Proposed Reduction to Section 956 Income Inclusions by Domestic Corporations Owning CFC Stock

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1 In This Issue 1 Proposed Reduction to Section 956 Income Inclusions by Domestic Corporations Owning CFC Stock 2 Minimizing Exposure to Five Possible Taxes 4 Decedent Transferred Partnership Interests, Not Assignee Interests 5 Tax Reform Implementation Tops IRS Commissioner s List 5 Final Regulations on Return Preparer Due Diligence 6 IRS Proposes Amendments on 401(k) Hardship Distributions February 2019 Volume 12 Number 3 7 Electing to Deduct Sales and Use Tax Instead of Property and Income Tax 8 Online Access to Edward Jones Tax Documents Proposed Reduction to Section 956 Income Inclusions by Domestic Corporations Owning CFC Stock Proposed regulations will reduce the Code Sec. 956 amount for certain domestic corporations that own stock in controlled foreign corporations (CFCs) (NPRM REG ; IR ). The proposed regulations aim to ensure that Code Sec. 956 is applied consistently with the new participation exemption system under Code Sec. 245A. Subpart F Rules Under subpart F rules, U.S. shareholders of a CFC are currently taxed on their pro rata shares of the CFC s subpart F income regardless of whether the income is distributed to the shareholders (Code Sec. 951(a)). Subpart F income generally includes the same as a dividend. This rule is intended to create symmetry by taxing effective repatriations of earnings in the same manner as actual repatriations of earnings. Participation Dividends Received Deduction passive income and other income that is readily The Tax Cuts and Jobs Act (TCJA) (P.L ) movable from one taxing jurisdiction to another added Code Sec. 245A, which allows a participation (Code Sec. 952). A U.S. shareholder is a United dividends received deduction (DRD), a 100% States person (e.g., individual citizen, domestic deduction for the foreign-source portion of corporation, etc.) that owns or is treated as dividends received by a domestic corporation owning 10% or more of the voting power or that is a U.S. shareholder of a specified 10% owned value of a foreign corporation (Code Sec. 951(b)). foreign corporation (any foreign corporation, other The U.S. shareholders of a CFC are taxed on their pro than certain passive foreign investment companies, rata share of the CFC s earnings that are invested in with a domestic corporation as a U.S. shareholder). U.S. property during the tax year and not distributed However, a domestic corporation cannot claim or otherwise taxed (the Section 956 amount ). U.S. a participation DRD for a dividend on any share shareholders are effectively taxed on foreign source of the foreign corporation s stock that the domestic earnings brought back to the United States, on the corporation holds for 365 days or less during theory that the returned earnings are substantially the 731-day period that begins 365 days before For tax and legal professionals only. Not for use with the general public. edwardjones.com/teamwork

2 the date when the share becomes ex-dividend with respect to the dividend, or to the extent the domestic corporation is obligated to make related payments on positions in substantially similar or related property (Code Sec. 246(c)). Under TCJA rules, a Section 956 inclusion in the gross income of a corporate U.S. shareholder is not eligible for the participation DRD because it is not a dividend. Tax Treatment Symmetry The new participation DRD exemption system has made the current broad application of Code Sec. 956 to corporate U.S. shareholders inconsistent with the Code section s purposes and the scope of the transactions it was meant to address. In response, the proposed regulations will do the following: Exclude corporate U.S. shareholders from the application of Code Sec. 956 as needed to maintain symmetry between the taxation of actual repatriations and effective repatriations, so neither an actual dividend to a corporate U.S. shareholder nor the shareholder s Section 956 amount will result in additional U.S. tax Reduce the Section 956 amount otherwise determined regarding a U.S. shareholder for a CFC s tax year, to the extent that the shareholder would be allowed a participation DRD had the shareholder received a distribution from the CFC equal to the Section 956 amount otherwise determined Under the proposed regulations, in many cases a corporate U.S. shareholder will not have a Section 956 inclusion as a result of a CFC holding U.S. property. Code Sec. 956 will still apply without modification to noncorporate U.S. shareholders such as individuals, to ensure amounts substantially equivalent to a dividend are treated similarly to actual dividends. This treatment will apply regardless of whether individuals elect under Code Sec. 962 to be taxed at corporate rates. Further, Code Sec. 956 will still apply without reduction to regulated investment companies (RICs) and real estate investment trusts (REITs), because they are not allowed to claim the participation DRD. Applicability Date The proposed regulations will apply to a CFC s tax years beginning on or after the date the Treasury decision adopting the rules as final is published in the Federal Register ( finalization date ), and a U.S. shareholder s tax years in or with which the CFC s tax years end. Additionally, for a CFC s tax years beginning before the finalization date, if a taxpayer and U.S. persons related to the taxpayer consistently apply the proposed regulations for all CFCs in which they are U.S. shareholders, the taxpayer can rely on the proposed regulations for a CFC s tax years beginning after Dec. 31, 2017, and a U.S. shareholder s tax years in or with which the CFC s tax years end. Minimizing Exposure to Five Possible Taxes When taxpayers compute their tax exposure, they should consider their specific situation and goals as well as reducing the impact of the following five types of taxes that could affect their income: Federal income tax Capital gains tax The 3.8% net investment income tax (NIIT) The additional Medicare or Hospital Insurance (HI) tax Federal Income Tax For tax years beginning after 2017 and before 2026, the tax rates for individuals are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Income deferral and acceleration strategies for individuals and businesses are discussed later in this article. The alternative minimum tax (AMT) 2

3 Capital Gains Tax Long-term capital gain from sales of assets held for over one year is taxed at 0%, 15% or 20%, depending on the taxpayer s taxable income. The 3.8% Net Investment Income Tax Year-end tax planning should include minimizing exposure to the NIIT, a 3.8% surtax imposed on the lesser of net investment income (NII) or the amount of modified adjusted gross income (MAGI) with foreign income added back that exceeds $200,000 for single and head-of-household taxpayers, $250,000 for married couples filing a joint return, and $125,000 for married couples filing a separate return. NII is based on the sum of the following: Gross income from interest, dividends, annuities, royalties and rents, unless those items are derived in the ordinary course of a trade or business Gross income derived from any passive trade or business Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business NII is the excess, if any, of that sum over the allowable deductions properly allocable to that gross income or net gain. The 3.8% NIIT applies to a trade or business if it is a passive activity of the taxpayer or a business of trading in financial instruments or commodities. Investment income does not include any amount subject to the self-employment tax or amounts distributed from retirement plans. Additional Medicare Tax An additional 0.9% Medicare tax is imposed on wages and self-employment income in excess of $200,000 for single and head-of-household taxpayers, $250,000 for married couples filing a joint return, and $125,000 for married couples filing a separate return. To avoid an underpayment penalty, taxpayers should make estimated tax payments that cover any liability for the 0.9% additional Medicare tax that is not covered by withholding. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. The Alternative Minimum Tax The Tax Cuts and Jobs Act (TCJA) did not eliminate the AMT for individuals (only corporate AMT), but the new law reduced the likelihood that most taxpayers will be subject to the tax by substantially increasing the AMT exemption amount for tax years 2018 through 2025: For joint returns and surviving spouses, $109,400 For single taxpayers, $70,300 For married couples filing separately, $54,700 These exemption amounts are reduced to 25% of the amount by which the taxpayer s alternative minimum taxable income (AMTI) exceeds the phase-out amounts, increased as follows: For joint returns and surviving spouses, $1 million For all other taxpayers except estates and trusts, $500,000 The AMT exemptions for individuals will completely phase out in 2018 at these AMTIs: $1,437,600 for married couples filing jointly and surviving spouses $781,200 for other unmarried taxpayers $718,800 for married couples filing separately Taxpayers with private activity bonds should time interest income receipt to avoid AMT exposure. Tax Planning to Avoid the AMT Taxpayers who must pay the AMT should consider year-end tax strategies that will avoid or minimize their exposure to the tax. Taxpayers can attempt to reduce AMT exposure by spreading their AMT preferences and adjustments over two years to take advantage of the exemption amount they have in each tax year. Taxpayers should use Form 1040, U.S. Individual Income Tax Return, and Form 6251, Alternative Minimum Tax Individuals, to estimate their taxable income and AMTI for this year and next year, and to calculate their expected tax bill for both years. In a tax year when AMT liability is inevitable, taxpayers may want to consider accelerating the receipt of ordinary income and postponing deductions until the following year. 3

4 Taxpayers subject to the AMT should find ways to avoid the following AMT risk factors or triggers: Exercise of in-the-money incentive stock options (ISOs). The bargain element (the difference between the market value of the shares on the exercise date and the taxpayer s exercise price under the ISO) does not count as income under the regular tax rules but does count as income under the AMT rules. Taxpayers should therefore consider spreading out exercises of any in-themoney ISOs over several years. Interest from private activity bonds that is tax-free for regular tax purposes but taxable under AMT rules. Though the interest on municipal bonds is tax-free under the regular tax rules, interest on private activity bonds is taxable under the AMT rules, which increases AMT exposure. Taxpayers with private activity bonds should time interest income receipt to avoid AMT exposure. Depreciation write-offs for machinery, equipment, computers, furniture and fixtures. These business assets must be depreciated over longer periods under the AMT rules, which increases the likelihood of owing the AMT. Under the TCJA, businesses can deduct the entire cost of many depreciable assets in year one under both the regular tax rules and the AMT rules if the assets are placed in service between Sept. 28, 2017 and Dec. 31, 2022 under Code Sec Taxpayers should consider expensing these assets rather than depreciating them. Decedent Transferred Partnership Interests, Not Assignee Interests In F.D. Streightoff, Est. (TC Memo , Dec. 61,297(M)), a decedent transferred partnership interests, and not assignee interests, to a revocable trust. The decedent transferred liquid assets to a limited partnership. An entity managed by the decedent s daughter was the general partner, and the decedent, his children and a child s spouse were the limited partners. The partnership agreement permitted certain transfers of partnership interests. Until approval as a substitute limited partner was granted to a recipient of a partnership interest, that recipient was treated as the holder of an assignee interest and did not have the same rights as the holder of a partnership interest. Partnership Interest Although the agreement transferring the decedent s limited partnership interest was identified as an assignment, the trust was given all rights associated with the decedent s interest, including the right to vote. The transfer agreement met all conditions outlined in the partnership agreement for the transfer of a limited partnership interest and admission as a substitute limited partner. As a result, the decedent transferred limited partnership interests, and not assignee interests, to the trust. In addition to the form of the transfer, the substance of the transaction also supported the conclusion that the decedent transferred partnership interests to the trust. Applicable Discount for Lack of Marketability The asset to be valued was the decedent s limited partnership interest with appropriate discounts applied. The parties retained experts who calculated the fair market value of the transferred interest based on the net asset value of the underlying partnership. The estate applied a discount for lack of control in valuing the interest. Because the decedent transferred an 88.99% interest, there was no lack of control, so no discount was applied. The government s expert calculated a discount for lack of marketability that took into consideration the partnership s diversification of assets, high liquidity, amount of control provided by the decedent s interest, and the right of first refusal granted in the partnership agreement. The estate s discount for lack of marketability was rejected because it was based on valuation of an assignee interest. 4

5 Tax Reform Implementation Tops IRS Commissioner s List Tax reform implementation is at the top of new IRS Commissioner Charles Rettig s list of priorities as chief of the agency, which he discussed at the American Institute of CPAs National Tax Conference. IRS Commissioner Rettig was nominated by President Donald Trump last February and confirmed by the Senate in September. Rettig was sworn in as the 49th IRS Commissioner on Oct. 1, Before leading the IRS, Rettig was a practicing tax attorney for over 30 years. Tax Reform In an informal outline of areas on which Rettig intends to focus, he stated, The top of the list is continuing to implement the Tax Cuts and Jobs Act, which contains the most sweeping tax changes in 30 years. The IRS has already made great progress in this area, but more remains to be done. The Tax Cuts and Jobs Act (TCJA) (P.L ) was signed into law by President Trump last December. The TCJA is expected to undergo further scrutiny and analysis in Congress because the House Ways and Means Committee will likely hold hearings next year on various provisions of the new law. IRS Guidance Rettig noted the IRS is committed to helping taxpayers and tax professionals understand the new tax law changes, as well as file timely and accurate returns next year. To that end, the IRS will continue to issue guidance related to tax reform. You can expect additional guidance in the next several weeks in a number of areas, he said, including TCJA provisions on the following: Opportunity Zones The limitation on the business interest expense deduction The base erosion and anti-abuse tax Additionally, the IRS will continue to update taxpayer forms and instructions related to new tax law provisions. According to Rettig, We re well on our way to having those completed in time for [2019] filing season. Final Regulations on Return Preparer Due Diligence Amendments to the tax return preparer regulations expand the scope of due diligence (T.D. 9842; IR ). The regulations apply to the due diligence penalty related to the following: The child tax credit The additional child tax credit The American opportunity tax credit For tax years beginning after Dec. 31, 2017, Congress expanded the penalty again to include preparers who fail to comply with requirements for determining eligibility to file as head of household. A taxpayer s eligibility to file as head of household The regulations are effective Nov. 7, Final Due Diligence Regulations The final regulations adopt without substantive Return Preparer Penalty Expanded changes the 2016 proposed regulations and the entirety of the 2018 proposed regulations. The For tax years beginning after Dec. 31, 2015, Congress final rules contain examples that illustrate how the expanded the penalty to include preparers who regulations work. Further, a detailed explanation are noncompliant in determining eligibility for, of the regulations is in the preambles to the 2016 or amount of, the child tax credit, additional child temporary regulation and the 2018 proposed rules. tax credit and American opportunity tax credit. 5

6 IRS Proposes Amendments on 401(k) Hardship Distributions The IRS is proposing to amend regulations for hardship distributions from 401(k) plans to reflect changes in the law. In particular, the proposed regulations would reflect changes in the Bipartisan Budget Act of 2018 (P.L ), and the Tax Cuts and Jobs Act (TCJA) (P.L ) (NPRM REG ). The IRS is also proposing housekeeping changes to reflect older legislation. Deemed Immediate and Heavy Financial Need The proposed regulations clarify that the meaning of casualty loss to a principal residence for purposes of a hardship withdrawal is unaffected by the new Code Sec. 165(h)(5) limit. The TCJA added that provision to limit the deduction to losses attributable to a federally declared disaster area for 2018 through The proposed regulations decouple the limit from the hardship withdrawal rules. Distribution Necessary to Satisfy Financial Need The proposed regulations reflect changes directed by the Bipartisan Budget Act, including eliminating the six-month prohibition on contributions following a hardship distribution, and allowing a distribution even though the employee did not take any available loan under the plan. Amount Available for Hardship Withdrawal The changes also would add a new The amendments would reflect the Bipartisan Budget expense category for damage incurred Act s increase in the maximum amount available for in federally declared disaster areas. distribution by adding non-grandfathered qualified nonelective contributions, qualified matching The changes also would add a new expense contributions and earnings on these contributions. category for damage incurred in federally declared disaster areas. The new safe harbor expense would Applicability be similar to relief given by the IRS after Hurricane The changes to the hardship distribution rules Maria and the California wildfires in Announcement generally would apply to distributions made in plan (I.R.B ). The change is intended to years beginning after Dec. 31, However, the eliminate any delay or uncertainty concerning access prohibition on suspending elective and employee to plan funds following a disaster that occurs in contributions as a condition of obtaining a hardship an area designated for individual assistance by distribution may be applied as of the first day the Federal Emergency Management Agency. of the first plan year beginning after Dec. 31, 2018, even if the distribution was made in the prior plan year. The revised list of safe harbor expenses may be applied to distributions made as early as Jan. 1,

7 Electing to Deduct Sales and Use Tax Instead of Property and Income Tax For tax years beginning after 2017 and before 2026, the total deduction that may be claimed for nonbusiness state and local real and personal property taxes, income and general sales taxes (if elected) is limited to $10,000 ($5,000 for married couples filing separately) (Code Sec. 164(b)(6)(B)). If a taxpayer lives in a state that imposes a sales tax but not an income tax, it may be beneficial to elect to deduct state and local general sales and use taxes as an itemized deduction, instead of deducting state or local income taxes. The election may also be beneficial if the taxpayer paid more in sales tax than income tax in a particular tax year because of big-ticket purchases. If taxpayers make this election, they may either deduct their actual sales and use taxes or add the actual amount of their sales tax for certain big-ticket items such as motor vehicles, boats, aircraft, homes (including mobile and prefabricated homes) and homebuilding materials to the amount from IRS-published tables. These tables are based on the average state-by-state taxpayer consumption of items other than the specified big-ticket items, taking into account total available income, number of exemptions claimed and the rate of state general sales taxation (Code Sec. 164(b)(5)). Taxpayers who want to deduct general sales and use taxes should purchase big-ticket items to maximize their itemized deduction for sales taxes. Building a Team of Professionals to Help Provide Solutions for Our Clients At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor. We want to work together as a team and offer value for your practice and clients. Using complementary skills and philosophies, we can help save time, money and resources while assisting mutual clients in planning for today s financial and tax challenges. The Connection journal content is provided by Wolters Kluwer and Edward Jones and published by Edward D. Jones & Co., L.P., d/b/a Edward Jones, Manchester Road, St. Louis, MO Opinions and positions stated in this material are those of the authors and do not necessarily represent the opinions or positions of Edward Jones. This publication is for educational and informational purposes only. It is not intended, and should not be construed, as a specific recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals only; it is not for use with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting upon any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances. Reprinted by Edward Jones with permission from Wolters Kluwer. All rights reserved. 7

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