IRC 1248: Gain on Sale of Controlled Foreign Corp Stock

Internal Revenue Code (IRC) Section 1248 is a specific provision within U.S. tax law designed to address the profits of certain foreign corporations held by U.S. persons. Its primary function is to prevent the indefinite deferral of U.S. tax on a foreign corporation’s accumulated earnings. When a U.S. shareholder sells their stock in such a corporation, this rule can change the character of the profit they receive.

Normally, the gain from selling stock is treated as a capital gain, which is often taxed at lower rates than ordinary income. Section 1248 alters this by recharacterizing all or part of that gain as dividend income. This ensures the shareholder pays tax on their share of the corporation’s untaxed foreign earnings at rates applicable to dividends, effectively treating the sale as if the corporation first paid out its profits immediately before the transaction.

Determining Applicability

The application of IRC Section 1248 hinges on satisfying three distinct tests related to the shareholder, the corporation, and the transaction. Failure to meet any one of these criteria means the rule does not apply, and the gain would be treated as a capital gain.

The first requirement is the shareholder test, which applies to any “U.S. person” who qualifies as a “U.S. Shareholder.” To be impacted, this person must own, or be considered to own through various ownership rules, at least 10% of the foreign corporation’s total voting power or the total value of its stock.

The second condition is the corporation test, which focuses on the status of the foreign entity. The rule applies only to the sale of stock in a “Controlled Foreign Corporation” (CFC). A foreign corporation is classified as a CFC if, on any day of its taxable year, more than 50% of its stock by vote or value is owned collectively by U.S. Shareholders.

The final test connects the shareholder and the CFC over time. Section 1248 is triggered if a U.S. Shareholder sells or exchanges stock in a corporation that was a CFC at any point during the five-year period leading up to the sale. The shareholder must also have held the stock while the corporation had this CFC status. This lookback period prevents shareholders from avoiding the rule by transferring ownership or breaking CFC status just before a sale.

Information Required for Calculation

Before calculating the amount of gain to be recharacterized under Section 1248, a taxpayer must gather detailed financial information. The first required data point is the total recognized gain on the stock sale. This is the difference between the amount realized from the sale and the shareholder’s adjusted basis in the stock. The amount realized includes cash, the fair market value of any property received, and any liabilities assumed by the buyer.

The most important information to obtain is the foreign corporation’s historical earnings and profits (E&P). The calculation specifically requires the post-1962 E&P of the CFC that is attributable to the shareholder’s stock. This involves a detailed analysis of the corporation’s financial history to compute E&P according to rules similar to those for domestic corporations.

A shareholder must also have clear documentation of their ownership history. The recharacterization only applies to E&P accumulated during the period the shareholder held the stock while the entity was a CFC, requiring precise records of purchase and sale dates.

Finally, the calculated E&P must be adjusted for any amounts that have already been taxed in the United States. This includes Previously Taxed Income (PTI) from other anti-deferral regimes, such as Subpart F inclusions or Global Intangible Low-Taxed Income (GILTI). These adjustments are necessary to prevent double taxation on the same earnings.

Calculating the Recharacterized Amount

The calculation of the recharacterized amount follows a multi-step process that compares the shareholder’s gain to their share of the corporation’s accumulated earnings. The first step is to determine the total gain recognized on the transaction. This figure, calculated as the sale price minus the shareholder’s adjusted basis, represents the maximum potential amount that could be treated as a dividend.

The second step involves determining the shareholder’s pro-rata share of the CFC’s applicable E&P. This is the portion of the corporation’s post-1962 E&P accumulated while the shareholder owned the stock and the corporation qualified as a CFC.

The third step applies the central principle of Section 1248, the “lesser-of” rule. The amount of gain recharacterized as a dividend is the lesser of the total recognized gain or the applicable E&P. This limitation ensures a shareholder is not taxed on more dividend income than their actual gain from the sale.

The final step is to determine the tax treatment of the different portions of the gain. The amount determined under the “lesser-of” rule is included in the shareholder’s gross income as a dividend. If the total gain from the sale is greater than the E&P amount, the excess portion generally retains its character as a capital gain. For example, if the total gain was $1,000 and the applicable E&P was $700, then $700 would be treated as dividend income and the remaining $300 as a capital gain.

A consequence of this recharacterization is its effect on foreign tax credits. Because a portion of the gain is treated as a dividend, a corporate U.S. shareholder may be able to claim deemed-paid foreign tax credits for the foreign income taxes paid by the CFC on those earnings.

Tax Reporting and Compliance

After calculating the recharacterized dividend and any remaining capital gain, the shareholder must report these amounts to the IRS. Failure to report correctly can lead to significant penalties. The primary reporting requirement for the disposition of stock in a CFC is filing Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” The shareholder must complete the relevant sections of Form 5471 that pertain to the disposition of stock and the application of Section 1248.

The different income components from the sale must be reported on the shareholder’s main income tax return. For an individual, the dividend portion is reported on Schedule B of Form 1040, while the capital gain is reported on Form 8949 and carried to Schedule D. For a corporate shareholder, the dividend and capital gain amounts are reported on Form 1120.

Any deemed-paid foreign tax credits associated with the dividend portion of the gain are claimed on Form 1116 for individuals or Form 1118 for corporations.