Transition tax on retained earnings – What entrepreneurs need to know

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transition tax on retained earnings foreign deferred income tax

transition tax on retained earnings foreign deferred income tax

The recent tax reform brings new taxes for entrepreneurs with foreign businesses, including the transition tax on retained foreign earnings. The transition tax starts with the 2017 tax return. Therefore, business owners with retained earnings need to make payments and elections for the transition tax.

Updated June 5, 2017 with latest IRS guidance on due dates

The new tax law takes away tax deferral on foreign earnings

Business owners with a non-US corporation could up to now defer US taxes on net income by leaving the money in the foreign business. The new tax law takes away this tax deferment on retained earnings.

Now every business must pay US income tax on the accumulated retained earnings, all the way back to 1987. Section 965 of the tax code requires “United States shareholders … to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States”.

What that means is that shareholders who own at least 10% of certain foreign companies must include their portion of the undistributed previously tax-deferred earnings in their personal income for the subsidiary’s last tax year.

Special lower transition tax rate on retained earnings

The accumulated retained earnings are taxed as if they were repatriated, albeit at a lower rate. Instead of the new standard corporate tax rate of 21%, or the individual income tax rates that go up to 37%, a lower transition tax rate applies to those retained foreign earnings.

After applicable deductions, the shareholder’s effective tax rate is 15.5% on his portion of the foreign cash position and 8% on non-liquid holdings such as real estate.

This is the tax holiday that many businesses and expat entrepreneurs have been waiting for in order to bring money back onshore.

Of course, if the money is distributed to the shareholders of US corporations, they then also have to pay tax on those dividends.

Transition tax payment schedule

To soften the immediate impact on the taxpayer, the new law allows for a payment schedule. (Section 965(h)) You can elect to pay the transition tax on retained earnings over a period of eight years.

The payment schedule is as follows:

  • 8% of the net tax liability for each of the first five installments,
  • 15% of the net tax liability for the sixth installment,
  • 20% of the net tax liability for the seventh installment, and
  • 25% of the net tax liability for the eighth installment.

Due date for electing the payment schedule – Updated

You must make the election to use the payment schedule by the due date, including extension, of your tax return. For expats, the tax due date is June 15 for the election and first installment. Otherwise the full amount is due with this year’s return. However, the IRS just announced on June 4 a filing relief. If you have already filed your return you can file an amendment wit the election by October 15, 2018.

You make the election by attaching a statement to your 2017 tax return. The statement must be signed under penalties of perjury.

Due dates for paying the transition tax – Updated

If you make this election, you must pay the first installment by the original due date of the tax return, without extension. For individuals this is April 17, 2018. Each succeeding installment is due on the April 15 tax deadline for each filing year. However, the IRS issued recent guidance to clarify dates for expats and to offer penalty and filing relief for the first year.

Guidance from the IRS issued April 2 indicates that expats with an automatic extension to June 15 for their tax return also  get June 15 as due date  for the first installment. On June 4 the IRS announced that it will waive late-payment penalties in certain cases.  It applies to people with less than $1 million in tax liability that make the election prior to the due dates or file an amended return with the election prior to October 15. This gives affected taxpayers more time.

The IRS requests that you make two separate payments: One transition tax payment for Section 965 tax, and one for your regular tax liabilities.

Next steps for business owners with foreign earnings

We still advise to make the payment by June 15 to avoid interest penalties. As you can see, the IRS is still defining the details of the tax law implementation, less than two weeks before the June 15 deadline for expats. Make sure that your tax accountant is familiar with these new requirements and latest guidance for businesses.

Going forward, you may also want to reevaluate your business structure, see if it still is the best structure for you in light of the new tax law.

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