The Transition Tax Campaign and Small Business — Soft Letters for a Hard-Luck Provision
The IRS has begun to communicate with individual taxpayers as part of a formal campaign to review calculations of the IRS §965 transition tax paid on the untaxed foreign earnings of certain specified foreign corporations.
The 2017 Tax Cuts and Jobs Act (TCJA) entirely transformed the substance of Internal Revenue Code (IRC) §965 (effectively creating “new IRC §965”) — dramatically impacting those specified foreign corporation (SFC) U.S. shareholders, including individuals, that directly or indirectly own at least 10% of the total combined voting power of all classes of the SFC’s voting stock. Specifically, new IRC §965 required such SFC U.S. shareholders to include in gross income their pro-rata share of the SFC’s pre-2018 accumulated and deferred foreign income. Those impacted shareholders were required to report this amount on their returns for the taxable year in which or with which their SFC’s taxable year ends (generally, 2017 and/or 2018). Impacted taxpayers were given a low incentive tax rate and a period of eight years or more to pay the tax.
Small Businesses Burdened by Transition Tax Complexities
The new IRC §965 transition tax was one of only a handful of provisions of the TCJA to take effect on 2017 tax returns. Since the TCJA was signed into law on December 22, 2017, with little legislative guidance, taxpayers and their limited pool of international-savvy advisors were forced to quickly address the complex rules. Suffice it to say there was a lot of math involved.
To put the transition tax effort in context, the revenue target was $338 billion and Treasury regulations noted that the rules could impact up to 100,000 taxpayers — tens of thousands of which would be small businesses. The magnitude of the repercussions on small businesses resulting from the IRC §965 overhaul cannot be overstated.
Some small businesses and advisors felt that the fact that the 2017 return disclosure obligations did not require detailed calculations to be submitted implied that the calculation could be done at a high level. However, for 2018 returns (the year after most taxpayers were required to include up to 30 years of prior earnings in their income), the IRS issued Form 965, which required the detailed calculations to be disclosed — forcing many taxpayers to scramble to rebuild the detail.
The Treasury Department and the IRS made a noble effort to issue guidance through the tax filing season, including a running Q&A, a series of notices, templates contained in Publication 5292 — and a helpful yet lengthy set of proposed regulations issued in August 2018.1 The situation was sufficiently challenging that the U.S. Securities and Exchange Commission provided public companies with additional time to complete mandatory financial reporting in “circumstances in which an entity does not have the necessary information available, prepared, or analyzed (including computations).”
Moreover, another indication of the complexity of the calculations is that new IRC §965(k) provides the IRS with an extension of the statute of limitations for an additional three years to assess the tax liability.
Despite clear and numerous indicators of distress, small businesses received no specific relief. Ultimately, the burdensome impact on small business was brought to light in several legal actions against the government, including most notably the case of expatriate and small businessman, Monte Silver.
Silver v. IRS: Small Business Fight Back
Silver is a dual citizen of the U.S. and Israel. He resides in Israel and owns an Israeli corporation through which he conducts his legal business. Early in 2019, Silver filed suit on behalf of himself and his corporation to seek relief that could be applied broadly to the tens of thousands of impacted small businesses (including an estimated 20,000 or more owned by U.S. citizens living abroad). The cost of filing the initial action was crowdfunded – a classic small business move.
The government’s response to Silver was a determination that his legal firm was not a small business. Although Silver reminded the government that it doesn’t get any smaller than one employee, the reply was that the determination of small business for purposes of transition tax obligations was based on the Small Business Administration criteria—which requires U.S.-based activity. With respect to small businesses that do have U.S. activity, Treasury has suggested they are neither sufficiently sophisticated nor resourced to have the extent of foreign corporate activity to warrant broad small business relief. As a further annoyance to the Silvers of the world, the “transition” for which new IRC §965 is named does not provide individual owners of foreign corporations with the future benefits available to U.S. corporations. Silver’s legal action is ongoing.
The conclusion that small businesses would not be broadly impacted by the transition tax is surprising, especially considering what is widely anticipated to be a large number of impacted taxpayers and the [dedication of sparse] IRS resources to launch a campaign to examine the compliance of small business owners. The latter development was an offshoot to a 2019 campaign (the IRS has over 50 campaigns running) to review transition tax calculations as well as certain planning conducted mostly by large companies. Thereafter, in early 2020, the IRS followed up the broad campaign with a more targeted formal campaign to examine the transition tax calculations of individuals –spearheaded by the IRS Director, Withholding and International Individual Compliance.
A Welcome “Do-Over” for Taxpayers
The IRS’s announcement of its individual campaign indicated that the IRS would address potential non-compliance through soft letters and examinations. Those letters are now being received by individual taxpayers, reminding them of their obligations under new IRC §965 (including associated disclosure requirements including Form 965). The IRS has been using soft letters in other compliance campaigns for several years. According to statements made by IRS representatives in the past, a typical soft letter is not an examination and there is no formal obligation of a taxpayer to respond.
Following a decade of budget cuts that have trimmed IRS enforcement staff by around 25%, the IRS currently has around 75,000 employees. Reviewing up to 100,000 potentially impacted taxpayers will be a challenge — even with an extra three years. In that light, it makes sense for them to encourage taxpayers to self-review their calculations — and possibly, those who amend their returns and reference the soft letter ID number can avoid the naughty list.
Whether you received the letter or not, you may benefit by reviewing the calculation in order to be prepared in the event of an examination. Furthermore, as previously noted, there are incentives available to minimize the tax cost. And finally, income included under new IRC §965 is generally available to be distributed without a further tax cost (even if you elected to pay overtime), or it can be used to reduce future capital gains on the sale of the foreign corporation.
Ideally, as the IRS pursues its campaign, it will take into consideration the harsh history of the application of the transition tax to small businesses. Whether as a result of a soft heart or a resource constraint, the IRS is now effectively giving taxpayers a do-over they should welcome.
- SAB 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (Dec. 22, 2017)
Author: Peter Palsen
International Tax Professional