The Tax Cuts and Jobs Act (TCJA) has had broad-reaching impact on all taxpayers for 2018 and going forward. This includes U.S. persons who are beneficiaries of foreign non-grantor trusts.
As a result of the TCJA suspending the deduction for miscellaneous itemized deductions, which includes the deduction for investment management fees, trust distributable net income (DNI) is likely to be higher in 2018 than it was in prior years. Therefore, to avoid accumulation of income and later imposition of the onerous “throwback” tax rules, foreign trusts will likely have to make larger distributions (before March 6, 2019) to their U.S. beneficiaries to clear out all 2018 DNI. This will result in more taxable income and higher tax liabilities for the U.S. beneficiaries on their personal income tax returns. Finally, if a trust has insufficient cash available to pay those larger distributions (since it used the cash to pay those non-deductible investment management fees), it may have to sell assets to generate cash, which could result in an unexpected increase in DNI for 2019. This cycle could continue until 2026, when miscellaneous itemized deductions may be reinstated or indefinitely if the miscellaneous itemized deductions are not reinstated.
Let’s take a step back and review how we got here.
Every trust is presumed to be a foreign trust unless it meets both the court test and the control test. A trust meets the first test if a court within the U.S. is able to exercise primary supervision over the administration of the trust. A trust meets the control test if one or more U.S. persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions. In other words, if one foreign person has authority to make one substantial decision, the control test is not met, and the trust is a foreign trust.
A foreign trust will be considered a grantor trust if either (i) the trust is revocable and, upon revocation, the assets re-vest in the settlor, or (ii) during the lifetime of the settlor and the settlor’s spouse, the only beneficiaries of the trust are the settlor and/or the settlor’s spouse.
A grantor trust is essentially disregarded for income tax purposes. The grantor or owner of the trust, usually the Settlor or other person making contributions to the trust, will be considered the owner of the trust and that person will continue to be subject to U.S. income tax on the income derived by the trust. A non-grantor trust is a separate taxpayer.
U.S. Income Taxation during a Settlor’s Life
Distributions made from a foreign grantor trust to a U.S. beneficiary during the lifetime of the settlor are typically considered gifts to the beneficiary from the settlor. The U.S. beneficiary has an obligation to file IRS Form 3520 to report receipt of any and all distributions from a foreign trust, even if the amount is just $1. Should the trust make a distribution to the settlor, who then makes a gift to a U.S. beneficiary, the beneficiary must file IRS Form 3520 only when the aggregate value of all such gifts exceeded $100,000 during the year.
While both of these circumstances subject U.S. beneficiaries to reporting obligations, they do not expose beneficiaries to U.S. income tax on the gifts/distributions they receive. On the other hand, when a corporation or partnership owned by a foreign grantor trust or its settlor makes a “gift” to U.S. beneficiaries, the IRS may recharacterize the transfer as a taxable dividend to the U.S. recipient. Furthermore, when gifts came from a foreign corporation or partnership owned by the trust or the settlor in 2018, the reporting threshold for Form 3520 is only $16,076. For this reason, direct transfers from a foreign corporation or partnership to a U.S. beneficiary should be avoided.
U.S. Income Taxation after a Settlor’s Death
A trust that was a grantor trust during the settlor’s life will be considered a foreign non-grantor trust for U.S. income tax purposes upon the settlor’s death. In additional to being reportable on Form 3520, any distributions to a U.S. beneficiary after that point are subject to U.S. income tax to the extent that the foreign non-grantor trust has current or accumulated income.
Distribution of a non-grantor trust’s current DNI to a U.S. beneficiary is taxable to the beneficiary and the character of that income generally flows through from the trust. Therefore, distributions attributable to the trust’s qualified dividend income or long-term capital gain entitles the beneficiaries to a reduced U.S. tax rate of 20 percent plus the 3.6 percent net investment income tax (NIIT). On the other hand, distributable net income that is not distributed in the same year becomes accumulated (undistributed) net income (UNI). Distributions of UNI are subject to a complicated set of “throwback tax” rules which allocate the UNI over the amount of time the trust has been in existence and imposes income tax, plus an interest charge, as if the income had been distributed pro rata over the accumulation period. The tax rate may be as high as 39.6%, plus NIIT and the interest charge may be substantial depending on the length of time that the trust has been in existence.
The trustee of the foreign trust typically provides an annual Foreign Non-Grantor Trust Beneficiary Statement to help beneficiaries understand and apply the appropriate U.S. tax treatment to the distributions they receive from foreign non-grantor trusts.
Impact of TCJA
Trusts are generally treated like individuals for tax purposes. For example, under the TCJA, a foreign trust that files a U.S. income tax return because it has income from a U.S. business, will face a top tax rate of 37 percent, reduced from 39.6 percent, on taxable income in excess of $12,500. At the same time, the TCJA reduces or eliminates many of the deductions to which trusts were previously entitled, including a new $10,000 limit on the deduction for state and local income taxes.
More importantly, the new tax law’s suspension of miscellaneous itemized deductions is likely to have a dramatic impact on the U.S. tax liability of U.S. beneficiaries of foreign trusts. These items, including tax-preparation fees, investment-management fees and unreimbursed business expenses, are no longer deductible for purposes of computing a trust’s DNI for 2018. The good news, however, is that expenses paid in the administration of an estate or a trust and that would not have been incurred if the property were not held in such estate or trust and that were not subject to the 2 percent adjusted gross income (AGI) limitation under prior law and are still fully deductible to the trust. This includes trustee fees and accounting, legal, and tax-return preparation fees to the extent such fees would not have otherwise been incurred by an individual.
In order to avoid the accumulation of income and the application of the throwback tax in future years, many foreign trusts will distribute all their DNI on an annual basis. Since it is difficult to compute a trust’s income for the year prior to the last day of the year, Section 663(b) of the tax code allows a trustee of a foreign trust to annually elect to treat a distribution in one year as though it was made on the last day of the prior year, as long as the distribution is made within the first 65 days of that next year. Thus, a calendar-year trust can make a distribution on or before March 6, 2019, to clear out all of its DNI from 2018 as long as it files its election with the IRS on or before June 15, 2019.
In order to make the 663(b) distribution on or before that 65th day, the trustee may find that they do not have sufficient cash on hand because they used the cash to pay those investment management fees. In that case, they may decide to sell assets which would potentially create additional gain that would be included in DNI for that year and the cycle starts all over again.
If you are a trustee of a foreign trust, you might consider starting the DNI computation process a little earlier this year to make sure that there is sufficient time to generate the cash needed to make the 663(b) distribution. If you are the beneficiary of a foreign trust, you might want to communicate with the trustee to make sure they are aware of these new rules.
The advisors and accountants with Berkowitz Pollack Brant work with settlors, trustees and beneficiaries of foreign trusts to help them understand and comply with U.S. tax and reporting obligations and to compute DNI and UNI.
About the Author: Arthur Dichter, JD, is a director of International Tax Services with Berkowitz Pollack Brant, where he works with multi-national businesses and high-net worth foreign individuals to structure their assets and build wealth in compliance with U.S. and foreign income, estate and gift tax laws. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
Sept. 28, 2018, marked the end of the IRS’s Voluntary Offshore Disclosure Program (OVDP), which provided reticent taxpayers with protection from criminal prosecution and an opportunity to pay reduced penalties when they came forward to report and pay taxes on unreported foreign income and assets. As a result, the IRS has put into place new, more expensive processes and procedures for taxpayers to come clean with the caveat that amnesty from criminal investigations and civil penalties will now be assessed by the IRS on a case-by-case basis.
Background
U.S. tax law requires U.S. citizens, resident aliens, trusts, estates and domestic entities to annually report to the IRS information about any and all foreign bank and financial accounts (FBAR) with an aggregate value of more than $10,000 in which they have an ownership interest.
Taxpayers who unwillingly forget to file an FBAR by the April 15 federal income tax filing deadline have an opportunity to correct the mistake by filing amended or delinquent tax returns or availing themselves of the IRS’s Streamlined Compliance Filing Procedures. Conversely, those taxpayers who willingly fail to file an FBAR will be exposed to criminal prosecutions and significant penalties of up to $100,000 or half of the highest account balance during the unreported year.
Current Options for Voluntary Disclosure
Despite the elimination of the OVDP, taxpayers still have an opportunity to voluntarily disclose those assets that they willingly failed to report avoid criminal prosecution and potentially minimize fraud and FBAR penalties.
Under the IRS’s new framework, taxpayers wishing to make a voluntary disclosure must first submit a timely pre-clearance request to the agency’s criminal investigation unit (CI), which, in turn, will determine if the taxpayer is eligible for the program. If CI grants clearance, taxpayers must submit all required voluntary disclosure documents and a narrative describing the facts and circumstances of their previous noncompliance, including details about assets, entities and related parties involved in the failure to report.
CI examiners will then gather information and build a case to determine the appropriate tax liabilities and applicable penalties, much in the same way that the IRS will audit taxpayers’ prior year returns. It is important for taxpayers to recognize that this new investigation and resolution framework involves many
- The IRS has the discretion to expand the scope of their investigation to taxpayer’s domestic assets and income.
- The disclosure period will now require examinations of the taxpayer’s returns for the most recent six years
- Fraud and FBAR penalties, which are now referred to as civil fraud penalties, will be applied to the one tax year over the six-year disclosure period in which the taxpayer would have incurred the highest tax liability. However, based on the facts and circumstances of each individual case, examiners have the ability to apply these penalties to each of the six years, or more when taxpayers do not cooperate with investigations.
- Taxpayers retain the right to appeal the IRS’s findings after an examination, but they also carry the burden of proof to present convincing evidence to justify an appeal.
While there is little doubt that the new framework for voluntary disclosure will result in higher penalties, taxpayers should discuss this option with their tax advisors in order to avoid criminal prosecution and related penalties.
About the Author: Andrew Leonard, CPA, is a director with Berkowitz Pollack Brant’s International Tax Services practice, where he focuses on pre- and post-immigration tax planning for individuals from South America, Asia and Europe and helps U.S. residents with foreign interests meet their filing disclosure requirements. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
Tax reform’s aim to protect the US tax base and prevent domestic companies from shifting jobs, manufacturing and profits to lower tax jurisdictions overseas resulted in a significant benefit to export businesses. Not only does the new law preserve the preferential tax treatment of Interest Charge-Domestic International Sales Corporation (IC-DISC), it also introduces a new tax incentive for C corporations that sell American-made goods or services to foreign customers for consumption outside of the U.S.
Interest Charge-Domestic International Sales Corporation (IC-DISC)
U.S. businesses that sell, lease or distribute goods made in the US to customers in foreign countries may realize significant tax benefits when they create an IC-DISC to act as their foreign sales agent to which they pay commission as high as 4 percent of gross receipts or 50 percent of taxable income from the sale of export property.
Essentially, a qualifying business forms the IC-DISC as a separate US-based “paper” company, typically with no offices, employees or tangible assets, to receive tax-free commissions that the business can claim as deductions that ultimately reduce its taxable income. The amount of the tax savings the business may reap for the commission it pays to the IC-DISC can be as high as 37 percent, depending on its structure (21 percent for C corporations beginning in 2018) and its source of income. Only when the IC-DISC distributes earnings to shareholders will there be a taxable event. At that time, the shareholders will be liable for paying taxes on the IC-DISC earnings at lower qualified dividend rates not to exceed 23.8 percent.
While businesses that make IC-DISC elections are most commonly exporters and distributors of U.S.-manufactured products or their components, software companies, architects, engineers and other contractors who provide certain limited types of services overseas may also qualify to take advantage of this permanent tax benefit.
Foreign Derived Intangible Income (FDII)
To encourage U.S. corporations to keep their exporting operations and profits in the country, the TCJA introduces a new tax-savings opportunity in the form of a deduction of as much as 37.5 percent on profits earned from Foreign Derived Intangible Income (FDII).
This new concept of FDII is defined as income C corporations earn from (1) sales or other dispositions of property to a foreign person for a foreign use; (2) an IP license granted to foreign person for a foreign use; and (3) services provided to a person located outside of the U.S. The types of services that qualify for FDII are not severely restricted, like they are for IC-DISC applications.
Under the law, FDII earned after Dec. 31, 2017, is subject to an effective tax rate of 13.125 percent until 2025, when the rate is scheduled to increase to 16.046 percent for a total FDII deduction of 21.87 percent. That’s quite an incentive for domestic businesses to use the U.S. as its export hub and distribute products made in the country to foreign parties located outside the country!
It is important to note that like most provisions of the tax code, the FDII deduction is subject to a number of restrictions and calculation challenges. For example, it applies only to domestic C corporations, which under the TCJA are subject to a permanent 21 percent income tax rate beginning in 2018, down from 35 percent before tax reform. In addition, the amount of the deduction is reduced annually by 10 percent of the corporation’s adjusted basis of depreciable tangible assets used to produce FDII.
Planning Opportunities
Corporate taxpayers that combine the benefits of an IC-DISC and the new FDII deduction may receive enhanced tax savings. However, every business entity is unique and not all businesses will qualify to apply the benefits of both export tax incentives. However, with proper planning under the guidance of experienced tax professionals, businesses can maximize the benefits that are available to them.
For example, an S corporation or LLC with an IC-DISC may not realize the added tax savings of the FDII deduction, which is only available to C corporations. While an S corporation may consider changing its entity structure to a C corporation to take advantage of the lower tax rate, it must first consider its unique business goals and weigh them in context against all of the new provisions of the new tax code, which will affect the tax liabilities of both the business and its shareholders.
Companies doing business across borders can successful plan around the new provisions of tax law with the strategic counsel and guidance of knowledgeable advisors and accountants with deep experience in these matters.
About the Author: James W. Spencer, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, where he focuses on a wide range of pre-immigration, IC-DISC, transfer pricing and international tax consulting issues for individuals and businesses. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service
The U.S. Supreme Court’s June 2018 decision in South Dakota v. Wayfair has far-reaching impact on the state and local sales tax (SALT) obligations and previous competitive advantages of online and foreign businesses that sell products into the U.S.
The court’s ruling eliminates the prevailing physical presence test, which requires sellers to collect sales tax from customers who live in states where they own property or employ workers.
Instead, the court, under Wayfair, introduces an economic nexus test based on the sellers’ sales volume into each state. More specifically, U.S. states may now impose sales tax collection obligations on sellers, foreign or domestic, that conduct more than $100,000 in sales or more than 200 transactions in their jurisdictions in a given year regardless of whether the sellers has a physical presence in that locale. This economic nexus standard varies by state.
For example, if a foreign company that sells tangible goods from its headquarters in South America into the U.S. meets the sufficient dollar/transaction threshold in a particular U.S. state, the company would be required to collect sales and/or use tax on all orders received from customers in that state. This would apply even if the company does not have a permanent establishment (PE) in that state. When the company’s sales meet the test for establishing a meaningful and substantial presence in multiple states, it would need to collect and remit sales tax in each of those jurisdictions. With economic nexus laws, states will now be able to enact or enforce sales or transaction threshold and compel more companies outside of their borders to collect tax on sales made to in-state customers.
The Wayfair decision places a significant administrative burden on foreign businesses. International tax treaties generally apply solely to income taxes on the federal level. As a general rule, tax treaties do not apply to U.S. states, and bilateral tax treaties generally do not apply to non-income taxes at the state level. Therefore, foreign companies with U.S. customers may not escape sales and use tax obligations on the state and local levels. Instead, non-U.S. companies have a potential U.S. tax collection and filing responsibility when they meet the sufficient dollar/transaction threshold in a particular state regardless of whether or not they have a permanent establishment (PE) there.
It is important to note that while the U.S. Commerce Clause prohibits states from imposing excessive burdens on interstate commerce without Congressional approval, the Supreme Court has demonstrated its authority to “formulate rules to preserve the free flow of interstate commerce” when Congress fails to enact legislation. In its opinion in Wayfair, the court affirms that the dollar/transaction threshold satisfies South Dakota’s burden to establish economic nexus and impose tax on businesses that are “fairly related to the services provided by the state,” including “the benefits of a trained workforce and the advantages of a civilized society”. This final factor, which demonstrates a fair relationship between the tax imposed and the services provided by a state, can be easily applied to foreign companies that conduct business in U.S. states.
Foreign businesses must consider how the Wayfair decision will affect their sales and profits, and they must take steps to comply with state-level taxation going forward. This may involve assessing the volume of their transactions in each U.S. state, gaining an understanding of and a method for applying the SALT regimes in each U.S. state to their sales orders, and developing communication to let customers know that sales tax will be added onto future purchases.
About the Author: Karen A. Lake, CPA, is state and local tax (SALT) specialist and an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
In an effort to prevent U.S. businesses from shifting profits offshore to low-tax countries, the Tax Cuts and Jobs Act imposes an annual tax on foreign income that exceeds 10 percent of a taxpayer’s return on all foreign depreciable assets, including plants, equipment and real estate. However, under this Global Intangible Low Taxed Income (GILTI) regime, U.S. owners of foreign corporations may exclude from this calculation some items of income, including income that is considered “high-taxed” (i.e., income subject to a local tax rate above 18.9 percent). While this can be a very powerful tool to avoid GILTI, the language used in the current version of the law does not exempt all income subject to high-tax. Rather, the exemption applies only to income subject to high-tax that would have otherwise been picked up on a pre-existing anti-deferral regime known as Subpart F.
As the IRS continues to issue guidance to help taxpayers apply the new law, it is possible that the agency will interpret the language contained in the TCJA to mean that only high-tax income already exempt from Subpart F income should be exempt from GILTI. At this point in time, it appears that this interpretation is very likely to be the correct one. The reason for this exemption is that if the IRS does not allow taxpayers to exempt from GILTI high-taxed income that would have been Subpart F, then the pre-existing exception to Subpart F would be rendered meaningless. This is because taxpayers would simply pick up that same income by the new tax law’s GILTI anti-deferral regime after exempting it under the older Subpart F rules.
Keeping this exception in mind, will more businesses feel GILTI under the new law? Maybe, maybe not.
U.S. C corporation taxpayers receive a credit against GILTI inclusions for foreign taxes they paid at the level of their foreign corporate subsidiaries (albeit a reduced benefit of 80 percent). They also receive a 50 percent deduction on GILTI income that reduces their corporate rate from 21 percent to 10.5 percent. In essence, if a U.S. C corporation has foreign entities that pay taxes locally, in a foreign jurisdiction, at a rate of 13.125 percent (20 percent more than the U.S. rate charged on GILTI of 10.5 percent), then, the foreign tax credits allowed against GILTI should theoretically eliminate the corporation’s U.S. tax liability. However, this is not always the case. For example, if a C corporation has interest expense at the U.S. level, it may allocate and apportion some of that amount in such a way as to reduce the entity’s foreign tax credit, and subsequently leave the entity with some additional U.S. tax liability.
What about U.S. individual taxpayers who may be taxed as high as 37 percent on GILTI income? They neither receive the 10.5 percent tax rate on GILTI inclusions, nor do they benefit from the possibility of getting credit for foreign taxes paid by foreign-owned subsidiaries. However, eligible taxpayers may be able to reduce their GILTI liability by making Section 962 elections to be treated similar to C corporations. When this occurs, a U.S. individual taxpayer may receive a credit for foreign taxes paid at the corporate level to be used against his or her individual GILTI liability.
Yet, the law does not yet make clear whether a Section 962 election would also allow an individual taxpayer to take advantage of all of the tax benefits afforded to C corporations. For example, it is yet to be seen if the IRS will permit an individual to apply the 50 percent deduction against GILTI inclusions that a C corporation may use to reduce its effective tax rate to 10.5 percent, rather than the 21 percent rate that a corporation would otherwise have on GILTI inclusions. Even without this deduction, a 21 percent tax rate would still be better than the maximum 37 percent that could apply to U.S. individuals. Currently, it appears that an individual making a Section 962 election will only be entitled to the 21 percent rate and will not receive the 50 percent deduction afforded to corporate taxpayers.
Are there any other options that a U.S. individual could employ to reduce or eliminate the GILTI inclusion? Since many foreign jurisdictions effectively tax income at a rate greater than 18.9 percent, U.S. individual taxpayers may be able to use the new tax law’s high-tax exception to avoid the GILTI inclusion. However, the language used in the new tax law relevant to the GILTI provision allows this exception only for income that would otherwise have been picked up as Subpart F income.
As an example, consider that a U.S. individual owns a foreign distribution business carried out by two foreign subsidiaries, CFC1 and CFC2. Both subsidiaries are located in different jurisdictions and subject to effective tax rates that are greater than 18.9 percent in their local countries. If CFC1 and CFC2 buy widgets from suppliers and then sell each widget in their local markets, the income on these transactions would not be considered Subpart F, regardless of the high local taxes the subsidiaries paid. Therefore, neither CFC1 nor CFC2 would be eligible for the GILTI exception to include income that would have been treated as Subpart F income, but for the high-tax exception. What if the operations change and, instead, CFC1 and CFC2 can treat their foreign income as Subpart F income (but for the high tax)? Presumably, this type of a change in operation would allow for an exemption from the GILTI inclusion.
No matter what the circumstances, taxpayers with offshore earnings should engage in careful advanced planning under the guidance of experienced international tax advisors to maximize their exemptions from GILTI. Under some circumstances, it may behoove taxpayers to restructure their international operations to avoid or minimize feeling GILTI in the future.
About the Author: Andre Benayoun, JD, is an associate director of International Tax Services with Berkowitz Pollack Brant, where he works with inbound and outbound multinational businesses and nonresident aliens on a variety of matters, including structuring for mergers, acquisitions and liquidations; planning for repatriation of profits; treaty analysis; tax-efficient debt financing; and pre-immigration tax planning. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
