The United States tax code presents a labyrinth of rules and regulations, particularly for U.S. residents with investments in foreign corporations. These complexities are magnified when dealing with Controlled Foreign Corporations (CFCs) and the associated immediate taxation of foreign earnings under Subpart F or the Global Intangible Low-Taxed Income (GILTI) regime. This article delves into Section 962 of the Internal Revenue Code (IRC), explaining its significance and utility for U.S. tax residents in managing their foreign investments more effectively.
The Challenge: Immediate Taxation of Foreign Earnings
For U.S. tax residents with investments in foreign corporations, including those held through pass-through entities such as partnerships and S corporations, immediate taxation of foreign earnings is a significant challenge. This taxation arises annually under the Subpart F or GILTI regimes, compelling taxpayers to include foreign income in their U.S. taxable income, often leading to double taxation without relief mechanisms available to corporate taxpayers.
Corporate vs. Individual Taxpayer Treatment
The tax burden disparity between corporate and individual taxpayers under the GILTI regime is stark. U.S. corporations benefit from a reduced federal income tax rate of 21 percent, a Section 250 deduction that allows them to deduct up to 50 percent of GILTI, and the ability to claim up to 80 percent of foreign taxes paid as a foreign tax credit. This combination of benefits significantly mitigates the impact of GILTI on corporate taxpayers.
Conversely, U.S. resident individuals are generally taxed at a federal income tax rate of up to 37 percent on GILTI, without access to the Section 250 deduction or foreign tax credits for GILTI. This discrepancy creates a substantial tax burden for individual taxpayers, necessitating a strategy to level the playing field. This is where Section 962 of the IRC comes into play.
How Section 962 Election Works
A Section 962 election allows U.S. individuals to elect to be taxed on their GILTI and Subpart F income at corporate tax rates. When an individual makes this election, they are effectively treated as if they own their CFC through a hypothetical domestic corporation. This election provides several advantages:
- Corporate Tax Rate: The taxpayer is subject to the 21 percent corporate tax rate instead of the higher individual rates.
- Section 250 Deduction: The taxpayer can avail the Section 250 deduction, reducing GILTI by 50 percent.
- Foreign Tax Credit: The taxpayer can claim an indirect foreign tax credit for taxes paid on the CFC’s net income in the foreign country, up to 80 percent of the foreign taxes paid.
Practical Example Of Section 962 Election
Consider a U.S. individual who wholly owns a CFC in Germany with net tested income of $1,000 for GILTI purposes, having paid $150 in foreign taxes. Without a Section 962 election, the individual faces a 37 percent tax rate on GILTI, resulting in $370 of U.S. tax, without any foreign tax credit or Section 250 deduction.
However, with a Section 962 election:
- The income is taxed at the corporate rate of 21 percent.
- The individual can deduct 50 percent of the GILTI under Section 250, reducing the taxable income to $500.
- Adding back the $150 foreign tax paid (gross-up), the taxable income becomes $650.
- Applying the 21 percent corporate tax rate results in $136.50 of U.S. tax.
- After claiming 80 percent of the $150 foreign tax as a credit ($120), the U.S. tax liability is reduced to $16.50.
Future Distributions And Tax Implications
The tax advantages of a Section 962 election extend to future distributions. In the example above, when the taxpayer eventually receives a distribution of $1,000 from the CFC, it will be taxed at the qualified dividend rate of 20 percent plus the 3.8 percent Net Investment Income Tax (NIIT), resulting in $238 of U.S. tax. Without the election, distributions would typically be subject to ordinary income tax rates, leading to higher tax liabilities.
When To Make A Section 962 Election
Despite its benefits, a Section 962 election is not always advantageous. Some scenarios where the election might not be beneficial include:
- Same-Year Repatriation: If the CFC’s earnings are repatriated in the same year, the benefits of the election may be negated.
- State Tax Considerations: Not all states follow the federal tax treatment. States like California do not tax Subpart F or GILTI until a distribution is made, meaning the Section 250 deduction and foreign tax credits may not be available for state tax purposes.
- Future Tax Increases: Future distributions from previously taxed earnings under a Section 962 election might be taxed at higher rates, potentially offsetting the initial benefits.
Conclusion
Section 962 of the IRC offers a powerful tool for U.S. tax residents with investments in foreign corporations to manage their tax liabilities more effectively. By allowing individuals to be taxed at corporate rates and claim deductions and credits typically available only to corporations, this election can significantly reduce the tax burden associated with GILTI and Subpart F income. However, the decision to make a Section 962 election should be based on a careful analysis of individual circumstances and potential future implications. Consulting with a tax professional is essential to navigate the complexities and determine the best tax strategy.
