GILTI Tax on Foreign Business Income Explained
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Is your foreign company (non-US) ready for tax season? GILTI Tax and Transition Tax has and will continue to blindside countless American business owners operating internationally. Not to be confused, Transition Tax and GILTI Tax are two separate components of the new international tax system.
In December 2017, Congress passed The Tax Cuts and Jobs Act (TCJA) that made several significant changes to the individualized income tax on foreign businesses. As implied, this bill seeks to cut out individual, corporate, and estate tax rates. One of the areas impacted was the foreign tax credits. In the past, U.S. residents had been able to defer taxation by holding earnings via a foreign entity. As a majority shareholder, you were only required to pay out taxes upon distributions of funds. With the TCJA came the Transition Tax, a one-time tax imposed by the IRS to transfer to the new GILTI tax. In other words, the IRS wants to tax the profits of foreign companies owned by American people, and this is how they manage it.
Like many parts of tax law, understanding this recent tax can seem overwhelming and complicated. We have answers from Leo, an experienced tax director with Expat U.S. Tax, who provided us with helpful information for Americans who own companies abroad.
What is the Transition Tax?
The Transition Tax, also known as Section 965, requires United States shareholders to pay a mandatory, one-time transition tax on the untaxed foreign profits of certain specified international corporations, as if those earnings had been repatriated to the United States.
What is the GILTI Tax?
GILTI Tax, ‘Global Intangible Taxed Income,’ applies to United States shareholders of controlled foreign corporations, ‘CFCs.’ A US owner of a CFC is required to report and pay U.S. federal taxes on their share of a CFC’s non-previously taxed and undistributed profits each year. Going forward, the shareholder will need to calculate their profits and pay what commonly referred to as GILTI Tax.
Who needs to worry about GILTI Tax?
The vast majority of people disagree with the concept of paying tax on profits they have yet to receive into their possession. The general principle in the tax world, is that you would want to receive the funds first, then pay the tax. In this case, however, funds are still sitting in the company, and you haven’t received those personally yet. Therefore, you don’t have the cash flow to pay the tax on profits quite yet. This creates a tax burden and cash flow issue for people.
What if I’m way behind on my U.S. tax returns?
There is a special IRS program to help you catch up on your U.S. taxes safely, without fines and penalties
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It’s for American citizens that didn’t know they had to file U.S. tax returns each year, and have therefore fallen behind. Some more than 30 years! With the IRS Streamlined Procedure, say goodbye to overdue tax returns, late fees, and penalties. If you have children, we can backdate your Child Tax Credit Refund for 3 years.
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Does this affect shareholders of small business owners?
Small and large companies can be subject to tax where that company is located, which results in a double tax. It can be challenging to pay for when you haven’t received monetary compensation. People often end up restructuring their company to avoid paying the double tax. There are other solutions, though. One answer is to ensure that the United States shareholder does not have a controlling interest in the company as a whole. If a person owned 100% of a company and they were a United States citizen, this would subject them to GILTI. This being said, they might consider options to reduce their shareholding or not owning the controlling interest of that company. If this person reduced their shareholding down to 50%, they would not be subject to GILTI Tax as long as the other shareholder(s) weren’t US citizens or Green Card holders. This shareholder would still have a 5471 reporting requirement to the IRS, since they still own of 50% of a non-US company. However, the GILTI tax would not apply.
Can I give someone partial ownership of my company to avoid the GILTI Tax?
It is possible. Anyone who is a non-U.S. citizen, doesn’t hold a Green Card and does not reside in America, can take half the shares of the company. Assuming they met these criteria, the company would not be defined as a controlled foreign corporation owned by a U.S. person. Of course, you would have to have contracts, agreements, and a great trust with this theoretical person.
A closer look at Section 962
This is an annual election one can make when they file the information return for a corporation. It is an attachment to the 5471 foreign corporation return that is then attached to an individual’s 1040 personal tax return. The election is something a person should determine on a year-by-year basis. One advantage of this option is that it allows you a lowered corporation tax rate of 21%, whereas the personal tax rate is typically 37%. The primary use of Section 962 is to attain the benefit of the lower corporation tax rate. Special deductions are available from the corporate point-of-view that is accessible through this election, and can bring tax on foreign company profits down to 10-13% and additionally become a tax credit. If the foreign company profits and is subjected to tax, the tax paid by the corporation can be deemed as an implausible foreign tax credit for someone who elected this. There can be cases in the home country where the tax rate is higher than 21%, and other instances in which you get full offset of foreign tax credit and you don’t pay taxes on profits at that point in time. The downside is that there is a possibility that a future tax issue could happen. If once that election is selected, and you have a distribution of profits later on in the form of a dividend, those dividends would be subjected to U.S. tax later on that year.
What to do if you have yet to file GILTI
We asked Leo about clients who filed their standard 5471 forms and their knowledge of GILTI Tax. Unfortunately, some people do not know what GILTI Tax is or may assume it does not apply to them for various reasons (they are self-employed or the business they own is small). When put in this situation, many owners believe they can bypass the fees by merely amending their tax returns. Leo informs us that this is ‘just opening a can of worms.’ If the IRS finds out after the fact, more problems and fees will occur. Higher interest rates, penalties, and more severe predicaments could result. Avoid these repercussions by taking care of it in the beginning. There are other ways to lessen your obligations to the IRS, and Expat Tax Online knows all the ins and outs of the system. With our expertise, we can help you catch up on U.S. taxes or enlighten you more about GILTI and Transition Tax.
Calculate tax now and pay later
Timing issues and the question of which tax rate is more beneficial can arise. The answer is to calculate each year to see whether it is tax beneficial to elect Section 962 or not. It will change yearly based on a few aspects:
- How high net profit was
- What foreign taxes were paid
- Corporate tax rates
- Corporate deduction
- Other individualized factors
It is possible to pay the taxes in the form of a salary or bonus. Tax experts advise international business owners to be proactive in determining whether or not they are subject to GILTI rules, and to estimate their tax liability early on and plan accordingly.
There may be other instances where the foreign tax credit isn’t qualified. If a local country does not impose corporate tax on an entity, there would be no foreign tax credit. If one shareholder has a controlled foreign corporation and holds net profit even if one makes the election, they must anticipate a minimum of a tax at least 10-13% for that net profit. However, that person will still have that dilemma of how to get distributions out of that company and what tax will transpire later when that distribution follows. That’s where a solution of changing the U.S. citizen shareholder ownership to no more than 50% can be helpful.
What should someone do if they want an expert’s advice or guidance?
We recommend not only learning as much as possible about your current situation, but also when managing with someone, you should produce a plan for the future. Developing a strategy after paying off your past obligations will ensure that stay current, eliminate all penalties, and help avoid having to file amendments for mistakes. Not all situations are the same; in fact, none of them are. When you work with a professional, you will have multiple options that provide you the ability to determine what suits your specific needs and requirements. At Expat Tax Online, we are ready to assist you with any questions or concerns you may have. Contact us here…
