holding period requirement is required in order for so-called “carried interest” (a partnership interest received in connection with the performance of services) of individuals to be taxed as long-term capital gain rather than ordinary income
- The additional first-year depreciation deduction is extended and modified (increasing the 50 percent allowance to 100 percent for property acquired and placed in service after September 27, 2017, and before January 1, 2023)
- The amount allowed to be expensed under section 179 is increased from $500,000 to $1 million
- Recovery period for certain real property is shortened
- For domestic corporations, the dividends received deduction is reduced for a less than 80%-owned corporation
- New base erosion anti-abuse taxes (BEAT) for certain corporations with average annual gross receipts of at least $500 million