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IRS Announces Changes to the Expat Transition Tax, Small Business Owners Overseas Affected

by
Bret Willoughby
on
6/13/2018
IRS Announces Changes to the Expat Transition Tax, Small Business Owners Overseas Affected

The most transformative part of the December 2017 Tax Cut and Jobs Act was on American shareholders of foreign corporations, specifically certain foreign businesses (controlled foreign corporations or CFCs). This includes individual American citizens who own CFCs. 

American Shareholders need to know there is the prior or “old way” corporate shareholders (including individual shareholders) were taxed.  Under the prior rules generally individual shareholders were only taxed when they took cash out of the business in the form of a wage, dividend or interest income. The new way individuals owning CFC are much more like pass through entities where the owner reports their share of income and expenses every year even when cash is not taken out of the foreign corporation.  Lastly, there is a one-time transition called “ the §965 transition tax (aka repatriation tax.)

But under the 2018 tax reform, the transition tax essentially switched from a worldwide system to a participation-and-exemption type of system. Initially designed to repatriate income held overseas by large multinational corporations, unfortunately small business owners and freelancer expats who own small and one-person CFCs are now being afflicted by this change. For expats who are shareholders of deferred foreign income corporations (DFICs, most of which are CFCs for small business owners overseas), they must include their pro-rata share of deemed repatriated earnings or the amount determined under §965. Since the law was intended to go into effect immediately, thus affecting tax returns for 2017, there hasn't been enough time for small business owners and shareholders living overseas to figure out what they owe and if their business interest subjects them to the transition tax now.

The IRS has announced a penalty relief program for expats who are affected by this major change. Estimated tax penalties will be waived for taxpayers who make all required estimated payments by June 15, 2018, even if they improperly applied 2017 overpayments to 2018 estimated taxes. Taxpayers who missed the April 18 filing deadline (June 18 if you live outside the U.S.), and thus the deadline to pay these new taxes, and owe less than $1 million in taxes can be relieved from the underpayment penalty if the first installment is paid by April 15, 2019. Interest will still apply.

The calculated §965 earnings amount held in cash or cash equivalents will be taxed at 15.5 percent with remaining earnings and profits (E&P) taxed at a reduced rate of 8 percent. Taxpayers can opt to pay their tax liability in installments over an eight-year period:

  • 8 percent of net tax liability in the first five years
  • 15 percent of net tax liability in the sixth year
  • 20 percent of net tax liability in the seventh year
  • 25 percent of the net tax liability in the eighth year

If you owe transition tax and have already filed your 2017 tax return, you can file an amended return to make the election to pay in eight installments. A tax professional experienced in expat tax matters and the transition tax can help you determine if your business holdings are subject to this tax and calculate your installments. Visit [TAX PRO PAGE] to learn more.

Bret Willoughby writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].

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Bret Willoughby

Bret Willoughby

Bret Willoughby is a practicing tax preparer for expats throughout the world. He created Providence Payroll to meet the needs of Churches, not-for-profit organizations and businesses with remote workers. His web-based payroll processing service benefits both employers and remote workers with an easy way to access payroll information. Clergy have unique payroll and tax-related issues, one that Providence Payroll is qualified to manage.

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