Earlier this month, the IRS issued voluminous proposed regulations (the Proposed Regulations) implementing Section 965 of the Internal Revenue Code. The Proposed Regulations can be viewed in their entirety here. Section 965 was enacted by the Tax Cuts and Jobs Act and imposes a one-time transition tax which requires certain US shareholders (US Shareholders) to include in income the accumulated deferred foreign income (the Section 965 Inclusion Amount) of certain foreign corporations. Subpart F income is income received by US Shareholders from certain foreign corporations, the same type of foreign corporations required to report the Section 965 Inclusion Amount.
The Proposed Regulations clarify a number of items related to the treatment of Subpart F income and the Section 965 Inclusion Amount under the Section 4940 net investment income tax for private foundations. The Proposed Regulations also have application to public charities and private foundations with debt-financed investments in their portfolios that generate Subpart F income and the Section 965 Inclusion Amount. The Proposed Regulations, if made final, will generally apply to tax years beginning before January 1, 2018. Specifically, Section 965 provides that the Subpart F income of affected foreign corporations in its last tax year that begins before January 1, 2018 (inclusion year) is increased by the greater of its accumulated post-1986 deferred foreign income determined on November 2, 2017, and December 31, 2017. This means that private foundations with such income sources must implement processes now in order to comply with these new rules.
Among other things, the Proposed Regulations clarify that:
- Subpart F income and the Section 965 Inclusion Amount are both included in calculating a private foundation’s Section 4940 net investment income tax. Prior to the issuance of the Proposed Regulations, there was no authority from the IRS stating that Subpart F income was to be included in the calculation of “net investment income” under Section 4940. Many private foundations took the position that it was not included. The Proposed Regulations will require a change in reporting for those foundations.
- Once finalized, the Proposed Regulations will be effective beginning the last taxable year that begins before January 1, 2018. If the Proposed Regulations never become final, the rules noted above never will be applicable. However, proposed regulations provide guidance as to the IRS’s position on a matter, and the IRS Office of the Chief Counsel generally looks to proposed regulations to determine the office’s position on an issue. It therefore is prudent to apply the Proposed Regulations as if they are final now rather than risk retroactive non-compliance if they are finalized and because, even if they never become final, they are a reflection of the position that the IRS likely will take on these matters.
Not every private foundation has investments that generate Subpart F income or the Section 965 Inclusion Amount and therefore the Proposed Regulations won’t be relevant to all private foundations. For those that do have such investments, however, there are a number of planning considerations:
- Subpart F income and the Section 965 Inclusion Amount are taxable only to “US Shareholders.” A “US Shareholder” for these purposes is a US Person (which includes US citizens, US residents, domestic corporations, and domestic partnerships) that owns 10% or more of the total combined voting power of all classes of stock entitled to vote of a foreign corporation or 10% or more of the total value of shares of all classes of stock of a foreign corporation.
- The reporting requirements of many private foundations will be driven largely by the information reported in the Schedules K-1 that they receive from their investments. If a Schedule K-1 reports either Subpart F income or a Section 965 Inclusion Amount, it should be included in the foundation’s calculation of its net investment income (or its unrelated business taxable income if so noted on the K-1).
- While the Proposed Regulations have most immediate relevance to private foundations, they are important for any tax-exempt organization (including a public charity) that has Subpart F income or a Section 965 Inclusion Amount from an investment that is debt-financed. That is because the positions reflected in the Proposed Regulations also clarify that such income sources are subject to the tax on unrelated business income to the extent they are debt-financed.