The 2017 Tax Cuts and Jobs Act (TCJA) has had a significant impact on US owners of foreign corporations. While US persons have always been subject to US tax on their worldwide income, owners of controlled foreign corporations (“CFCs,” or a foreign corporation with US shareholders that own more than 50% of the corporation) were able to defer tax on the foreign source income of their CFC with the exception of certain categories of income (what is known as “Subpart F” income). Prior to TCJA, active foreign business income earned by a CFC was not taxable to the US owner until such income was distributed to them as a dividend. Therefore, it made sense to forego paying themselves a taxable salary and, instead, keep the earnings undistributed in the CFC.
What GILTI Is
With the passage of TCJA, US shareholders who own at least 10% of a CFC are now taxed each year on the CFC’s GILTI (Global Intangible Low-Taxed Income) – GILTI is essentially the CFC’s income excluding Subpart F income (which continues to be currently taxed), regardless of whether the CFC US shareholder has actually received the CFC income as a dividend. Furthermore, there has been a greater negative impact on individual US shareholders of a CFC, arising from the TCJA’s disparate treatment of individual vs. corporate shareholders with respect to applicable deductions, credits, and tax rates. For instance, corporate shareholders have a GILTI tax rate of 10.5%, compared to US individual rates of up to 37%.
How US Owners of Controlled Foreign Corporations Can Reduce Their GILTI
There are several approaches individual US shareholders can take to mitigate the effect, such as electing to be taxed as a domestic corporation or disregarded entity or forming a US C corporation to take ownership of the CFC. However, the increased administrative and filing burdens associated with these strategies can be substantial for the sole owner of a small business. For the individual freelancer who qualifies for the Foreign Earned Income Exclusion (FEIE) and operates through a foreign corporation, there may be a simpler option: pay herself a salary in an amount that reduces GILTI to no more than her standard deduction (or total itemized deductions). This approach works best for the CFC owner who:
- Qualifies for FEIE
- Has CFC net income of roughly $115,000 or less
- Has minimal income otherwise
- Operates a service-based business (or otherwise has minimal depreciable property)
- Is a resident in a low-to-no-tax jurisdiction
How GILTI Is Calculated
First, let’s walk through a brief and simple overview of how GILTI is calculated in the case of a US shareholder who has a single, profitable CFC:
- CFC’s gross income, less deductions and Subpart F income = Tested Income
- Certain depreciable assets used in the business = QBAI (Qualified Business Asset Investment)
- 10% of QBAI = DTIR (Deemed Tangible Income Return)
- Tested Income, less DTIR = GILTI, taxable to the US shareholder
Now consider the case of Sarah, who has a public relations business that she operates through a foreign LLC (FC), which she solely owns. She spends 35 days or less in the US and meets all other requirements for the FEIE. She is single, takes the standard deduction, and does not have any other income or deductions.
In 2018, FC had gross receipts of $50,000 for services provided to clients and no Subpart F income. FC had operating expenses of $2,000 and does not own any depreciable business property.
Compare her US income tax both with and without a salary:
This example illustrates how the sole owner of a small controlled foreign corporation may mitigate the impact of GILTI without filing certain elections or restructuring their business. Of course, any planning should include the consideration of the impact of utilizing the Foreign Tax Credit instead of FEIE, as well the effect on any foreign corporate and individual taxes.
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