Posted by Karen Munoz, EA

What Is The Transition Tax?

What Is The Transition Tax?

Some laws remain relatively unchanged for decades, if not centuries. However, tax laws are not timeless and must reflect an ever-changing global economy, complex government changes, and, sometimes, volatile market conditions. Karen Munoz, EA, is a tax professional who takes the time to understand the latest tax law changes, ensuring the financial health of her clients, whether in Transition Tax or any other of your tax needs.


In 2017, Congress passed the most important tax legislation since 1986. Known as the Tax Cuts and Jobs Act of 2017, the new regulations affected much of the Federal Tax Code. In addition to changing tax reporting standards and modifying personal income tax calculations, the law also introduced a new compliance standard called the transition tax.


Understanding Section 965 Transition Tax

The Tax Cuts and Jobs Act (TCJA) added Section 965 to the U.S. tax number. In general, this section requires U.S. shareholders to pay a transitional tax on the exempt foreign profits of certain foreign companies, as if those gains had been repatriated to the United States.

Previously, entrepreneurs could defer U.S. corporate income tax by owning assets in a foreign corporation. Section 965 eliminates this ability and requires U.S. taxpayers to pay the new tax on previously tax-exempt assets dating back to 1987.


What Is a Specified Foreign Company?

In the context of Section 965, the IRS defines a specific foreign corporation as:

  • A foreign company, other than a passive foreign investment company, that has a U.S. shareholder that is a domestic company.

  • Any foreign company holding more than 50% of the total combined voting rights of all classes of shares of that voting company or the total value of that company's shares is owned or deemed to be owned by U.S. shareholders within the taxable year.


Who is Affected By The Transition Tax?

Individuals and corporations are potentially subject to Section 965 if they own at least 10% of a foreign corporation's shares. In some cases, individuals may choose to be treated as corporate partners to pay for the transition fee. In this case, the affected person may be entitled to a lower tax rate, although the side effects may outweigh these benefits. Tax professionals can help people determine when to apply this and when it is most financially beneficial to maintain the individual tax rate. In particular, any U.S. shareholder who has already completed Form 5471 must pay Section 965 taxes, although some shareholders may be exempt. Also, shareholders who have never completed Form 5471 may still be subject to Section 965.

These considerations came into effect in the 2017 fiscal year and should be included in all future statements. Because Section 965 is so complex that it extends to other international taxation areas, businesses, and individuals will need to rely on tax professionals' experience to ensure compliance. This situation is further complicated because most tax professionals continue to adapt to the new tax code. Professionals interested in following a career in international tax will need to fully understand the new regulations to deliver maximum value to their clients.


What is The Transition Tax Rate?

Under Section 965, corporations must pay a 15.5% transition tax on accumulated earnings and profits (E&P) that are related to cash assets. Other activities are subject to an 8% transition fee.

Persons in the highest tax category are subject to a transitional tax of 17.5% on exploration and production attributable to monetary assets and a 9.1% tax on non-monetary assets. These taxes exclude the tax on net investment income.


Addressing Taxpayer Considerations.

Potential taxpayers affected by Section 965 must take the following steps to ensure full compliance:

  • Taxpayers must first determine whether they were interested in one or more specific foreign businesses during the current fiscal year.

  • In this case, taxpayers must define the non-taxed E & P amount included in the tax return for that year.

  • Shareholders who are required to pay tax have the option of paying the transition tax in a single installment or must elect to pay the tax in eight annual installments.

  • If taxpayers choose to pay in installments, they must pay 8% of the amount due in each of the first five, 15% of the sixth installment deposit, 20% in the seventh, and 25% in the last installment.

  • Anyone with a transitional tax liability who does not comply with Section 965 may be subject to tax penalties and will likely have to pay interest on the original net debt.

The transition tax adds a level of complexity for some individuals and businesses, which means that they will need tax professionals' experience to ensure compliance. Since this problem affects taxpayers with very different tax considerations, professionals may need to specialize in specific tax compliance rules.


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Karen Munoz, EA
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