Dividends received deduction

We’ve all heard about the profits that publicly-held U.S. corporations have generated overseas, and how those profits have, until now, escaped U.S. income taxation by virtue of not having been repatriated to the U.S.

It should be noted, however, that many closely-held U.S. corporations are also actively engaged in business overseas, and they, too, have often benefited from such tax deferral.

What follows is a brief description of some of the rules governing the U.S. income taxation of the foreign business (“outbound”) activities of closely-held U.S. businesses, and the some of the important changes thereto under the Tax Cuts and Jobs Act.[1]

Taxation of Foreign Income

U.S. persons[2] are subject to tax on their worldwide income, whether derived in the U.S. or abroad.

In general, income earned directly (or that is treated as earned directly[3]) by a U.S. person from its conduct of a foreign business is subject to U.S. tax on a current basis; for example, the income generated by the U.S. person’s branch in a foreign jurisdiction.

However, income that is earned indirectly, through the operation of a foreign business by a foreign corporation (“FC”), is generally not subject to U.S. tax on a current basis; instead, the foreign business income earned by the FC generally is not subject to U.S. tax until the income is distributed as a dividend to a U.S. owner.[4]

CFC Anti-Deferral Regime

That being said, the controlled foreign corporation (“CFC”) anti-deferral regime may cause a U.S. owner of a CFC to be taxed currently in the U.S. on its pro rata shares of certain categories of income earned by the CFC (“Subpart F income”) regardless of whether the income has been distributed as a dividend to the U.S. owner.

A CFC generally is defined as any FC if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that are “U.S. Shareholders” – i.e., U.S. persons who own at least 10% of the CFC’s stock (which, prior to the Act, was measured by vote only).

In effect, the U.S. Shareholders of a CFC are treated as having received a current distribution of the CFC’s Subpart F income[5], which includes foreign base company income, among other items of income.

“Foreign base company income” includes certain categories of income from business operations, including “foreign base company sales income,” and “foreign base company services income,” as well as certain passive income.

The U.S. Shareholders of a CFC also are required to include currently in income, their pro rata shares of the CFC’s untaxed earnings that are invested in certain items of U.S. property, including, for example, tangible property located in the U.S., stock of a U.S. corporation, and an obligation of a U.S. person.[6]

Several exceptions to the definition of Subpart F income, including the “same country” exception, may permit continued deferral for income from certain business transactions.[7] Another exception is available for any item of business income received by a CFC if it can be established that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate.[8]

A U.S. Shareholder of a CFC may also exclude from its income any actual distributions of earnings from the CFC that were previously included in the shareholder’s income.

The Act

For the most part, the Act did not change the basic principles of the CFC regime; these anti-deferral rules will continue to apply[9], subject to certain amendments.

However, the Act also introduced some significant changes to the taxation of certain U.S. persons who own shares of stock in FCs.

CFCs

The Act amended the ownership attribution rules so that certain stock of a FC owned by a foreign person may be attributed to a related U.S. person for purposes of determining whether the U.S. person is a U.S. Shareholder of the FC and, therefore, whether the FC is a CFC.[10] For example, a U.S. corporation may be attributed shares of stock owned by its foreign shareholder.

The Act also expanded the definition of U.S. Shareholder to include any U.S. person who owns 10% or more of the total value – as opposed to 10% of the vote – of all classes of stock of a FC. It also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before the inclusion rules apply.

Dividends Received Deduction (“DRD”)

The Act introduced some new concepts that are aimed at encouraging the repatriation of foreign earnings by U.S. taxpayers; stated differently, it removes an incentive for the overseas accumulation of such earnings.[11]

The keystone provision is the DRD, which allows an exemption from U.S. taxation for certain foreign income by means of a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned FCs by regular domestic C corporations[12] that are U.S. Shareholders of those FCs.

In general, a “specified 10%-owned FC” is any FC with respect to which any domestic corporation is a U.S. Shareholder.[13]

The term “dividend received” is intended to be interpreted broadly. For example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the participation DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership’s dividend from the FC. In addition, any gain from the sale of CFC stock that would be treated as a dividend would also constitute a dividend received for which the DRD may be available. That being said, it appears that a deemed dividend of subpart F income from a CFC will not qualify for the DRD.

In general, the DRD is available only for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned FC; i.e., the amount that bears the same ratio to the dividend as the undistributed foreign earnings bear to the total undistributed earnings of the FC.[14]

The DRD is not available for any dividend received by a U.S. Shareholder from a FC if the FC received a deduction or other tax benefit from taxes imposed by a foreign country. Conversely, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD, including any foreign taxes withheld at the source.[15]

It should be noted that a domestic C corporation is not permitted a DRD in respect of any dividend on any share of FC stock unless it satisfies a holding period requirement. Specifically, the share must have been held by the U.S. corporation for at least 366 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. The holding period requirement is treated as met only if the specified 10%-owned FC is a specified 10%-owned FC at all times during the period and the taxpayer is a U.S. Shareholder with respect to such specified 10%-owned foreign corporation at all times during the period.

Transitional Inclusion Rule[16]

In order to prevent the DRD from turning into a “permanent exclusion rule” for certain U.S. corporations with FC subsidiaries, the accumulated earnings of which have not yet been subject to U.S. income tax – and probably also to generate revenue – the Act requires that any U.S. Shareholder (including, for example, a C corporation, as well as an S corporation, a partnership, and a U.S. individual) of a “specified FC” include in income its pro rata share of the post-1986 deferred foreign earnings of the FC.[17] The inclusion occurs in the last taxable year beginning before January 1, 2018.[18]

This one-time mandatory inclusion applies to all CFCs, and to almost all other FCs in which a U.S. person owns at least a 10% voting interest. However, in the case of a FC that is not a CFC, there must be at least one U.S. Shareholder that is a U.S. corporation in order for the FC to be a specified FC.

The deferred foreign earnings of such a FC are based on the greater of its aggregate post-1986 accumulated foreign earnings as of November 2, 2017[19] or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.[20]

A portion of a U.S. taxpayer’s includible pro rata share of the FC’s foreign earnings is deductible by the U.S. taxpayer, thereby resulting in a reduced rate of tax with respect to the income from the required inclusion of accumulated foreign earnings. Specifically, the amount of the deduction is such as will result in a 15.5% rate of tax on the post-1986 accumulated foreign earnings that are held in the form of cash or cash equivalents, and an 8% rate of tax on those earnings held in illiquid assets. The calculation is based on the highest rate of tax applicable to U.S. corporations in the taxable year of inclusion, even if the U.S. Shareholder is an individual.[21]

Installment Payments

A U.S. Shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of a FC’s post-1986 accumulated foreign earnings in eight equal installments. The net tax liability that may be paid in installments is the excess of the U.S. Shareholder’s net income tax for the taxable year in which the foreign earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion.

An election to pay the tax in installments must be made by the due date for the tax return for the taxable year in which the undistributed foreign earnings are included in income. The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.[22]

The Act also provides that if (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. Shareholder’s assets, (3) the U.S. Shareholder ceases business, or (4) another similar circumstance arises, then the unpaid portion of all remaining installments is due on the date of such event.

S corporations

A special rule permits continued deferral of the transitional tax liability for shareholders of a U.S. Shareholder that is an S corporation. The S corporation is required to report on its income tax return the amount of accumulated foreign earnings includible in gross income by reason of the Act, as well as the amount of the allowable deduction, and it must provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of this tax liability until the shareholder’s taxable year in which a prescribed triggering event occurs.

This shareholder election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018 (i.e., by March 15, 2018 for an S corporation with a taxable year ending December 31, 2017).

Three types of events may trigger an end to deferral of the tax liability: (i) a change in the status of the corporation as an S corporation; (ii) the liquidation, sale of substantially all corporate assets, termination of the of business, or similar event; and (iii) a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for tax liability in the same manner as the transferor.[23]

If a shareholder of an S corporation has elected deferral, and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any tax liability and related interest or penalties.[24]

In addition, the electing shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect.[25]

After a triggering event occurs, a shareholder may be able elect to pay the net tax liability in eight equal installments, unless the deferral-ending triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, in which case the installment payment election is not available, and the entire tax liability is due upon notice and demand.[26]

Observations

As stated earlier, many closely-held U.S. companies (“CH”) are engaged in business overseas, and many more will surely join them.

Although the Act ostensibly focused on the tax deferral enjoyed by large, publicly-traded multinationals, its provisions will also have a significant impact on CH that do business overseas.

Regardless of its form of organization, a CH has to determine fairly soon the amount of its 2017 U.S. income tax liability resulting from the inclusion in income of any post-1986 accumulated foreign earnings of any CFC of which it is a U.S. Shareholder.

Similarly, in the case of any FC of which the CH is a U.S. Shareholder, but which is not a CFC, the CH must determine whether there is a U.S. corporation (including itself) that is a U.S. Shareholder of the FC. If there is, then the CH will be subject to the mandatory inclusion rule for its share of the FC’s post-1986 accumulated foreign earnings.

The CH and its owners will then have to determine whether to pay the resulting income tax liability at once, in 2018, or in installments.

Of course, if the CH is an S corporation, each of its shareholders will have to decide whether to defer the tax liability until one of the “triggering event” described above occurs.

After the mandatory inclusion rule has been addressed, the CH may decide whether to repatriate some of the already-taxed foreign earnings.

Looking forward, if the CH is a regular C corporation, any dividends it receives from a FC of which it is a U.S. Shareholder may qualify for the DRD.

C corporation CHs that may be operating overseas through a branch or a partnership may want to consider whether incorporating the branch or partnership as a FC, and paying any resulting tax liability, may be warranted in order to take advantage of the DRD – they should at least determine the tax exposure.

Still other CHs, that may be formed as S corporations or partnerships, must continue to be mindful of the CFC anti-deferral regime.

It’s a new tax regime, and it’s time for old dogs to learn new “tricks.” Woof.


[1] Pub. L. 115-97 (the “Act”). We will not cover the “minimum tax” provided under the new “base erosion” rules applicable to certain U.S. corporations – those with more than $500 million of average annual gross receipts – that make certain payments to related parties.

[2] Including all U.S. citizens and residents, as well as U.S. partnerships, corporations, estates and certain trusts. For legal entities, the Code determines whether an entity is subject to U.S. taxation on its worldwide income on the basis of its place of organization. For purposes of the Code, a corporation or partnership is treated as domestic if it is organized under U.S. law.

[3] As in the case of a U.S. partner in a partnership that is engaged in business overseas.

[4] It should be noted that certain foreign entities are eligible to elect their classification for U.S. tax purposes under the IRS’s “check-the-box” regulations. As a result, it is possible for such a foreign entity to be treated as a corporation for foreign tax purposes, but to be treated as a flow-through, or disregarded, entity for U.S. tax purposes; the income of such a hybrid would be taxed to the U.S. owner.

[5] Prior to the Act, and subject to certain limitations, a domestic corporation that owned at least 10% of the voting stock of a FC was allowed a “deemed-paid” credit for foreign income taxes paid by the FC that the domestic corporation was deemed to have paid when the related income was distributed as a dividend, or was included in the domestic corporation’s income under the anti-deferral rules.

[6] This inclusion rule is intended to prevent taxpayers from avoiding U.S. tax on “dividends” by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[7] For example, the CFC’s purchase of personal property from a related person and its sale to another person where the purchased property was produced in the same foreign country under the laws of which the CFC is organized.

[8] This rate was 35% prior to the Act; the Act reduced the rate to 21%, which should make it easier for some CFCs to satisfy this exception. In that case, the U.S. Shareholder of a CFC will not be subject to the CFC inclusion rules – in other words, it can continue to enjoy tax deferral for the foreign earnings – if the foreign corporate tax rate is at least 19%; i.e., 90% of 21%. This will benefit U.S. persons who otherwise do not qualify for the DRD, discussed below.

[9] For example, CFCs should continue to refrain from guaranteeing their U.S. parent’s indebtedness.

[10] The pro rata share of a CFC’s subpart F income that a U.S. Shareholder is required to include in gross income, however, will continue to be determined based on direct or indirect ownership of the CFC, without application of the new attribution rule.

[11] This moves the U.S. toward a “territorial” system under which the income of foreign subsidiaries is not subject to U.S. tax.

[12] The DRD is available only to regular C corporations. As in the case of dividends paid by U.S. corporations to individuals or to an S corporation, no DRD is available to such shareholders.

[13] Query whether the DRD, combined with the new 21% tax rate for C corporations will encourage U.S. corporations that have substantial foreign operations to remain or become C corporations and to operate overseas only through foreign subsidiary corporations. Unfortunately, the Act also denies non-recognition treatment for the transfer by a U.S. person of property used in the active conduct of a trade or business to a FC.

[14] “Undistributed earnings” are the amount of the earnings and profits of a specified 10%-owned FC as of the close of the taxable year of the specified 10%-owned FC in which the dividend is distributed. A distribution of previously taxed income does not constitute a dividend.

[15] In this way, the Act seeks to avoid bestowing a double benefit upon the U.S. taxpayer; however, foreign withholding tax may prove to be a costly item.

[16] See IRS Notice 2018-13 for additional guidance.

[17] Any amount included in income by a U.S. Shareholder under this rule is not included a second time when it is distributed as a dividend.

[18] Beware, calendar year taxpayers.

[19] The date the Act was introduced.

[20] The portion of post-1986 earnings and profits subject to the transition tax does not include earnings and profits that were accumulated by a FC prior to attaining its status as a specified FC.

[21] A reduced foreign tax credit is also allowed.

[22] If installment payment is elected, the net tax liability is not paid in eight equal installments; rather, the Act requires lower payments for the first five years, followed by larger payments for the next three years. The timely payment of an installment does not incur interest.

[23] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[24] The period within which the IRS may collect such tax liability does not begin before the date of an event that triggers the end of the deferral.

[25] Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[26] The installment election is due with the timely return for the year in which the triggering event occurs.

Our last three posts focused on those provisions of the Tax Cuts and Jobs Act[1] that apply specifically to pass-through entities, including partnerships and S corporations.

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part II

The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

The New Deduction for “Qualified Business Income”: Tax Simplification Gone Awry?

Today, we turn our attention to domestic C-corporations (“C-corp”) and to some of the ways in which the taxation of their U.S.-sourced income is impacted by the Act.[2]

Why a “C” Corp?

By far, most closely held U.S. businesses are formed as pass-through entities, including sole proprietorships, partnerships, limited liability companies (“LLC”), and S corporations (“S-corp”).

C-Corporation

That being said, a number of closely held businesses are C-corps. Many of these would not qualify as S corps (for example, their capital structure may include preferred stock, or some of their shareholders may not be eligible to own stock of an S corp.). Others were formed before the advent of LLCs. Still others were formed as C-corps so as to avoid the pass-through of their taxable income to their shareholders (for example, where the owners were taxable at a higher individual income tax rate, or where the owners would be subject to self-employment tax on their share of the business income, or where the business did not plan to distribute its profits to its owners).

What is it?

A “corporation” is a business entity that is organized under a federal or state law that describes or refers to the entity as “incorporated” or as a “corporation.”

It also includes a business entity that was not formed under one of these laws but that elects to be treated as a corporation (an “association”) for tax purposes.[3]

In general, a C-corp is a corporation for which its shareholders cannot elect that it be treated as an S corporation (for example, because it is not a “small business corporation”), or have not so elected for whatever reason.

How is it Taxed?

A C-corp. is a taxable entity. It files an annual tax return on which it reports its gross income and its deductions and calculates its taxable income, on which it pays a corporate-level income tax.

When the C-corp. distributes its after-tax profits to its shareholders in the form of a dividend, the shareholders pay tax on the amount distributed to them.

Thus, the C-corp.’s taxable income is taxed twice: once to the corporation and, upon distribution, to its shareholders.

Prior to the Act, corporate taxable income was subject to tax under a graduated rate structure. The top corporate tax rate was 35% on taxable income in excess of $10 million.

As in the case of other taxpayers, certain items of revenue and certain items of expenditure are excluded in determining a C-corp.’s taxable income. Some of these items were modified by the Act.

For example:

  • the gross income of a corporation generally did not include any contribution to its capital;
  • a corporate employer generally could deduct reasonable compensation for personal services as an ordinary and necessary business expense – however, the Code limited the deductibility of compensation with respect to a “covered employee” of a publicly held corporation to no more than $1 million per year, subject to an exception for performance-based compensation (including, for example, stock options and SARs);
  • a C-corp. could reduce its dividends received from other taxable domestic corporations by 70%-to-100% of such dividends, depending upon its ownership interest in the distributing C-corp.;
  • Interest paid or accrued by a C-corp. generally was deductible in the computation of its taxable income, subject to various limitations;
    • for example, the Code limited the ability of a C-corp. to deduct its interest expense in certain situations where the corporation’s debt-to-equity ratio was “too high” and the deduction would not be “offset” by a matching inclusion in the gross income of the creditor (the “earnings stripping” rules);
  • if a C-corp. had a net operating loss (“NOL”) for a taxable year (the amount by which the C-corp.’s business deductions exceeded its gross income), the NOL could be carried back two years and carried forward 20 years to offset the C-corp.’s taxable income in such years.

In addition, a 20% alternative minimum tax (AMT) was imposed on a C-corp. if its AMT (based on its alternative minimum taxable income, which was calculated to negate the benefit of certain preferences and income deferrals that were allowed in determining its regular taxable income) exceeded its regular tax.

The Act

As a result of the Act:

  • the corporate tax rate is reduced to a flat 21%;[4]
  • the term “contribution to capital” does not include (a) any contribution in aid of construction or any other contribution as a customer or potential customer, and (b) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such) – thus, these contributions will now be taxable;
  • the performance-based exception to the limitation on the deductibility of certain compensation paid by a publicly traded corporation is eliminated, and the limitation is extended to include certain corporations the equity of which is not publicly traded, such as large private C- or S-corps with registered debt securities;[5]
  • the 70% and 80% dividends received deductions are reduced to 50 percent and to 65%, respectively;
  • the earnings stripping rules are expanded such that the deduction for business interest for any taxable year (including on debt owed to unrelated persons) is generally limited to the sum of (a) business interest income for such year, plus (b) 30% of the corporation’s adjusted taxable income for such year;[6]
    • “adjusted taxable income” means the taxable income of the corporation computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to a business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; and (4) certain other business deductions;
    • “business interest” means any interest paid or accrued on indebtedness properly allocable to a business (it excludes investment interest);
    • “business interest income” means the amount of interest includible in the gross income of the corporation for the taxable year which is properly allocable to a business (and not investment);
    • the amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely;
    • significantly for smaller businesses, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million;
    • significantly for real estate businesses, at the corporation’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, is not treated as a trade or business for purposes of the limitation – thus, the limitation does not apply to such an electing trade or businesses;
  • the carryover NOL deduction for a taxable year is limited to 80% of the corporation’s taxable income, the two-year carryback is repealed, and carryovers may be carried forward indefinitely;[7]
  • the corporate AMT is repealed.

These changes are effective for taxable years (and for losses arising in taxable years) beginning after December 31, 2017.[8]

Employee-Shareholders?

The Act also made certain changes that may affect the “rank-and-file” employees of a corporation to whom the corporate employer may offer shares of its stock as compensation for their services.

“Property” for Services

In general, an employee to whom shares of employer stock are issued as compensation must recognize ordinary income in the taxable year in which the employee’s right to the stock is transferable or is not subject to a substantial risk of forfeiture, whichever occurs earlier (“vesting”).

Thus, if the employee’s right to the stock is vested when the stock is transferred to the employee, the employee recognizes income in the taxable year of such transfer, in an amount equal to the fair market value (“FMV”) of the stock as of the date of transfer (less any amount paid for the stock).

If, at the time the stock is transferred to the employee, the employee’s right to the stock is unvested – for example, the employee must render a specified number of years of service in order for the stock to vest – the employee does not recognize income attributable to the stock transfer until the taxable year in which the employee’s right becomes vested. In that case, the amount includible in the employee’s income is the FMV of the stock as of the date that the employee’s right to the stock becomes vested (less any amount paid for the stock).[9]

In general, these rules do not apply to the grant of a nonqualified option on employer stock. Instead, these rules apply to the transfer of employer stock by the employee on exercise of the option; specifically, if the right to the stock is substantially vested on transfer (the time of exercise), income recognition applies for the taxable year of transfer. If the right to the stock is unvested on transfer, the timing of income inclusion is determined under the rules applicable to the transfer of unvested stock. In either case, the amount includible in income by the employee is the FMV of the stock as of the time of income inclusion, less the exercise price paid by the employee.[10]

The Act

In the case of a closely held business, the grant of stock in the employer corporation has almost always been limited to a small number of executive, or “key,” employees of the corporation.

Over the years, many such employees have, for various reasons, sought ways to further defer the recognition of compensation income attributable to unvested stock (for example, by extending the required period of service).[11]

The Act actually provides a way to achieve such additional deferral, but in a way that does not benefit a corporation’s top executives, and that is not likely to be utilized by established closely held businesses, though it may help some start-up companies.[12]

Under the Act, a qualified employee may elect to defer the inclusion in income of the FMV of qualified stock transferred to the employee by the eligible employer in connection with the exercise of a stock option or the settlement of a restricted stock unit (“RSU”):

  • the election to defer income inclusion (“inclusion deferral election”) with respect to qualified stock must be made no later than 30 days after the time the employee’s right to the stock is vested;
    • A corporation is an eligible corporation if
      • no stock of the employer corporation was readily tradable on an established securities market during any preceding calendar year, and
      • the corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the U.S. are granted options, or RSUs, with the same rights and privileges to receive qualified stock;
  • If an inclusion deferral election is made, the income must be included in the employee’s income for the taxable year that includes the earliest of:
  • the first date the qualified stock becomes transferable;
    • the date the employee first becomes an excluded employee;
      • an excluded employee with respect to a corporation is any individual (1) who owned 1% of the corporation at any time during the calendar year, or who owned at least 1% of the corporation at any time during the 10 preceding calendar years, (2) who is, or has been at any prior time, the CEO or CFO of the corporation, (3) who is a family member of such individuals, or (4) who has been one of the four highest compensated officers of the corporation for the taxable year, or for any of the 10 preceding taxable years;[13]
    • the first date on which any stock of the employer becomes readily tradable on an established securities market;
    • the date five years after the first date the employee’s right to the stock becomes substantially vested; or
    • the date on which the employee revokes the inclusion deferral election.

Having Fun Yet?

The more I read and analyze the Act, the more I realize its potential implications for closely held businesses, and the more I recognize[14] that “only time will tell,” as the saying goes.

That being said, the C-corp-related changes under the Act, discussed briefly above, raise some interesting questions, among which are the following:

  • Will the reduced rated rate induce an S-corp or its shareholders to give up its “S” election, either by revoking it, or by admitting new investors or changing its capital structure?[15]
  • Will the reduced rate cause the shareholders of a target C-corp to abandon their attempts to by-pass the C-corp, to the extent possible, in connection with the sale of its business?[16]
  • Will the limitation on the deduction of interest cause a corporation to rethink its capital structure, causing it to rely less on borrowed funds?
  • Will the elimination of the two-year NOL carryback, plus the addition of the 80%-of-taxable income cap, have an adverse effect on the recovery of a distressed corporation?[17]

The answers to these, and other, questions will best be answered by considering the unique facts and circumstances of each closely held corporate taxpayer and of its shareholders.

Taxpayers will have to review the Act’s changes with their tax advisers, consider and map out the implications thereof as to their business, and then plan accordingly.


[1] Pub. L. 115-97; the “Act.”

[2] Please note that some of the items discussed herein are not unique to C-corps, but because C-corps are liable for tax (unlike their pass-through brethren – at least in most cases), I chose to discuss these items as they apply to C-corps. By the same token, other C-corp-related changes have been covered in other posts; for example, re the application of the cash method of accounting, see The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[3] For example, a single member LLC that would otherwise be disregarded for tax purposes, but for which “the box has been checked” to treat it as an association/corporation for tax purposes.

[4] This 21% rate will also be applied to situations that determine tax liability by reference to the corporate tax rate; for example, the calculation of the built-in gains tax on S-corps.

[5] For example, a private company that does not qualify for an exemption to the securities registration requirements may have to register an offering of debt or convertible debt.

[6] This limitation rule also applies to partnerships and S corps at the entity level; special rules are provided for passing through the consequences of the rule to partners and S-corp. shareholders.

[7] See the discussion of “excess business losses” for non-corporate taxpayers at The 2017 Tax Act: Other “Pass-Through” Tax Provisions – Part I 

[8] It should be noted that existing indebtedness is not grandfathered under the new limitation for deducting interest.

[9] If the employee’s right to the stock is unvested at the time the stock is transferred to the employee, the employee may elect, within 30 days of transfer, to recognize income in the taxable year of transfer (a “section 83(b)” election). If the election is made, the amount of compensatory income is capped at the amount equal to the FMV of the stock as of the date of transfer (less any amount paid for the stock).

[10] A section 83(b) election does not apply to the grant of options by a closely held corporation. Moreover, under Sec. 409A of the Code, the exercise price of a nonqualified option cannot be less than the FMV of the underlying stock at the time the option is granted; otherwise, any spread may be includible in the employee’s income.

[11] Though doing so also defers the start of their holding period for the stock.

[12] Query whether this adds anything to the benefit provided under Sec. 83(b) for a stock in a presumably little-to-no-value start-up corporation.

[13] Except for family, basically the employees to whom such stock or options have traditionally been granted.

[14] Like the tax pun there? “Realize” and “recognize.”

[15] Perhaps – at least where the S-corp is not planning a sale of its business or is not in the habit of making regular distributions to shareholders. Before the Act, a non-materially-participating shareholder of an S-corp faced a tax of 43.4% (39.6% + 3.8%) on his pro rata share of the corporation’s income vs. a maximum C-corp tax rate of 35%; after the Act, the comparison is between 40.8% (37% + 3.8%) and 21%.

[16] For example, by arguing for the presence and sale of personal goodwill.

[17] For example, by removing its ability to receive a refund from those earlier years.