The GILTI inequality between corporate and noncorporate taxpayers
The Global Intangible Low Taxed Income, or GILTI, has created a lot of challenges for taxpayers, since it was instituted by the Tax Cuts and Jobs Act of 2017.
By all means, GILTI is not a simple concept to understand, but in its most simplistic form it taxes U.S. taxpayers on income generated in a Controlled Foreign Corporation (CFC), where the foreign corporation is located in a tax jurisdiction with a lower tax rate than in the United States.
In my opinion, one of the main problems with GILTI is that it creates an inequality between corporate and noncorporate taxpayers.
For all taxpayers, the GILTI income is calculated as the CFC income, minus 10 percent of tangible assets minus depreciation, minus interest expense to unrelated parties. However, the corporate taxpayers can deduct 50 percent of the GILTI income if the U.S. corporation has a profit for the year under code section 250, and also claim a foreign tax credit up to 80 percent of the taxes that were paid on the GILTI includable income in the foreign country.
Here is an example that will help bring the concept home: The CFC has income of $1,000,000 for the tax year, tangible assets are $600,000, depreciation is $100,000, interest to unrelated parties is $10,000, and foreign tax paid is $100,000. The U.S. corporation will report GILTI of $940,000 (the $1,000,000 income minus $10,000 interest expense, minus $50,000 deduction for the business assets, while tangible assets are $600,000 minus $100,000 depreciation multiplied by 10 percent). Now the corporation can claim a 50 percent deduction equaling $470,000, so only $470,000 of the income will be taxable. For a U.S. corporation, the tax rate is 21 percent, hence the income tax on GILTI will be $98,700 ($470,000 times 21 percent), the foreign tax credit available will be $75,200 (GILTI of $940,000 divided by total income $1,000,000, equals 94 percent; then 94 percent times $100,000 in foreign taxes, times 80 percent limitation).
Individuals and partnerships, which are the primary noncorporate taxpayers are subject to the same rules, without the same benefits. Income is calculated in the same manner — the CFC income, minus 10 percent of tangible assets minus depreciation, minus interest expense to unrelated parties. However, the non-corporate taxpayers do not get to deduct 50 percent of the GILTI, and are taxed instead on the full amount. It is also not clear if the real intention is to limit the non-corporate taxpayers on claiming up to the 80 percent foreign tax credit, as this credit might be considered an indirect foreign tax credit under section 902, which was repealed under the Tax Cuts and Jobs Act of 2017.
The example here will be a lot simpler — using the data in the example above for the corporate taxpayers, the GILTI will be calculated exactly the same. Hence, GILTI will be $940,000, as in the example above, but there is no 50 percent deduction, and most likely the foreign tax credit is not available for the noncorporate taxpayers. Moreover, if the noncorporate partner is in the highest tax bracket of 37 percent, this is an additional 16 percent tax due on top of what the corporate taxpayer pays, and without the 50 percent deduction that the corporate taxpayer gets, this is essentially a 26.5 percent differential in tax on the same GILTI.
Planning options for noncorporate taxpayers
One of the planning options available to a noncorporate taxpayer who is an LLC is to make an election to be taxed as a corporation. This would allow the LLC to receive the 50 percent deduction, be taxed at a lower tax rate, and claim the foreign tax credit on the reportable GILTI.
Another planning option is available in case the CFC is qualified to make an entity classification election. In such a case, the CFC will make the election to be classified as a partnership (if the CFC has multiple owners), or a disregarded entity (if the CFC has one owner). The benefit of such an election is that the U.S. taxpayer will be able to flow through the income and the foreign tax credit associated with the income to their tax return. The foreign tax credit would not be considered as an indirect credit, and will be available to claim by the US taxpayer.
The final planning option that should be mentioned without extending the scope of this article is the long (and perhaps) forgotten code section 962. A U.S. individual shareholder of a CFC can make an annual 962 election to pay the tax on its subpart F income at the corporate tax rate, instead of the individual tax rate. This code section might be forgotten, because before the Tax Cuts and Jobs Act of 2017 corporate tax rates were very close to individual tax rates, and the active trade or business income of a CFC was not taxable if it stayed outside the U.S. However, now with GILTI creating its own subpart F category on active trade or business income, and corporate tax rates being lower, this election can make a lot of sense for individuals in the highest tax bracket of 37 percent, as they will be only subject to 21 percent tax on their GILTI.
Light at the end of the tunnel
While the IRS has not specifically confirmed that noncorporate taxpayers can get the foreign tax credit for 80 percent of the foreign taxes paid by the CFC on the GILTI, the IRS did propose regulations that would allow an individual making the 962 election to also be eligible for the 50 percent GILTI deduction, lowering the effective tax rate to 10.5 percent. With such proposed regulations, I do believe that the IRS has seen the inequality burdened by the noncorporate taxpayers and is working on fixing it.