Decedent Transition Tax Liability Puts Estates In Tough Spot

The Tax Cuts and Jobs Act of 2017 introduced a one-time “transition” tax under Internal Revenue Code Section 965 on the deferred earnings and profits of certain foreign corporations owned by U.S. persons. To alleviate the harsh consequences of this tax, Congress allowed the tax liability to be deferred and paid over an eight-year period or until the occurrence of an “acceleration event.” Recent regulations by the U.S. Department of the Treasury clarify the definition of an acceleration event to include a taxpayer’s death and place additional burdens on the decedent’s estate, its beneficiaries and transferees.

Section 965 “Transition” Tax Background

Section 965 imposes a federal income tax on the accumulated post-1986 earnings of a deferred foreign income corporation for the 2017 tax year. A deferred foreign income corporation includes any U.S. shareholder that owns an interest in a controlled foreign corporation, or any foreign corporation that has at least one domestic C corporation as a shareholder. In such situations, the U.S. shareholder must include as a Subpart F inclusion the greater of the accumulated post-1986 deferred foreign income of such foreign corporation as of Nov. 2, 2017, or as of Dec. 31, 2017.[1] The deemed inclusion was taxed at a special rate ranging from 8% to 15.5% for C corporations and from 9.05% to 17.5% for individuals.

As a way of easing the impact on affected taxpayers, Congress provided exceptions to the acceleration of tax by offering further deferral until the occurrence of certain circumstances, known as acceleration events and triggering events.

Section 965(i) pertains specifically to shareholders of an S corporation, allowing them to elect to indefinitely defer the payment of the transition tax until there is a triggering event. A more widely applicable exception is Section 965(h), which provides that any affected U.S. shareholder may elect to pay the Section 965 liability in installments over an eight-year period with no interest charged on the liability until a certain acceleration event occurs.

Acceleration of Payment

Section 965(h)(3) reflects that the deferred Section 965 transition tax will be due immediately to the extent there is an acceleration event, defined as:

• Liquidation or sale of substantially all the assets of the taxpayer,
• A cessation of business by the taxpayer,
• Or any similar circumstance.

However, the statute itself did not explicitly address how the death of an individual taxpayer affects the deferred transition tax under Section 965(h).[2] Practitioners wondered if the death of an individual taxpayer would serve to accelerate the transition tax liability.

In August 2018, the Treasury issued proposed regulations that provided that the liquidation, sale, exchange or other disposition of substantially all of the assets of the person, including for an individual, by reason of death, is an acceleration event for purposes of Section 965(h).[3] Thereafter, the Treasury received a comment requesting that death not be treated as an acceleration event under Section 965(h) because death is specifically mentioned as a triggering event in Section 965(i).

However, the Treasury in February 2019 issued final regulations rejecting the comment and adopting the position of the proposed regulations. In the preamble to the final regulations, the Treasury explained that the death of an individual taxpayer is similar to any transfer or other disposition of substantially all of the assets of a taxpayer, and, accordingly, is a similar circumstance that should be an acceleration event.

Transfer Agreement

Section 965(h)(3) provides that an acceleration of payment of the deferred Section 965 tax shall not apply in the situation where a buyer purchases a taxpayer’s assets, if the buyer enters into an agreement with the Treasury where the buyer agrees to be liable for the remaining tax installments in the same manner as the taxpayer had been. The proposed regulations further provided that a “covered acceleration event” would allow the transferor and transferee to enter into a transfer agreement to prevent the immediate acceleration of the payment of tax. However, the proposed regulations specifically excluded the death of an individual from the covered acceleration events that allow for a transfer agreement.

The Treasury received a comment requesting that if a taxpayer’s death was treated as an acceleration event for purposes of the Section 965(h) election, that such death be treated as a covered acceleration event and thus be eligible for a transfer agreement and serve to preserve deferral. In rejecting this comment, the Treasury noted in the preamble that there were administrative difficulties with transferring liabilities and executing transfer agreements in the event of death. The Treasury further noted there could be multiple beneficiaries in the case of death, and multiple transferees are not permitted for purposes of deferring tax under Section 965(h).

Effects of Treasury Position on Section 965

The final regulations are clear that an individual who elected to defer the Section 965 transition tax over an eight-year period will have such tax accelerated upon death, and a transferee of said shares will not be allowed to enter into a transfer agreement to prevent the acceleration of the transition tax.

To add insult to injury, the unpaid portion of all remaining installments are due on the date of death. This position by the Treasury puts the decedent’s estate, its beneficiaries and transferees in a difficult position. It presumes that the executor of the estate and/or estate beneficiaries are intimately aware with the decedent’s affairs as they relate to the foreign corporation(s) in question, as well as the decedent’s tax affairs. Additionally, it places a financial strain at a time when cash may not be readily
available to pay the liabilities of a decedent’s estate.