It has come to my attention that some advertisers have made vague references to helping individual taxpayers claim the same “tax breaks” as “the big boys.” What exactly is meant by “tax breaks” or “big boys” is neither here nor there, (although I assume for purposes of this article that what is referred to as the “big boys” are large C corporations). What is clear is the tax planning opportunities that arise through the new tax on global intangible low-taxed income (“GILTI”). Unlike the hazy references of said tax advertisers, GILTI may offer tax planning opportunities to individual shareholders of controlled foreign corporations (“CFCs”).
C corporate shareholders of CFCs are now entitled to important benefits that are unavailable to their non-corporate counterparts: they are entitled to a 50 percent deduction against any GILTI inclusion, and generally can use foreign taxes paid by the CFC to offset U.S. tax on GILTI. This brings us back to the advertisers’ claims: can an individual taxpayer claim the same tax breaks as the “big boys” or C corporations? At least for the limited purposes of GILTI tax planning, the Internal Revenue Code Section may allow noncorporate CFC shareholders to claim the same tax breaks as corporate CFC shareholders. This article will discuss significant potential tax planning options that may be available to noncorporate CFC shareholders.
The Significance of Internal Revenue Code Section 962
In 1962, the highest marginal tax bracket for individuals was 91 percent. At the same time the highest corporate tax rate was 52 percent. With this backdrop, Congress enacted the Subpart F provisions of the Internal Revenue Code. The provisions of Internal Revenue Code Subpart F is designed to include passive foreign source income into a CFC shareholder’s U.S. taxable income. This passive foreign source income is includible in a CFC shareholder’s U.S. income whether it is distributed to the shareholder or not. Concerned about the impact this Subpart F “phantom income” may have on CFC shareholders, Congress enacted Internal Revenue Code Section 962. This code section authorized noncorporate taxpayers the opportunity to reduce their individual tax rates to the more beneficial corporate rates. It also permitted noncorporate CFC shareholders the ability to deduct deemed-paid tax credits authorized by Internal Revenue Code Section 901 for foreign taxes paid by the CFC.
The intent behind Section 962 is clearly reflected in its legislative history which provides in relevant part: “[t]he purpose of [Section 962] is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. [This code section] gives such individual assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.” See S. Rep. No. 1881, 87th Cong. 2d Sess 92 (1962).
In order for a noncorporate CFC shareholder to claim the more beneficial corporate rates and claim deductions for taxes paid by the CFC overseas, the shareholder is required to make a Section 962 election. Once a Section 962 election is made, any gross income the individual shareholder receives from the CFC will taxed at applicable corporate tax rates. This would permit shareholders to utilize Sections 11 (defining corporate tax rates) instead of Section 1 (defining individual tax rates) to determine their tax rates (the benefits of Code Section 1 is that it permits repatriated dividends of a CFC to be taxed at a 23.8 percent (compared to ordinary rates of 37 percent) if the CFC operates in a jurisdiction with a US tax treaty). Second, the individual shareholder would be entitled to claim a credit for foreign taxes paid by the CFC as if they were a domestic corporation formed under Subpart C of the Internal Revenue Code.
Making the Section 962 Election
According to the regulations promulgated under Section 962, an individual CFC shareholder should timely make a Section 962 for each tax year to which the election relates. See Treas. Reg. Section 1.962-3(b). With that said, there is even some authority which permits a “late” Section 962 elections. See Dougherty v. Commissioner, 60 T.C. 917 (1973), acq. GCM 36325 (June 26, 1975).
Can a Section 962 Election be Made to Mitigate the Harsh Tax Impacts of a GILTI Inclusion?
Up until very recently, federal corporate and individual tax rates were both taxed at maximum rates of around 39 percent. As a result of the parity between the individual and corporate tax rates, unless a noncorporate CFC shareholder wished to take advantage of a qualified dividend rates under Section 1(h)(11), making a Section 962 election did not make much sense. This all changed as of January 1, 2018, when the corporate rates fell to 21 percent and, after taking into consideration a Section 250 deduction (permitting a 50 percent deduction of GILTI income to a U.S. shareholder), the GILTI rates were taxed at only 10.5 percent. At the same time, individual CFC shareholders pay up to 37 percent on GILTI inclusions and cannot claim a 50 percent deduction under Section 250 to reduce the GILTI tax inclusion. So can individual CFC shareholders make a Section 962 election to be taxed at the reduced corporate rates and to be permitted to take a 50 percent deduction under Section 250? As of this date, the answer is somewhat unclear. Although the answer to the above question may be unanswered at this point, there are strong policy reasons grounded in legislative history which supports allowing [noncorporate] CFC shareholders to be taxed as C corporations for GILTI inclusion purposes. We begin with the legislative history of Section 962 which provides that:
“[t]he purpose of [Section 962] is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.” See S. Rept. No. 1881, 1962-3 C.B. 784 1962 [emphasis added].
The legislative history also supports that a Section 962 electing shareholder should be treated no differently than if the electing shareholder invested in an actual C corporation that in turn owned the CFC. The reference to “undistributed foreign earnings,” clarifies that it was intended to mean that an electing individual be treated as a domestic corporation that owns a CFC. It does not stand for the fact that the individual should be treated as a corporation acting through a foreign branch. Thus, because an individually owned U.S. C corporation would be entitled to the Section 250 deduction, the Section 962 electing shareholder should receive the same treatment. See the Florida State Bar “Request for Regulatory Clarification to Confirm that a Code Section 250 Deduction Applies to an Electing Code Section 962 Shareholder.”
Clearly, there are compelling arguments taken from the legislative history of Section 962 to extend the 10.5 tax rate to noncorporate CFC shareholders. With that said, in order for individual CFC shareholders to achieve the desired GILTI effective tax rate of 10.5 percent, a Section 250 deduction must be utilized. Although the legislative history to Section 962 supports noncorporate CFC shareholders utilizing being taxed at lower corporate rates and claiming-paid credits for taxes paid by CFCs overseas, Section 962 is silent in regards to the Section 250 deduction afforded to corporate CFC shareholders. The problem is that Section 250 was not in existence when Section 962 was enacted in 1962. The complicate matters, Section 250 does not mention extending the deduction to noncorporate CFC shareholders.
At this point, the international tax bar is awaiting guidance from the Internal Revenue Service on this matter in the form of a regulation. Until the Internal Revenue Service issues guidance on whether or not a noncorporate CFC shareholder can claim a Section 250 deduction by making a Section 962 election, the answer to this question will remain unclear.
Is a Noncorporate CFC Shareholder any Better Off Making a Section 962 Election Compared to Holding a CFC Interest in a C Corporation?
Given the fact that the rules governing Section 962 election are unsettled, some may feel that noncorporate CFC shareholders may be simply better off shifting his or her interest into a “blocker” C corporation for tax planning purposes. However, there are a number of reasons why a shareholder may not want to drop his or her CFC interest into a C corporation in lieu of making a Section 962 election. First, and most importantly, putting a CFC interest into a C corporation may result in an additional layer of tax. This could result in the recognition of additional taxes on the sale of the CFC and excess earnings. Second, anyone considering utilizing a C corporation for GILTI tax planning purposes should consider state tax implications. Most states do not recognize the GILTI provisions of the Internal Revenue Code and do not have reduced tax rates for offshore income and/or C corporate income. Inserting a C corporate entity into a CFC structure may result in a significant state tax increase. Finally, in a number of states, C corporations require costly annual fees to maintain.
Although questions still exist regarding the extent of the tax benefits of making a Section 962 election, the benefits could be substantial once the Internal Revenue Service issues guidance in this area. Maybe soon we will all know if an individual taxpayer (at least for GILTI purposes) can claim the “same tax breaks as the big boys.”
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.
