How to Prepare an IRC 965 Transition Tax Statement

The Internal Revenue Code (IRC) Section 965 transition tax was introduced as part of the Tax Cuts and Jobs Act of 2017 (TCJA). This one-time tax was a component of the United States’ shift from a worldwide tax system to a territorial one. Its purpose was to impose a tax on the accumulated and previously untaxed foreign earnings of certain foreign corporations owned by U.S. shareholders. These earnings, which had been deferred from U.S. taxation under the prior system, were treated as if they had been brought back, or repatriated, to the U.S.

The tax applies to the final taxable year of these foreign corporations that began before January 1, 2018. For the U.S. owners, this income inclusion occurred in their 2017 or 2018 tax year.

Determining Applicability and Calculating Net Tax Liability

The Section 965 tax applies specifically to a “U.S. Shareholder” of a “Specified Foreign Corporation” (SFC). A U.S. Shareholder is a U.S. person or entity that owns 10% or more of the total combined voting power of a foreign corporation. An SFC is defined as either a Controlled Foreign Corporation (CFC), where U.S. Shareholders own more than 50% of its vote or value, or a foreign corporation with at least one corporate U.S. shareholder.

The tax is triggered if the SFC is also a “Deferred Foreign Income Corporation” (DFIC), meaning it has accumulated post-1986 deferred foreign income greater than zero. This deferred income is measured on one of two specific dates: November 2, 2017, or December 31, 2017. The calculation begins by determining a U.S. Shareholder’s pro-rata share of this post-1986 earnings and profits (E&P), which have not been previously subjected to U.S. tax. This amount constitutes the shareholder’s Section 965(a) inclusion.

From this initial inclusion amount, the calculation allows for a reduction based on the shareholder’s share of E&P deficits from other specified foreign corporations. This step ensures the tax is levied on the net accumulated foreign earnings across all of the shareholder’s relevant foreign holdings. The result of this netting process is the final amount of foreign earnings that will be subject to the transition tax.

The next step involves calculating the shareholder’s aggregate foreign cash position, which represents the shareholder’s pro-rata share of the cash and cash equivalents held by their SFCs. The law provides for a participation deduction that results in two different effective tax rates. A 15.5% rate applies to the portion of earnings held in cash or cash equivalents, and an 8% rate applies to the remaining earnings.

Applying these respective rates to the appropriate portions of the income inclusion determines the shareholder’s total net tax liability under Section 965.

Required Information for the Transition Tax Statement

A taxpayer subject to the transition tax must attach a detailed statement to their income tax return. This document, often referred to as the IRC 965 Transition Tax Statement, must be attached to the return for each year a taxpayer has a Section 965-related obligation, such as making an installment payment. The statement must include the following information:

• The total Section 965(a) inclusion amount.
• The aggregate foreign cash position.
• The aggregate amount of foreign E&P deficits that were used to reduce the initial income inclusion.
• The calculated Section 965(c) deduction amount.
• The total net tax liability under Section 965.
• Information for each SFC, including its name, Employer Identification Number (if any), its E&P, and its cash position.
• Any penalties being reported.

Making Section 965 Elections

Taxpayers affected by the transition tax were provided with several elections to manage the payment of their liability, which must be made with the filing of the relevant tax return. The most common of these is the Section 965(h) election, which permits a taxpayer to pay their net tax liability in eight annual installments. This option was designed to ease the immediate financial impact of the one-time tax.

The installment schedule under the Section 965(h) election is back-loaded. The first five installments are each 8% of the total liability, the sixth is 15%, the seventh is 20%, and the final installment is 25%. Making this election does not accrue interest on the deferred tax amounts. However, certain subsequent events, such as the sale of substantially all company assets, can trigger an acceleration of the remaining unpaid installments.

Another choice is the Section 965(i) election, available exclusively to shareholders of S corporations. This election allows the shareholder to defer payment of their portion of the Section 965 liability indefinitely until a “triggering event” occurs. Such events include the S corporation ceasing to be an S corporation, the shareholder disposing of their stock, or the liquidation or sale of substantially all of the S corporation’s assets. Other elections were also available for taxpayers with a net operating loss or for those structured as Real Estate Investment Trusts (REITs).

Filing the Statement and Paying the Tax

The prepared IRC 965 Transition Tax Statement, or the more recent IRS forms that formalize the reporting, must be attached to the taxpayer’s annual income tax return. The IRS released a series of forms, including Form 965 and Form 965-A for individual taxpayers, which are filed as attachments to the main return like Form 1040 or Form 1120.

The net tax liability calculated under Section 965 is reported on a specific line of the main tax return. If no election was made, the full tax liability was due with the return for the inclusion year. For taxpayers who made the Section 965(h) election, payments are made annually by the due date of the tax return, without extensions.

Each installment payment must be made separately from the regular income tax payment for that year. After filing, taxpayers should maintain records of their calculations, statements, and payments, as the Section 965 liability can have ongoing relevance for many years.