While the Tax Cuts and Jobs Act (TJCA) produced many complicated changes that practitioners are still studying and debating, there’s been scant mention of a change that focused on international tax from a U.S. perspective, which can acutely impact a domestic estate. That issue is the transition tax for certain specified foreign corporations (SFCs). This tax may generate a cash liquidity crunch and warrants consideration of some potential planning concepts.
Transition Tax
Specifically, for SFCs that have accumulated post-1986 deferred foreign income, Internal Revenue Code Section 965(a) imposes a transition tax on a “United States shareholder” (U.S. shareholder), which is a defined term subject to certain reductions, exemptions and taxation rate decisions as well as limitations on foreign tax credits. When the TJCA was enacted, the U.S. shareholder was required to pay the transition tax on April 15, 2018. To limit complications if corporate stock was purchased after TJCA enactment, for purposes of this article, it will be assumed that payment was due April 15, 2018.
However, on April 15, 2018, the U.S. shareholder was permitted an election to defer payment of the transition tax under IRC Section 965(h). A shareholder who made this election would pay the transition tax in eight installments. He would pay 8% for the first five years. In Years 6, 7 and 8, payments of 15%, 20% and 25%, respectively, would be required. If the required payment isn’t timely made, even as a result of the ultimate determination of what the tax should have been on Internal Revenue Service audit and adjustment, the remaining deferred tax payment is immediately due. According to Treasury Regulations Section 1.965-7(b)(3), the immediate payment requirement is labeled a result of a “triggering event.”
While the above may be read as affecting only the international tax or even international estate planner, the reality is that it can profoundly impact the estate plan or administration of a totally domestic client who just owns, directly or pursuant to very complex attribution rules through an estate or trust, stock in a foreign corporation. That’s because Treas. Regs. Section 1.965-7(b)(3) defines death of a shareholder as a triggering event that requires immediate payment of the outstanding deferred transition tax on date of death. As such, if your client fails to pay the remaining transition tax the day a loved one died, interest and penalties will accrue, unless the client can show reasonable cause to get a penalty abatement. As odd a result as this might be, and leaving aside that the decedent’s estate will be entitled to an estate tax deduction for the accelerated transition tax payment, this is the current state of the U.S. tax law.
Important Definitions
To understand the estate-planning implications, we must first understand the definition of the terms “U.S. shareholder” of “an SFC.” A U.S. shareholder isn’t simply a U.S. citizen or noncitizen resident alien who’s a shareholder of a foreign corporation that’s classified as an SFC. Rather, a U.S. shareholder needs to hold a 10% or more shareholding interest. To then be an SFC, the foreign corporation would require U.S. shareholders to have more than 50% shareholdings.
For example, if a foreign corporation has in aggregate 100 U.S. individuals and entities as shareholders (and leaving aside complicated family attribution rules) or five such shareholders holding 10% interests, it wouldn’t be an SFC.
Adding to the complication, the amount subject to the new transition tax can be reduced under Section 965(b) for accumulated losses in other SFCs of which they’re shareholders. Further, there’s a Section 965(c) participation exemption for accumulations related to the SFC’s foreign cash position. To parse through the foreign cash position calculation requires significant information, knowledge and documentation. Generally, the cash position will be the sum of: (1) cash, (2) net accounts receivable (that is, accounts receivable less accounts payable), and (3) the fair market value of marketable securities, commercial paper, foreign currency and any obligation with a term of less than one year and any asset determined to be economically equivalent by the IRS.
It’s basically impossible to ensure proper calculation of the Section 965(a) transition tax and exact follow-through on deferral payments, as well as have the executor, personal administrator or trustee have cash to pay the remaining deferral amount on the date of death of the U.S. shareholder. It’s very unlikely that a sophisticated, domestic estate planner will know about the issue and what to timely do about it.
Proactive Planning
Proactive estate planning for a potential transition tax deferral’s acceleration (while understanding that the exposure decreases each year the U.S. individual is alive) due to the passing of a U.S. individual might involve creating a line of credit at the corporate or shareholder level with the U.S. shareholder’s business’ banking relationship. Another approach is for the U.S. individual to potentially gift shares to a noncitizen, nonresident family member or friend. While this may make use of the lifetime exemption and possibly generate a gift tax, for some, it might be the right answer.
Another approach, assuming insurability, is for the U.S. individual to settle an irrevocable life insurance trust and buy life insurance. Your client may also consider a guaranteed universal life insurance policy in which the cash surrender value is relatively thin compared to other permanent life insurance policies. But, if all requirements are timely met and no loans or distributions are received, the death benefit is guaranteed to a stated age. Alternatively, consider an indexed universal life insurance policy, which combined with premium financing if interest rates cooperate, may limit out-of-pocket premium payments while providing necessary liquidity from a death benefit on an acceleration event.