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March 22, 2018 - Haoshen Zhong

GILTI vs Passthrough Deduction

GILTI vs passthrough deduction

If you were paying attention to the tax law rewrite last year, you may have heart the term “global intangible low-taxed income” (GILTI). It is supposed to establish a minimum tax on foreign source income for multinational corporations. It also affects US citizens and residents.

We previously covered what happens under default GILTI rules and with a corporate rate election. The basic idea is that most of the profits of the foreign corporation are taxed to the US shareholders directly every year.

If the country where the business is located has high corporate income tax, it is generally better for US shareholders to elect to apply corporate tax rates to GILTI. If the country where the business is located does not have corporate income tax, the US shareholders would need to make a decision between paying more taxes in the long run (corporate rate election) or paying more tax annually (default rules).

Usually, there is another way to pay US tax: Use a pass through entity, so the income is passed to the owner under partnership or disregarded entity rules rather than under GILTI rules. The new tax rules added a deduction for pass through income. It is section 199A of the Code. Let us see whether the passthrough deduction or GILTI works better for someone who runs a business abroad.

Our assumptions

To preserve continuity, let us work with the same example as before.

A US citizen moves to Israel and starts a software company.

The company develops its own software and licenses the software to unrelated enterprises. The licensing royalties are its only source of income. It qualifies for the 16% reduced corporate tax rate and the 20% reduced dividend tax rate in Israel because of Israeli incentives for tech companies (preferred enterprise).

Aside from the US citizen, the company has a 3 employees in Israel, none of whom is a US citizen or resident. The company rents an office. It owns $10,000 or so of furniture and computing equipment.

The company’s annual revenue is about $900,000, and its expense are about $400,000 (not including income tax). Of the expenses, $100,000 reflects the US citizen’s salary.

The US citizen owns 60% of this company, and the other employees own 40%.

Summary of results under GILTI

We have a corporation that has:

  • Annual revenue of $900,000
  • Business expenses of $400,000
  • Income before tax of $500,000, of which our US citizen’s share is 60%, or $300,000
  • Israeli corporate tax of $80,000
  • Tangible business assets of $10,000

Here are the abbreviated results under GILTI rules. For the full explanation of how we arrived at the explanation, please see the linked previous posts.

The default rules

Under the default rules, this is what happens.

Here is how we calculate the GILTI inclusion and US tax on the GILTI:

  • GILTI = 251,400
  • US tax on GILTI = 0.37 x 93,018

Here is the Israeli tax, should the company distribute dividends:

  • Israeli tax on dividends: 0.2 x 252,000 = 50,400
  • Israeli wealthy person tax: 0.03 x 252,000 = 7,560

But the Israeli tax on dividends is imposed in the year of distribution, not annually. When it is distributed, the tax is classified into different baskets of foreign tax based on the earnings that created the dividends. Reg. §1.904-6(b)(2)(i). During the tax law change, Congress added new foreign tax credit baskets for GILTI and foreign branch income. IRC §904(d)(1)(A), (B). I believe the Israeli tax, when imposed, would be a tax on GILTI, because the dividends are the result of GILTI.

This means the US citizen may or may not get to use the Israeli tax as a foreign tax credit, depending on whether he has GILTI in the year of distribution or the year before distribution.

At distribution, there is a net investment income tax = 0.038 x 252,000 = 9,576

Annually, it costs $93,018 of US tax and $48,000 of Israeli tax on the $300,000 of pre-tax profits allocated to the US citizen’s 60% share. This is an effective tax rate of 47%.

To get profits in the hands of the US citizen, there is at minimum an additional US net investment income tax of $9,576, bringing the total effective tax rate to 50%. In the worst case scenario, the US citizen has no GILTI in the year of distribution or the year before distribution, meaning the Israeli tax of $57,960 on the dividends is in addition to the previous taxes, bringing the effective tax rate to a rather impressive 70%.

Corporate rate election

Under the corporate rate election, below is the abbreviated result for the taxes with a corporate rate election.

Here is how we calculate the GILTI inclusion and US tax on the GILTI:

  • Tested income before gross up = 0.6 x (900,000 – 400,000 -80,000) = 252,000
  • Gross up for foreign taxes paid: 252,000 / (900,000 – 400,000 – 80,000) x 80,000 = 48,000
  • Tested income = 252,000 + 48,000 = 300,000
  • GILTI = 300,000 – 0.1 x 0.6 x 10,000 = 299,400
  • US tax on GILTI = 0.21 x 299,400 = 62,874

And here is the foreign tax credit:

  • Inclusion percentage = 299,400 / 300,000
  • Tested foreign income taxes = 0.6 x 80,000 = 48,000
  • Foreign tax credit = 0.8 x 2,994 / 3,000 x 48,000 = 38,323

Net US income tax = 62,874 – 38,323 = 24,551

This is the income tax on the dividends, when they are actually distributed:

  • Non-section 962 E&P: 0.6 x (900,000 – 400,000 – 80,000) = 252,000
  • Excludible section 962 E&P: 24,551
  • Dividends included in income: 252,000 – 24,551 = 227,449
  • Tax on dividends: 0.2 x 227,449 = 45,490
  • Israeli tax on dividends: 0.2 x 252,000 = 50,400
  • Israeli wealthy person tax: 0.03 x 252,000 = 7,560
  • US tax after foreign tax credit: $0
  • $4,910 of unused foreign tax credit carry forward.

Of course, when dividends are distributed, net investment income tax = 0.038 x 252,000 = 9,576

Annually, it costs $24,551 of US tax and $48,000 of Israeli tax on the $300,000 of pre-tax profits allocated to the US citizen’s 60% share. This is an effective tax rate of 24%.

To get profits in the hands of the US citizen, there is an additional US tax of $9,576 and an additional Israeli tax of $57,960. This brings the combined tax rate to 47%.

The passthrough deduction

The new tax law added a pass through deduction. It is section 199A of the Code. The idea is that when an individual conducts a business through a pass through entity–a partnership or a single member LLC, for example–he may get a deduction to reduce the effective tax rate on the income from the business.

The exact wording is a bit ugly, so I will just write the formula in section 199A(a):

Passthrough deduction = min(combined qualified business income amount, 0.2 x (taxable income – net capital gain – qualified cooperative dividends)) + min(0.2 x qualified cooperative dividends, taxable income – net capital gain)

Note that this deduction is available for a taxpayer other than a corporation. IRC §199A(a). This means our US citizen will need to use some sort of pass through entity for is software business. Let us assume that he organizes a US limited liability company with the same percentages of ownership as with the company and runs his business through the US LLC. He does not use an Israeli company.

Let us parse through these terms to see why, as a result of running the business from Israel, the US citizen does not get the passthrough deduction.

Net capital gain and taxable income

Net capital gain and taxable income are used in the same way as in other parts of the Code. To make it easier, let us assume that net capital gain is 0.

Qualified cooperative dividends

As the name “qualified cooperative dividends” indicates, this term relates to cooperatives. IRC §§199A(e)(4), 1388. Let us assume that our US citizen is not part of a cooperative, so he does not have any qualified cooperative dividends.

The passthrough deduction, simplified

We are assuming no net capital gain and no qualified cooperative dividends, so this reduces the passthrough deduction to the following:

Passthrough deduction = min(combined qualified business income amount, 0.2 x taxable income)

We are now left with the passthrough deduction being the combined qualified business income amount, capped at 20% of the taxable income.

Combined qualified business income amount

This term is a bit long, so let us take it step by step.

Combined qualified business income amount = min(0.2 x qualified business income from qualified trade or business, max(0.5 x W-2 wages from the qualified trade or business, 0.25 x W-2 wages from the qualified trade or business + 0.025 x unadjusted basis of qualified property)) IRC §199A(b).

There are a lot of terms here that are defined in section 199A. To keep this post from being too long, we will take a shortcut. We note that the combined qualified business income amount is the minimum of 2 figures, so if we can show either figure is 0, then we can say the combined qualified business income amount is 0.

In our situation, we can show that the qualified business income from qualified trade or business is 0, as follows:

Qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business. IRC §199A(c)(1).

Qualified items of income, gain, deduction, and loss is items of income, gain, deduction, and loss to the extent that they are effectively connected with a trade or business within the US and included in determining taxable income. IRC §199A(c)(3)(A).

To be qualified business income, it must be effectively connected with a US trade or business. Here, we have a US LLC. But all its employees are in Israel and work in Israel. The business develops software and sells or licenses them from Israel. There might be US source income–royalties collected from the US, for example–, but the income would not be effectively connected with a US trade or business, because there is no activity that takes place in the US.

This means qualified business income is 0. What happens now?

Combined qualified business income amount = min(0.2 x 0, another non-negative number) = 0

Passthrough deduction = min(0, 0.2 x taxable income) = 0

Because this business operates in Israel, there is no pass through deduction. The full amount is taxable in the US at ordinary income tax rates. This is a problem for essentially any US citizen who lives abroad and owns a business abroad: If the business is conducted abroad, then the US citizen does not get the pass through deduction.

Tax results with a passthrough entity

Here is how the income tax works. I am going to exclude the $100,000 of salary from this calculation, even though it is part of the US citizen’s passthrough income, because the GILTI rules did not account for the tax on the salary.

US tax

  • Profits allocable to US citizen = 0.6 x 500,000 = 300,000
  • Self-employment income (not including own salary) = 300,000
  • Self-employment tax = 0.124 x 128,400 + 0.029 x 300,000 + 0.009 x (300,000 – 200,000) = 25,522
  • Self-employment tax deduction = 0.062 x 128,400 + 0.0145 x 300,000 = 8,231
  • Taxable income allocable to US citizen = 291,769
  • US tax on income = 107,955

Under the passthrough scenario, the US tax is about $108,000 of income tax and about $25,500 of self-employment tax out of $300,000 of profits, or 44%. There is no additional tax to take the profits out of the LLC, because it is a passthrough entity in both the US and Israel.

Foreign tax credit

What about the Israeli income tax and the foreign tax credit? I am not sure how the Israeli tax works for this type of entity, so I cannot show a calculation, but we can make some observations.

First, the foreign tax credit cannot reduce tax liability below 0, so the combined income tax between Israel and the US cannot be lower than the US income tax.

Second, the US and Israel do not have a social security totalization agreement, so the US citizen cannot avoid the self-employment tax. He may need to pay Israeli social insurance tax in addition to the US self-employment tax.

Third, the self-employment tax is not available as a tax credit against income tax, so that $25,500 of self-employment tax will be there regardless of how the foreign tax credit works.

The US tax calculated (44% of the profits) thus represents the minimum effective tax rate.

What is the best result? From purely a tax perspective, the corporate rate election appears to be the best choice by a significant margin: The annual tax cost is much lower than the other options, and the total tax to get profits in hand is not much higher. But there will be higher accounting costs, and you will need to spend more time each year becoming friends with your accountant. I leave you to judge whether that is worth the tax savings.

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