IRS Takes Controversial Approach to Characterization of Separately Stated Item of Subpart F Income

The IRS recently refused to give a ruling on whether a U.S. shareholder of a controlled foreign corporation can make a retroactive election. The issue was whether a U.S. shareholder that owns a CFC through a 100 percent owned S corporation has an amount included in their income. The IRS says they don’t have the ability to make the election because the income is included through the S corporation, not directly. This decision has potential implications for other U.S. international tax rules. A Controlled Foreign Corporation (CFC) is a foreign company owned by more than 50% by people in the US. US shareholders who own 10% or more of the CFC’s voting stock have to include a portion of the CFC’s income in their taxes. There’s a rule that allows individuals who own a CFC to pay taxes at the corporate rate instead of the individual rate. This helps to make sure they don’t pay more taxes than they would if they owned a similar company in the US. If a U.S. individual who owns shares in a foreign corporation decides to make a special tax election (called a §962 election), they will be taxed at corporate tax rates on the income from those shares. They can also get a tax credit for foreign taxes paid on that income. But if they receive a distribution of income from the corporation later on, they might have to pay taxes on that income again. Also, if the individual owns shares in an S Corporation, they have to report their share of the income separately for tax purposes. A U.S. citizen and resident who owned a company in Hong Kong had to deal with the IRS examining their tax returns. The IRS proposed an adjustment of over $20 million in income due to certain loans made by the Hong Kong company to the U.S. company. The taxpayer tried to make a special election to lower their tax bill, but they needed an extension because the deadline had passed. The IRS argued that the sole shareholder of an S corporation that owns a foreign corporation is not eligible for a certain tax election because they do not have a certain type of income. They based their argument on a previous court case involving a U.S. corporation that owned a foreign company. In that case, the court had to decide if the U.S. corporation should include the foreign company’s income in its tax return. The IRS said the U.S. corporation should be treated as owning the foreign company’s stock directly, while the U.S. corporation argued that it should not be considered the owner because it couldn’t vote the stock. The Tax Court said that not all U.S. shareholders of a foreign company need to include its income in their taxes, only the ones who own the company’s stock directly or indirectly. In this case, Textron didn’t directly own the shares of the company, a trust did. The court said the trust had to include the company’s income in its taxes, but because of other tax rules, Textron ended up having to include the trust’s income in its taxes. So, the court’s decision means that the income from the foreign company has to be included in Textron’s taxes. The IRS argued that the taxpayer couldn’t make a certain tax election because they didn’t have a specific type of income, even though the S corporation they were part of did. The IRS said that the taxpayer’s share of the income from the S corporation didn’t count the same way as if they had the income directly. However, the taxpayer argued that the way the IRS was looking at it was flawed, and that according to the partnership rules, each partner has to separately consider their share of income from the partnership. Basically, when a partner in a partnership gets income from the partnership, they have to treat it as if they got that income directly from the source. So, if the partnership had income from a foreign corporation, the partner is treated as if they got that income from the foreign corporation. The IRS says that this doesn’t count for a special tax election, but that doesn’t make sense based on the rules and what lawmakers have said. It should still count, because the whole point of the special tax election is to make sure that people aren’t unfairly taxed. There was a rule that said S corporations should be treated like partnerships for tax purposes. The taxpayer owned a S corporation all by themselves, so they argued that the partnership rule shouldn’t apply. They said they should be treated as if they owned the corporation directly. But the IRS disagreed with them. The IRS has previously supported the position that indirect ownership through a partnership can qualify for certain tax credits. If the IRS does not allow individual partners to make a certain tax election, it could lead to potential abuse and unintended consequences. For example, it could allow tax-exempt organizations to avoid paying taxes on certain income by using a domestic partnership. This was likely not Congress’ intent, but it could happen if the IRS sticks to its position. These sections of the tax code talk about how foreign income is taxed for U.S. shareholders who own part of a foreign company. The rules are supposed to apply to people who own through a domestic partnership, but the IRS is saying they don’t. This goes against what Congress wanted, so it’s causing a problem. The IRS issued Notice 2009-7, saying that taxpayers can’t avoid paying taxes on certain foreign income by using a domestic partnership. It seems like the IRS only believes this when it benefits them. Section 962 was made to make sure everyone pays taxes on this income equally, no matter how they earn it. The IRS should make clear rules about how to handle this income for tax purposes. This text discusses tax laws related to U.S. taxpayers who own foreign companies. It mentions regulations that allow the IRS to give more time to file certain tax elections if the taxpayer acted reasonably and in good faith. It also refers to different sections of the tax code that are relevant to this topic, as well as reports and rulings that provide additional information. Overall, the text is quite technical and may be challenging to understand without background knowledge in tax law. This part talks about a tax lawyer and associate who are members of the Tax Section. They have law degrees and are admitted to practice law in Florida. The firm they work for is well known in the legal field. The column they wrote is about tax laws and regulations.

Source: https://www.floridabar.org/the-florida-bar-journal/irs-takes-controversial-approach-to-characterization-of-separately-stated-item-of-subpart-f-income/