An obscure tax provision from the 1960s that was left untouched by President Donald J. Trump's overhaul could let wealthy individual investors seize for themselves the largest corporate tax cut in U.S. history.
The measure — signed into law by President John F. Kennedy — was designed to prevent Americans from indefinitely shielding themselves from taxes by keeping investments offshore. It forced them to pay taxes annually on these investments, but gave them the option to have that income taxed at the corporate rate instead of at individual rates.
For the past few decades, investors have had little reason to pick the corporate rate, since it was nearly the same as the top personal rate.
But that all changed in December, when Mr. Trump's tax law slashed the corporate rate to 21% — 16 percentage points lower than the top federal individual income tax rate.
"It's almost never been used until now," said David S. Miller, a tax attorney with Proskauer Rose. "As far as I can tell, we just forgot about it."
Since Mr. Trump signed the tax legislation, accountants, attorneys and the Internal Revenue Service have spent months attempting to discern its implications. One reason for the struggle is that rather than replace old tax laws with a new regime, Republicans grafted the new law onto decades of old regulations, leading to unintended consequences. Tax professionals say they think the offshore loophole could help wealthy Americans who have investments that yield interest, rent or royalties defer millions of dollars in taxes.
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Double Taxation
Here's how it works: An investor creates a company overseas, known as a controlled foreign corporation. Then he or she places bonds, rental properties or other investments that generate passive income into the corporation and elects to pay the corporate rate every year, instead of the ordinary income tax rate.
There's a catch, though. The taxpayer pays the corporate rate as long as the money is kept abroad, but if the income is distributed back to the taxpayer in the U.S., then it would be taxed again, Mr. Miller said. That makes it ideal for investors who are looking to let their earnings grow for years offshore.
Philip Hodgen, a tax lawyer in Pasadena, Calif., said he held a webinar with other tax professionals about the workaround in May, which 140 people watched.
The potential corporate rate cash-in derives from a complicated and controversial part of the tax code known as Subpart F. Congress passed the section in 1962 in an attempt to prevent companies from deferring taxes in overseas subsidiaries by keeping the profits abroad. Despite the deterrent, researchers have estimated that U.S. companies stashed more than $3 trillion of their earnings overseas. The recent tax law creates a mandatory tax — at a one-time low rate — that applies to those offshore earnings.
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IRS Case
Subpart F also includes a section, 962, that allows individual taxpayers to act as if a "phantom" domestic corporation stands between them and their foreign company. Congress created that section as a way to put individuals on equal footing with those who held actual domestic corporations that owned a foreign subsidiary.
It's still unclear which rate taxpayers will face when they collect the money in the U.S. from their foreign corporations. The IRS and a taxpayer are currently battling in court to settle whether the money should be treated as ordinary income or a qualified dividend, which would only be subject to the long-term capital gains rate of 20%. If the taxpayer loses, that could mean investors would face rates as high as 37% on the distributions.
Both sides have filed motions for partial summary judgment but are still awaiting the court's decision.
Electing for corporate tax treatment could result in some taxpayers ultimately paying more in taxes — given the double taxation — if they plan on collecting it in the near term, Mr. Hodgen said. Investors should weigh how many years they plan on letting the investments stay offshore and calculate the benefit, he said.
The corporate loophole may ultimately be best suited for the wealthiest investors who don't actually need access to the money, said David Rosenbloom, a tax attorney for Caplin & Drysdale.
"You pay corporate taxes but you can't get your hands on the money," Mr. Rosenbloom said.
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