Tax loophole from 1960s could let wealthy tap 21% corporate rate

Provision related to investments held offshore could save wealthy Americans millions in taxes

Jul 11, 2018 @ 8:41 am

By Bloomberg News

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.

(More: Homeowners looking to dodge property tax caps turn to Alaskan trusts)

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.

(More: Pass-through tax strategies for business-owner clients)

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.

(More: Higher estate-tax exemption level could mean less work for advisers)


What do you think?

View comments

Recommended for you

Upcoming Event

Oct 09


Diversity & Inclusion Awards

Attend the industry’s first event celebrating diversity and inclusion as well as recognizing those who are leading the financial services profession in this important endeavor. Join InvestmentNews, as we strive to raise awareness, educate... Learn more

Featured video


The bizarro world of DOL and SEC rule supporters

Managing editor Christina Nelson talks with senior reporter Mark Schoeff Jr. about why groups that supported the Labor Department's fiduciary rule oppose much of the SEC advice package, and vice versa.

Latest news & opinion

10 most affordable U.S. cities for renters

Here are the U.S. cities that are most affordable for renters, according to Business, which compared the cost of rent to average salaries.

9 best - new - financial adviser jokes

Scroll through for nine new financial adviser laughs.

Captrust, prominent 401(k) advice firm, ramps up its wealth management business

Captrust wants to grow annual revenue from wealth management to 50% from 30% over the next five years.

Fidelity CEO says zero-fee funds aimed at expanding its universe

Johnson says way to prosper in financial services is 'by building relationships.'

SEC advice rule contains a huge hole

Jay Clayton aims to clear up investor confusion by drawing a distinction between brokers and advisers in the agency's proposed package of revised standards. But where do dual registrants fit?


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting It'll help us continue to serve you.

Yes, show me how to whitelist

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print