A Section 962 election is a tax strategy that allows U.S. individuals who own shares in controlled foreign corporations (CFCs) to be taxed as if they were a domestic corporation. By making this election, you can benefit from the lower corporate tax rate (21%) and claim foreign tax credits, potentially reducing your overall U.S. tax liability on foreign earnings.
If you’re wondering how to make this election, what the benefits and drawbacks are, and how it could impact your tax situation, this guide will answer your questions and provide actionable steps.
What is a Section 962 Election?
A Section 962 election is a provision under the Internal Revenue Code (IRC) that allows individual U.S. shareholders of controlled foreign corporations to benefit from a corporate tax treatment on certain foreign earnings. This election is a strategic tax planning tool for U.S. individuals with foreign investments, enabling them to reduce their U.S. income tax liability on foreign earnings by opting to be taxed at corporate rates rather than higher individual income tax rates.
How Does the Election Work?
Under a Section 962 election, a U.S. individual shareholder’s share of a CFC’s income is treated as if it were earned by a domestic C corporation:
- Hypothetical Domestic Corporation: The election creates a scenario where the CFC’s income is treated as if it passed through a hypothetical domestic corporation. This hypothetical entity calculates the shareholder’s pro rata share of Subpart F income, GILTI income, and other earnings.
- Tax Computation: The individual’s gross income under Section 962 includes their pro rata share of the CFC’s net income, but the tax imposed is at the federal corporate tax rate. This means the individual pays tax on foreign earnings at 21% rather than their ordinary income tax rates.
- Foreign Tax Credits: The election allows the individual to claim a deemed paid credit for foreign taxes paid by the CFC. These credits offset the U.S. federal tax liability, ensuring that income taxed abroad is not double-taxed in the U.S.
- Actual Distribution: When the CFC makes actual distributions of previously taxed earnings, such amounts may be subject to additional U.S. tax. However, these distributions are typically taxed at the reduced qualified dividend rate rather than ordinary income tax rates.
How to Make a Section 962 Election?
To make a Section 962 election, you need to follow a few key steps. First, you must prepare a written statement to include with your annual U.S. tax return. This statement should clearly indicate that you are electing treatment under Section 962 and specify which income it applies to, such as Global Intangible Low-Taxed Income (GILTI) and Subpart F income.
After preparing the statement, you must complete several forms to calculate and report your tax obligations. The primary forms include:
- Form 8992: This form is used to calculate your share of GILTI income. It is essential to determine how much of your CFC’s income will be subject to U.S. taxation.
- Form 8993: This form is necessary to compute the Section 250 deduction, which can significantly reduce the amount of GILTI subject to U.S. tax.
- Form 1116: This form allows you to claim foreign tax credits for taxes paid by the CFC. These credits are crucial in preventing double taxation of the same income.
Finally, file your completed tax return along with the election statement and the supporting forms. Since the process can be complex, working with a tax advisor is highly recommended to ensure accuracy and compliance with U.S. tax laws.
How Can a Section 962 Election Reduce Your Tax Burden?
One of the most significant benefits of making a Section 962 election is the opportunity to be taxed at the lower corporate tax rate of 21%, rather than the much higher individual tax rates that can go up to 37%. This can result in substantial tax savings, especially for individuals with significant foreign income.
Another advantage is the ability to claim foreign tax credits. When you elect Section 962 treatment, you are allowed to take an indirect foreign tax credit for the taxes paid by your CFC. This ensures that the same income is not taxed twice—once in the foreign jurisdiction and again in the U.S.
Additionally, the Section 250 deduction can reduce the amount of GILTI subject to U.S. tax. For tax years before 2026, this deduction cuts the taxable GILTI by 50%, effectively halving the amount of income subject to tax. After 2025, the deduction decreases to 37.5%, but it still offers meaningful tax relief.
What are the drawbacks of making the election?
While the Section 962 election provides immediate tax relief, there are potential drawbacks to consider. For instance, when your CFC distributes income to you as dividends, those distributions may be subject to additional U.S. tax. This means that even though the income was previously taxed under the Section 962 election, you could face further tax liabilities when you actually receive the money.
Another drawback is the increased complexity of tax reporting. Making a Section 962 election requires you to complete multiple forms, maintain detailed records, and ensure accurate calculations of foreign taxes paid. Errors in reporting can lead to penalties or missed opportunities for tax savings.
Additionally, the election may not always be beneficial, depending on your CFC’s foreign tax rate. For example, if the CFC’s foreign tax rate exceeds 18.9%, the high-tax exemption may render the election unnecessary, as GILTI income would already be excluded from U.S. taxation. In such cases, making the election adds complexity without providing significant benefits.
When Is a Section 962 Election Worth It?
The decision to make a Section 962 election depends on your specific circumstances, particularly the foreign tax rate of your CFC. If your CFC’s foreign tax rate is between 13.125% and 18.9%, the election can provide substantial tax benefits. At a rate of 13.125%, the combination of foreign tax credits and the Section 250 deduction can eliminate U.S. tax liability on GILTI altogether. If the foreign tax rate reaches 18.9%, the high-tax exemption comes into play, removing GILTI from U.S. taxation entirely and making the election unnecessary.
However, if the foreign tax rate is below 13.125%, you may still owe some U.S. tax on GILTI, but the election can help reduce the overall tax burden. It is essential to consider the potential impact of the election on future distributions as well, since previously taxed income (PTI) may still trigger additional taxes when paid out.
How do Foreign Tax Credits lower your tax liability?
Foreign tax credits play a crucial role in determining the effectiveness of a Section 962 election. These credits allow you to offset U.S. taxes with the taxes paid by your CFC in the foreign jurisdiction. For instance, if your CFC’s foreign tax rate is 13.125% or higher, the foreign tax credits, combined with the Section 250 deduction, can effectively eliminate U.S. tax on GILTI. This makes the election particularly advantageous for taxpayers with moderately taxed CFCs.
When the foreign tax rate reaches 18.9%, the high-tax exemption removes GILTI from U.S. taxation entirely, simplifying your tax situation and reducing the need for a Section 962 election. Understanding these thresholds is essential for making an informed decision about whether the election is right for you.
Maximize Your Tax Benefits with Expert Guidance
A Section 962 election can be a valuable tool for U.S. taxpayers with foreign investments. It offers lower tax rates, foreign tax credits, and the Section 250 deduction to reduce U.S. tax liability on GILTI and Subpart F income. However, its effectiveness depends on your CFC’s foreign tax rate and your financial goals.
While the election provides immediate tax benefits, it adds complexity and may lead to future tax liabilities on distributions. Our team of international tax preparers is here to answer your questions and guide you through the process. We also offer free tax consultations via email to support you.
