Strategies to Deal with CFCs with Lifestyle-level Net Profit

Reader’s Question about CFC Strategies

This week is a quick break from the FIRPTA content, to answer a reader question about CFCs.

An American living abroad owns 100% of a CFC. Here is the question.

What we know and infer from this question:

The CFC’s net profit is classified as Subpart F income.
The CFC is profitable, but not hugely profitable. It’s hard to know what “much” Subpart F income looks like I’m going to guess it’s low six figures, at most.

In short, this sounds like a classic “minimultinational” situation. This is a foreign corporation that generates lifestyle business levels of profit. It is not a volcano of cash.

So that’s what I’m going to talk about. What does an American individual shareholder do with the CFC in a situation like that?

Three strategies

If you do not like the default tax treatment for U.S. shareholders of CFCs – and there is much to not like – there are three strategies to consider.

Salary strategy: Pay yourself a salary to zero out the CFC’s net profit.
Dividend strategy number 1: pay the net profit to yourself as a dividend and make the Section 962 election for the CFC’s income.
Dividend strategy number 2: pay the net profit as a dividend and use the high-tax exception.

Reject the parent/subsidiary idea

What about a domestic C corporation parent / CFC subsidiary structure?

I don’t like that strategy because you are solving a U.S. tax problem by adding complexity in both the United States (parent corporation Form 1120, etc.) and the other country (the added foreign country tax compliance of having a U.S. corporation as a shareholder rather than a resident individual).

I prefer the via negativa approach championed by Nassim Nicholas Taleb:

Don’t fix an already-complex tax problem by adding more complexity.

The Results, According to My Excel Skills

Under the tax assumptions I make (tax rates in the USA and the other country, etc.) the strategies rank from best to worst as follows,

“Pay it all out as salary” and no dividend – 35%
Section 962 election with a dividend – 54.1%
High-tax exception with a dividend – 54.1%
Default CFC taxation with a dividend – 76.6%

This is the combined effect of U.S. and [COUNTRY] tax loads.

Excel Model of Four Scenarios

I don’t want to make this email a massive wall of text, so I created a little side-by-side comparison super-simple model of CFC taxation treatment, comparing the tax results for an individual shareholder under four scenarios.

In all cases, the idea is to distribute all the profit every year – as my reader is asking – and see what the worldwide tax load of each strategy will be.

Download the spreadsheet through ShareFile here: CFC Taxation Spreadsheet

Strategy 1. Zero Net Profit With Deductible Compensation

The practical strategy is simple, and I generally recommend it as a first option. If the CFC has no net profit, there can be no [COUNTRY] corporate income tax ($0 x 25% = $0). If the CFC has no net profit, then there is no passthrough Subpart F income to the U.S. shareholder.

All of the CFC’s net profit is paid as salary to the shareholder, who pays [COUNTRY] income tax on the salary. U.S. income tax on the salary will almost certainly be eliminated by foreign tax credit or the foreign earned income exclusion.

As a result, the expected outcome will be zero corporate-level income tax in the foreign country, normal individual income taxation in the foreign country on the salary paid out, and zero individual income taxation in the United States because of foreign tax credit.

Thus, the maximum cost of this strategy is simply the foreign country individual tax rate.

Objection: payroll taxes, extra friction, labor laws, etc. might be imposed because of the other country’s income tax laws. Yeah, that’s why you will run the numbers (modify the Excel worksheet I’m giving you) to see if the numbers work.
Objection: the CFC is so profitable that you can’t possibly pay a salary/bonus that high. Yeah, so pay what you can, and use the Section 962 election or high-tax exception to cover the rest of the profit. Something is better than nothing.
Objection: the other country’s tax authority will reclassify this as a dividend instead of compensation. Yeah, OK. Concede defeat and use the Section 962 strategy or high-tax exception instead.

Strategy 2. The Section 962 Election Strategy

The second strategy uses the Section 962 election to reduce the worldwide tax burden of being a U.S. shareholder of a CFC.

Foreign tax credit offsets Subpart F income tax liability

The Section 962 election’s strategy has one massive benefit: it allows the U.S. individual shareholder to claim a foreign tax credit on Form 1040 for foreign country corporate income tax paid by the CFC.

Or, pointing you to the Code: IRC §962(a)(2) allows an individual taxpayer to claim the IRC §960 deemed foreign tax credit.

For every dollar of U.S. income tax liability for the U.S. shareholder caused by the Subpart F income inclusion, expect a dollar of foreign tax credit from IRC §960. The individual U.S. shareholder’s net U.S. individual tax liability on Subpart F income is expected to be zero.

Foreign tax credit offsets income tax on dividend income

The net profit paid out as a dividend to the shareholder (remember my reader wants to pull all of the cash out of the corporation every year) is individual dividend income in the foreign country and the United States.

The shareholder pays individual income tax in the foreign country, and almost certainly the foreign tax credit will completely eliminate U.S. income tax on the dividend.

Regrettably, the net investment income tax is not offset by foreign tax credit. (I have opinions about the NIIT. Don’t get me started.)

Result

Tax is paid at the foreign corporation level (on corporate net profits) and at the individual level in the foreign country (on dividend income). Additionally, U.S. net investment income tax is paid on the dividend income received.

Using the assumptions in my model, the total tax load is 54.1%.

Strategy 3. The High-Tax Exception Strategy

The third way to deal with the problem is to use the high-tax exception.

Subpart F income inclusion eliminated

When you calculate the amount of a CFC’s Subpart F income (also global intangible low-taxed income, for that matter) you can choose to not have it included in the shareholder’s gross income.

You can do this if the CFC’s foreign corporate tax rate on that income is sufficiently high: at least 90% of the U.S. corporate tax rate = 21% x 90% = 18.9%. My model assumes a foreign country corporate income tax rate of 25%, so this scenario qualifies.

You can see the subtraction for the high-taxed Subpart F income, at, for example, Instructions for Form 5471, Worksheet A, line 13g. For global intangible low-taxed income, you can see it on Form 5471, Schedule I-1, line 2c.

This eliminates the passthrough of Subpart F income to the U.S. shareholder, and the U.S. individual income tax liability created by IRC §951(a).

Foreign tax credit offsets dividend income tax liability

All of the net profit of the CFC is distributed out as a dividend to the U.S. individual shareholder.

It’s a dividend because the distribution of cash is from the CFC’s untaxed earnings and profits. IRC §301(c)(1). The U.S. individual shareholder pays foreign country individual income tax on dividend income received.

The foreign country's individual income tax rate is usually higher than the U.S. income tax rate on dividend income (typically I expect to see these dividends treated as a qualified dividend taxable at 20%). Thus, the foreign tax credit rules will eliminate U.S. income tax liability on dividend income.

Again, net investment income tax of 3.8% of dividend income received will be payable in the United States and will not be offset by the foreign tax credit rules.

Result

Corporate income tax is paid in the foreign country on the CFC’s net profit. Foreign individual income tax is paid on the dividend paid by the CFC to the U.S. individual shareholder. U.S. net investment income tax is paid on the dividend income.

The combined tax rate of all of those taxes, using my assumptions in the Excel model, is 54.1%.

Conclusion . . .

For CFCs that generate lifestyle-supporting levels of profit, pay out everything as compensation every year. Zero out the net profit.

Otherwise, use either the Section 962 election strategy or the high-tax exception strategy to reduce (but not eliminate) the pain of the CFC income inclusion rules of IRC §951(a) and IRC §951A(a).