The New Pass-Through Deduction and International Flow-Through Structures
The new tax reform legislation offers some generous savings on business taxes, including a new pass-through deduction. The tax rate on pass-through income is as low as 29.6 percent. Companies with international flow-through structures must determine if they are eligible for the deduction and whether to consider a tax-optimal entity restructure.
Understanding foreign flow-through structures for U.S. tax purposes
Depending on the facts and business objectives, an international flow-through structure is generally most tax-efficient when U.S. individuals, partnerships, S corporations, and trusts are owners in the foreign entity.
International flow-through structures consist of foreign entities that are treated as corporations in their respective jurisdictions but treated as a disregarded entity or partnership for U.S. tax purposes by making a U.S. check-the-box election. Under the U.S. check-the-box rules, foreign entities can also be used that default to partnership or disregarded status without a formal election.
International flow-through structures are efficient for U.S. tax purposes because they allow for one level of tax, which generally ends up being the U.S. marginal rate of the taxpayer. The reason for this is that a direct foreign tax credit is available for the tax paid by the entity in the foreign jurisdiction.
This corporate-level tax flows through and is creditable for U.S. tax purposes. In a deferral structure, where the foreign entity is treated as a corporation for U.S. purposes, the foreign entity-level tax is not creditable when U.S. individuals, partnerships, S corporation, and trusts are owners in the foreign entity.
Determining if foreign flow-through income is eligible for the new pass-through deduction
The new law provides for a maximum 20 percent deduction for qualified business income (QBI). With a new maximum individual rate of 37 percent, assuming no limitation on the pass-through deduction, the effective rate for pass-through income would be 29.6 percent.
QBI includes income, gains, deductions, and losses from a qualified trade or business. These are items that are effectively connected with a trade or business within the United States but do not include capital gains or capital losses or dividends; they do, however, include interest income properly allocable to the trade or business. If the taxpayer’s business is a specified business activity, an additional limitation applies.
Specified business activities are not well-defined. Section 199A tells us to look at Section 1202(e)(3)(A), but without considering architects or engineers. This leaves us with “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”
Because the generated income must be associated with a U.S. trade or business, income flowing from foreign flow-through structures is not eligible for the pass-through deduction (assuming none of the income is effectively connected with a U.S. trade or business).
If a U.S. individual with a schedule C business, partnerships, or S corporation that has a U.S. trade or business and is making sales to foreign persons (including related foreign persons), such income would be eligible for the pass-through deduction because it meets the definition of QBI. The requirement for income to be associated with a U.S. trade or business is consistent with the policy objectives to make U.S. businesses more competitive and bring foreign operations back to the United States.
Deciding on an optimal U.S. and foreign structure under the new tax law
The tax-optimal structure depends on the facts and circumstances of the U.S. and international business operations and an understanding of how the accumulated cash will be used. The chart below illustrates the effective tax rate under three basic examples, and each assumes there are no limitations on the pass-through deduction. This assumes that the U.S. business generates $1 of domestic income and the foreign entity another $1 of foreign income.
On the surface, a U.S. C corporation structure with a foreign deferral structure appears attractive to those who wish to reinvest profits into the business. A C corporation and deferral structure can clearly accumulate more capital and expand its operations faster with a 21 percent annual tax cost, as opposed to the 29.6 percent income tax generally levied on U.S. pass-through income and 37 percent rate on foreign pass-through income.
Where corporate earnings are reinvested in productive assets and the earnings are distributed far into the future, the C corporation and foreign deferral structure may provide a better after-tax cash-flow result on a present-value basis. If, however, the accumulated cash in either the U.S. or foreign entity will be distributed on a current basis to the ultimate U.S. shareholders, a flow-through structure may be most advantageous.
The key to choosing the right structure is developing reasonable forecasts and running models on the various scenarios. Ultimately, the best business model should drive the structure and not necessarily the tax results.
Remember, these changes aren’t written in stone
Running the numbers is enlightening, but when contemplating this decision, several factors should also be included in the modeling and analysis, including:
- Whether earnings will be distributed to owners or reinvested to fund future growth
- Whether the corporation holds appreciating assets, such as real estate or intangible assets
- The business exit strategy and timeline for owner(s)
- Impact of state taxes on overall after-tax cash flow
It’s also helpful to keep in mind that this legislation isn’t permanent. The law, as written, sunsets the individual and tax-favored pass-through rates after December 31, 2025. And while the corporate rates do not have a sunset provision, this bill did not get bipartisan support; a change in congressional control could reverse or alter the tax rates. If you switch to a C corporation and the corporate rate rises, getting back to pass-through taxation could be challenging.
How we can help
Our international tax professionals can help you understand and apply these complex provisions based on your company’s specific fact patterns and multinational situations. We can work with you to optimize tax benefits and mitigate exposure to risk.