Understanding the Section 965, Transition Tax [all in one guide]
![Understanding the Section 965, Transition Tax [all in one guide]](https://tfxstorageimg.s3.amazonaws.com/sqsldiy9gscx6try7wf7a3gsiix0)
This article is for informational purposes only and does not constitute legal or tax advice.
Always consult with a tax professional for your specific circumstances.
Section 965, commonly referred to as the Transition Tax, was enacted to tax the accumulated and previously untaxed earnings of certain foreign corporations owned by US shareholders.
It serves as a transition from a worldwide tax system to a territorial system.
Key components of Section 965
The Section 965 Transition Tax encompasses various critical elements that define its scope and application.
From specific tax rates for different types of assets to the entities affected and the available payment options, understanding these components is essential for compliance.
Additionally, the IRS mandates detailed reporting requirements that must be meticulously followed.
Let's delve into these key aspects:
1. Tax rate
- Corporations: A tax rate of 15.5% applies to cash and cash equivalents, while an 8% rate applies to other assets.
- Individuals: The tax rate for individuals varies based on their specific circumstances.
2. Affected entities
- US shareholders: Those owning at least 10% of a specified foreign corporation are subject to the tax.
- Specified foreign Corporations: The tax applies to Controlled Foreign Corporations (CFCs) and other foreign corporations with a significant number of US shareholders.
3. Payment options
- Installment payments: Taxpayers may elect to pay the Transition Tax in eight annual installments.
- Deferral for S corporations: S corporation shareholders may elect to defer the Transition Tax until specific triggering events occur.
4. Compliance requirements
- Form 965: Detailed reporting on IRS Form 965 is required.
- Additional forms: Other forms, such as Form 965-A for individual shareholders, may also be necessary.
- Timely filing: Accurate and timely filing is essential to avoid penalties and interest.
Purpose of the Section 965 Transition Tax
"Section 965 is not merely a one-time tax; it has ongoing implications and requires careful consideration," - tax expert
The Transition Tax serves as a bridge from the previous worldwide tax system to the new territorial system.
It aims to tax accumulated foreign earnings that were previously deferred from US taxation.
Additionally, the IRS mandates detailed reporting requirements that must be meticulously followed.
Who is subject to the Transition Tax?
US shareholders owning at least 10% of a specified foreign corporation are subject to the tax.
This includes individuals, partnerships, trusts, estates, and corporations.
Transition Tax vs. GILTI Tax
The Transition Tax (Section 965) and the Global Intangible Low-Taxed Income (GILTI) Tax are two distinct provisions in the US tax code that affect US shareholders of foreign corporations.
While they share some similarities in their focus on foreign income, they differ in several key aspects:
| ASPECT | Transition Tax (Section 965) | GILTI Tax |
|---|---|---|
| Purpose | One-time levy on deferred foreign earnings during the shift from a worldwide to a territorial system. | Discourage shifting profits to low-tax jurisdictions by taxing certain foreign income at a reduced rate. |
| Tax Rate | Corporations: 15.5% on cash, 8% on other assets. Individuals: Varies. |
Corporations: 10.5% (2018-2025), 13.125% (after 2025). Individuals: May differ. |
| Affected Entities | US shareholders owning at least 10% of a specified foreign corporation. | US shareholders of Controlled Foreign Corporations (CFCs). |
| Payment Options | Option to pay in installments over eight years. | N/A |
| Inclusions | N/A | Income from intangible assets such as patents, trademarks, copyrights. |
| Compliance | Detailed reporting on IRS forms, including Form 965. | Reporting requirements include Form 8992 and related schedules. |
Key differences
- Nature of tax: The Transition Tax is a one-time charge, while the GILTI Tax is an ongoing provision.
- Scope: The Transition Tax applies to all accumulated foreign earnings, whereas GILTI targets income from intangible assets.
- Tax rates: Different tax rates and structures apply to each provision.
- Compliance requirements: Distinct reporting requirements and forms are associated with each tax.
Calculating the Transition Tax
The calculation involves multiple steps, including determining the accumulated post-1986 deferred foreign income, applying specific tax rates, and considering foreign tax credits.
The process can be complex, and professional guidance is often recommended.
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Top 5 Section 965 general questions
1. What is the payment in installments?
The Section 965 Transition Tax provides an option for taxpayers to pay their net tax liability in eight annual installments.
This provision aims to ease the financial burden of the tax and provide flexibility in payment.
Here's what you need to know:
a) Specific rules and eligibility criteria
- Election to pay in installments: Taxpayers must make an affirmative election to pay in installments. This election is irrevocable once made.
- Interest: Interest may accrue on the deferred amounts, depending on the taxpayer's specific circumstances.
- Triggering events: Certain events, such as the sale of the business, can accelerate the installment payments, requiring the entire remaining balance to be paid immediately.
b) Required installment and the percent due
- Installments 1 to 5: 8% of the total tax liability is due for each of the first five installments.
- Installment 6: 15% of the total tax liability is due.
- Installment 7: 20% of the total tax liability is due.
- Installment 8: 25% of the total tax liability is due.
c) Payment methods
- Various payment methods are available, including electronic payments through EFTPS.gov, wire transfers, and mailing checks or money orders.
- Specific instructions and payment codes may apply, depending on the payment method chosen.
2. What are the reporting requirements?
Compliance with Section 965 requires detailed reporting on various IRS forms, including but not limited to:
- Form 965: Used to report the Section 965(a) inclusion amount, the deduction under Section 965(c), and the net tax liability under Section 965.
- Form 965-A: Individual US shareholders use this form to report their share of the Section 965(a) inclusion amount, the deduction under Section 965(c), and their net tax liability under Section 965.
- Form 5471: May be required for US shareholders of certain foreign corporations.
NOTE! Accurate and timely reporting is essential to avoid penalties and ensure proper compliance with the law.
3. Impact on S corporations
For S corporation shareholders, the Transition Tax presents unique considerations:
- Deferral option: Shareholders may elect to defer the Transition Tax indefinitely until a triggering event occurs, such as a sale of shares, liquidation, or cessation of the S corporation's business.
- Special rules: The deferral option is subject to specific rules and conditions. Careful planning and understanding of these rules are needed to take advantage of this provision.
- Potential pitfalls: Failure to comply with the requirements or properly elect the deferral can result in unexpected tax liabilities.
NOTE! Pro tax help is often necessary to navigate these complexities and make informed decisions.
4. Exceptions and exemptions
Section 965 includes certain exceptions and exemptions that may reduce or eliminate the Transition Tax liability:
- Earnings thresholds: Corporations with accumulated earnings below specific thresholds may be exempt.
- Other exceptions: Detailed analysis of the law may reveal other exceptions applicable to specific situations.
- Careful analysis required: Understanding these exceptions requires a careful analysis of the law and often professional assistance to apply them correctly.
5. What are the consequences of non-compliance?
Non-compliance with Section 965 can have serious consequences:
- Penalties: Failure to comply can lead to substantial penalties, including fines and additional tax assessments.
- Interest: Interest may accrue on unpaid tax liabilities, increasing the overall cost of non-compliance.
- Legal consequences: In extreme cases, legal action may be taken against non-compliant taxpayers.
- Resolution: Prompt action and professional assistance are essential for resolving non-compliance issues. Engaging a tax expert can help navigate the complexities of the law and achieve a favorable resolution.
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Bottom line
The Section 965 Transition Tax is a complex and multifaceted provision that requires careful consideration and planning.
Whether you are an individual or a business entity, understanding the nuances of Section 965 is essential for compliance and strategic planning.
FAQ
Yes, Section 965, also known as the Transition Tax, is a one-time tax. It was enacted to tax previously deferred foreign earnings as the U.S. shifted from a worldwide tax system to a territorial system.
Section 965(a) defines the amount that must be included in a U.S. shareholder's income as a result of the Transition Tax. Section 965(b) provides adjustments to the amount, particularly related to deficits in earnings and profits among specified foreign corporations. Together, they determine the net tax liability.
The final Section 965 regulations provide detailed guidance on the calculation and reporting of the Transition Tax. They include specifics on the tax rates, affected entities, payment options, and compliance requirements. The regulations were finalized to clarify the implementation of the tax provision.
Taxpayers have the option to pay the Transition Tax in eight annual installments. Specific percentages are due each year, starting with 8% for the first five installments, then increasing to 15%, 20%, and 25% for the final three installments.
An example of a transition tax is the Section 965 Transition Tax itself. It was implemented to tax accumulated foreign earnings that were previously deferred, as the U.S. transitioned to a new territorial tax system. For a U.S. corporation with $1 million in cash held overseas, the Transition Tax might apply at a rate of 15.5%, resulting in a one-time tax liability of $155,000.