Private equity investors need to think carefully before opting into a generous tax deduction on some foreign income, or risk paying more U.S. taxes in the long run.
The tax overhaul created a 50 percent deduction for a new income category, called global intangible low-taxed income (GILTI), but the statute only made it available to corporations. In Internal Revenue Service proposed rules (REG-104464-18) released March 4, the Treasury Department extended the deduction to individuals, by allowing them to elect to be taxed as corporations.
But the attractive deduction could leave private equity shareholders with substantial compliance hurdles and a second layer of tax down the road, practitioners say. Taxpayers, including some individuals and small businesses, should model the results carefully before making the election, according to practitioners, since there are instances where election isn’t favorable.
“One shareholder could say this election is their savior while another says the corporate tax treatment will result in a significant double tax. Those could be equally true, it just depends on how the numbers work out,” said Robert Russell, an attorney at Alliantgroup LP who formerly worked at the IRS and Treasury.
“The question is whether you’re going to pay more tax in the long run,” Russell said.
The rules are scheduled to be published officially in the Federal Register on March 6, and comments are due to the IRS by May 6.
By singling out the deemed distributions earned by U.S. shareholders from foreign corporations, now known as GILTI, lawmakers hoped to stop companies from shifting profits offshore and ensure that they pay something on overseas profits earned in low-tax jurisdictions.
Individuals who are now eligible for the election can be divided into two groups: those that have direct investments in controlled foreign corporations and those that have an indirect investment through a partnership, said Cory Perry, an international tax senior manager in Grant Thornton’s Washington National Tax Office.
The deduction, in tax code Section 250, effectively cuts the tax rate on corporations’ GILTI to 10.5 percent before tax credits can reduce it further. Individuals taxable at up to 37 percent may seek to lower their tax bills by opting into the corporate rate and applying foreign tax credits.
“This prevents the need for costly restructuring, such as inserting a domestic holding company. Many taxpayers were considering such an alternative as a back-up plan,” Perry said.
“But what is a better answer today is not always a better answer down the road,” Perry said.
The corporate tax treatment election does result in double taxation of the individual just as though the person invested through a corporation—but that is a consequence of the mechanics of the election, said John Harrington a partner at Dentons in Washington and chair of the Bloomberg Tax International Advisory Board.
Future Tax Trap?
Individuals generating income overseas are generally subject to a single layer of tax when dividends are distributed or deemed distributed. But under the election, individuals would be subject to tax in the year earnings are deemed distributed and again when dividends are actually distributed, which could undo the benefits of the election.
“If I was an investor of a publicly traded partnership who has been allocated GILTI income, I can see how it would certainly be fun to pay corporate rates, reduced by the Section 250 deduction,” said Glenn Dance, a Washington-based managing director at Grant Thornton and former IRS official.
The election could result in inadvertent adjustments to the basis of an individual or corporate partner’s interest in a partnership, which ultimately increases their taxable gains.
For example, if an individual opting into corporate tax treatment is allocated $100 of GILTI from a partnership, and they get a deduction of $50, the basis of their interest is only increased by the remaining $50, Dance said. Furthermore, if and when the cash is distributed by the controlled foreign corporation, it would represent a dividend of $100 and generate a second layer of tax to the partners.
“This means that the benefit of the Section 250 deduction is only a timing difference, not a permanent benefit, which may frustrate legislative intent,” Dance said.
To mitigate the unexpected increases to future tax bills, practitioners say individuals and corporate partners electing into the deduction need to keep track of the distributed amounts that are subject to tax.
“The compliance burden becomes significantly more burdensome,” Russell said.
Individuals opting into corporate tax treatment need to file a statement with their tax returns for the taxable year in which they wish to make the election, which could be an onerous process of filing for small businesses and individuals.
“It’s another calculation, and you have to have those calculations ready for whenever you decide to make the deemed dividend,” Russell said.
On Jan. 30, a lawsuit was filed against the IRS and Treasury that challenged the applicability of the new international tax rules—like GILTI and the one-time transition tax—to small businesses that qualify as controlled foreign corporations.
Allowing individuals to opt into the deduction “handles 10 percent of the relief we seek in the lawsuit,” Monte Silver, the tax lawyer based in Israel who filed the suit, told Bloomberg Tax in a March 5 email. Small businesses are suffering under the regime, since it was aimed at multinationals, he said.
“It would be better if we could get the same benefits as corporations without the election because there are a variety of tax implications when investors receive dividends,” he said.