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Taxation of U.S. Shareholders of Foreign Corporations After Tax Reform

Posted on June 10, 2019
Paul S. Lee
Paul S. Lee
Ellen K. Harrison
Ellen K. Harrison

Ellen K. Harrison is a partner at McDermott Will & Emery, and Paul S. Lee is the global fiduciary strategist of the Northern Trust Company.

The authors would like to thank Carlyn S. McCaffrey, Kevin M. Hall, Steve Hadjilogiou, and Daniel Bell of McDermott for multiple helpful edits.

In this first installment of a two-part article, the authors examine changes made by the Tax Cuts and Jobs Act that estate planners should consider if they represent U.S. taxpayers who have foreign investments, nonresident aliens who have U.S. investments, or estate plans that involve the transfer of assets owned by an NRA or a foreign trust to U.S. beneficiaries. The second installment will discuss planning strategies to mitigate some of the adverse tax consequences of the TCJA.

Copyright 2019 Ellen K. Harrison and Paul S. Lee. All rights reserved.

A major issue in representing foreign persons and U.S. persons with foreign investments is the treatment of investments in foreign corporations that are classified either as controlled foreign corporations or passive foreign investment companies. The tax rules that apply to CFCs and PFICs were designed to prevent the tax law from making investments in foreign corporations more attractive than investments in comparable domestic corporations. However, the rules go beyond leveling the playing field and can produce punishing tax treatment.

For example, to prevent the deferral of U.S. tax through ownership of a CFC or a PFIC, the rules sometimes tax U.S. owners on undistributed income of foreign corporations and treat as taxable some dispositions of shares of foreign corporations that would otherwise be nontaxable transfers (such as gifts or trust distributions to beneficiaries). The undistributed income is a deemed dividend that is not a qualified dividend and is therefore taxable at a higher rate than would apply to a dividend from a U.S. corporation. Moreover, rules that attribute ownership of stock in a CFC or PFIC owned by a trust to its beneficiaries (including stock deemed to be owned indirectly by a trust through an entity owned by the trust) may expose U.S. persons to tax on income that they have not received, have no right to receive, and may never receive, with respect to stock that they are unable to sell. As this report explains, the Tax Cuts and Jobs Act1 expanded those rules.

I. The Corporate Anti-Deferral Tax Regimes

A. The CFC Regime

1. What Is a CFC?

A CFC is a foreign corporation that meets an ownership test: More than 50 percent of the stock must be owned by U.S. Shareholders.2 A person is not a U.S. Shareholder unless such person owns at least 10 percent of the stock by vote or value.3 Both ownership thresholds must be met for the corporation to be a CFC. For example, if 11 unrelated U.S. persons own shares of a foreign corporation equally, the corporation is not a CFC because none of the U.S. owners own 10 percent of the stock. Both ownership thresholds are tested after taking into consideration not only direct ownership, but also indirect and constructive ownership. For example, if I own 9 percent of the stock of a foreign corporation and my daughter owns 1 percent, both of us meet the 10 percent threshold, although each of us is treated as owning and taxed on only the income allocable to the shares we own directly or indirectly and not constructively.4

2. How U.S. Shareholders of CFCs Are Taxed

The CFC tax rules are designed to avoid the deferral of subpart F income (which includes passive income and some other types of income) accruing to U.S. Shareholders through the ownership of foreign corporations.5 That goal is achieved by requiring that subpart F income be taxed as if it were distributed by the CFC to the U.S. Shareholder in the year the income was earned by the foreign corporation,6 and by requiring gains on the sale of shares of a CFC to be characterized as dividend income to the extent that the corporation had earnings and profits attributable to the years the U.S. Shareholder owned the shares.7

If a foreign corporation is a CFC at any time during a tax year, every U.S. Shareholder who directly or indirectly owns stock in the corporation on the last day in the tax year in which it is a CFC must include in gross income (regardless of whether the CFC makes a distribution) for the tax year in which or with which that tax year of the corporation ends their pro rata share of the corporation’s subpart F income for the year. Subpart F income and global intangible low-taxed income (which, as discussed later, is taxed as subpart F income) are effectively taxed as dividend income that does not qualify for the preferential rate on qualified dividends. A U.S. Shareholder will have subpart F income only if the corporation has E&P in the relevant tax years, computed using U.S. principles. The pro rata share is the amount that would have been distributed with respect to the stock that the U.S. Shareholder owns directly or indirectly in the corporation if, on the last day of the tax year in which the corporation is a CFC, the corporation had distributed pro rata to its shareholders an amount that (1) bears the same ratio to its subpart F income for the tax year as (2) the part of the year during which the corporation is a CFC bears to the entire year, reduced by specified dividend distributions received by any other person during that year with respect to the stock.8

U.S. Shareholders include persons who own shares indirectly through one or more foreign entities. For a foreign estate or trust, beneficiaries are deemed to own shares in proportion to their beneficial interests.9 The proportional interests of beneficiaries is determined based on all the facts and circumstances and taking into account the purposes for which the attribution of ownership rules are being applied. For example, if the rules are being applied to determine who is taxable on the subpart F income, generally the indirect owners will be the persons who are entitled to receive income.10 However, it is not clear how proportional interests of beneficiaries are determined for a discretionary trust.11

U.S. Shareholders may exclude from income amounts distributed to them from a CFC that are attributable to amounts previously taxed to them under section 951.12 U.S. Shareholders may increase their basis in the CFC by the amounts previously taxed to them, and they must reduce their basis as previously taxed income is distributed.13 The U.S. Shareholder’s successors in interest can enjoy the same benefits.14 The basis adjustment reduces gain on a sale of shares of a CFC that occurs before the previously taxed amounts are distributed. This is done to avoid double inclusion. However, when CFC shares are indirectly owned by a beneficiary of a trust, the basis adjustment rules do not function properly because the basis adjustment that is allowed is an adjustment to the beneficiary’s basis in the trust, not an adjustment in the shares of the CFC.15 A basis adjustment to a trust interest does not enter into the calculation of a beneficiary’s income from a trust.

3. Changes Made by the TCJA

The TCJA made four important changes to the CFC regime: (1) it modified the definition of U.S. Shareholder; (2) it changed the rules for attribution from some foreign persons; (3) it eliminated the requirement that a corporation be a CFC for a minimum of 30 days before subpart F income can be taxable to U.S. Shareholders; and (4) it created a new category of income taxable as subpart F income — GILTI (discussed in Part 2 of this article).16

a. Definition of U.S. Shareholder. Before the TCJA, the definition of U.S. Shareholder was based solely on the ownership of 10 percent of the voting stock. A U.S. Shareholder is now any U.S. person who directly, indirectly, or constructively owns 10 percent of the voting stock or stock whose value is at least 10 percent of the value of all stock of the corporation.

b. Attribution from foreign persons. The TCJA also changed constructive ownership attribution rules for determining whether the ownership threshold is met for a person to be a U.S. Shareholder.

Section 958(b) provides that the constructive ownership rules of section 318(a) apply to the extent that the effect of the application is, inter alia, to treat a U.S. person as a U.S. Shareholder and to treat a corporation as a CFC, with some modifications. One important modification is that stock owned by a nonresident alien (other than a trust or estate) is not considered owned by a citizen or resident individual in applying the family attribution rules.17 For example, if two spouses each own 50 percent of a foreign corporation and one spouse is an NRA and one is a U.S. citizen, the corporation is not a CFC because shares owned by the NRA spouse cannot be attributed to the U.S. citizen spouse. This rule is not changed.

Before the TCJA, shares owned by a foreign partner, beneficiary, owner, or shareholder were not attributed to a U.S. partnership, trust, estate, or corporation. The TCJA repealed that exception. For example, suppose that a foreign parent corporation owns 95 percent of a foreign subsidiary and 100 percent of a domestic subsidiary. The domestic subsidiary owns the other 5 percent of the foreign subsidiary. As a result of the repeal of section 958(b)(4) by the TCJA, the shares owned by the foreign parent are attributed to the domestic subsidiary, which causes the foreign subsidiary to be a CFC and the domestic subsidiary to be a U.S. Shareholder. This means that the U.S. subsidiary is taxable on 5 percent of the subpart F income of the foreign subsidiary (related to the direct ownership by the U.S. subsidiary). If the U.S. subsidiary did not directly own stock in the foreign subsidiary, the foreign subsidiary would still be considered a CFC, but in that case no subpart F income would be taxable to the U.S. subsidiary because it would not own, directly or indirectly (only constructively), shares of the foreign subsidiary.

In the above example, if the foreign parent owned less than 50 percent of the stock of the domestic corporation, the foreign subsidiary would not be a CFC because none of the foreign parent’s shares would be treated as constructively owned by the U.S. corporation. Attribution to a corporation (the domestic subsidiary in the above example) requires that the parent own at least 50 percent of the stock of the domestic corporation.18 For trusts, attribution requires that either (1) the value of the beneficiary’s interest, assuming the maximum exercise of discretion in her favor, has an actuarial value of at least 5 percent of the value of the trust; or (2) the beneficiary is the owner of the trust under the grantor trust rules.19 There is no similar de minimis ownership rule for attribution to partnerships and estates.20

Regulations under section 965 limit attribution for purposes of the transition tax (discussed later) to attribute ownership from a foreign partner, beneficiary, or owner to a U.S. partnership or trust only if the foreign partner, beneficiary, or owner owns at least 10 percent of the U.S. entity (the de minimis rule).21 However, the de minimis rule does not apply for other purposes.

Proposed regulations issued May 2022 provide that there no longer will be downward attribution from shareholders, partners, beneficiaries, and owners to corporations, partnerships, trusts, or estates regardless of the level of ownership of such shareholder, partner, beneficiary, or owner. Thus, a lower tier entity would not be treated as constructively owning shares of a CFC owned by its shareholder, partner, beneficiary, or owner. The preamble makes it clear that a corporation is not treated as constructively owning shares of a CFC that are owned by a 51 percent shareholder.

c. The 30-day rule. Before the TCJA, U.S. Shareholders were not subject to tax on the undistributed income of a CFC unless the corporation qualified as a CFC for an uninterrupted period of 30 days or more during the year.

The TCJA eliminated the 30-day requirement. Therefore, if a U.S. person inherits shares of a foreign corporation from an NRA decedent and the ownership thresholds are met, the U.S. Shareholder will be taxed on her pro rata share of the corporation’s subpart F income. For example, if a U.S. person acquires 100 percent of the shares of a foreign corporation from a decedent, the corporation would be a CFC, and a fraction of its subpart F income earned in that year would be taxable to the U.S. person. If the U.S. person retained the stock until the end of the year, the numerator of the fraction would be the number of days in the year that the U.S. person owned the stock, and the denominator would be the number of days in the corporation’s tax year.

Before the TCJA, a U.S. person that inherited shares from a foreign person could make a check-the-box election retroactive to within 29 days of the death of the foreign person and avoid tax under the CFC rules. If the election was a deemed liquidation, this allowed a tax-free basis adjustment for the assets owned by the CFC.23 As a result of the TCJA, a U.S. Shareholder of a CFC will be taxed if she owns shares at any time during the year on a portion of the CFC’s subpart F income. Subpart F income would include any gain realized on a deemed liquidation, thus eliminating the tax-free basis step-up for the CFC’s assets. Tax can be avoided only if the check-the-box election is effective before death. In this case, the corporation would never become a CFC. However, a check-the-box election with a pre-death effective date also would eliminate the estate tax shield of holding assets through a foreign corporation.

Not all foreign corporations qualify for a check-the-box election.24 If a check-the-box election is made, the entity becomes either disregarded (if there is only one shareholder) or a partnership (if there is more than one shareholder). If the classification of the entity was relevant for U.S. tax purposes before the election was made, the election by the corporation to be a disregarded entity or a partnership is a deemed liquidation.25 The check-the-box election may have an effective date of up to 75 days before the election is filed.26 Thus, the check-the-box election gives the U.S. person that inherits the shares more time to accomplish a timely liquidation.

Because a U.S. person is deemed to indirectly own shares owned by a foreign estate or trust in proportion to her beneficial interest in the estate or trust, the change of ownership may occur on the date of death, even if the U.S. person does not acquire direct ownership. For example, if the shares are held in a foreign grantor trust, the foreign grantor will be deemed the owner of the shares during her lifetime.27 Upon her death, the beneficiaries will be deemed to own the shares held by a foreign non-grantor trust in proportion to their beneficial interests.28

Check-the-box planning is still important after the TCJA because it allows a U.S. Shareholder more control over the timing of the deemed liquidation and therefore the amount of subpart F income on which she will be taxable. As mentioned earlier, the pro rata share of subpart F income of a CFC that is taxable to the U.S. Shareholder is based on the number of days in the tax year that the U.S. person was a U.S. Shareholder of the CFC. For example, if the U.S. Shareholder acquired the shares on June 1 and the deemed liquidation as a result of the check-the-box election occurred on June 2, the pro rata share of subpart F income taxable to the U.S. Shareholder would be 1/181 because there would be only 181 days in the final tax year of the CFC — January 1 to June 2.29 If the U.S. Shareholder acquired the shares on January 1 and the deemed liquidation occurred on January 2, half of the subpart F income would be taxable to the U.S. person. If the NRA died in December and the corporation is on a calendar year, a retroactive check-the-box election effective after death but in the prior year would produce a very small fraction. The amount of subpart F income that will be taxable to a U.S. Shareholder is reduced when the numerator of the fraction is as small as possible and the denominator is as large as possible. As the previous examples illustrate, this is easier to accomplish if the shares are inherited later in the tax year. Minimizing the numerator is made simpler if the foreign corporation is eligible to make a check-the-box election.

Owning U.S. situs assets through a foreign corporation may avoid U.S. estate tax because stock of a foreign corporation is foreign situs for U.S. estate tax purposes.30 However, an NRA investor does not need to invest through a foreign corporation to shield non-U.S. securities from U.S. estate tax. Therefore, those non-U.S. investments should either not be made through a foreign corporation or be made through a different foreign corporation than the one that invests in U.S. securities. It is also important to use a foreign corporation that is eligible for a check-the-box election.31 This permits the check-the-box election for the corporation that is not needed for an estate tax shield to be made effective before the death of the NRA owner.

U.S. real estate should be owned in a separate structure because the deemed liquidation of the foreign corporation would be taxable.32

B. The PFIC Regime

1. What Is a PFIC?

A PFIC is a foreign corporation that has mostly passive income or passive-income-producing assets. Unlike the CFC rules, the PFIC rules apply without regard to any threshold ownership by U.S. persons. A foreign corporation is a PFIC if 75 percent or more of its gross income is passive or the average percentage of assets it holds that produce passive income is at least 50 percent.33 The 50 percent test is based on value for publicly traded securities, or on adjusted basis if the shares are not publicly traded and the corporation either is a CFC or elects to value assets at their adjusted basis.34 Subject to limited exceptions,35 passive income is foreign personal holding company income as defined in section 954(c) (a category of income included in the definition of foreign base company income, which is considered subpart F income). Foreign personal holding company income includes dividends, interest, royalties not derived from an active trade or business, rents not derived in the conduct of an active trade or business, annuities, gains from property transactions (excluding business property or inventory), commodities transactions, foreign currency gains, and income equivalent to interest. A typical PFIC would be a foreign mutual fund or other pooled investment vehicle that is structured as a corporation or treated under U.S. entity classification rules as an association taxable as a corporation.36

a. Insurance company exception. Insurance companies, by their nature, hold significant liquid investments that produce passive income. If these assets and income were classified as passive for purposes of the PFIC rules, most foreign insurance companies would be PFICs. Recognizing the importance of passive investments to an active insurance business, Congress provided an exception from passive income for income derived in the active conduct of an insurance business (the active insurance exception). The TCJA amended the active insurance exception to PFIC classification.

For tax years beginning after December 31, 2017, only income derived by a qualifying insurance corporation in the active conduct of an insurance business is eligible for the exception.37 A foreign corporation is a qualifying insurance corporation during a tax year if (1) it would be subject to tax under subchapter L if it were a domestic insurance corporation and (2) its applicable insurance liabilities constitute more than 25 percent of its total assets. The term “applicable insurance liabilities” is narrowly defined: Loss and loss adjustment expenses of a life or property and casualty insurance business are counted. But only limited reserves are considered in determining applicable insurance liabilities — deficiency, contingency, and unearned premium reserves are specifically excluded. And the amount of the applicable insurance liabilities is limited to the lesser of (1) the amounts reported to the applicable insurance regulator on the insurance company’s financial statements and (2) amounts determined under regulations, if promulgated.

U.S. owners of foreign insurance companies failing the 25 percent applicable insurance liabilities test are granted a limited, partially subjective, alternative active insurance exception test. Under this alternative test, a U.S. person may treat a foreign corporation as a qualifying foreign corporation if: (1) its applicable insurance liabilities constitute at least 10 percent of its total assets; (2) it is, under regulations promulgated by the IRS, predominately engaged in an insurance business; and (3) its failure to satisfy the 25 percent applicable insurance liabilities test is “due solely to runoff-related or rating-related circumstances involving such insurance business.” It is unclear whether the alternative test is self-executing or instead requires the issuance of regulations.

Foreign insurance companies facing PFIC classification because of the narrowed active insurance exception have options. Those on the border should reevaluate operations to satisfy the new requirements. Those that will not qualify should consider domesticating or filing section 953(d) elections to be taxed as domestic corporations, which would extricate their U.S. owners from the PFIC rules. Alternatively, insurance companies may choose to remain offshore but provide their U.S. owners with notice of PFIC status and comply with the requirements to permit those owners to treat the insurance company as a qualified electing fund (QEF), thereby avoiding the harsh PFIC anti-deferral regime, described later. In all cases, foreign insurance companies with U.S. owners should analyze the new active foreign insurance exception and evaluate the potential impact on their U.S. owners.

b. Look-through rule. In determining whether a foreign corporation is passive, a look-through rule applies if the corporation owns 25 percent or more of the stock of another corporation.38 For example, if FC1 owns 25 percent of the stock of FC2, which is engaged in an active trade or business, 25 percent of FC2’s income and 25 percent of its assets are attributed to FC1 in determining whether FC1 is a PFIC.

c. Exception for some U.S. Shareholders of a CFC. A corporation will not be a PFIC for any year after December 31, 1997, for a shareholder if that shareholder qualifies as a U.S. Shareholder and the foreign corporation is a CFC during that year.39 Because that U.S. Shareholder is currently taxable on her share of the CFC’s subpart F income, it is unnecessary to subject her to the PFIC regime. However, if the corporation was previously a PFIC for that shareholder, the corporation remains a PFIC. For example, if a shareholder held PFIC shares in year 1 and in year 2 the entity became a CFC, the PFIC taint from year 1 would carry forward, but the PFIC rules for year 2 would be inapplicable.

d. ‘Once a PFIC, always a PFIC’ rule. If a foreign corporation is a PFIC in any year in the shareholder’s holding period, then in any subsequent year it remains subject to the PFIC regime of taxation even if it would not otherwise qualify as a PFIC.40 This is referred to as the “once a PFIC, always a PFIC” rule. An exception applies to corporations during the start-up year (defined as the first year in which the corporation has gross income) if it is not a PFIC in the following two years and no predecessor of that corporation was a PFIC. A second exception applies to a corporation that would otherwise first become a PFIC because of the sale of a business and the temporary reinvestment of proceeds in passive income producing assets, if the corporation does not meet the definition of a PFIC in the following two years.

There are two additional exceptions to the “once a PFIC, always a PFIC” rule. Under the first exception, the rule does not apply to a U.S. shareholder that makes a timely and valid QEF election (as discussed later) for the first tax year in which the shareholder holds the PFIC shares.41 The second exception provides that the rule does not apply for any year after the year in which a valid mark-to-market election (also discussed later) is in effect for the PFIC shares held by the shareholder.42

2. How Shareholders of a PFIC Are Taxed

a. Distributions. Unlike the normal rules of U.S. taxation of corporations and shareholders, a PFIC’s E&P are generally not relevant to the taxation of a PFIC distribution. Rather, the taxation of a PFIC distribution depends on its size compared with distributions in prior years. Distributions fall into two categories: excess and non-excess.

An excess distribution is a distribution to a shareholder that is more than 125 percent of the average distributions made to the shareholder who owns the shares directly or indirectly for the prior three years (or the years in the shareholder’s holding period if less than three years).43 A distribution that is made in the first year of the shareholder’s holding period is not an excess distribution.44 In calculating 125 percent of average distributions for the prior years, only prior year non-excess distributions are counted. A non-excess distribution is the part of a distribution that is not an excess distribution. A non-excess distribution is taxed to the shareholder based on the general rules of U.S. corporate income taxation, which will generally result in dividend treatment.45 However, the non-excess distribution will not be a qualified dividend taxable at the capital gains tax rate because a PFIC by definition is not a qualified foreign corporation.46

Because shares owned by a foreign shareholder are not PFIC shares,47 a U.S. Shareholder who inherits stock from a foreign person is not treated as receiving an excess distribution in the first year of her ownership. The distributions in the first year will count in calculating whether future distributions are excess distributions. The holding period begins on the date the shares are inherited from a foreign person.

Excess distributions are subject to a special tax regime. The taxpayer must first allocate the distribution pro rata to each day in the shareholder’s holding period for the shares.48 Whether the PFIC had E&P in those years is irrelevant. The portion of the excess distribution that is allocated to the current year and the pre-PFIC years is included in the taxpayer’s income for the year of receipt as ordinary income.49 A pre-PFIC year is a tax year beginning before December 31, 1986, or a year in which the shares were owned by an NRA.50 The portion of the excess distribution allocated to other years in the taxpayer’s holding period (the prior PFIC years51) is not included in the shareholder’s income. Rather, it is subject to a deferred tax, which is added to the tax that is otherwise due.52 In calculating the deferred tax, the taxpayer multiplies the distribution allocated to each prior PFIC year by the highest marginal tax rate for the prior PFIC year.53 The aggregate amount of the tax for each year is treated as unpaid tax.54 The taxpayer must then compute interest on those “unpaid” taxes as if the shareholder had not paid the tax for each prior PFIC year when due, using the applicable federal underpayment rate.55 The taxpayer includes the deferred tax and interest as separate line items on her individual income tax return.56

For example, if A acquired PFIC shares in 1990 but was an NRA from 1990 to 2000 and a U.S. taxpayer from 2001 through 2010, an excess distribution received in 2010 would be allocated to all years in A’s holding period, but the amount allocated to 1990-2000, which are pre-PFIC years, would be included in current-year income as ordinary income. Amounts allocated to 2001-2009, which are prior PFIC years, would be subject to the deferred tax and interest charge described earlier. If A were a trust and not an individual, only the amount allocated to the current year would be included in the calculation of distributable net income, because distributable net income is based on the trust’s taxable income with some adjustments.57

The deferred tax and interest calculation is similar to the default method for computing tax on an accumulated distribution from a foreign trust under subchapter J.58 However, the tax and interest on an excess distribution can exceed the amount the taxpayer receives. There is no cap similar to the one in section 668(b) for the throwback tax.

If the PFIC shares in the above example were owned by a foreign trust and the default method for determining accumulation distributions had not been elected, a distribution to a beneficiary of the amount the trust received from the PFIC, assuming it is allocated to fiduciary income, would not be an accumulation distribution because a distribution of an amount that does not exceed fiduciary net income is not an accumulation distribution.59 No interest charge would be imposed unless a U.S. beneficiary of Trust A was deemed to indirectly own the PFIC shares. This is why the IRS is intent on attributing ownership to beneficiaries. In our view, this is not the right approach. The better solution would be to amend the rules of subchapter J to preserve the interest charge, such as by treating distributions from the PFIC as creating undistributed income for the trust in the years the income was deemed to have been accumulated in the PFIC. In the above example, the excess distribution allocated to prior PFIC years (2001-2009) would be treated as undistributed net income of the foreign trust for each year. The undistributed net income would be subject to the accumulation distributions rules of subchapter J, including an interest charge, when distributed to a U.S. beneficiary.

b. Dispositions. Gains realized on the disposition of PFIC shares are taxed in the same manner as excess distributions.60 This means that gains are taxable as ordinary income to the extent allocable to the current year and pre-PFIC years and are subject to the deferred tax regime to the extent allocable to prior PFIC years. The first-year exception in section 1291(b) does not apply to gains (which are not “excess distributions” but only taxed as excess distributions under section 1291(a)(2)), but if a disposition occurs in the first year in the taxpayer’s holding period, all the gain should be allocated to the current year. Unfortunately, it appears that any losses on a disposition would be capital losses. This leads to unreasonable results.

For example, assume that U.S. person A inherits shares of a PFIC from an NRA. The shares are worth $1 million and acquire a new basis of $1 million at the NRA’s death. The PFIC owns shares in another PFIC. A’s share of the indirectly owned PFIC is worth $300,000, and A’s share of the basis is $100,000 (because the basis of the shares the NRA owned indirectly were not adjusted at her death). If A sells the shares of the PFIC for $1 million shortly after the NRA’s death, there will be little or no gain on the shares A owned directly, but according to proposed regulations there would be gain of $200,000 on the shares that A owned indirectly and ceased to own indirectly after the sale.61 That gain is taxed as an excess distribution. There are no prior PFIC years in this example, so all the gain is allocated to the current year and taxed as ordinary income.62 A should receive a basis adjustment of $200,000 to the shares she owned directly for the income she recognized on the sale of shares she owned indirectly.63 However, the basis adjustment is not helpful because the loss would be a capital loss and therefore would not materially reduce A’s tax on the ordinary income of $200,000. However, if A made a QEF election (discussed below) for the shares she inherited and owns directly and for the shares of any underlying PFICs she owns indirectly, this result should be avoided because any gain would be capital gain and the capital loss would offset the gain.64

To the extent provided in regulations, gain is recognized on any transfer of shares in a PFIC even if gain would not otherwise be recognized (for example, a gift).65 The amount of gain is the excess of the fair market value of the shares over basis. Only proposed regulations have been issued.66 Under those proposed regulations, the following are taxable dispositions: a sale, an exchange, a gift, a transfer at death, an exchange under a liquidation or a section 302(a) redemption, a distribution described in section 311, 336, 337, 355(c), or 361(c), and the expatriation of a U.S. citizen or resident.67 Exceptions to the general rule of recognition apply for a gift to a U.S. person (other than a charitable organization) or to a passthrough entity if the transferor continues to own the PFIC shares indirectly. Gain is not recognized to a shareholder on a transfer at death provided that the will does not permit transfer to either a foreign beneficiary or a trust, whether domestic or foreign, that is not a grantor or beneficiary-owned trust owned by a U.S. person.68 A transfer to a testamentary complex trust will be taxable even if the trust is a domestic trust. Proposed regulations provide that the taxable event is deemed to occur the moment before death and that the gain is taxable on the decedent’s final return.69

c. Basis rules. PFIC shares are nominally eligible for a step-up in basis at death. However, section 1291(e)(1) provides that a succeeding shareholder’s basis in PFIC shares is the fair market value of the shares on the date of death reduced by the difference between the new basis under section 1014 and the decedent’s adjusted basis immediately before the date of death.70 Thus, a succeeding shareholder’s basis in PFIC shares received from a decedent is limited to the adjusted basis of the decedent before death. However, PFIC shares inherited from an NRA decedent do acquire a new basis.71

d. Exceptions. The PFIC regime is avoided if the QEF or mark-to-market elections are made, as discussed below. The PFIC regime also is not applicable to stock that is marked to market under section 475 or any other provision of Chapter I, “Normal Taxes and Surtaxes.”72 The regime also does not apply to some U.S. Shareholders of CFCs, as mentioned earlier.73

3. PFIC Elections

a. QEF elections. A U.S. person, other than a tax-exempt organization,74 who directly or indirectly owns the shares of a PFIC can elect to be taxed on her pro rata share of the PFIC’s E&P by making a QEF election.75 The election is made by the first U.S. person in the chain of title.76 The election must be made on a return filed by the due date for the year of the election.77 A retroactive election may be made in the year the shareholder can show that she first knew or had reason to know that the corporation was a PFIC, or later if she obtains the commissioner’s consent.78 The election may be made only if the PFIC provides the shareholder with the information she needs to calculate her tax liability.79

A domestic passthrough entity, which includes an estate or trust, may make a QEF election, in which case “shareholders owning stock of a QEF by reason of an interest in a domestic trust or estate take into account the section 1293 inclusions with respect to the QEF shares under the rules applicable to inclusions of income from the trust or estate.”80 The term “shareholders” does not include domestic partnerships, S corporations, or grantor or beneficiary-owned trusts, except for information reporting purposes. Domestic estates and non-grantor trusts are not excluded from the definition of shareholder.81 However, beneficiaries of domestic estates and non-grantor trusts may be indirect owners.82 Thus, it is uncertain whether a domestic trust that makes a QEF election can report income from the PFIC as a result of the QEF election and pay tax on that income to the extent that distributions are not made to beneficiaries (applying the usual rules of subchapter J), or whether the beneficiaries who are deemed to be the indirect owners must report the income regardless of whether it is received.

If a QEF election is made for all years in the shareholder’s holding period in which the corporation was a PFIC, the PFIC tax regime is not applicable.83 In this case, the PFIC is referred to as a “pedigreed QEF.”84 If a QEF election is in effect for only some years, the PFIC regime continues to apply unless a purging election is made.85 There are two kinds of purging elections: a deemed sale election and a deemed dividend election.86 A deemed sale election is an election to treat the shares as if they were sold, gain was recognized, and the shares were repurchased.87 A deemed dividend election is available only to shareholders of a CFC that is also a PFIC (regardless of whether the shareholder is a U.S. Shareholder). It is an election to treat all post-1985 E&P as distributed.88 A purging election causes the shareholder to be treated as receiving an excess distribution.

If a purging election is not made and the QEF election is not in effect for all years in the shareholder’s holding period during which the corporation was a PFIC, dividends and gains continue to be taxable under the PFIC regime.89 However, dividends paid from undistributed income that was previously taxed as a result of the QEF election are not again taxed when distributed.90 Similarly, if a QEF election is made, the basis in the PFIC shares is increased by the undistributed E&P that are taxed as a result of the QEF election.91

A shareholder who makes a QEF election also may elect to extend the time for payment of tax imposed on undistributed earnings as a result of a QEF election, although an interest charge is imposed on the deferred tax liability.92

b. Mark-to-market election. If the shares of a PFIC qualify as marketable stock,93 a U.S. person who directly or indirectly owns the shares of the PFIC can make a mark-to-market election to pay tax at ordinary income rates on unrealized appreciation in the value of PFIC shares (operating as if the PFIC stock were sold at the end of each year).94 If the PFIC shares have declined in value, the loss may be deducted as an ordinary loss, but only to the extent of gains previously taxed to the taxpayer. The deferred tax and interest charge regime described earlier does not apply to any year after that in which a mark-to-market election is in effect.95 For the year of the election, the deferred tax and interest charge can be avoided if the PFIC was previously a pedigreed QEF or if the PFIC is a regulated investment company that makes an election to pay the interest charge that otherwise would have been incurred under section 1291(c)(3).96 A retroactive mark-to-market election may be made in accordance with reg. section 301.9100.

If a U.S. person is treated as indirectly owning PFIC shares that are subject to a mark-to-market election, any disposition that results in the U.S. person being treated as no longer owning the shares, such as a disposition of the shares by the person who directly owns the shares, is treated as a disposition by the U.S. owner, but the holding period will be deemed to begin on the first day of the first tax year beginning after the last tax year for which the mark-to-market election was in effect.97

The indirect ownership rules under the mark-to-market regime apply only to shares owned through foreign entities, “except as provided in regulations.”98 In this case, unlike the rules for section 1291 attribution, applicable regulations only attribute ownership from foreign entities.99 A CFC that owns stock in a PFIC for which a mark-to-market election is in effect is treated as a U.S. person, the amount taken into income is subpart F income, and the U.S. Shareholder is not taxed under the PFIC rules.100 This rule does not apply to a shareholder who is not a U.S. Shareholder for purposes of the CFC rules.

Upon the death of a person who has made a mark-to-market election, the transferee’s basis is a carryover basis limited to fair market value on the date of death.101 If an NRA who owns shares in a PFIC becomes a U.S. taxpayer and makes a mark-to-market election, the shareholder’s basis is the greater of fair market value on the first day of her tax year as a U.S. taxpayer and adjusted basis on that date.102

4. Indirect Ownership

As under the CFC rules, U.S. Shareholders are taxed on income attributable to PFIC shares that they own directly or indirectly. Under the indirect ownership rules, beneficiaries of an estate or trust may be treated as owning the shares owned directly or indirectly by the estate or trust. The regulations provide limited guidance on how to determine when a beneficiary will be deemed to indirectly own PFIC shares owned by an estate or trust. The regulations state that beneficiaries own PFIC shares in proportion to their beneficial interests, but there is no guidance on how to determine beneficial ownership among the beneficiaries of a discretionary trust.

Depending on how indirect ownership is determined, a U.S. beneficiary may be taxable on (1) distributions from a PFIC that are not made to her and that she has no right to receive and (2) dispositions of PFIC shares not made by her and that she does not control, including nontaxable dispositions.

Section 1298(b)(5) provides that:

Under regulations, in any case in which a United States person is treated as owning stock in a passive foreign investment company by reason of subsection (a) —

  1. any disposition by the United States person or the person owning such stock which results in the United States person being treated as no longer owning such stock, or

  2. any distribution of property in respect of such stock to the person holding such stock,

shall be treated as a disposition by, or distribution to, the United States person with respect to the stock in the passive foreign investment company. [Emphasis added.]

For example, if a trust distributed PFIC shares to a foreign beneficiary and the shares had been treated as indirectly owned by a U.S. beneficiary, the U.S. beneficiary would be deemed to have disposed of her shares for fair market value and realized gain that is taxable as an excess distribution equal to the excess of value over basis. If the trust is a U.S. trust, gain would be recognized by it under proposed regulations if shares of a PFIC are distributed to a beneficiary other than a U.S. individual or a domestic corporation (other than an S corporation).103

Even though section 1298(b)(5) by its terms requires implementing regulations, the IRS maintains that this rule concerning indirect dispositions can apply without the need for final regulations, which still do not exist.104 In TAM 200733024 the IRS took the view that the beneficiaries would be deemed to indirectly own PFIC shares owned by a trust based on historic patterns of distributions the trust had been making. The attribution of ownership defeated an attempted stripping distribution — a sale of PFIC shares in year 1 and a distribution in that year to foreign beneficiaries, and an equivalent distribution in year 2 to the U.S. beneficiaries.

Although the statute and the regulations make it clear that a beneficiary of an estate or trust will be deemed to indirectly own PFIC shares held directly or indirectly by the estate or trust — regardless of whether the estate or trust is domestic or foreign105Treasury has given U.S. taxpayers no guidance on how to determine indirect ownership, and it has provided only limited guidance on how the PFIC rules are to apply to estates and trusts and their beneficiaries. There seems little purpose in looking through a domestic estate or trust, because it could pay the same tax on PFIC shares that a beneficiary would pay if the beneficiary were treated as the indirect owner.106

To date, applicable regulations have reserved on the issue of how beneficiaries of an estate or trust are to report amounts distributed from PFICs that they are deemed to own indirectly,107 and on deemed dispositions of indirectly owned PFIC shares.108 Proposed regulations provide that a disposition occurs upon the happening of any event as a result of which an indirect shareholder’s ownership in the PFIC is reduced or eliminated.109 Any gain is an excess distribution allocated over the indirect owner’s holding period (not the actual owner’s holding period). The basis of the indirect owner’s interest in the entity directly owned by her is increased by the gain recognized.

For a trust beneficiary, her interest in the entity directly owned by her is the trust, and the basis of a trust has no effect on the tax treatment of distributions made from the trust to her under the rules of subchapter J. Further, the direct owner (here the trust) may increase the basis in the shares by the gain recognized by the indirect owner.110 The principles of sections 959 and 961 are to apply to distributions from a PFIC that are attributable to previously taxed income.111 However, proposed regulations reserve on the subject of how to apply these principles to trusts, estates, and their beneficiaries.112 Guidance is necessary because the application of these principles to trusts may cause tax to be imposed on one beneficiary (for example, an income beneficiary who is treated as indirectly owning shares of the PFIC), and the exclusions or basis adjustments under the principles of sections 959 and 961 may benefit another beneficiary (for example, a remainder beneficiary) if the distribution of PTI or the sale of shares occurs after the income beneficiary’s interest has terminated. Moreover, the termination of the income beneficiary’s interest in the trust may be a deemed disposition of the beneficiary’s indirectly owned PFIC shares so that the beneficiary who received no benefit would be taxed again on the unrealized gain.

Pending further guidance, the preamble to the 1992 proposed regulations advised taxpayers to “apply the PFIC rules and Subchapter J in a reasonable method that preserves the interest charge.”113 The preamble to temporary regulations issued in 2013 similarly advised taxpayers:

These temporary regulations also provide special rules for nongrantor trusts and grantor trusts. In particular, Treas. Reg. section 1.1291-1T(b)(8)(iii)(D) provides that if a foreign or domestic grantor trust directly or indirectly owns PFIC stock, a person that is treated under sections 671 through 679 as the owner of any portion of the trust that holds an interest in the stock is considered to own an interest in the stock held by that portion of the trust. In addition, Treas. Reg. section 1.1291-1T(b)(8)(iii)(C) provides that, in general, if a foreign or domestic estate or nongrantor trust directly or indirectly owns PFIC stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock. The cross-referenced notice of proposed rulemaking on this subject in this issue of the Bulletin requests comments on the determination of proportionate ownership by a beneficiary of PFIC stock held by a domestic or foreign estate or nongrantor trust. Until further guidance is provided on estate and trust attribution rules, beneficiaries of estates and nongrantor trusts that hold PFIC stock subject to the section 1291 regime should use a reasonable method to determine their ownership interests in a PFIC held by the estate or nongrantor trust. Moreover, until further guidance is provided, beneficiaries of estates and nongrantor trusts that are subject to the section 1291 regime with respect to PFIC stock held by the estate or nongrantor trust are exempt from section 1298(f) filing requirements for taxable years in which the beneficiary is not treated as receiving an excess distribution (within the meaning of section 1291(b)) or as recognizing gain that is treated as an excess distribution (under section 1291(a)(2)) with respect to the stock of the PFIC that the beneficiary is considered to own through the estate or trust. See, for example, section 1.1298-1T(b)(3)(iii).114

However, the final regulations were silent on these critical issues.

II. Changes Made by the TCJA

A. The Section 965 Transition Tax

In general, before the TCJA, U.S. Shareholders were not taxed on the active business income of foreign corporations until dividends were paid (or were deemed paid as a result of a CFC investing in U.S. property), or shares were sold. This created an incentive to keep profits offshore. Only subpart F income was taxed on a flowthrough basis to U.S. shareholders of CFCs.

One of the most significant changes made by the TCJA is the enactment of section 965, a transition tax on U.S. Shareholders (as defined for purposes of the CFC rules) of specified foreign corporations. A specified foreign corporation is a CFC or any foreign corporation that is not a CFC that has a corporate U.S. Shareholder115 (although a PFIC that is not a CFC is not a specified foreign corporation).116 The tax is referred to as a “transition tax” because it was part of a transition from a deferral tax system to a participation exemption tax regime. Under the new participation exemption tax regime, foreign earnings from an active trade or business can be distributed free of tax (through a 100 percent dividends received deduction) to corporate U.S. Shareholders that own at least 10 percent of the stock.117 This eliminates a disincentive to keeping profits offshore. As part of this transition, some U.S. Shareholders of foreign corporations were required to include as subpart F income for 2017 the untaxed and undistributed foreign earnings that were accumulated by those corporations since 1986. The U.S. Shareholders of those corporations are subject to this transition tax on the shareholders’ pro rata shares of that subpart F income. Unfortunately, the transition tax also applies to individual shareholders, who do not get the benefit of the participation exemption tax regime because dividends paid to individual shareholders that represent foreign E&P that have not previously been subject to U.S. tax remain subject to U.S. tax when distributed.

1. Calculation of the Transition Tax

A person who is a U.S. Shareholder, as defined for purposes of the CFC rules, is required to include in gross income her share of all post-1986 previously untaxed accumulated earnings of a specified foreign corporation measured as of November 2, 2017, or December 31, 2017, whichever is greater, that was owned by the U.S. Shareholder in the last tax year that began before January 1, 2018 (2017 for a calendar-year taxpayer). This amount is taxed as subpart F income. A U.S. Shareholder’s share of deficits of specified foreign corporations offsets the amount includable in income.118 The netting of positive and negative E&P as well as the determination of the cash position of the foreign corporation which affects tax rate is done at the level of a domestic flow-through entity and not at the level of the owner of the domestic flow-through entity.119

Individual U.S. Shareholders (including trusts and estates) are subject to the transition tax but do not benefit from the participation exemption tax regime. As discussed in Section II.B, corporate U.S. Shareholders (but not individuals) that own 10 percent of the stock of a foreign corporation may deduct the foreign-source portion of dividends received from the foreign corporation (other than a PFIC120) if a one-year ownership requirement is met.121

The transition tax is imposed at a reduced rate.122 To the extent that the specified foreign corporation’s assets consist of assets other than cash and cash equivalents, the maximum tax rate is an “8 percent equivalent percentage”;123 and to the extent that its investments consist of cash and cash equivalents, the maximum tax rate is a “15.5 percent equivalent percentage.”124 The equivalent percentages are achieved by allowing a deduction under section 965(c) sufficient to reduce the tax rate to the stated percentages.125 However, the deductions are keyed off the tax rates applicable to domestic corporations.126 As a result, and because individual rates are higher than corporate rates, the maximum equivalent percentage rates for individuals, estates, and trusts are 9.05 percent and 17.5 percent for calendar-year foreign corporations and 14.05 percent and 27 percent for fiscal-year foreign corporations. If a U.S. taxpayer expatriates, the person must pay a tax equal to 35 percent of the section 965(c) deduction.127

The section 965(c) deduction is an above-the-line deduction used to compute adjusted gross income and is not an itemized deduction.128 Therefore, this deduction is available to individuals. However, the section 965(c) deduction is not available to offset a shareholder’s net investment income tax (aka the Medicare tax)129 or the tax imposed by section 4940 on tax-exempt organizations.130

A deemed paid foreign tax credit offsets the transition tax for corporate U.S. Shareholders of a specified foreign corporation and for individual U.S. Shareholders of a CFC who make an election under section 962 to be taxed at corporate rates.131 However, the deemed paid credit for foreign taxes associated with the earnings subject to the transition tax is reduced to take into account the deduction allowed by section 965(c). The amount disallowed is 77.1 percent of the foreign taxes on earnings subject to tax at an 8 percent rate, and 55.71 percent of the foreign taxes on the earnings subject to tax at a 15.5 percent rate.132

2. Deferral Elections

In addition to lower rates, U.S. Shareholders are allowed deferral elections under section 965(h) and (i).

a. Who makes the election? A domestic passthrough owner who is subject to the transition tax, and not the domestic passthrough entity, makes the deferral election.133 A domestic passthrough entity includes a partnership, S corporation, or any other person other than a corporation to the extent that the income or deductions of the person are included in the income of one or more direct or indirect owners or beneficiaries.134 A domestic trust is subject to income tax on a portion of the section 965(a) amount, and its beneficiaries or owners are subject to tax on the remaining portion. The domestic trust is treated as a passthrough entity for the portion of the income on which it is not taxable. 135 Thus, the non-grantor trust can make a deferral election for its share of the transition tax, and the beneficiaries may make elections for their shares of the tax.

The person who is liable to pay the transition tax (for example, the direct owner or the owner of a domestic passthrough entity, such as a grantor of a grantor trust, a partner of a partnership, a member of a limited liability company, or a beneficiary of the portion of a trust taxable to the beneficiary) can elect to pay the transition tax over eight years.136 In the first five years, only 8 percent of the tax is due; in the sixth year, 15 percent is due; in the seventh year, 20 percent is due; and in the eighth year, 25 percent of the tax is due. No interest is due on the deferred tax. If the transition tax is later increased, the deficiency can be prorated over the unpaid installments, unless the underpayment was the result of negligence, intentional disregard of rules and regulations, or fraud.137

b. Acceleration events for tax deferred under section 965(h)The tax deferred by a section 965(h) election may be due sooner if an acceleration event occurs. The tax is due on the date of the acceleration event.138

Acceleration events include139:

  • failure to timely pay an installment;

  • liquidation, sale, exchange, or other disposition of substantially all of the assets of the person making the installment election, including bankruptcy or death (for an individual);

  • for a person that is not an individual, cessation of business by the person;

  • any event that results in the person no longer being a U.S. person;

  • change in membership of a consolidated group; and

  • a determination by the IRS that there was a material misstatement or omission in a transfer agreement.

Death of the person who is liable for the transition tax is an acceleration event and requires immediate payment of any tax deferred under a section 965(h) election.140 In some cases (a “covered” acceleration event), but not for death, which is not a covered acceleration event, an acceleration event will not accelerate the time for payment of tax if within 30 days of the acceleration event, a transfer agreement is signed and filed by an eligible transferee. An eligible transferee must agree to assume the deferred tax liability (although the transferor, if it continues to exist, remains jointly and severally liable for the tax) and represent that the eligible transferee is able to pay tax.141 An eligible transferee is “a single United States person that is not a domestic pass-through entity . . . that acquires substantially all of the assets of an eligible section 965(h) transferor.”142 For acceleration events occurring on or before February 5, the date of publication of final regulations under section 965, a transfer agreement must have been filed by March 7 to maintain deferral. Section 9100 relief is not available.143

Note that it is not the taxpayer’s transfer of shares of the specified foreign corporation that necessarily is an acceleration event, but rather a disposition of substantially all of the assets of the taxpayer who owes the transition tax. Therefore, a transfer of shares of a specified foreign corporation by an individual shareholder to a subchapter C corporation would not be an acceleration event if the shares did not represent substantially all of the assets of the individual. On the other hand, a transfer by a non-grantor trust to a C corporation of substantially all of its assets would be an acceleration event. However, a subchapter C corporation is an eligible transferee, so the acceleration event is a covered acceleration event and a transfer agreement may be filed to prevent acceleration of the tax. An eligible transferee is a single U.S. person who is not a domestic passthrough entity and who receives substantially all of the assets of the transferor.144 Therefore, a transfer of all the assets of a non-grantor trust to a flow-through entity, such as another trust, a subchapter S corporation, or a partnership, would be an acceleration event that is not a covered acceleration event. Similarly, the conversion of a grantor trust to a non-grantor trust may be an acceleration event that is not a covered acceleration event. A transfer agreement would not be available to avoid acceleration of the tax. A subchapter S election by a C corporation might be an acceleration event (because the tax ownership changes). A subchapter S election by a C corporation might be an acceleration event (because tax ownership changes). The regulations do not clarify whether a change of tax ownership that does not change ownership for property law purposes is a disposition for purposes of section 965(h)(3). If so, because the resulting entity is a domestic passthrough entity, the tax would be accelerated and a transfer agreement would not be available to defer tax.

According to the preamble, nonrecognition events may be acceleration events, such as transferring the stock of the specified foreign corporation in a section 351 or 721 exchange, inbound F reorganizations, and liquidations of foreign subsidiaries.145 The regulations do not clarify whether decanting, reformation, modification, merger, severance, or material modification of trusts are acceleration events. If they are acceleration events, and if the transferee is a domestic flow-through entity, the transfer would not be a covered acceleration event, and tax would be due immediately.

3. Triggering Events

For a shareholder of a subchapter S corporation that is a U.S. Shareholder of a specified foreign corporation, all the transition tax can be deferred in full until a triggering event occurs.146 The treatment of triggering events is much more taxpayer-friendly than the treatment of acceleration events.

Because of the more favorable treatment afforded to S corporations, some taxpayers transferred stock of CFCs or specified foreign corporations to subchapter S corporations before the last day of the CFC’s last year beginning before January 1, 2018, or they made entity classification elections to have LLCs taxed as S corporations. There was concern that these transfers might be disregarded under an antiabuse rule. However, the final regulations take the position that the antiabuse rules do not apply to disregard a transfer of stock by a U.S. shareholder to a domestic corporation, including an S corporation, as long as the taxable amount and the aggregate foreign cash position of the specified foreign corporation is not changed.147 This rule also applies to entity classification elections made effective on or before November 2, 2017.

Triggering events include:

  • the U.S. shareholder ceasing to be an S corporation;

  • the liquidation, sale, exchange, or other disposition of substantially all of the assets of the S corporation, including bankruptcy and a cessation of its business;

  • a transfer of any shares of the S corporation (including because of death or otherwise) that results in a change of ownership for federal income tax purposes; and

  • a determination by the IRS that there has been a material misrepresentation or omission in a transfer agreement.

If an S corporation shareholder transfers less than all her shares, the transfer will be a triggering event only for the portion of shares transferred.148 Moreover, as long as there is only one transferee for each portion of the shares transferred, there can be multiple transferees for a section 965(i) election. Separate transfer agreements are signed for each portion.

If a triggering event occurs, deferral may continue if (1) the triggering event is a covered triggering event; (2) there is an eligible transferor and an eligible transferee;149 and (3) a transfer agreement is timely filed.150 As for a section 965(h) election, death is a triggering event for purposes of the section 965(i) election, but unlike the section 965(h) election, death is a covered triggering event for purposes of section 965(i), so continued deferral of the payment of tax is possible.151 For a triggering event resulting from death, a transfer agreement is due to be filed on the due date (determined without extensions) for the decedent’s final income tax return. In other cases, the due date for the transfer agreement is 30 days after the date of the triggering event.

The transfer agreement must be signed by an eligible transferee. In the case of death, the executor of the decedent’s estate is the eligible transferee unless the identities of the beneficiaries (other than a domestic passthrough entity) who are entitled to receive the shares of the S corporation are known as of the due date for filing the transfer agreement, in which case the beneficiaries are the eligible transferees. For a qualified subchapter S trust or grantor trust, the eligible transferee is the person who is treated as the owner of the stock. For a testamentary trust or a trust that makes a section 645 election, the eligible transferee is the executor of the estate.152

If an executor is the eligible transferee, a second triggering event occurs when the estate transfers shares of the S corporation to the beneficiaries. The executor and the beneficiaries then must sign and file the transfer agreement within 30 days of the transfer of shares. The transferor, the transferee, and the S corporation are all jointly and severally liable for the unpaid transition tax.153 As with a section 965(h) election, the transfer agreement must contain a representation that the transferee is able to pay the transition tax, and if the debt leverage ratio of the transferee exceeds 3 to 1, the IRS may not allow continued deferral of the tax.

Following a triggering event, payment of all the transition tax may continue to be deferred if a transfer agreement is signed. If a transfer agreement is unavailable or is not timely signed and filed, the transferee can elect to pay the tax in installments over eight years as described earlier.154 However, if the triggering event is the liquidation, sale, or disposition of substantially all the assets of the S corporation; bankruptcy; or cessation of business, the election to pay the 965(a) tax in installments requires the consent of the IRS.

While the tax is deferred under a section 965(i) election, the taxpayer (and any eligible transferee) must file annual reports.155 Failure to file reports is not a triggering event, but a penalty equal to 5 percent of the deferred tax applies if the annual report is not timely filed.156

The statute of limitations begins to run on the collection of the tax deferred under section 965(i) when a triggering event occurs.157

B. Dividends Received Deduction — Section 245A

The TCJA enacted section 245A to allow domestic corporations to deduct the foreign portion of a dividend received from a “specified 10 percent owned foreign corporation.” A specified 10-percent-owned foreign corporation is a corporation for which the domestic corporation is a U.S. Shareholder,158 but the definition specifically excludes any PFIC.159 The foreign-source portion of the dividend is the fraction of undistributed earnings that is foreign-source divided by total undistributed earnings.160 No foreign tax credit or deduction is allowed for foreign taxes paid on a dividend for which a deduction is allowed. Section 246(c)(5) imposes a one-year holding period requirement to qualify for the deduction allowed by section 245A.

Section 245A allows all future profits from an active trade or business of a foreign corporation that are earned by a corporate U.S. Shareholder and are not subpart F income or GILTI to avoid corporate-level U.S. tax. Subpart F income will continue to be taxable. However, individual U.S. Shareholders cannot deduct the foreign portion of dividends received from a specified 10-percent-owned foreign corporation.

When a U.S. Shareholder sells stock in a CFC, the portion of gain realized that is attributable to the seller’s share of untaxed E&P may be taxed as a dividend.161 Because of new section 245A, treating some portion of the gain as a dividend may reduce the U.S. tax owed by a seller that is a domestic corporation. However, section 1248 did not incorporate the new definition of U.S. Shareholder enacted in the TCJA for purposes of section 951(b), and it still defines U.S. Shareholder solely by reference to ownership of voting shares (and not vote or value).

C. CFC Investment in U.S. Property — Section 956

A U.S. Shareholder is deemed to receive a dividend, and therefore is subject to U.S. tax, on amounts that the CFC invests in U.S. property.162 Because section 245A eliminates tax on the foreign-source portion of dividends actually paid by a specified 10-percent-owned foreign corporation to corporate U.S. Shareholders, proposed regulations under section 956163 provide that an amount otherwise taxable under section 956 as a deemed dividend is reduced to the extent that the U.S. Shareholder would be allowed a deduction under section 245A if the U.S. Shareholder had received an actual dividend from the CFC. Because section 245A does not apply to individuals, individuals will receive no benefit from the proposed regulations, and thus will continue to be taxable on both actual dividends and deemed dividends (under section 956).

D. New GILTI Tax — Section 951A

The TCJA enacted section 951A, which requires U.S. Shareholders of a CFC to include in subpart F income their share of the CFC’s GILTI. In general, the GILTI provision is designed to impose a minimum residual U.S. tax on each shareholder’s income of a CFC exceeding a 10 percent return on that shareholder’s pro rata share of the CFC’s qualified business asset investments (tangible depreciable property used in a trade or business),164 reduced by some interest expense and, for corporate shareholders, a partial foreign tax credit. However, unlike subpart F income, GILTI is determined on an aggregate basis at the U.S. Shareholder level. The formula to compute GILTI is:

GILTI = net tested income - ((10 percent of QBAI) - qualified interest expense)

Net tested income does not include subpart F income, income that would have been subpart F income but for the high-taxed income exception, income effectively connected with a U.S. trade or business, or some dividends from related persons. Interest expense is taken into account only to the extent that the corresponding interest income is not taken into account in determining net tested income — for example, because it is paid to an unrelated person. The QBAI of a CFC with a tested loss is not taken into account in calculating net tested income.

As discussed in Section II.E, corporate U.S. Shareholders and individual taxpayers who make a section 962 election to be taxed at corporate rates may deduct 50 percent of GILTI and take a foreign tax credit for 80 percent of foreign income taxes associated with GILTI.165 If a credit is claimed, all the foreign income taxes associated with GILTI are added to income, and then a deduction is allowed for 50 percent of the gross-up.166

Below is an example showing the different tax rates for corporations and individuals. Suppose that a CFC has $100 of GILTI and pays $10 of foreign tax. The CFC has $40 basis in depreciable tangible personal property used in generating the GILTI and has no interest expense. A corporate U.S. Shareholder would have tested income of $90 ($100 - $10), which would be reduced by $4 (10 percent of $40 of QBAI). The GILTI would be $86. The corporate U.S. Shareholder would have gross income of $96 ($86 + $10 gross-up) and then deduct 50 percent of that amount, or $48. The tax before credits would be 21 percent of $48 = $10.08. The tax would be reduced by 80 percent of the foreign tax paid (80 percent of $10 = $8), and the net liability would be $2.08. If the foreign tax credit exceeds the U.S. tax liability, the excess foreign tax credit or excess deduction may not be credited or deducted in any other year.

For an individual U.S. Shareholder (other than a shareholder who makes a section 962 election), the net tax would be $31.82. The GILTI would be $86 ($100 - $10 - $4), and tax at the 37 percent rate would be $31.82. Plus, an individual may be liable for the 3.8 percent Medicare tax. There would be no foreign tax credit for tax paid by the corporation.

If the individual U.S. Shareholder made a section 962 election to be taxed on the income of the CFC as if she were a corporation, the tax calculation would be the same as for a corporate shareholder. Although it was not clear from the statute that the deduction allowed by section 250 would be available to individual shareholders who made a section 962 election, proposed regulations released March 4 confirm that the deduction will be allowed.167 However, if this election is made, a portion of CFC income subject to tax as GILTI will be subject to tax as a dividend when distributed to the individual. The portion of the dividend income treated as excludable is limited to the amount of the tax paid on that income.168 If a section 962 election is not made, all the GILTI is PTI that may be excluded when later distributed.169 The basis adjustment allowed by section 961 also is limited to the amount of tax paid.170

Assuming that the income of the CFC would be subject to tax to an individual shareholder at a rate of 37 percent plus the 3.8 percent Medicare tax (an aggregate tax rate of 40.8 percent, and further assuming that the dividend from the CFC to an individual shareholder who makes a section 962 election would be taxable as a qualified dividend under section 1(h)(11)), the combined effective tax rate resulting from a section 962 election is lower, even if the section 250 deduction were not allowed. Assume $100 of CFC income, which is taxed at 21 percent at the corporate level. The CFC distributes the after-tax amount ($79), which is taxed at 23.8 percent ($18.80). The combined tax is $39.80. The individual tax without an election would be $40.80.

E. Deduction for FDII and GILTI — Section 250

New section 250 allows a domestic corporation a deduction equal to 50 percent of the sum of (1) (A) its GILTI and (B) the amount treated as a dividend under section 78 that is attributable to GILTI (the GILTI-attributable gross-up amount), and (2) 37.5 percent of foreign-derived intangible income.171 FDII is a domestic corporation’s deemed intangible income multiplied by the ratio of foreign-derived deduction-eligible income (FDDEI) to its total deduction-eligible income (DEI). Deemed intangible income is DEI exceeding a 10 percent return on QBAI (as defined for purposes of GILTI). DEI is foreign-derived income less expenses.

The formula for FDII can be expressed as follows:

FDII = (DEI - (10 percent of QBAI))

Multiplied by the following fraction:

(FDDEI/DEI)

FDDEI is income earned in connection with property sold to a foreign person for foreign use, services to a foreign person, and services regarding foreign property.172 DEI means, for any domestic corporation, the excess (if any) of the gross income of the corporation determined without regard to specific types of income (noted below) over deductions (including taxes) properly allocable to that gross income.173 Royalty and rental income is deduction eligible if the licensed or leased property is used in connection with providing goods or services to foreign persons. However, subpart F income, section 956 investments in U.S. property, GILTI inclusions, dividends from CFCs, and foreign branch income are excluded from deduction-eligible income.

The effect of the deduction is to tax GILTI at the rate of 10.5 percent (50 percent of 21 percent) less FTCs. The effect of the 37.5 percent deduction for FDII is to tax income from providing sales and services to foreign persons at an effective tax rate of 13.125 percent. For tax years beginning after December 31, 2025, the deduction for GILTI is reduced to 37.5 percent and the deduction for FDII is reduced to 21.875 percent, producing an effective tax rate of 13.125 percent for GILTI and 16.406 percent for FDII.

A foreign tax credit is allowed for 80 percent of the foreign taxes associated with GILTI. However, section 78 requires inclusion in gross income of the full amount of taxes taken as a credit (the GILTI-attributable section 78 gross-up amount), and not only 80 percent.

As with subpart F income, the amount of GILTI included in the income of a U.S. Shareholder (before the 50 percent deduction) becomes PTI for purposes of section 959, and a basis adjustment is allowed under section 961.

F. Sales of Partnership Interests

A foreign person who is a general or limited partner in a partnership engaged in a U.S. trade or business is deemed to be engaged in that trade or business.174 When a limited partnership conducts a business activity in the United States through a fixed place of business in the United States, each limited partner is deemed to have a place of business in the United States.175

In Rev. Rul. 91-32, 1991-1 C.B. 107, the IRS concluded that this rule applied not only to income from the business carried out by the partnership, but also to gain realized on the disposition of that partnership interest. In Grecian Magnesite Mining,176 the Tax Court rejected the conclusion in Rev. Rul. 91-32: The court held that gain from the redemption or sale of a partnership interest by a foreign person is a capital transaction, so if the seller is foreign, the gain is foreign-source income except for gain attributable to U.S. real property owned by the partnership and section 751 items. An exception applies only if the gain is attributable to a U.S. office or other fixed place of business. However, gain is not attributable to the fixed place of business in the United States if that office is not involved in the sale and the sale was not made in the ordinary course of the partnership’s business carried on in that office. This rule allowed the purchaser of the partnership interest to acquire a new basis in partnership assets, assuming certain elections were made, without the seller recognizing gain. The parties agreed that the portion of the gain attributable to a U.S. real property interest owned by the partnership was taxable.177

The TCJA added paragraph (8) to section 864(c) to provide that gain or loss on the sale or exchange of a partnership interest is effectively connected income or loss to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all its assets at fair market value as of the date of the sale or exchange. This change resulted in an outcome that was similar to the IRS’s position in Rev. Rul. 91-32. A partner’s share of the gain or loss is determined in the same manner as the partner’s share of the non-separately stated taxable income or loss of the partnership. To enforce this tax, the TCJA also amended the partnership withholding rules to require a transferee to deduct and withhold a tax equal to 10 percent of the amount realized on the disposition of a partnership interest by a non-U.S. taxpayer.178 Withholding applies to the entire amount realized, not only the amount attributable to the effectively connected income. No withholding is required if the transferor furnishes an affidavit that the transferor is a U.S. person. If the transferee fails to withhold, the partnership has a withholding obligation.

In Notice 2018-8, 2018-4 IRB 352, the IRS suspended the withholding obligations for dispositions of interests in some publicly traded partnerships, and in Notice 2018-29, 2018-16 IRB 495, it provided interim guidance for withholding on sales of interests in non-publicly traded partnerships. Under this interim guidance, withholding is not required if the transferor certifies that there is no gain or that the transfer results in a small amount of ECI. Further, withholding is not required if the transferor certifies that for each of the past three years, the transferor’s share of ECI from the partnership was less than 25 percent of the transferor’s total income from the partnership, or if the partnership certifies that less than 25 percent of the gain the partnership would have realized had the partnership sold all its assets would be from assets effectively connected with the partnership’s U.S. trade or business.

Proposed regulations179 were released May 7, 2019, for withholding required on the transfer by NRAs of partnership interests under new section 1446(f). The proposed regulations adopt many of the rules in Notice 2018-29. The proposed regulations also explain the withholding rules for sales of publicly traded partnerships that will become effective when the regulations become final. Withholding obligations for publicly traded partnerships are shifted from the buyer to the broker, who is in a better position to know whether the transferor is an NRA. The proposed regulations also address the application of double-tax treaties to modify the withholding obligations under section 1446(f).

As a result of this change, a foreign person holding an interest in a partnership engaged in a U.S. trade or business directly rather than through a domestic corporation no longer may be able to provide a basis adjustment to partnership assets to a purchaser without paying U.S. tax on the sale. A foreign person’s sale of shares of the domestic corporation that owns the partnership interest will avoid U.S. tax, but the purchaser will not obtain a new basis in partnership assets. Although a sale of the partnership interest by the domestic corporation will be taxable, the sale will avoid the new withholding rules.

FOOTNOTES

1 P.L. 115-97. The Senate parliamentarian removed the short title “Tax Cuts and Jobs Act” as extraneous. Hereinafter, P.L. 115-97 will nonetheless be referred to as the TCJA.

3 Section 951(b). “U.S. Shareholder” means, for any foreign corporation, a U.S. person (as defined in section 957(c)) that owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of that foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of that foreign corporation.

4 Section 951(a)(1) taxes U.S. Shareholders on stock that they own or are treated as owning under section 958(a). Section 958(a) defines indirect ownership. Section 958(b) defines constructive ownership.

5 Section 956 also requires U.S. Shareholders to include in income an amount equal to investments made by the CFCs in specified U.S. property.

6 Section 951. Amounts included under this section are taxable as ordinary income even if an actual divided might qualify as a qualified dividend taxable at capital gains rates. Section 1(h)(11). Dividends paid by qualified foreign corporations are qualified dividends. Qualified foreign corporations are (1) those eligible for the benefits of a comprehensive income tax treaty with the United States that includes exchange of information provisions, (2) corporations organized in specified U.S. possession, and (3) foreign corporations whose stock is traded on a U.S. stock exchange. A PFIC may not be a qualified foreign corporation, however.

11 Reg. section 1.958-1(d), Example 3, illustrated the application of indirect ownership rules by reference to a trust that had three beneficiaries who had fixed and equal shares of trust income and principal, but most foreign trusts are wholly discretionary. The IRS has not published any guidance on how to apply the facts and circumstances test of section 958(a)(2) to determine proportionate ownership of beneficiaries of discretionary trusts. But see TAM 200733024 (discussing how a facts and circumstances test would apply to a beneficiary of a foreign non-grantor trust who indirectly owned shares in a PFIC).

12 Section 959. For a U.S. Shareholder who makes a section 962 election, the exclusion is the amount of tax paid rather than the amount included in gross income.

13 Section 961. For a U.S. Shareholder who makes a section 962 election, the adjustment to basis is limited to the tax paid rather than the amount included in gross income.

15 Reg. section 1.961-1(a) and (b)(1)(iii).

16 Hereinafter, subpart F income is treated as including GILTI.

23 Sections 331 and 334.

24 Reg. section 301.7701-2 contains a list of foreign entities classified as per se corporations for which a check-the-box election is not allowed.

25 Reg. section 301.7701-3(g)(1). Classification is relevant if it affects the liability of any person for federal tax or information purposes, or if it affects the determination of the amount of tax to be withheld by a withholding agent, the type of tax or information return to file, or how the return must be prepared. Reg. section 301.7701-3(b)(ii) and (d)(i). If the classification was not relevant for U.S. tax purposes, the check-the-box election may be treated as an initial classification and not a deemed liquidation. Reg. section 301.7701-3(d)(2). Relevance is defined in reg. section 301.7701-3(d)(1)(i) by reference to whether it affects the income tax liability or information reporting of a U.S. taxpayer. The regulation states that there is relevance if classification of the entity “might affect the documentation that the withholding agent must receive from the entity, the type of tax or information return to file or how the return must be prepared.” There is no gain if there is no deemed liquidation, but the treatment of the entity as a disregarded entity or a partnership from inception means that there is no shield from U.S. estate tax if the entity owns U.S.-situs assets (unless you believe, as some do, that a single-member limited liability company or a partnership also is an effective estate tax shield). The tax consequences of a deemed liquidation are the same as the tax consequences of an actual liquidation — the corporation recognizes gain on the distribution of appreciated assets, which gain is subpart F income, and all assets acquire a new basis in the hands of the shareholders. Sections 336(a) and 334(a).

26 Reg. section 301.7701-3(c)(1)(iii). Form 8832, “Entity Classification Election,” is used for this purpose.

28 Section 958(a)(5); reg. section 1.958-1(b).

29 For purposes of sections 951 to 964, the holding period of the shares does not include the date of acquisition but includes the date of disposition. Reg. section 1.951-1(f).

30 Section 2104(a). Some treaties classify shares of a U.S. corporation as non-U.S. situs unless associated with a permanent establishment. For example, estate tax treaties with Australia, France, Germany, the Netherlands, and the United Kingdom do not allow the United States to impose estate tax on intangibles unless associated with a permanent establishment in the United States. In those cases, a retroactive check-the-box election to cause a deemed liquidation to occur on the day before death would re-base the investment portfolio to date-of-death values without exposure to either the CFC regime or U.S. estate tax.

31 Entities classified as corporations under reg. section 301.7701-2(b)(1), (3), (4), (5), (6), (7), and (8) are ineligible for a check-the-box election. Reg. section 301.7701-3(a).

35 Exceptions include income from the active conduct of a banking business or insurance business, and interest, dividends, rents, and royalties received from a related person as defined in section 954(d)(3). A related person is an individual, corporation, partnership, trust, or estate who controls or is controlled by the foreign corporation. Control means direct or indirect ownership of more than 50 percent of the vote or value of the stock (for a corporation) or more than 50 percent of the beneficial interests (for a partnership, trust, or estate).

36 See ILM 201003013: A Canadian mutual fund structured as a trust under Canadian law was classified as a corporation under U.S. classification rules in reg. section 301.7701-1 through -4.

39 Section 1297(d). However, this exception will apply if the corporation was a PFIC unless the shareholder makes a purging election under section 1298(b)(1).

41 Reg. section 1.1291-1(b)(2)(ii); prop. reg. section 1.1291-1(c)(1). A PFIC to which this exception applies is sometimes referred to as a “pedigreed QEF.”

42 See section 1296(j), reg. section 1.1291-1(c)(4), and reg. section 1.1296-1(f) and (h)(2)(ii).

45 Prop. reg. section 1.1291-2(e)(1).

47 Reg. section 1.1291-9(j)(1): A corporation will not be treated as a PFIC for a shareholder for those days included in the shareholder’s holding period when the shares, or a person whose holding period is included in the shareholder’s holding period, is not a U.S. person within the meaning of section 7701(a)(3).

49 Section 1291(a)(1)(B). As mentioned in the text, a PFIC is by definition not a qualified foreign corporation.

51 Prior PFIC years and pre-PFIC years are different. Pre-PFIC years are tax years in which the PFIC regime had not yet been enacted and years in which the corporation was not a PFIC, which includes years in the shareholder’s holding period in which the shares were owned by an NRA. Prop. reg. section 1.1291-1(b)(3). Prior PFIC years are years in a shareholder’s holding period before the current year that are not pre-PFIC years. If a shareholder makes a purging election, years before the year of the election are no longer considered to be in the shareholder’s holding period. Sections 1291(d)(2)(C)(ii) and 1298(b)(1); reg. sections 1.1291-9, -10, 1.1297-3, and 1.1298-3.

58 See instructions to Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts,” for an explanation of the default rule.

59 Section 665(b) provides that a distribution that does not exceed income for the year is not an accumulation distribution. The term “income” for this purpose means fiduciary net income. Section 643(b).

61 Prop. reg. section 1.1291-3(e)(4).

62 Prop. reg. section 1.1291-3(e)(2).

63 Prop. reg. section 1.1291-3(e)(4)(iii).

66 Prop. reg. section 1.1291-3 and -6.

67 Prop. reg. section 1.1291-3(b) and -6(b). A pledge is also a disposition under reg. section 1.1291-3(d).

68 Prop. reg. section 1.1291-6(c). Gains realized on the disposition of PFIC shares owned by a pooled income fund are not taxed if the gain is permanently set aside for the charitable remainder beneficiary.

69 Prop. reg. section 1.1291-6(d)(2).

72 Section 1291(d) (flush language).

74 Reg. section 1.1295-1(d)(1) and (6).

85 Reg. section 1.1291-1(c)(2).

89 Prop. reg. section 1.1291-1(c)(2).

93 Stock that is regularly traded on an established securities exchange generally qualifies as marketable stock for this purpose. See section 1296(e) and reg. section 1.1296-2.

97 Reg. section 1.1296-1(f) and (g)(1).

101 Section 1296(i). The decedent’s tax basis would have been increased for unrealized gains before death.

103 Prop. reg. section 1.1291-6(a)(2) and (c)(2)(i).

106 If the domestic trust is a charitable remainder trust, treating it as the owner of the shares would eliminate the risk of attributing ownership to the annuitants.

107 Prop. reg. section 1.1291-2(f)(2)(i).

108 Prop. reg. section 1.1291-3(e)(5)(ii).

109 Prop. reg. section 1.1291-3(e)(4)(iii).

110 Id.

111 Prop. reg. section 1.1291-3(e)(4)(iv).

112 Prop. reg. section 1.1291-3(e)(5)(ii).

113 1992-1 C.B. 1124, 1127.

115 Prop. reg. section 1.965-1(47) defines U.S. Shareholder by reference to the definition in section 951(b).

116 Section 965(e); reg. section 1.965-2(f)(45)(iii).

117 Section 245A. Section 245A(b)(1) defines a specified 10-percent-owned foreign corporation as a foreign corporation that has a domestic corporation that is a “United States shareholder.” There is no cross-reference to the definition of U.S. Shareholder in section 951(b), which includes shares owned directly, indirectly, and constructively in determining whether the 10 percent ownership threshold is met. It is likely that the same definition used in section 951(b) will be adopted when regulations are issued.

119 Reg. section 1.965-5(d)(3). See Part II.F of the preamble to the regulations, at 8.

121 Section 246(e)(5).

122 The reduced rate is not applicable to taxes imposed by section 4940 or section 1411. Reg. section 1.965-3(f)(3) and (4).

125 Section 965(c). The deduction is not an itemized deduction. Reg. section 1.965-3(f)(1).

126 Section 965(c)(2)(A). The deduction is based on the highest rate of tax imposed under section 11.

130 Reg. section 965-3(f)(3).

131 Section 960 allows U.S. shareholders of CFCs to credit foreign taxes paid by the foreign corporation. The deemed paid credit is allowed only to corporations and to individuals who make a section 962 election. For specified foreign corporations that are not CFCs, domestic corporate shareholders and shareholders who make a section 962 election generally would be entitled to a deemed paid credit under section 902 because section 965 requires inclusion in income for the last tax year of a deferred foreign corporation beginning before January 1, 2018. Section 960 was amended by the TCJA effective for tax years beginning after December 31, 2017, to apply only to CFCs, but the tax imposed by section 965 was for the prior year, when the deemed paid credit (then allowed by section 902) was not so limited.

135 Reg. section 1.965-2(f)(28). This regulation provides: “For example, if a domestic trust is subject to federal income tax on a portion of its section 965(a) inclusion amount and its domestic pass-through owners are subject to tax on the remaining portion, the domestic trust is treated as a domestic pass-through entity with respect to such remaining portion.”

136 Section 965(h); reg. section 1.965-7(b)(1). For a domestic passthrough entity, the person who is treated as the owner of the entity makes the election — for example, the grantor of a grantor trust. A subchapter S shareholder may elect to defer all the tax, as discussed later.

140 Reg. section 1.965-7(b)(3)(iii)(A)(1)(ii). Death is not a covered acceleration event and therefore is ineligible for a continuation of installment payments if the parties file a transfer agreement.

145 T.D. 9843, preamble at VII.B.1.

149 An eligible transferee is a single U.S. person other than a domestic passthrough entity. Reg. section 1.965-7(c)(3)(iv) provides that an eligible transferee includes a person treated as the owner of the subchapter S shares under reg. section 1.1362-6(b)(2). For multiple partial transfers, a separate transfer is deemed made to each transferee, and a separate transfer agreement is signed for each.

151 Reg. section 1.965-7(c)(3)(iv) provides that a covered triggering event includes a transfer of shares, including by reason of death or otherwise that results in a change of ownership for federal income tax purposes.

153 Reg. section 1.965-7(c)(3)(iv)(D)(2) and (c)(4).

158 Section 245A(b)(1). There is no cross-reference to the definition of U.S. Shareholder in section 951(b), although this is the probable intent. Incorporation of this definition may be necessary to allow indirect and constructive ownership to count toward the 10 percent ownership threshold necessary to take the deduction under section 245A.

159 Section 245A(b)(2).

167 Prop. reg. section 1.962-1(b)(1)(i)(B)(3); REG-104464-18. The preamble to the section 250 regulations at page 50 recites the legislative history of section 962 (S. Rep. No. 87-1881, 1962-3 C.B. 784, 798) in support of this regulation. Section 962 was intended to allow individual shareholders to incur tax burdens “no heavier than they would have been had they invested in an American corporation doing business abroad.”

170 Section 961(a) (last sentence).

174 Section 875(1); reg. section 1.864-2(c)(2)(ii) excepts partnerships that trade in securities for their own accounts unless they are dealers.

175 Rev. Rul. 85-60, 1985-1 C.B. 187; Donroy Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962).

176 Grecian Magnesite Mining, Industrial and Shipping Co. v. Commissioner, 149 T.C. 63 (2017).

END FOOTNOTES

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