HR1, also known as the “Tax Cuts and Jobs Act” (“the Act”), imposes a one-time transition tax on U.S. Shareholders of Specified Foreign Corporations (“SFC”), including S corporations, through a mandatory repatriation as set forth in §965. The mandatory repatriation applies to any accumulated deferred foreign income to be included on U.S. federal income tax returns for the tax year beginning before January 1, 2018. A “specified foreign corporation” is defined as (i) a controlled foreign corporation (“CFC”), or (ii) any foreign corporation in which a domestic corporation is a U.S. shareholder. The repatriated amounts are taxed at reduced rates of 15.5% or 8% depending on the characterization of the deferred foreign income.
Furthermore, there are provisions within §965 that apply solely to S corporations that are U.S. Shareholders of SFCs. Specifically, any S corporation shareholder that has an inclusion under §965 may elect to defer their potential tax liability under §965(i)(1) until the occurrence of a triggering event, as described below. The election must be made by each shareholder, individually, not later than the due date for the shareholder’s tax return which includes the close of the taxable year of the S corporation in a manner that the Secretary of the Treasury shall provide. On March 13, 2018, the IRS issued guidance in the form of an FAQ on the manner and format in which an election must be made.
Additionally, the shareholder is required to report their accrued deferred net tax liability on each tax return starting with the year the election is made and for each taxable year thereafter until the full amount has been assessed on the returns or, consequently, a five percent penalty will be assessed on the unreported amounts. Moreover, the S corporation will be held jointly and severally liability for the payment of any tax resulting under §965 if its shareholders make an election to defer payment.
The previously mentioned triggering events are as follows: (i) The S corporation ceases to be an S corporation, which could include a conversion into a C corporation; (ii) a liquidation or sale of substantially all of the assets of the S corporation or a cessation of business by the S corporation; or (iii) a transfer of stock in the S corporation by the shareholder, even if it is due to death. In the year a triggering event occurs, the shareholder must recognize the previously deferred §965 tax liability on their tax return. However, each S corporation shareholder taxpayer that must include tax as a result of a triggering event may then make an election, on the tax return due for the taxable year in which the triggering event occurs, to pay the §965 tax liability over eight years.
In the case that a shareholder only transfers part of their stock in the S corporation to a transferee, the triggering event only concerns the transferred stock, not the retained portion. In the case of a transfer of stock, the transferee may be able to enter into an agreement with the IRS to avoid a triggering event. This would involve the transferee stepping into the shoes of the original taxpayer with respect to the deferred §965 net tax liability associated with that stock.
As guidance is being issued regularly related to §965 and the above items may be expanded upon or modified at any time, please reach out to Michael Fejes at 310.826.4474, for more information.