With U.S. tax reform on the horizon, many are anticipating a potential one-time deemed repatriation tax imposed on accumulated foreign earnings. To prepare, 10 percent or more U.S. individual shareholders of controlled foreign corporations (CFC) may consider transferring their CFC holdings to an S corporation or eligible U.S. limited liability company (LLC) by the end of 2017. This could potentially defer the deemed repatriation tax.
Both the House and Senate tax reform bills provide for a one-time deemed repatriation tax imposed on 10 percent or more U.S. shareholders of CFCs on all nonpreviously taxed accumulated foreign earnings. “Nonpreviously taxed accumulated foreign earnings” in this context means CFC earnings that haven’t been previously subject to U.S. taxation at either the foreign corporation level or U.S. shareholder level. Accumulated foreign earnings held in cash or cash equivalents would be taxed at a 14 percent tax rate under the House bill. They’d be taxed at as high as a 16.4 percent tax rate for individuals (14.5 percent for C corps) under the Senate bill. Accumulated foreign earnings held in illiquid assets would be taxed at 7 percent under the House bill or as high as an 8.5 percent for individuals (7.5 percent for C corps) under the Senate bill. Both bills would allow for an election to pay the deemed repatriation tax over an eight-year installment period.
This one-time deemed repatriation tax wouldn’t only be imposed on larger corporations, e.g., Apple, GE or Google, as part of a corporate shift to a territorial/participation exemption system of taxation on foreign earnings. As the tax reform bills are currently written, this deemed repatriation tax also would be imposed on 10 percent or more U.S. individual shareholders of CFCs, even though the participation exemption system only would apply to domestic C corp shareholders of CFCs. This includes indirect U.S. individual shareholders holding an interest in a CFC through a partnership.
However, both bills provide that U.S. shareholders of an S corp owning a 10 percent or greater interest in a CFC would be eligible to make an election to defer the one-time deemed repatriation tax on accumulated foreign earnings until the S corp has a triggering event, such as a conversion to a C corp, liquidation of the S corp, sale of S corp assets or sale of S corp stock by its shareholders. Holding a CFC investment through an S corp is the only means by which a 10 percent or more individual U.S. shareholder can defer the one-time deemed repatriation tax on nonpreviously taxed accumulated foreign earnings beyond the eight-year installment period under the House and Senate tax reform bills.
The one-time deemed repatriation tax would be triggered on most U.S. individual shareholders’ 2017 tax returns with the eight-year installment period election necessary on the 2017 tax return. The election for S corp shareholders to defer the tax also would need to be made on most U.S. shareholders’ 2017 tax returns.
U.S. individual shareholders who don’t currently hold their CFC investments through a U.S. corporation should immediately consider talking to their tax advisors about making a tax-free transfer of their CFC investments—or their partnership investments that hold CFC stock—to a controlled S corp or a U.S. LLC eligible to make an S corp election by the end of 2017. This would create eligibility to make the S corp shareholder deferral election of the one-time deemed repatriation tax in the event tax reform is passed with such a provision. The benefit of using a U.S. LLC is that a U.S. shareholder could wait until tax reform has passed—when there’s more clarity concerning the one-time deemed repatriation tax—and subsequently file an S corp election for the LLC with an effective date retroactive to the LLC’s formation date. For an existing U.S. LLC that has not previously elected to be classified as a corporation, a retroactive S corp election could be made with an effective date in December 2017 or late S corp election relief retroactive to January 1, 2017, may be available as provided in the IRS instructions for Form 2553. For an LLC to be eligible to make an S corp election, it could have up to 100 members, all of whom are U.S. citizens or resident alien individuals, or are certain qualified domestic trusts, and it could only have one class of membership units.
Contact Chris or your trusted BKD advisor if you have questions.