Editor: Lori Anne Johnston, CPA, J.D.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, brought new attention to a provision of the Internal Revenue Code that had long been forgotten: Sec. 962, Election by Individuals to Be Subject to Tax at Corporate Rates. This provision was enacted as part of the Revenue Act of 1962, P.L. 87-834, which introduced the Subpart F rules of the Code.
Subpart F requires U.S. shareholders of a controlled foreign corporation (CFC) to take into current income their pro rata share of Subpart F income. When Subpart F was enacted, the top federal tax rate for corporations was 52% while individuals were taxed at rates as high as 91% and could not take advantage of indirect foreign tax credits available to corporations. With these facts in mind, Congress adopted Sec. 962 to ensure that individuals' tax burdens with respect to undistributed foreign earnings of their CFCs would be no heavier than if the individuals had instead invested in an American corporation doing business abroad. Under Sec. 962, individuals can make an election to pay tax on Subpart F income at corporate rates (and claim indirect foreign tax credits under Sec. 962(a)).
More recently, the TCJA required U.S. shareholders to take into account their pro rata share of a CFC's global intangible low-taxed income (GILTI) in a way that is similar to Subpart F. The GILTI rules in new Sec. 951A affect the vast majority of U.S. shareholders of CFCs. Because of the significant reduction in the federal corporate tax rate to 21%, taxpayers began to seek relief from GILTI inclusions by making Sec. 962 elections. Prop. Regs. Sec. 1.962-1, issued in March 2019, allows individuals to make a Sec. 962 election with respect to a GILTI inclusion. Taxpayers who make a Sec. 962 election for corporate rates may also deduct 50% of the amount of the GILTI inclusion under Sec. 250.
While the impact of a Sec. 962 election at the federal level is relatively clear, state tax treatment of the election is murky at best. Few states fully conform to the Code. In fact, most only partially conform or do not conform at all. Moreover, there is often a lack of guidance on any particular issue. Until now, shareholders had rarely invoked the Sec. 962 election to be taxed at corporate rates, and, as a result, most states have provided no specific guidance on how to treat a Sec. 962 election for state income tax purposes. In assessing the state impact of a Sec. 962 election, taxpayers may wish to consider the interaction between federal and state rules governing mechanical compliance, including what a particular state might consider its starting point for taxable income as well as any specific provisions passed with respect to GILTI.
The basics of Sec. 962 elections
When an individual U.S. shareholder of a CFC has an income inclusion under either Subpart F or GILTI and makes an election pursuant to Sec. 962 to be taxed at corporate rates, the amount of income itself is not reported on Form 1040, U.S. Individual Income Tax Return. Instead, taxpayers must track that information separately, attach a statement to the tax return, and report any tax directly on Form 1040, line 12a.
All taxpayers must include Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), with a U.S. tax return to calculate GILTI. Corporations are required to file Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), and Form 1118, Foreign Tax Credit — Corporations, in order to calculate the deduction under Sec. 250 and to claim a foreign tax credit, respectively. This raises the following question: Should an individual who makes a Sec. 962 election also file Forms 8993 and 1118? Sec. 962 and the underlying regulations repeatedly say that individuals who make a Sec. 962 election must calculate their income, deductions, and foreign tax credits "as if [the income inclusions] were received by a domestic corporation." Thus, an individual taxpayer who claims a Sec. 250 deduction or a foreign tax credit with regard to a Sec. 962 election should consider filing Forms 8993 and 1118 as a protective measure (see also Prop. Regs. Sec. 1.250(a)-1(d)).
However, this method of reporting this income and related tax liability does not have a direct correlation with the amount that is technically included in the individual's gross income under Sec. 11, which accounts for "all income from whatever source derived." Sec. 962 may determine the rate of tax that may apply, but Secs. 951(a) and 951A dictate how to include the income.
When an actual distribution is made, the earnings and profits (E&P) are "included in ... gross income" to the extent they exceed the amount of income tax paid by such shareholder under Sec. 962 (Regs. Sec. 1.962-3(a)). The phrase "included in gross income" should not be overlooked. E&P distributed from a corporation to its shareholders generally qualifies for federal tax purposes as a dividend (Sec. 316(a)). The rate at which the dividend is taxed depends on whether the foreign corporation is considered a "qualified foreign corporation." That term is defined as either a corporation incorporated in a U.S. possession (e.g., Puerto Rico or Guam) or a corporation "eligible for benefits of a comprehensive income tax treaty with the United States" (Sec. 1(h)(11)(C)). A dividend from a qualified foreign corporation is taxed as a qualified dividend at long-term capital gain rates (Sec. 1(h)(11)(B)). Any other foreign dividend would be treated as ordinary income.
Federal tax planning
On its face, a Sec. 962 election seems like a slam-dunk for an individual U.S. shareholder in a CFC. A 21% corporate tax rate, a 50% deduction, and a foreign tax credit can greatly reduce an individual's tax liability and in some cases eliminate it entirely in the year in which the income is recognized. In reality, however, this benefit is a timing difference, as the subsequent distribution will be subject to tax. Exactly how much tax is due depends on the amount of tax originally paid under Sec. 962, the jurisdiction in which the non-U.S. corporation is domiciled, and its ability to qualify for treaty benefits.
For example, if a taxpayer has a GILTI inclusion but no residual tax liability due to full coverage of foreign tax credits, a subsequent distribution may create a taxable dividend to the extent the distribution exceeds the amount of tax paid (including deemed paid credits). That dividend paid from a qualified foreign corporation would be taxed currently at 20% plus potentially an additional 3.8% net investment income tax. However, that same dividend paid by a nonqualified foreign corporation would be taxable at full ordinary rates to that individual. In some situations, taxing the subsequent distribution as ordinary income could actually create a higher effective tax rate than if no Sec. 962 election were made. Therefore, from a federal tax planning perspective, it is important to consider all the facts and circumstances and to carefully model out the tax impacts on future cash distributions as well as the administrative costs associated with the additional compliance related to a Sec. 962 election.
State tax planning
As discussed above, regardless of how GILTI and Subpart F income are reflected on Form 1040 when a Sec. 962 election is made, the amount of that income is included in the taxpayer's gross income. While a Sec. 962 election affects the rate of tax paid on the income, it does not affect the amount of income recognized. Therefore, GILTI and Subpart F would still be included in adjusted gross income (AGI) and subsequently in federal taxable income (FTI) for an individual.
For the states that use AGI or FTI as the starting point to calculate state taxable income (STI), GILTI and Subpart F would be taxed when the income is recognized regardless of whether any federal tax is paid due to the Sec. 962 election, unless that specific state has explicit rules excluding GILTI or Subpart F income where a Sec. 962 election is made. Additionally, most states do not recognize the Sec. 250 deduction, and foreign tax credits generally do not apply at the state level, which could result in incremental state, but not federal, tax.
A complex situation can get more complex when a distribution of earnings is made in a later year. The distribution, if in excess of tax previously paid under Sec. 962, is includible in federal gross income of the individual taxpayer as either a qualified or nonqualified dividend and, therefore, would form part of AGI or FTI. Absent any adjustments on a state tax return, that distribution could be taxed by a state. However, as previously mentioned, that income may have already been taxed at the state level when it was taken into account as GILTI or Subpart F income on the taxpayer's federal return. To avoid double taxation, that distribution would need to be removed from STI, but there may not be clear authority for doing so.
It is imperative to note that each state must be considered on a case-by-case basis. Outside of Georgia, there is little to no mention of Sec. 962 in state statutes. Georgia, for its part, does not recognize the Sec. 962 election, which could result in the double taxation of income subject to the election in Georgia and other states that take a similar approach.
The importance of information tracking
Taxpayers making a Sec. 962 election should keep detailed workpapers and records regarding:
- Backup for the Sec. 962 tax calculation consisting of:
- The amount of income included under Sec. 951(a) or 951A;
- The Sec. 250 deduction calculation; and
- The foreign tax credit calculation.
- Cash distributions from the CFC; and
- Each state's calculation of tax on GILTI and Subpart F, both when income is recognized federally and when an actual distribution is made.
Where an individual makes a Sec. 962 election, the above information will be extremely helpful in determining how to tax a subsequent distribution once the states release guidance on how the federal Sec. 962 election should be treated for state purposes. Taxpayers should expect significant scrutiny of their positions by state tax authorities given the lack of guidance, and complete documentation will be critical in mounting a successful defense.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.