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Sec 965 Tax & Disregarded Entity Election

Sec 965 Tax & Disregarded Entity Election
Ines Zemelman, EA
28 August 2018
Can you explain the transition tax on the corporation? Is it based on the revenue or the amount of cash left at the end of the year? In other words, will I have to pay next year, assuming I have very little revenue, but still money left in the corp account?

Transition Tax in simple terms

Transition tax is based on two factors, cash left at the end of the year and amount of untaxed earnings. After having paid the transition tax you will start with a clean slate. It does not matter that you have money left in the corporate account. It has been already taxed. For 2018 and the following years your corporation will pay tax on annual net corporate earnings (income remaining after expenses, losses and capital improvements). This is referred to as "GILTI" income. It will be taxed as ordinary income like Subpart F income. If you pay yourself a salary from the corporate earnings, it is eligible for exclusion from your taxable income under the foreign earned income exclusion. This salary will be counted as an expense to your business, thus reducing the GILTI component. If you do not take the exclusion for any reason but you pay yourself a salary or dividends then tax paid on that income in your resident country (ie France) will be applied as a foreign tax credit to reduce potential tax due. Corporate taxes do not qualify for a credit on the personal return. The cash balance will not trigger tax in future years because you will not have previously unpaid earnings.

Had you elected to be treated as a disregarded entity, you would have paid US tax in the US in the past on those deferred earnings that are now subject to mandatory inclusion to your 2017 personal income.

Sec 965 Tax & Disregarded Entity Election

Could I have avoided Sec 965 transition tax if I my CFC was disregarded entity? The short answer is yes. As with most things in life, don’t judge a book by its cover. Yes, if your CFC was disregarded entity you would not have paid mandatory repatriation tax aka Sec 965 tax. However, had you elected to be treated as a disregarded entity, you would have paid US tax in the US in the past on those deferred earnings that are now subject to mandatory inclusion to your 2017 personal income. A disregarded entity cannot have retained earnings. All business income after expenses is included in the owner’s personal income in the year when income was received. On top of that, you would be paying 15.2% self-employment tax on net business income.

Election cannot be taken retroactively

Last but not least: in a hypothetical situation where election to treat your foreign limited company as a disregarded entity was a tax-favorable solution for you, this election may not be taken retroactively. The election is not active more than 75 days prior to the date the election is filed (75 days look-back rule).

Ines Zemelman, EA
founder of Taxes for Expats