The Tax Cut and Jobs Act brought many changes to taxpayers in past years. From the changes to tax rates, standard deduction, child tax credits, and deductions for medical, charity, and state and local taxes, US taxpayers are having a hard time keeping up, and for good reason. Due to these changes, American expat entrepreneurs are becoming familiar with a new term: GILTI. Don’t let the GILTI feeling get you down – find out a few simple ways expats can tackle GILTI and the benefits and disadvantages of each scenario below!
What Is GILTI?
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 Will GILTI Affect American Expat Entrepreneurs?
At Greenback, we are seeing GILTI apply to many expats who have formed or are considering forming a corporation in a foreign country. Though many are already accustomed to filing a Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) each year with their personal US tax return. However, they are now wondering how GILTI applies to them, how they will be taxed on their foreign corporation, and what options they have for mitigating the GILTI.
Below are four scenarios describing how GILTI could apply to an American expat entrepreneur who owns a foreign corporation.
Example #1: American expat entrepreneur who files form 5471 and pays the highest marginal rate.
If you elect to file Form 5471 and pay GILTI tax each year at the highest individual marginal tax rate (up to 37% in 2021), the GILTI income from the foreign entity will be taxed at ordinary rates, which can be up to 37% if you are in the highest US tax bracket. Your marginal tax rate can vary from year to year depending on your taxable income. When the foreign entity’s income is taxed under GILTI, all of your foreign earnings will then be considered Previously Taxed Income (PTI), and therefore will not be subject to taxation again when you take dividends from the foreign company.
So, the foreign entity’s income is taxed each year as it is earned at your US individual tax rates and is then non-taxable dividend income when you actually take the dividends from the company. The biggest downside to this is that the foreign corporate taxes that the entity will pay each year in the foreign country cannot be taken as a Foreign Tax Credit on your individual US tax return, so you’re subjecting the same earnings to double-taxation.
Example #2: American expat entrepreneur who files Form 5471 and makes a Section 962 election to be taxed as a corporation.
If you elect this option, you would pay GILTI tax each year at the corporate rate (21%). There is a potential option to make a Section 962 election whereby an individual can pay the GILTI tax as if the individual were a US corporation (at the recently reduced corporate tax rate of 21%). Obviously, a 21% tax rate is lower and preferable to a 37% tax rate. Another added benefit to this is that a foreign tax credit of up to 80% of foreign corporate taxes paid can be used to offset the tax from the GILTI inclusion. Depending on the tax rate in the foreign country, this could potentially offset the US tax on GILTI or at least a good majority of it.
The downside to this option is that when you take dividends from the company, the dividends will be taxable on your personal tax return because they are not considered PTI. Therefore, you’re subject to two tiers of taxation: the GILTI tax at corporate rates (21%) under a Section 962 election (potentially offset by foreign tax credits) plus the tax on the qualified dividends (15%). When you receive dividends from the foreign entity, you are often paying foreign taxes in the foreign country on that dividend income, and therefore would be able to take a Foreign Tax Credit to offset the US tax on the dividend income (potentially offsetting the full amount of US tax on the dividends depending on the foreign tax rate).
Because of the lowered tax rate on GILTI and the ability to utilize both corporate and personal foreign taxes paid for foreign tax credits, this is generally a preferable option for many taxpayers.
Example #3: American expat entrepreneur who files Form 8832 to be treated as a Disregarded Entity, files Schedule C and Form 8858 annually, and claims exemption from US self-employment tax under a Totalization Agreement.
This approach is applicable for US shareholders who own 100% of a CFC and live in a foreign country that has a Totalization Agreement in place with the United States, and is attractive because it could mitigate the GILTI tax. The foreign disregarded entity’s information would be reported on Form 8858. Additionally, electing to be taxed as a disregarded entity means the income would then be reported as self-employment income on Schedule C, which is taxed at individual tax rates (up to 37%) and taxed again at self-employment tax rates (15.3%).
The benefit to reporting the earnings on Schedule C is that the Foreign Earned Income Exclusion could be used to reduce the taxability of the income on Schedule C (up to $108,700 per individual for 2021). The Foreign Tax Credit can be used to offset any US income taxes incurred from the Schedule C earnings. The potential downfall to reporting as a disregarded entity on Schedule C is the self-employment tax of 15.3%. To negate this tax, claim an exemption from US social security taxes under a Totalization Agreement between the US and the foreign country in which you reside by attaching a statement and a Certificate of Coverage to your tax return each year.
Example #4: American expat entrepreneur who forms a US C-corporation and places the foreign corporation shares within the US corporation.
US C-corporations are also responsible for GILTI tax but are allowed a Section 250 deduction of 50% of GILTI included in gross income, which would cut the GILTI tax in half. It also would allow a foreign tax credit of up to 80% of foreign corporate taxes paid, which can be used to offset the GILTI tax. Depending on the tax rate in the foreign country, this might offset the GILTI tax entirely – or at least a good portion of it. The downside is that you have to form a US C-corporation and incur the legal fees and formation costs in addition to the annual tax reporting requirements involved with a corporation. Additionally, when you want to issue dividends from the foreign corporation, those would need to be paid to the US parent corporation and then distributed to you personally from there, incurring multiple layers of taxation. The added effort with this approach may be worthwhile for foreign companies with millions of dollars in revenue. However, for smaller foreign entities owned by one US expat, utilizing the Section 962 election or the disregarded entity election option is often preferable.
An Example of How GILTI Is Calculated
Next, 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 2020, she had gross receipts of $50,000 for services provided to clients and no Subpart F income. She 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.
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
Want Expert Advice on Your Expat Taxes?
Greenback’s team of experts is ready to make sure your taxes are prepared correctly without any hassle, including GILTI. Schedule a consultation today, and you can make the best possible plans for your foreign corporation.