How Does the 965 Installment Payment Work?

The Tax Cuts and Jobs Act of 2017 introduced a one-time “Transition Tax” under Internal Revenue Code Section 965. This tax targeted the accumulated foreign earnings of certain foreign corporations, requiring U.S. shareholders to pay tax on these deemed repatriated earnings. To ease the potential financial strain of this liability, the law allows taxpayers to pay the amount owed in installments over eight years. This option provides flexibility for those managing the financial impact of the mandatory inclusion of foreign earnings. The installment method is a formal election that must be properly made to be effective.

Eligibility for the Installment Election

The option to pay the Section 965 net tax liability in installments is available to any “U.S. shareholder” who owes the tax. A U.S. shareholder is defined as a U.S. person, which can be an individual or a domestic corporation, partnership, or trust, that owns at least 10% of a specified foreign corporation. The tax applies to these shareholders’ shares of deferred foreign income from entities like Controlled Foreign Corporations (CFCs).

The election to pay in installments, formally known as the Section 965(h) election, is made at the shareholder level. This means the U.S. shareholder is responsible for making the election, not the foreign corporation whose earnings are being taxed.

It is important to distinguish this from a separate provision available to shareholders of S corporations. Under Section 965(i), these shareholders can elect to defer their liability indefinitely until a triggering event occurs, which differs from the eight-year plan available to all U.S. shareholders.

Making the Election and the Payment Schedule

To use the eight-year payment plan, a taxpayer must make a formal election under Section 965(h). This election is not automatic and must be made with a timely filed tax return for the year the foreign income is included, which for most was the 2017 or 2018 tax year.

The process involves attaching a statement to the federal income tax return that states the taxpayer is choosing to pay their Section 965 net tax liability in installments. Taxpayers must also complete and file Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System. Its Schedule H is where the installment election is formally recorded.

Once a valid election is made, the payment schedule is fixed over an eight-year period. The first installment is due on the original due date of the tax return for the inclusion year, without regard to extensions. The payment amounts are:

• Years 1-5: 8% of the total liability each year
• Year 6: 15% of the total liability
• Year 7: 20% of the total liability
• Year 8: 25% of the total liability

Taxpayers with an outstanding liability must also file Form 965-A, Individual Report of Net 965 Tax Liability, with their income tax return each year until the tax is fully paid. This form tracks the status of the installment payments.

Events That Accelerate Payment

After a taxpayer elects to pay the Section 965 liability in installments, certain events can disrupt the eight-year schedule. The most straightforward triggers are a failure to pay an annual installment by its due date or a failure to file the required annual Form 965-A. If either of these occurs, the entire unpaid portion of the tax liability becomes due and payable immediately, and interest will be charged on the outstanding balance.

The acceleration of payments can also be triggered by significant changes in the taxpayer’s business operations. For instance, if the taxpayer liquidates, sells, or otherwise disposes of substantially all of their assets, the deferral benefit of the installment plan is terminated. This includes situations like a declaration of bankruptcy or the cessation of the business. The remaining unpaid installments become due on the date of such an event.

A change in the relationship with the underlying foreign corporation can also trigger acceleration. If an event occurs that causes the taxpayer to no longer be a U.S. shareholder of the specified foreign corporation that generated the tax liability, the deferral may end. In these circumstances, the unpaid portion of all remaining installments is accelerated and becomes due on the date of the triggering event.