US Expat Business Owners May Get Hit with Transition Tax

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Are you an American or U.S. green card holder living overseas who owns a foreign company? If so, you may be on the hook for a new tax that you did not have to pay in previous years, called the transition tax.

The new tax, which took effect at the end of 2017 thanks to the Tax Cuts and Jobs Act, involves a 15.5 percent tax on foreign earnings held in cash and 8 percent on other earnings, such as illiquid holdings. If you are a U.S. shareholder of a controlled foreign corporation, or a small business owner living overseas, you will likely be affected by this tax law change.

The transition tax applies to companies’ accumulated earnings and profits going back to 1986. The effect appears to be greater for small business owners than for corporations, given that corporations are able to take a 100 percent dividends received deduction, meaning that large corporations can repatriate their dividends to the U.S. without paying any taxes.

On the other hand, U.S. small business owners living overseas do not have the option of repatriating dividends back to the U.S. without paying taxes, and this may very well affect their operational cash flow overseas, not to mention throw in some added complexity into the mix. Indeed, for Americans living in high-tax locales overseas, this could be up being quite a burden, since they would pay high taxes in their country of incorporation, as well as get hit with a potential 15.5 percent tax on repatriated earnings to the U.S.

It is important to note that this filing requirement and tax is payable only by U.S. owners of a controlled foreign corporation, which means scenarios in which one owns a greater than 50 percent share in a foreign corporation.

If you are liable for paying this transition tax, the IRS is allowing taxpayers to make installment payments over the course of eight years. In this scenario, for the first five years, one would pay 8 percent of the tax owed. Payments would then increase in subsequent years. For instance, it would be 15 percent in the sixth year, 20 percent in the seventh year, and 25 percent in the eighth year. 

Given the transition tax was signed into law in 2017 and took effect in 2018, originally, taxpayers had until April 18, 2018 to make the first payment, but the IRS granted a grace period and agreed to waive penalties for those who made the first payment by April 15, 2019. 

If you are a U.S. shareholder of a controlled foreign corporation or a small business owner living overseas, you may be liable to pay this transition tax. If you are affected by this transition tax and have not made any payments or declared ownership in your foreign company, you may be facing numerous penalties not just related to the transition tax, but also reporting the ownership of your foreign corporation. Therefore, we advise you to engage a tax advisor knowledgeable about expat taxation, and in particular, the transition tax.