Tag: taxes

Staying on Course: Navigating Election Year Issues for Exempt Organizations

With the 2024 election cycle underway, it is important for exempt organizations to understand and comply with relevant restrictions on political campaign activities to safeguard their tax-exempt status and avoid triggering excise tax penalties. This alert provides an overview of the political campaign rules applicable to exempt organizations and specifically highlights the restrictions on political campaign activities applicable to Section 501(c)(3), 501(c)(4), and 501(c)(6) organizations.

Restrictions on Political Activities

Exempt organizations are subject to certain restrictions regarding their participation in political campaign activities, and the amount of permissible participation is a key distinction between Section 501(c)(3), 501(c)(4), and 501(c)(6) organizations. To comply with these restrictions, an exempt organization must (1) know their specific tax-exempt status and the restrictions that apply to them, (2) understand what activities constitute political campaign activities, (3) avoid activities that violate the applicable restrictions, and (4) mitigate the risk that activities conducted by employees in their individual capacities are attributed to the organization.

Prohibited Political Campaign Intervention for Section 501(c)(3) Organizations

Section 501(c)(3) organizations are subject to an absolute prohibition on participation or intervention in political campaign activities. Organizations that violate this ban are subject to the revocation of their tax-exempt status and the imposition of excise tax penalties on both the organization itself and organization managers who approve expenditures used for impermissible political purposes. Therefore, Section 501(c)(3) organizations must avoid activities that violate the prohibition on political campaign intervention.

Prohibited political campaign intervention occurs when an exempt organization “participates in, or intervenes in” a “candidate’s” campaign for “public office” (Section 501(c)(3)).

The term “candidate” refers to any person who has declared an intent to run for national, state, or local office and likely includes incumbents until they announce an intention not to run. A candidate also includes individuals who have yet to declare an intention to run for public office, but whose potential candidacy generates significant public speculation. The term “public office” broadly refers to any national, state, or local elective office, as well as any elected position in a political party.

An organization is considered to “participate in, or intervene in” political campaign activity by making contributions to political campaign accounts or making public statements on behalf of the organization in favor of or in opposition to a candidate for public office. Specifically, the Internal Revenue Service (IRS) regulations define participation in a political campaign as “publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to . . . a candidate” (Treas. Reg. § 1.501(c)(3)-1(c)(3)(iii)). The IRS regulations also note that political campaign intervention is not limited to these specified activities.

The IRS has interpreted prohibited political campaign intervention to include even some nonpartisan educational activities. For example, the IRS has ruled that an organization that was formed to promote public education violated the prohibition on political campaign activities when it announced the names of the school board candidates it considered most qualified following an objective review of the candidates’ qualifications (Rev. Rul. 67-71, 1967-1 C.B. 125).

These restrictions on political campaign activities do not extend to the officers, directors, or employees of a 501(c)(3) organization, provided they are acting in their individual capacities. It is particularly important, however, to mitigate the risk that any personal political activities conducted by officers, directors, or employees will be attributed to the organization. An exempt organization should ensure their employees do not use institutional resources to engage in personal political campaign activities or act in a manner that suggests they are speaking on behalf of the organization when engaged in campaign advocacy. Exempt organizations should adopt clear policies regarding political activities and institutional resources and communicate the importance of such policies to employees during an election year.

Permissible Political Activities

Some educational activities that are election-related are permissible, however, and will not be considered prohibited campaign intervention. In order to be considered “educational,” the activities must present “a sufficiently full and fair exposition of the pertinent facts” (Treas. Reg. § 1.501(c)(3)-1(d)(3)). The information presented must “permit an individual or the public to form an independent opinion or conclusion” and not be biased. Activities that satisfy this definition may be considered permissible educational activities rather than prohibited or restricted political activities.

The following types of educational activities, although election-related, are generally permissible:

  • Voter Registration: Voter registration drives are not considered political campaign activities if they are conducted in a nonpartisan and fair manner. An organization conducting the voter registration drive should not expressly advocate for or against any candidates or political parties as part of the voter registration. They also generally should not name candidates or provide their party affiliations. If any candidates are named, all candidates should be named. All persons interested in registering must also be permitted to register, regardless of their political preference or party affiliation.
  • Voter Education: Certain forms of voter education, such as the distribution of voter guides and voting records, may qualify as an educational activity provided the organization avoids editorial commentary and ensures the materials cover a broad range of issues. Organizations must not demonstrate a preference toward a certain candidate or only cover a narrow range of issues when engaging in voter education activities.
  • Candidate Debates and Forums: Providing a fair, neutral forum for candidate debates may qualify as an educational activity so long as the debate provides equal time to all qualified candidates. Organizations should be particularly careful to include all qualified candidates, cover a broad range of topics, have a nonpartisan group compose the questions, and clarify that the candidates’ views are not the views of the exempt organization. The moderator selected by the organization can ensure the candidates follow the ground rules for the debate, but they should not ask questions or comment on the candidate’s statement in a way the indicates support or opposition to the candidate or their positions.

Section 501(c)(4) Organizations

Section 501(c)(4) social welfare organizations have more latitude to engage in political campaign activities than Section 501(c)(3) organizations. Section 501(c)(4) organizations are not subject to an absolute ban on campaign intervention, but instead are permitted to engage in some limited political activities, provided they remain primarily engaged in social welfare activities. The IRS will compare an organization’s political activities and expenditures (plus its non-exempt activities) with its social welfare activities to determine whether the organization remains primarily engaged in promoting social welfare consistent with its tax-exempt status. Accordingly, Section 501(c)(4) organizations should maintain records to ensure they remain primarily engaged in social welfare activities during an election year. If a Section 501(c)(4) organization engages in political activities, it must also provide its members with a notice of how much of their dues were used towards political activities and determine the proxy tax on those expenditures. If member dues are used for political campaign activities, then a portion of the dues may not be a deductible business expense under Section 162.

Section 501(c)(6) Organizations

Business leagues described in Section 501(c)(6) are subject to the same less-stringent rules regarding political campaign activities as Section 501(c)(4) organizations. Section 501(c)(6) organizations may engage in some political activities on a limited basis, provided such political activities are not the organization’s primary activity. If a Section 501(c)(6) organization engages in political activities, it must also provide its members with a notice of how much of their dues were used towards political activities and determine the proxy tax on those expenditures. If member dues are used for political campaign activities, then a portion of the dues may not be a deductible business expense under Section 162.

Related Restrictions

The scope of this alert is limited to restrictions on political campaign activities under federal tax law. Exempt organizations are also subject to campaign finance restrictions and requirements by the Federal Election Commission, as well as rules regarding legislative or lobbying activities imposed by the IRS, the Lobbying Disclosure Act of 1995, and other federal, state, and local laws, which are beyond the scope of this alert.

© 2024 ArentFox Schiff LLP
For more news on Restrictions for Tax-Exempt Organizations during Election Years, visit the NLR Tax section.

Inflation’s Effect on Taxes – The Good and the Bad

Many federal tax provisions are adjusted for inflation annually, but not all. Rising inflation may result in lower tax bills for many taxpayers in 2023. Unfortunately, the impacts of inflation on taxpayers will not lower their 2022 tax bills even though inflation is at the highest level in the past 40 years.

The standard deduction is indexed for inflation. In 2023, for married couples filing joint tax returns, the standard deduction increased by $1,800 to $27,700; and for single taxpayers the standard deduction increased by $900 to $13,850.

The tax rates for individual tax filers have not changed (with the highest tax rate remaining at 37%), but the income levels have increased between the brackets. For example, in 2023, the 32% tax bracket starts at $364,200 for married couples filing jointly (up from $340,100 in 2022); and the 35% bracket for married couples filing jointly starts at $462,500 (up from $331,900 in 2022).

Estates of decedents who die in 2023 will have an estate tax exemption of $12,920,000 (up from $12,060,000 in 2022). The gift tax exclusions also increased to the same amounts and the annual gift exclusion increased to $17,000 per donee, which allows a married couple to gift $34,000 using their annual exclusion with no limit on the number of donees.

Social security recipients will enjoy an 8.7% increase in their monthly benefits in 2023 compared to 2022.

Other increases, as a result of rising inflation, include higher maximum contributions to retirement plans, health savings accounts and flexible spending accounts.

Inflation will impact taxpayers, employees and employers negatively as well. Employees, employers and self-employed individuals will be subject to social security taxes on earnings of $160,200 (up from $147,000 in 2022).

The limitation on itemized deduction for state and local tax has not increased, although state and local taxes have generally increased and the personal exemption continues to remain at zero. Finally, there has been no reduction in the long-term capital gains tax rate or increase in the deduction for capital losses which remains limited to $3,000 per year in excess of capital gains.

Article By Edwin I. Josephson of Chuhak & Tecson, P.C.

For more tax legal news, click here to visit the National Law Review.

© 2023 Chuhak & Tecson P.C.

What Taxpayers in the U.S. and Abroad Need to Know about FBAR Compliance

United States taxpayers have an obligation to report their foreign financial accounts (i.e., offshore or foreign bank accounts) to the federal government. While there are thresholds that apply, these thresholds are relatively low, so most offshore account holders will need to file reports on an annual basis. One of these reports is the Report of Foreign Bank and Financial Accounts, more commonly known as an FBAR (Foreign Bank Account Report).

For U.S. taxpayers, FBAR compliance is extremely important. This is true for taxpayers residing both domestically and overseas. The FBAR is required for US citizens because foreign banks don’t have the same reporting obligations as US-based institutions. Noncompliance in reporting foreign bank accounts can lead to civil or criminal penalties; and, in many cases, failure to file an FBAR will lead to an examination of the taxpayer’s other recent tax filings as well.

“The obligation to file an FBAR applies to most U.S. taxpayers with offshore bank accounts. While many taxpayers are unaware of the FBAR filing requirement, this unawareness is not an excuse for noncompliance. Taxpayers with delinquent FBARs can face substantial penalties regardless of why they have failed to file.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

Technically, FBARs are due on Tax Day along with taxpayers’ annual income tax returns. However, all taxpayers receive an automatic extension to October 15—with no need to file a request and no risk of incurring additional penalties.

10 Key Facts about FBAR Compliance for U.S. Taxpayers

As the extended October 15 FBAR deadline is fast approaching, here is an overview of what taxpayers in the U.S. and abroad need to know:

1. The FBAR Filing Requirement Applies to U.S. Taxpayers Who Hold Foreign Financial Accounts

The FBAR filing requirement applies to U.S. taxpayers who hold foreign financial accounts. It also applies to taxpayers who have “signature or other authority” over these foreign accounts. These obligations exist under the federal Bank Secrecy Act (BSA). Taxpayers covered under the BSA must file FBARs with the Financial Crimes Enforcement Network (FinCEN) annually.

While the FBAR filing requirement applies to most types of foreign financial accounts, there are exceptions. For example, FBAR compliance is not required with respect to accounts:

  • Owned by governmental entities
  • Owned by foreign financial institutions
  • Held at U.S. military banking facilities
  • Held in individual retirement accounts (IRAs)
  •  Held in certain other retirement plans

FinCEN has publicly taken the position that accounts solely holding cryptocurrency also do not qualify as foreign financial accounts for purposes of FBAR compliance. However, FinCEN has also stated that it “intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding [FBARs] to include virtual currency as a type of reportable account.” As a result, U.S. taxpayers who hold cryptocurrency overseas should continue to review FinCEN’s regulatory announcements to determine if their offshore cryptocurrency accounts will trigger FBAR compliance obligations in the future.

2. The FBAR Reporting Threshold is $10,000

The requirement to file an FBAR applies only to U.S. taxpayers whose foreign financial accounts exceed $10,000 during the relevant tax year. This is an aggregate threshold, meaning that it applies to all foreign financial accounts jointly, and the obligation to file an FBAR is triggered if the aggregate value of a taxpayer’s foreign financial accounts exceeds the $10,000 threshold at any point and for any length of time.

3. U.S. Taxpayers Must File Their FBARs Online

A person residing in the United States who has a financial interest in or signatory power over a foreign financial account is required to file an FBAR if the total value of the foreign financial accounts at any time during the calendar year exceeds $10,000. While U.S. taxpayers have the option to e-file their annual income tax returns, taxpayers must file their FBARs online. Taxpayers can do so through FinCEN’s website.

4. The IRS Enforces FBAR Compliance

Even though U.S. taxpayers must file their FBARs with FinCEN, the Internal Revenue Service (IRS) is responsible for enforcing FBAR compliance. This means that taxpayers that fail to meet their FBAR filing obligations must be prepared to deal with the IRS when it uncovers their delinquent filings. It also means that delinquent filers must follow the IRS’s procedures for coming into voluntary compliance to avoid unnecessary penalties—as discussed in greater detail below.

5. FBAR Filers May Also Need to File IRS Form 8938

In addition to filing an annual FBAR, U.S. taxpayers who own foreign financial accounts may also need to file IRS Form 8938. The obligation to file this form applies to U.S. taxpayers who own foreign financial assets (not solely foreign financial accounts) that exceed the thresholds established under the Foreign Account Tax Compliance Act (FATCA).

6. There are Special Mechanisms for Filing Delinquent FBARs

When individuals learn that they are at risk of facing an IRS audit or investigation due to failure to file an FBAR, their first instinct is often to file any and all delinquent FBARs right away.

However, this is not the IRS’s preferred approach, and it can expose taxpayers to penalties and interest unnecessarily.

The IRS offers two primary mechanisms for U.S. taxpayers to correct FBAR filing deficiencies—one for civil violations and one for criminal violations. The primary mechanism for correcting civil violations is to make a “streamlined filing,” while taxpayers who are at risk for criminal prosecution must make a “voluntary disclosure” to IRS Criminal Investigation (IRS CI).

As the IRS explains, the option to make a streamlined filing is “available to taxpayers certifying that their failure to report foreign financial assets and pay all tax due in respect of those assets did not result from willful conduct on their part.” The ability to make this certification of non- willfulness is critical. If a taxpayer falsely certifies to non-willfulness (or if the IRS determines that a taxpayer’s certification is fraudulent), the IRS can reject the taxpayer’s streamlined filing and pursue criminal enforcement action.

For those who have willfully failed to file FBARs, coming into compliance generally involves using IRS CI’s Voluntary Disclosure Practice (VDP). As stated by IRS CI, “If you have willfully failed to comply with tax or tax-related obligations, submitting a voluntary disclosure may be a means to resolve your non-compliance and limit exposure to criminal prosecution.” However, as IRS CI also states, “[a] voluntary disclosure will not automatically guarantee immunity from prosecution.”

With this in mind, when seeking to correct past FBAR filing failures, U.S. taxpayers need to make informed and strategic decisions. To do so, they should rely on the advice of experienced legal counsel. While streamlined filings and voluntary disclosures both provide protection from prosecution, they offer protection under different circumstances, and taxpayers must follow a stringent set of procedures to secure the available protections.

7. Failure to File an FBAR Can Lead to Civil or Criminal Prosecution

One of the key requirements for securing protection under the IRS’s streamlined filing compliance procedures or the VDP is that the taxpayer must not already be the subject of an IRS audit or investigation. When facing audits and investigations related to FBAR noncompliance, taxpayers must assert strategic defenses focused on avoiding civil or criminal prosecution.

Both the BSA and FATCA provide federal prosecutors with the ability to pursue civil or criminal charges. Typically, civil cases focus on unintentional violations, while prosecutors pursue criminal charges in cases involving intentional efforts to conceal foreign financial assets from the U.S. government. However, prosecutors may choose to pursue civil charges for “willful” violations as well; and, in some cases, asserting a strategic defense will involve focusing on keeping a taxpayer’s case civil in nature.

8. The Penalties for FBAR Non-Compliance Can Be Substantial

Why is it important to keep an FBAR non-compliance case civil? The simple answer is that in civil cases prison time isn’t on the table. Under the BSA, U.S. taxpayers charged with intentionally failing to file an FBAR can face a criminal fine of up to $250,000 and up to five years of federal imprisonment.

But, even in civil cases, a finding of FBAR noncompliance can still lead to substantial penalties. For non-willful violations, taxpayers can face fines of up to $10,000 per violation. For willful violations prosecuted civilly, taxpayers can face fines of up to 50% of the undisclosed account value or $100,000, whichever is greater (subject to a maximum penalty of 100% of the account value).

9. U.S. Taxpayers Who Have Questions or Concerns about FBAR Compliance Should Seek Help

Given the substantial risks of FBAR non-compliance, U.S. taxpayers who have questions or concerns about compliance should seek help promptly. They should consult with an experienced attorney, and they should work closely with their attorney to make informed decisions about their next steps.

10. FBAR Filers Must Keep Records On-Hand

Finally, in addition to filing their FBARS with FinCEN online, U.S. taxpayers who are subject to the BSA must also comply with the statute’s recordkeeping requirements. Minimally, taxpayers must retain the following records for each account they disclose on an FBAR:

  • Account number
  • Account type
  • Name on the account
  • Name and address of the foreign bank holding the account
  • Maximum value of the account during the relevant tax year

According to the IRS, “the law doesn’t specify the type of document to keep with this information,” and taxpayers typically “must keep these records for five years from the due date of the FBAR.”

Article By Dr. Nick Oberheiden of Oberheiden P.C.

For more tax law legal news, click here to visit the National Law Review.

Oberheiden P.C. © 2022

Now is a Good Time to Confirm Your S Corporation Status

On October 11, 2022, the IRS published Revenue Procedure 2022-19 providing taxpayers with liberalized procedures for resolving common S corporation issues. Previously, taxpayers would have needed costly IRS letter rulings for certainty on their S corporation status. The new procedures are simpler and less expensive.

The IRS has separately assured taxpayers that LLCs that are classified as S corporations may also qualify for this liberalized relief.

Inadvertent loss of S corporation status can have significant tax consequences and can make your business a less attractive acquisition target. For example, an S corporation that reverts to a C corporation may be subject to a double layer of tax going back several years. As a result, potential acquirers of any S corporation invariably request representations on the validity of the S corporation status.

The new Revenue Procedure describes common situations that the IRS has historically treated as not affecting the validity of S corporation status or qualified S corporation Qsub status, such as:

  1. One class of stock requirement in the governing provisions (including the concept that commercial contractual agreements are not treated as binding agreements unless a “principal purpose” of the agreement is to circumvent the one class of stock requirement);

  2. Disproportionate distributions inadvertently creating a second class of stock;

  3. Certain inadvertent errors or omissions on Form 2553 or Form 8869;

  4. Missing administrative acceptance letters for S corporation or Qsub elections;

  5. Federal income tax return filings inconsistent with an S election; or

  6. Governing provisions that allow for non-identical treatment of shareholders, such as differing liquidation rights (allowing for retroactive corrections).

For these common situations, there are now simpler and cheaper procedures to preserve S corporation status. For example, for certain small errors such as missing officer signatures, S corporations may follow the same simplified procedures as the late election relief procedures in Revenue Ruling 2013-30. Those procedures do not require a private letter ruling request, but only the original election form with a reasonable cause statement. As another example, if the issue is non-identical governing provisions and no disproportionate distributions were made, the S corporation may simply be retroactively treated as an S Corporation if it meets certain eligibility requirements and keeps a copy of a signed statement in its files.

Shareholders of uncertain S corporations should consider taking advantage of these new relaxed and cheaper procedures for curing S corporation mistakes. Each different type of error has a different cure with specific requirements.

Article By Christie R. Galinski and Samuel L. Parks of Miller Canfield

For more corporate law legal news, click here to visit the National Law Review.

© 2022 Miller, Canfield, Paddock and Stone PLC

IRS Delays Additional Amendment Deadlines for Major Retirement Legislation

The IRS has extended additional deadlines for required retirement plan amendments, similar to the extensions we discussed last month found here. Notice 2022-45 extends the deadline for amending qualified retirement plans to comply with certain provisions of:

  • The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”)

  • The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (“Relief Act”)

Notice 2022-45 specifically extends the amendment deadlines for Section 2202 of the CARES Act and Section 302 of the Relief Act. Section 2202 of the CARES Act permitted plans to: (1) provide coronavirus-related distributions, (2) increase retirement plan loan sizes, and (3) pause retirement plan loan payments. Section 302 of the Relief Act permitted qualified disaster distributions.

Notice 2022-45 extends the amendment deadlines relating to the applicable provisions in the CARES and Relief Acts for non-governmental qualified plans and 403(b) plans to December 31, 2025. Governmental plans (including qualified plans, 403(b) plans maintained by public schools, and 457(b) plans) are granted further delays depending on the underlying circumstances of the plan sponsor.  These extended deadlines under Notice 2022-45 align with the previous deadline extensions under Notice 2022-33. Accordingly, most plan sponsors will be able to adopt a single amendment to comply with the SECURE Act, BAMA, the CARES Act, and the Relief Act.

Notably, tax-exempt 457(b) plans do not appear to be covered by the relief granted by either Notice 2022-33 or Notice 2022-45. Accordingly, these plans remain subject to a December 31, 2022, amendment deadline.

Article By Brian T. Gallagher, Samantha A. Kopacz, and Samuel L. Parks of Miller Canfield

For more tax law legal news, click here to visit the National Law Review.

© 2022 Miller, Canfield, Paddock and Stone PLC

Your Horse May Be Subject to IRS Seizure

The Internal Revenue Service (IRS) has broad powers to seize assets in payment of outstanding taxes including income tax, excise tax, employment tax, and estate and gift tax. Assets the IRS can seize in exercise of its levy power are those that constitute “property or rights to property” of the taxpayer as defined under local law. Equine industry assets that could be subject to seizure include real estate, equipment, and the horses themselves, although horses valued below $10,090 are exempt from levy. For example, in 2012 the IRS seized hundreds of horses to collect a tax debt from a defendant convicted of stealing millions of dollars in city funds. The defendant used the funds to finance the breeding and showing of American quarter horses. The government auctioned off more than 400 of the seized horses to pay the defendant’s outstanding federal tax obligation.

But because animals require food and veterinary care and could die, the IRS has specific procedures relating to the seizure of livestock, such as horses. If the horses are considered “perishable goods,” section 6336 of the Internal Revenue Code (the Code), which provides the statutory requirements for disposing of perishable goods, will apply. Under section 6336, if it is determined that the seized property is liable to perish, the IRS must appraise the value of the property and either return it to the owner or put it up for immediate sale. The Internal Revenue Manual (IRM) provides further guidance on what constitutes perishable property. IRM 5.10.1.7 (12-20-2019) says that the property must be tangible personal property and have a short life expectancy or limited shelf life.

Prior to July 1, 2019, the definition of perishable goods included property that may “become greatly reduced in price or value by keeping, or that such property cannot be kept without great expense.” Horses would seem to fit within either or both of these categories. Now, under the revised definition of perishable goods, a collection officer would have to show that the horse had a short life expectancy.

A revenue officer seeking to seize perishable property must determine that the property cannot be kept and sold at a public sale under normal sale time frames set forth in section 6335 of the Code. Despite the change in the definition of perishable goods in 2019, the IRM suggests that examples of property likely to perish “may be food, flowers, plants or livestock [emphasis added].” Once the revenue officer determines that the property is perishable, he must secure approval of this finding. The determination is subject to high-level IRS review and planning, including an estimate of the expected net sale proceeds to be received from a forced sale. If the revenue officer concludes that the property is not perishable, sale of the seized property must proceed under normal procedures and within the time frames set forth in the Code.

A recent Bloomberg news article reported that the U.S. government had seized a 15-year-old Holsteiner that had been purchased for $750,000. The horse was a champion show jumper. As might be expected, the cost of maintaining the horse was high. IRS agents determined it would cost $45,000-$50,000 a year to feed the horse, not including the medical costs it might incur. The IRS also learned the value of the horse had dropped sharply from its $750,000 purchase price. Thus, in an unusual deal, the government sold the horse to the taxpayer’s daughter (for whom it had been purchased originally) for $25,000.

The considerations, planning, coordination, documentation, and approval of these types of sales may discourage a revenue officer from seizing perishable property like horses where other assets may be levied more easily. Nonetheless, sometimes the IRS will take action to seize a horse perceived to be valuable, like with the Holsteiner, even if it is not deemed perishable under the Code definition.

Article By Barbara T. Kaplan and Scott E. Fink of Greenberg Traurig, LLP

For more tax law legal news, click here to visit the National Law Review.

©2022 Greenberg Traurig, LLP. All rights reserved.

A Summary of Inflation Reduction Act’s Main Energy Tax Proposals

On August 7, the Senate passed the Inflation Reduction Act of 2022 (the “IRA”). The IRA contains a significant number of climate and energy tax proposals, many of which were previously proposed in substantially similar form by the House of Representatives in November 2021 (in the “Build Back Better Act”).

Extension and expansion of production tax credit

Section 45 of the Internal Revenue Code provides a tax credit for renewable electricity production. To be eligible for the credit, a taxpayer must (i) produce electricity from renewable energy resources at certain facilities during a ten-year period beginning on the date the facility was placed in service and (ii) sell that renewable electricity to an unrelated person.[1] Under current law, the credit is not available for renewable electricity produced at facilities whose construction began after December 31, 2021.

The IRA would extend the credit for renewable electricity produced at facilities whose construction begins before January 1, 2025. The credit for electricity produced by solar power –which expired in 2016—would be reinstated, as extended by the IRA.

The IRA would also increase the credit from 1.5 to 3 cents per kilowatt hour of electricity produced.

A taxpayer would be entitled to increase its production tax credit by 500% if (i) its facility’s maximum net output is less than 1 megawatt, (ii) it meets the IRA’s prevailing wage and apprenticeship requirements,[2] and (iii) the construction of its facility begins within fifty-nine days after the Secretary publishes guidance on these requirements.

In addition, the IRA would add a 10% bonus credit for a taxpayer (i) that certifies that any steel, iron, or manufactured product that is a component of its facility was produced in the United States (the “domestic content bonus credit”) or (ii) whose facility is in an energy community (the “energy community bonus credit”).[3]

Extension, expansion, and reduction of investment tax credit

Section 48(a) provides an investment tax credit for the installation of renewable energy property. The amount of the credit is equal to a certain percentage (described below) of the property’s tax basis. Under current law, the credit is limited to property whose construction began before January 1, 2024.

The IRA would extend the credit to property whose construction begins before January 1, 2025. This period would be extended to January 1, 2035 for geothermal property projects. The IRA would also allow the investment tax credit for energy storage technology, qualified biogas property, and microgrid controllers.

The IRA would reduce the base credit from 30% to 6% for qualified fuel cell property; energy property whose construction begins before January 1, 2025; qualified small wind energy property; waste energy recovery property; energy storage technology; qualified biogas property; microgrid controllers; and qualified facilities that a taxpayer elects to treat as energy property. For all other types of energy property, the base credit would be reduced from 10% to 2%.

A taxpayer would be entitled to increase this base credit by 500% (for a total investment tax credit of 30%) if (i) its facility’s maximum net output is less than 1 megawatt of electrical or thermal energy, (ii) it meets the prevailing wage and apprenticeship requirements, and (iii) its facility begins construction within fifty-nine days after the Secretary publishes guidance on these requirements.

In addition, a taxpayer would be entitled to a 10% domestic content bonus credit and 10% energy community bonus credit (subject to the same requirements as for bonus credits under section 45). The IRA would also add a (i) 10% bonus credit for projects undertaken in a facility with a maximum net output of 5 megawatts and is located in low-income communities or on Indian land, and (ii) 20% bonus credit if the facility is part of a qualified low-income building project or qualified low-income benefit project.

Section 45Q (Carbon Oxide Sequestration Credit)

Section 45Q provides a tax credit for each metric ton of qualified carbon oxide (“QCO”) captured using carbon capture equipment and either disposed of in secure geological storage or used as a tertiary injection in certain oil or natural gas recovery projects.  While eligibility for the section 45Q credit under current law requires that projects begin construction before January 1, 2026, the IRA would extend credit eligibility to those carbon sequestration projects that commence construction before January 1, 2033.

The IRA would increase the amount of tax credits for projects that meet certain wage and apprenticeship requirements. Specifically, the IRA would increase the amount of section 45Q credits for industrial facilities and power plants to $85/metric ton for QCO stored in geologic formations, $60/metric ton for the use of captured carbon emissions, and $60/metric ton for QCO stored in oil and gas fields.  With respect to direct air capture projects, the IRA would increase the credit to $180/metric ton for projects that store captured QCO in secure geologic formations, $130/metric ton for carbon utilization, and $130/metric ton for QCO stored in oil and gas fields.  The proposed changes in the amount of the credit would apply to facilities or equipment placed in service after December 31, 2022.

The IRA also would decrease the minimum annual QCO capture requirements for credit eligibility to 1,000 metric tons (from 100,000 metric tons) for direct air capture facilities, 18,750 metric tons (from 500,000 metric tons) of QCO for an electricity generating facility that has a minimum design capture capacity of 75% of “baseline carbon oxide” and 12,500 metric tons (from 100,000 metric tons) for all other facilities.  These changes to the minimum capture requirements would apply to facilities or equipment that begin construction after the date of enactment.

Introduction of zero-emission nuclear power production credit

The IRA would introduce, as new section 45U, a credit for zero-emission nuclear power production.

The credit for a taxable year would be the amount by which 3 cents multiplied by the kilowatt hours of electricity produced by a taxpayer at a qualified nuclear power facility and sold by the taxpayer to an unrelated person during the taxable year exceeds the “reduction amount” for that taxable year.[4]

In addition, a taxpayer would be entitled to increase this base credit by 500% if it meets the prevailing wage requirements.

New section 45U would not apply to taxable years beginning after December 31, 2032.

Biodiesel, Alternative Fuels, and Aviation Fuel Credit

The IRA would extend the existing tax credit for biodiesel and renewable diesel at $1.00/gallon and the existing tax credit for alternative fuels at $.50/gallon through the end of 2024.  Additionally, the IRA would create a new tax credit for sustainable aviation fuel of between $1.25/gallon and $1.75/gallon.  Eligibility for the aviation fuel credit would depend on whether the aviation fuel reduces lifecycle greenhouse gas emissions by at least 50%, which corresponds to a $1.25/gallon credit (with an additional $0.01/gallon for each percentage point above the 50% reduction, resulting in a maximum possible credit of $1.75/gallon). This credit would apply to sales or uses of qualified aviation fuel before the end of 2024.

Introduction of clean hydrogen credit

The IRA would introduce, as new section 45V, a clean hydrogen production tax credit. To be eligible, a taxpayer must produce the clean hydrogen after December 31, 2022 in facilities whose construction begins before January 1, 2033.

The credit for the taxable year would be equal to the kilograms of qualified clean hydrogen produced by the taxpayer during the taxable year at a qualified clean hydrogen production facility during the ten-year period beginning on the date the facility was originally placed in service, multiplied by the “applicable amount” with respect to such hydrogen.[5]

The “applicable amount” is equal to the “applicable percentage” of $0.60. The “applicable percentage” is equal to:

  • 20% for qualified clean hydrogen produced through a process that results in a lifecycle greenhouse gas emissions rate between 2.5 and 4 kilograms of CO₂e per kilogram of hydrogen;

  • 25% for qualified clean hydrogen produced through a process that results in a lifecycle greenhouse gas emissions rate between 1.5 and 2.5 kilograms of CO₂e per kilogram of hydrogen;

  • 4% for qualified clean hydrogen produced through a process that results in a lifecycle greenhouse gas emissions rate between 0.45 and 1.5 kilograms of CO₂e per kilogram of hydrogen; and

  • 100% for qualified clean hydrogen produced through a process that results in a lifecycle greenhouse gas emissions rate of less than 0.45 kilograms of CO₂e per kilogram of hydrogen.

A taxpayer would be entitled to increase this base credit by 500% if (i) it meets the prevailing wage and apprenticeship requirements or (ii) it meets the prevailing wage requirements, and its facility begins construction within fifty-nine days after the Secretary publishes guidance on the prevailing wage and apprenticeship requirements.

FOOTNOTES

[1] All references to section are to the Internal Revenue Code.

[2] The IRA would require new prevailing wage and apprenticeship requirements to be satisfied in order for a taxpayer to be eligible for increased credits. To satisfy the prevailing wage requirements, a taxpayer would be required to ensure that any laborers and mechanics employed by contractors or subcontractors to construct, alter or repair the taxpayer’s facility are paid at least prevailing local wages with respect to those activities. To satisfy the apprenticeship requirements, “qualified apprentices” would be required to construct a certain percentage of the taxpayer’s facilities (10% for facilities whose construction begins before January 1, 2023 and 15% for facilities whose construction begins on January 1, 2024 or after). A “qualified apprentice” is a person employed by a contractor or subcontractor to work on a taxpayer’s facilities and is participating in a registered apprenticeship program.

[3] An “energy community” is a brownfield site; an area which has (or had at any time after December 31, 1999) significant employment related to the extraction, processing, transport, or storage of coal, oil, or natural gas; and a census tract in which a coal mine closed or was retired after December 31, 1999 (or an adjoining census tract).

[4] A “qualified nuclear power facility” is any nuclear facility that is owned by the taxpayer, that uses nuclear energy to produce electricity, that is not an “advanced nuclear power facility” as described in section 45J(d)(1),  and is placed in service before the date that new section 45U is enacted.

“Reduction amount” is, for any taxable year, the amount equal to (x) the lesser of (i) the product of 3 cents multiplied by the kilowatt hours of electricity produced by a taxpayer at a qualified nuclear power facility and sold by the taxpayer to an unrelated person during the taxable year and (ii) the amount equal to 80% of the excess of the gross receipts from any electricity produced by the facility (excluding an advanced nuclear power facility) and sold to an unrelated person during the taxable year; (y) over the amount equal to the product of 2.5 cents multiplied by the kilowatt hours of electricity produced by the taxpayer at a qualified nuclear power facility and sold by the taxpayer to an unrelated person during the taxable year.

[5] “Qualified clean hydrogen” is hydrogen that is produced (i) through a process that results in a lifecycle greenhouse gas emissions rate of no more than 4 kilograms of CO₂e per kilogram of hydrogen, (ii) in the United States, (iii) in the ordinary course of the taxpayer’s trade or business, (iv) for sale or use, and (v) whose production and sale or use is verified by an unrelated party. The IRA does not explain what “verified by an unrelated party” means.

Article By David S Miller, Amanda H Nussbaum, Martin T Hamilton, J. Tyler Moser, and Rita N. Halabi of Proskauer Rose LLP

For more tax law legal news, click here to visit the National Law Review.

© 2022 Proskauer Rose LLP.

The Biden Administration Proposes Mark-to-Market Minimum Tax on Individuals With More than $100 Million in Assets

Summary and Background.  On March 28, 2022, the Biden Administration proposed a 20% minimum tax on individuals who have more than $100 million in assets.  The minimum tax would be based on all economic income (which the proposal refers to as “total income”), including unrealized gain.  The tax would be effective for taxable years beginning after December 31, 2022.  The minimum tax would be fully phased in for taxpayers with assets of $200 million or more.

Under the proposal, an individual’s 2023 minimum tax liability would be payable in nine equal annual installments (e.g., in 2024-2032).  For 2024 and thereafter, the minimum tax liability would be payable in five annual installments.  The tax may be avoided by giving away assets to section 501(c)(3) organizations (including private foundations or donor-advised funds) or 501(c)(4) organizations before the effective date of the legislation so as to avoid the $100 million threshold.

The Biden proposal is an attempt to appeal to Senator Joe Manchin (D-W.Va.) and address some criticisms of Senator Ron Wyden’s (D-Or.) mark-to-market proposal.  Senator Manchin has expressed support for a minimum 15% tax on individuals, and this support was apparently an impetus for the proposal.  Senator Manchin has not, however, expressed support for a mark-to-market minimum tax, and the Biden Administration does not appear to have received any support from Senator Manchin before releasing its proposal.

The five-year payment period is an attempt to address concerns that Wyden’s proposal might overtax volatile assets, and to “smooth” taxpayers’ cash flows without the need for the IRS to issue refunds.  Under the Biden Administration’s proposal, installment payments of the minimum tax may be reduced to the extent of unrealized losses.

The minimum tax is being described as a “prepayment” that may be credited against subsequent taxes on realized income.  This description provides a backup argument on constitutionality: the minimum tax isn’t a tax on unrealized income but is merely a prepayment of tax on realized income.

Operation of the Minimum Tax.  The minimum tax would apply to taxpayers with wealth (assets less liabilities) in excess of $100 million.  The proposal does not define liabilities, and does not indicate whether a taxpayer would be deemed to own the assets of his or her children, or trusts.  Therefore it is unclear as to whether a taxpayer who is close to the $100 million threshold may avoid the tax by giving away assets to children.  As mentioned above, a taxpayer can give assets to section 501(c)(3) or 501(c)(4) organizations to avoid the threshold, and so, if the minimum tax is enacted, donations to charity would be expected to dramatically increase.

The proposal phases in for taxpayers with wealth between $100 million and $200 million.  The phase in is achieved mechanically by reducing the tax liability to the extent that the sum of (w) the minimum tax liability, and (x) the uncredited prepayments exceeds two times (y) the minimum tax rate, times (z) the amount by which the taxpayer’s wealth exceeds $100 million.  Thus, for a taxpayer with $150 million of wealth and a zero basis and no prior prepayments, the $30 million of minimum tax liability would be reduced by $10 million to equal $20 million.  ($10 million is amount by which (x) $30 million exceeds (y) $20 million, which is 40% [two times the minimum tax rate] times $50 million [the amount by which the taxpayer’s wealth exceeds $100 million].)

A taxpayer subject to the minimum tax would make two calculations:  Their “normal” tax liability under our current realization system, and the “minimum” tax under the proposal. Tax would be paid on the greater of the two.

For purposes of the 20% minimum tax, the taxpayer would include all unrealized gain on “tradeable assets.”  The proposal does not define tradeable assets.  Tradeable assets would be valued using end-of-year market prices.  The taxpayer would also include all unrealized gain on “non-tradeable assets.”  Non-tradeable assets would be valued using the greater of (i) the original or adjusted cost basis, (ii) the last valuation event from investment (i.e., a round of equity financing), (iii) borrowing (i.e., a lender’s appraisal), (iv) financial statements, or (v) other methods approved by the IRS.  Original or adjusted cost basis would be deemed to increase at a rate equal to the five-year Treasury rate plus two percentage points.  The five-year Treasury rate is currently 2.76% and so, at today’s rates, non-traded assets without a valuation event would deemed to increase in value at a 4.76% annual rate.  The proposal would not require valuations of non-tradeable assets.

While a taxpayer would be subject to the minimum tax if it exceeds the normal tax, as mentioned above, payment of the minimum tax would be made in equal annual installments (nine for the first year of minimum tax liability and five thereafter).

So, assume that a taxpayer purchases an equity interest in a non-traded C corporation on January 1, 2023 for $200 million.  The taxpayer has no realized income and no other assets.  The taxpayer would have zero “normal” tax.  Assume that the five-year Treasury rate is 2.76%.  The investment would be deemed to increase in value by 4.76% (to $209.5 million).  The minimum tax would be 20% of $9.5 million, or $1.9 million.  If this was the taxpayer’s first year subject to the minimum tax, the minimum tax liability would be $211,111 in each of years 2024-32, subject to the “illiquid exception” described below.  If the taxpayer subsequently sells the C corporation, it would credit the minimum tax prepayments against his or her income tax liability.

Payments of the minimum tax would be treated as a prepayment available to be credited against subsequent taxes on realized gains.

The Biden Administration has separately proposed that death would give rise to a realization event.  If a taxpayer’s prepayments in excess of tax liability exceed gains at death, the taxpayer would be entitled to a refund.  The refund would be included in a single decedent’s gross estate for estate tax purposes.  Net uncredited used prepayments of a married decedent would be transferred to the surviving spouse (or as otherwise provided in regulations).

In contrast to Senator Wyden’s proposal, which does not require that tax be paid on unrealized gain for non-traded assets, and instead imposes a deferral charge upon realization, the Biden Administration’s proposal generally requires that minimum tax be calculated with respect to all unrealized gain, including deemed appreciation on non-traded assets, subject to an “illiquid exception.”  If tradeable assets held directly or indirectly make up less than 20% of a taxpayer’s wealth, the taxpayer may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability.  A taxpayer that makes this election would be subject to a deferral charge upon realization to the extent of gain, but the deferral charge would not exceed 10% of unrealized gain.  The proposal does not indicate the rate of the deferral charge.

This aspect of the Biden Administration’s proposal provides a meaningful benefit to “illiquid” taxpayers and encourages taxpayers to become “illiquid” to qualify for the exception.  The proposal provides that tradeable assets held “indirectly” are treated as owned by the taxpayer for this purpose and therefore it is unclear whether and to what extent taxpayers can contribute tradeable assets into nontradeable vehicles to qualify for the illiquid exception.  The proposal would provide the IRS with specific authority to issue rules to prevent taxpayers from inappropriately converting tradeable assets to non-tradeable assets.

Estimated tax payments would not be required for minimum tax liability, and the minimum tax payments would be excluded from the prior year’s tax liability for purposes of computing estimated tax required to avoid the penalty for underpayment of estimated taxes.

The tax is expected to affect 20,000 taxpayers (in contrast to roughly 700 under Wyden’s plan) but to generate approximately the same amount of revenue as Wyden’s proposal: $360 billion over ten years as estimated by the Treasury Department (which is expected to be around $550 billion over 10 years under the Joint Committee on Taxation’s “scoring” methodology).

Article By Robert Gaut, Martin T Hamilton, and Colleen Hart at Proskauer Rose LLP

For more tax law legal news, click here to visit the National Law Review.

© 2022 Proskauer Rose LLP.

Why is Section 962 Back in the Spotlight? [Podcast]

In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.

Transcript:

PAUL D’ ALESSANDRO

Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris.  How are you doing this morning, Megan?

MEGAN FERRIS

Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.

PAUL D’ ALESSANDRO

Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?

MEGAN FERRIS

Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income.  Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures.  One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC.  Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate.  Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate.  But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income.  And that’s great for corporations.  An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC.  The individual pays up to 37% U.S. tax on GILTI, end of story.  So, as you can see, the disparity between individual and corporation taxation can be quite dramatic.  And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.

PAUL D’ ALESSANDRO

Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?

MEGAN FERRIS

Right.  So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election.  So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s.  Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. Section 962 gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings will be no heavier than they would have been had they invested in an American corporation doing business abroad.”  So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics.  This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election.  So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.

PAUL D’ ALESSANDRO

Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?

MEGAN FERRIS

An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.

PAUL D’ ALESSANDRO

So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on.  The election applies to all CFCs that are owned by the individual.  So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances.  So I think we kind of gave an overview here of Section 962 and why it matters now.  But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?

MEGAN FERRIS

Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%.  There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI.  But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes.  With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement.  There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders.  And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion.  Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation.  And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion.  So, I’ll give an example.  We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC.  The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income.  From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client.  And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid.  We recommended making a Section 962 election, which he did.  Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation.  U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid.  And when CFC eventually distributes the income, the client is taxed on their distribution.  However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%.  So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.

PAUL D’ ALESSANDRO

So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit.  On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise.  So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now.  Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?

MEGAN FERRIS

That’s a great question, Paul.  Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France.  But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%.  And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations.  Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual.  As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction.  Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required.  On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer.  Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC.  Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.

PAUL D’ ALESSANDRO

So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said.  The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%.  Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions.  And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about.  That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located.  Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation.  So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation.  And with that, I think we’ve concluded our first podcast.  I hope you all enjoyed it and found it useful.  We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year.  Megan, is there anything you want to say before we sign off?

MEGAN FERRIS

Thanks, Paul. I think you made some great points just to wrap up there.  And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.

PAUL D’ ALESSANDRO

Okay.  Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.

 

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