Tax reform: Individual taxpayers and the Sec. 962 election

By Ian Halligan, ATT, CTA (U.K.), E.A., Chicago, and Lynette Stolarzyk, J.D., LL.M., Minneapolis

Editor: Mark Heroux, J.D.

Sec. 962 allows an individual U.S. shareholder (including a trust or estate) to elect to be taxed at corporate income tax rates on certain Subpart F income under Sec. 951(a). While this provision has historically had limited applicability, the new "repatriation tax" under P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), may cause individual partners and shareholders of flowthrough entities (as well as direct individual shareholders) with controlled foreign corporations (CFCs) that have foreign subsidiaries with earnings and profits (E&P) subject to the repatriation tax to obtain a deferred tax rate benefit by making this election.

The TCJA requires that, for the last tax year beginning before Jan. 1, 2018, any U.S. shareholder of a CFC must include in income its pro rata share of the accumulated post-1986 E&P; the Subpart F income of the foreign corporation is increased by the greater of the accumulated post-1986 deferred E&P of the corporation, determined as of Nov. 2, 2017, or as of Dec. 31, 2017 (measurement dates) (Sec. 965(a)). Sec. 965(c) allows a dividends-received deduction against this repatriation inclusion, resulting in the application of a 15.5% rate to earnings held in cash (or cash equivalents) and an 8% rate to earnings held in noncash assets.

Absent a Sec. 962 election, while individual shareholders will still obtain the dividends-received deduction under Sec. 965, they will be immediately subject to U.S. tax on the relevant E&P inclusion at their marginal income tax rates, unless, in the case of an S corporation shareholder, a Sec. 965(i)(1) election is made to defer the triggering event. Separately, only 8% of the tax liability would be due for 2017 if a Sec. 965(h)(1) election is filed electing an eight-year installment term.

In making a Sec. 962 election, the individual is effectively taxed at the U.S. corporate tax rate, which may be higher than the individual's marginal tax rate, but the individual is entitled to a credit for the indirect foreign taxes paid by the foreign corporation (by virtue of the mechanics of the Sec. 78 gross-up calculation that applies to corporate shareholders in receipt of foreign dividends from a CFC). This provision increases the income taxable to the shareholder by a pro rata share of the foreign corporate taxes paid by the CFC, but because those taxes are then available for credit against the individual taxpayer's U.S. tax liability, the net tax result can actually be, initially, economically advantageous.

The chart "Comparisons Without and With Sec. 962 Election" (below) considers an example where the CFC has $2 million of E&P, $1 million of which is held in cash and $1 million of which is held in noncash assets, along with a tax pool of $857,143 (with an assumed foreign tax rate of 30%).

Comparisons without and with Sec. 962 election

Note that the Sec. 962 election for eligible shareholders might not make sense absent an intention to defer actual repatriation of the underlying foreign earnings for a meaningful period or even indefinitely. This is because a later distribution of the elected Sec. 962 E&P might include the full original E&P subject to the deemed repatriation, reduced only for any U.S. tax actually paid on the earlier deemed distribution. There is potential for a later inclusion of those earnings at rates that might be considerably higher than that allowed for repatriation tax purposes in the absence of a Sec. 962 election, for which the time value of money might not justify making a Sec. 962 election.

Additionally, there is a longstanding lack of clarity on whether a distribution of Sec. 962 E&P is an inclusion, which is not eligible for qualified dividend income treatment, rather than a dividend. If that is the case, few taxpayers would make a Sec. 962 election absent deferral of that Sec. 962 E&P into near-perpetuity, as they may be taxed at 37% on a distribution of that E&P (again, less federal tax paid on the initial inclusion), rather than the 23.8% alluded to above. Obviously, this requires a closer analysis for taxpayers with any plans of a significant time deferral of distributing the E&P.

The Sec. 962 election can be made on a year-on-year basis and is made on a timely filed U.S. tax return, including amended returns, but it will apply to all appropriate CFCs of the shareholder making the election for the year.

In summary, a Sec. 962 election allows the possibility of deferring tax until a later actual repatriation of corresponding Sec. 962 E&P. However, there is a very real possibility that the value of the deferral may be offset by a higher tax rate applying to those earnings when they are distributed in the future.

EditorNotes

Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

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