Is the Transition Tax income, that is supposed to be distributed tax free, trapped for individuals with CFCs that elect Sec. 962 (corporate tax) treatment on their GILTI inclusions for 2018 and subsequent years?

Many individual US taxpayers that own foreign corporations known as Controlled Foreign Corporations (CFCs) had a shock when the new tax law required them to pick up their share of the retained earnings of these CFCs in 2017.  The shock was somewhat lessened by three factors:

1. The Transition Tax income was taxed at low rates (9% and 17.5%).
2. The tax could be paid over an 8-year period.
3. Future distributions of this income could be distributed without any further US tax.

There was also a new tax provision - Global Intangible Low-Taxed Income or GILTI - that for 2018 and subsequent years requires the current year inclusion of income from their CFCs for income supposedly earned from intangible assets.  Both provisions involved deemed income where the individual did not necessarily receive any actual cash with which to pay the taxes. 

To lessen the tax, many of these individuals may take advantage of the Sec. 962 election that was enacted back in 1962. This would lessen the blow by allowing the individuals to tax the deemed inclusion amounts at the lower corporate tax rates and claim certain taxes paid by the CFCs as a credit against the taxes, which is a Sec. 960 credit.  However, when these particular amounts are subsequently distributed, they are taxable (except for the tax paid at the time of the election), unlike the Transition Tax income mentioned above.

The IRS has been busy issuing guidance on all the new tax law provisions but has not yet issued specific rules related to the distribution ordering rules when there is a Sec. 962 election involved.  It is possible that distributions in 2018 and subsequent years will first come out of the Sec. 962 income pools rather than the Transition Tax income pools (which would be tax free).  This may come as a surprise to many taxpayers who were counting on tax-free distributions to help lessen the tax blow from 2017.  Proposed regulations where a Sec. 962 election is not made allow for the Transition Tax income pools to come out first, which is encouraging, but not a guarantee that final regulations will allow this when a Sec. 962 election has been made for the GILTI income.

Depending upon the guidance that will be issued, there might be planning to consider trying to keep these Transition Tax income amounts from being totally blocked as distributions are made in 2019 and future years.  This again highlights the unforeseen consequences of this new tax act, and that the facts of each taxpayer’s situation must be analyzed carefully and without preconceived fixes.

Do you have concerns about the Transition Tax impacts you? Contact us today for help. Thank you.

Matthew Hitchcock, CPA contributed to this blog post.