Section 951A GILTI Tax Avoidance: Ten Tricks
For some small businesses and individuals, the new Section 951A GILTI tax creates a huge planning challenge and compliance burden.
And what’s worse? Many of these folks don’t even know yet that they have to deal with a new tax.
No kidding, this could get ugly. Fast.
Section 951A GILTI Tax in a Nutshell
The Section 951A GILTI tax—GILTI stands for “global intangible low-taxed income”—requires these U.S. taxpayers to pay taxes on a proportional share of all or some of the income earned inside a foreign corporation.
Example: A small business owns 100 percent of a small foreign corporate subsidiary making $100,000 a year. This small business needs to calculate the Section 951A GILTI tax on the $100,000, report those calculations on its 5471 form, and then pay any taxes owed.
Example: An individual invests in a foreign small family business earning $1,000,000 annually. If the individual’s ownership percentage equals 20 percent, she first needs to determine whether the Section 951A tax applies to the $200,000 “share” of income she indirectly earns (20 percent of the $1,000,000). If Section 951A does apply, she then needs to calculate the GILTI tax, report those calculations on her 5471 form, and finally pay any taxes owed.
GILTI for Small Businesses and Individuals
Large, sophisticated businesses served by big accounting firms already know (and surely have planned for) Section 951A. But we’re finding that scary numbers of smaller businesses and individual investors seem oblivious to the new law.
Any small business or individual with international investments, however, needs to deal with the GILTI tax issue.
Tax practitioners, therefore, can provide enormous value to clients by helping them either avoid the Section 951A tax completely or by minimizing the actual taxes paid. And fortunately, a rich set of planning tactics exist.
Trick #1: Reduce Ownership Percentage Below Threshold
A first tactic to look at? Can a taxpayer reduce shareholdings below the threshold that triggers the Section 951A tax?
The Section 951A GILTI tax hits U.S. taxpayers who own 10% or more of a controlled foreign corporation.
Accordingly, a taxpayer who owns just over that 10 percent threshold may want to look at dialing down her or his ownership percentage. Dropping from 10 percent to 9 percent, for example, “solves” the GILTI problem.
One important wrinkle to consider, however: In determining percentages, tax law requires taxpayers to include stock owned through foreign entities. And it also requires taxpayers to use the Section 318 constructive ownership rules. For Section 318, an individual counts shares owned by a spouse, children, grandchildren, and parents as her or his own shares. And an individual counts shares owned directly or indirectly through a corporation he controls, a partnership he owns an interest in, or a trust he’s a beneficiary of—and vice versa.
A taxpayer could not, therefore, get around the GILTI rules by giving or selling his stock to a spouse, his parents, children, or grandchildren. Nor could a taxpayer get around GILTI by splitting his interest in a foreign corporation among a bunch of different entities he controls. The constructive ownership rules count those shareholdings, too.
Trick #2: Fail the Controlled Foreign Corporation Test
The Section 957 controlled foreign corporation definition suggests another gambit for avoiding GILTI in some situations: A U.S. taxpayer may want to orchestrate failing the controlled foreign corporation test.
Tax law defines a controlled foreign corporation as a foreign corporation where U.S. shareholders owning at least 10 percent of the corporation collectively own more than 50 percent of the corporation. In some situations, failing this “test” may make sense.
Example: A foreign corporation with five unrelated U.S. taxpayer shareholders who each own 11 percent shares counts as a controlled foreign corporation. If the U.S. taxpayers reconfigure their ownership so these five shareholders each own 10 percent shares, that change should mean the foreign corporation no longer counts as “controlled.”
The one wrinkle with this gambit? Tax law is clever, and defines “control” as not just owning more than 50% of the shares by value, but also more than 50% of the shares by voting power. So a scheme where U.S. shareholders only own 50% or less of the corporation, but still get more than 50% of the votes on major shareholder decisions, almost certainly won’t work.
Trick #3: Elect Disregarded Entity or Partnership Status
Our office’s “favorite” trick for avoiding Section 951A GILTI tax? Elect to have the foreign entity treated as a disregarded entity or partnership.
Often, this choice is available to a taxpayer. (One needs to check the Section 301.7701-2 regulations for entity classification choices available to a particular entity.) And when the choice exists, making an election moots Section 951A.
Two reminders about this approach: First, if a taxpayer elects to treat a foreign corporation as a disregarded entity or partnership, the taxpayer reports the foreign entity’s income on the U.S. taxpayer’s U.S. tax return. (This is bad.) But if the taxpayer elects, then the taxpayer also reports the foreign income taxes as credits on the U.S. taxpayer’s U.S. tax return. (This is good.) In many cases, the taxes and the credits offset each other—or nearly so.
A second reminder: Electing disregarded entity or partnership status for a foreign entity previously treated as a corporation triggers a deemed liquidation of the foreign corporation. That deemed liquidation in turn triggers income taxes, potentially, on the taxpayer’s U.S. tax return. Accordingly, these taxes may need to be considered.
Trick #4: Make a Section 962 Election
An old statute, Section 962, provides a last-minute gambit for mostly avoiding the Section 951A GILTI tax: A taxpayer may elect to treat any interests in controlled foreign corporations as if they are owned not directly, but indirectly through a “virtual” U.S. corporation.
The Section 962 election results in two benefits for individuals. First, the Section 951A GILTI tax calculations use the taxpayer’s marginal tax rate on the GILTI income. Regular corporations, as compared to individuals, pay a pretty low 21 percent flat income tax rate. That means the taxpayer uses that 21 percent rate of the “virtual corporation” for the GILTI calculations.
The Section 962 election also produces a second benefit for individuals. With a Section 962 election in place, the taxpayer gets deemed-paid foreign tax credits for the foreign taxes paid by the controlled foreign corporation. The credits reduce the virtual corporation’s GILTI tax.
Example: Before the Section 962 election, a high-income taxpayer with $100,000 of GILTI income might pay a 37 percent tax, or $37,000 in GILTI taxes. However, with the Section 962 election, the taxpayer would pay a 21 percent tax tentatively, or $21,000 in GILTI taxes. In addition, the taxpayer potentially would get a tax credit for 80 percent of the foreign taxes paid on the $100,000 of GILTI income. If the foreign corporation pays $25,000 in foreign taxes, the deemed-paid foreign tax credits might equal $20,000, thereby reducing the net taxes paid to just $1,000.
Tax practitioners and taxpayers late to planning for the Section 951A GILTI tax probably want to consider a Section 962 election for the 2018 year.
Keep in mind, however, a predictable downside to creating that “virtual” corporation: That corporation triggers the traditional double-taxation inherent in a regular corporation on any dividends from the foreign corporation. And here’s one subtle nuance of the Section 962 election that tripped up a taxpayer in the recent Smith v. Commissioner (151 T.C. 5) case: That dividend often isn’t eligible for qualified dividend treatment.
Trick #5: Hold GILTI Income Source in a Real Corporation
The Section 962 election just described provides two of the benefits of holding an interest in controlled foreign corporation through a real U.S. corporation. But looking forward to 2019 and beyond, some taxpayers may want to actually set up a corporation and then contribute their controlled foreign corporation interest to that corporation.
Why? Holding a controlled foreign corporation interest through a real domestic corporation gives the U.S. taxpayer two additional benefits compared to a Section 962 election.
The first benefit is that when the U.S. corporation pays a dividend to its owners, those dividends will be qualified dividends under U.S. tax law.
The second benefit is the Section 250 foreign-derived intangible income deduction. This deduction essentially halves GILTI tax for U.S. C corporation taxpayers.
Note: Holding interests in controlled foreign corporations through a real corporation, then, delivers four benefits: the 21 percent tax rate, the deemed-paid foreign tax credits, certainty of qualified dividend income treatment, and then the foreign-derived intangible income deduction.
Tax practitioners who make a Section 962 election for 2018 may want to move quickly to set up a real U.S. corporation for 2019 to take advantage of the Section 250 deduction starting in 2019.
Trick #6: Revoke Subchapter S Status
A related trick: If someone owns an S corporation which in turn owns a controlled foreign corporation interest, the S corporation’s shareholders may want to revoke the Subchapter S status.
That revocation, which can be made for 2019 anytime before March 15th, 2019, means the controlled foreign corporation interest would held by a regular corporation starting in 2019.
That regular corporation, of course, means a 21 percent flat tax rate, deemed-paid foreign tax credits, certain qualified dividend income treatment, and foreign-derived intangible income deductions.
Trick #7: Reduce Controlled Foreign Corporation Income
A simple but powerful trick needs to mentioned somewhere in this discussion: Reducing the income of the controlled foreign corporation.
For example, adding legitimate deductions to the controlled foreign corporation’s tax return (such as expenses for growing the business) should reduce the controlled foreign corporation’s income and will therefore reduce any GILTI tax.
As another example, adjusting transfer pricing so the U.S. parent corporation makes more and the foreign corporation makes less may reduce the controlled foreign corporation’s income and the related GILTI tax.
The above techniques don’t work as long-term solutions. They may, however, work as stop-gap measures for 2018.
Trick #8: Reduce Taxpayer’s Taxable Income
Individual taxpayers should also look the possibility they can reduce GILTI taxes by reducing their U.S. tax return taxable income.
For an individual taxpayer, as noted earlier, the GILTI tax formula in effect uses a taxpayer’s marginal tax rate. A low marginal tax rate means a lower GILTI tax.
If someone does something to dramatically lower their U.S. tax return taxable income—use big bonus depreciation deductions in 2018, for example—that reduction minimizes the GILTI tax.
Trick #9: Exit the Controlled Foreign Corporation
Some individuals and at least a few businesses should probably consider a crude, if effective, tax planning gambit: Terminating their ownership interest in a controlled foreign corporation that triggers the GILTI tax.
Here’s why termination sometimes makes sense to consider: Unfortunately, a taxpayer with low GILTI income and a low GILTI tax still needs to prepare the time-consuming 5471 forms.
Furthermore, these forms are not just expensive, they are risky to prepare. (The penalty for failing to file a 5471 form, or for filing a 5471 that isn’t substantially complete, starts at $10,000. And word on the street is, the IRS more regularly assesses this penalty these days than it has in the past.)
Someone with a very small, strategically insignificant foreign business interest, therefore, may want to look at just dumping that investment and removing that complexity from their return.
Trick #10: Ignore the Section 951A GILTI Tax
One final “response” to the burden of the Section 951A tax accounting bears mentioning.
Taxpayers in a few small business and investment situations may simply want to ignore the tax and its complexity.
No, no, don’t misunderstand us. These taxpayer’s accountants will still need to deal with the Section 951A calculations, the 5471 forms and then any resulting income taxes.
But high-income taxpayers with small controlled foreign corporation investments may want to focus their tax planning on other more significant opportunities.
Example: A taxpayer with $5 million of taxable income and $100,000 of GILTI income may just want to accept paying the 37 percent GILTI tax on the $100,000.
Four closing comments: First, tax practitioners and taxpayers who don’t work regularly on international tax planning issues need to be careful using any of the tricks discussed above. Review the relevant regulations carefully before you pull the trigger on some tactic. (People probably also want to wait for final regulations whenever possible.)
Second, if you’re a tax practitioner with clients impacted by Section 951A, you possibly should have been filing 5471 forms in past. You will, accordingly, want to check out whether you need to go back and file these late returns. (By the way, filing late 5471s counts as another activity you need to be really careful about.)
Third, if you need to deal with the Section 951A GILTI tax for some client, you probably want to make sure the Section 965 transition tax was correctly handled on the 2017 tax return and 5471. The Section 965 transition tax probably should have been paid by any taxpayers who need to deal with the Section 951A GILTI tax. We think a number of taxpayers and tax practitioners missed this requirement due largely to the crazy timing the transition tax required.
And fourth, note that when Congress passed the new GILTI rules, it included a provision authorizing the Treasury to create regulations to prevent avoidance of the GILTI tax, as the Treasury determines appropriate [Section 951A(d)(4)]. The Treasury has released proposed regulations that include anti-abuse rules, but no regulations have been finalized on this topic yet. Accordingly, as you plan around GILTI you’ll want to stay on top of this evolving area of tax law.
If you’re a tax accountant who needs to learn the Section 951A GILTI tax stuff in detail, you may be interested in looking at our Preparing International Tax Returns of U.S. Taxpayers monograph.
Like our other monographs for CPAs and attorneys, it provides practitioners with a way to get up to speed in few hours—rather than spend days or longer reading the statutes, regulations, and case law. We provide a money back guarantee and free updates.
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