Understanding the Section 962 Election: A Tool for U.S. Individuals with Foreign Corporations

If you’re a U.S. taxpayer who owns or controls a foreign corporation, you may have heard about the Section 962 election. This provision of the tax code can be a powerful tool to help manage your U.S. tax bill on certain types of foreign income—but it also comes with some important caveats. In this post, we’ll break down what the Section 962 election is, how it works, and what you should consider before using it.

Section 962 can be beneficial but should be discussed with a cross-border tax specialist.

What Is the Section 962 Election?

Section 962 is a special election that U.S. individuals (including trusts and estates) can make when they are required to include certain types of income from a foreign corporation on their U.S. tax return. This typically happens if you own at least 10% of a foreign corporation that is classified as a "controlled foreign corporation" (CFC). Under U.S. tax law, you may have to pay tax on your share of the CFC’s income—even if you don’t actually receive any cash from the company.

Normally, individuals pay tax on this income at their personal income tax rates, which can be as high as 37%. However, Section 962 allows you to elect to be taxed as if you were a U.S. corporation on these inclusions. This means you get the benefit of the lower corporate tax rate (currently 21%) and, in some cases, can claim a credit for foreign taxes paid by the foreign corporation (an "indirect foreign tax credit")—something individuals usually can’t do.

How Does the Section 962 Election Work?

Here’s a step-by-step overview:

1. Income Inclusion: As a U.S. shareholder of a CFC, you may have to include certain types of the CFC’s income (like Subpart F income or GILTI—Global Intangible Low-Taxed Income) on your U.S. tax return.

2. Making the Election: You can choose, on a year-by-year basis, to make a Section 962 election for that year. This election applies to all your CFCs for that year.

3. Tax Calculation: If you make the election, you calculate the U.S. tax on these inclusions using the corporate tax rate (21%), rather than your individual rate.

4. Foreign Tax Credits: You can claim an indirect foreign tax credit for foreign taxes paid by the CFC on the income you’re including—just like a U.S. corporation would.

5. Future Distributions: When you eventually receive an actual distribution of these previously taxed earnings from the CFC, you may have to pay additional U.S. tax if the distribution exceeds the U.S. tax you already paid under Section 962.

   
   

Example: How Section 962 Can Help

Let’s say you own 100% of a foreign corporation that earned $1,000 in profits. The foreign corporation paid $300 in foreign taxes (a 30% rate). Under the U.S. tax rules, you have to include this $1,000 in your U.S. taxable income.

• Without Section 962: You pay tax at your individual rate (let’s say 37%), so you owe $370 in U.S. tax. You generally can’t claim a credit for the $300 in foreign taxes the company paid.

• With Section 962: You pay tax at the corporate rate (21%), so you owe $210. Plus, you can claim a credit for 80% of the $300 in foreign taxes ($240), which more than covers your U.S. tax bill—so you may owe no additional U.S. tax on this income.

This can result in significant tax savings, especially if the foreign corporation is in a high-tax country.

What Are the Downsides?

While Section 962 can lower your immediate U.S. tax bill, it’s not always a slam dunk. Here are some important considerations:

1. Tax on Future Distributions

When you eventually receive a cash distribution from the foreign corporation, you may have to pay U.S. tax again on the amount that exceeds the U.S. tax you already paid under Section 962. This can result in a form of double taxation.

• If the foreign corporation is in a country with a tax treaty with the U.S., the distribution may qualify for the lower "qualified dividend" rate (typically 20%).

• If not, the distribution may be taxed at your ordinary income rate.

  
  

2. Complexity

The calculations for Section 962 are complicated. You have to track the income inclusions, the taxes paid, and the future distributions carefully. Mistakes can be costly, and not all tax software handles these elections well. It’s highly recommended to work with a tax professional experienced in international tax.

3. Potential for Double Taxation

If you don’t eventually receive a distribution, you may not get the full benefit of the foreign tax credits. And if you do, you may face additional U.S. tax at that time.

4. No Access to Certain Deductions

While Section 962 allows you to use the corporate tax rate and claim indirect foreign tax credits, you don’t get all the benefits that a real U.S. corporation would, such as the dividends received deduction under Section 245A.

When Does Section 962 Make Sense?

Section 962 is most beneficial when:

• The foreign corporation is in a high-tax country (so you can use the foreign tax credits).

• You don’t expect to receive large distributions from the foreign corporation soon.

• You want to defer U.S. tax or reduce your current U.S. tax bill on CFC income.

It may be less beneficial if:

• The foreign corporation is in a low-tax country (so there are few or no foreign tax credits).

• You plan to distribute all the earnings soon (which could trigger additional U.S. tax).

• You’re not comfortable with the added complexity.

  
  

Key Takeaways

• Section 962 can lower your U.S. tax bill on certain foreign corporation income by letting you use the corporate tax rate and claim indirect foreign tax credits.

• It can also lead to additional U.S. tax when you receive distributions from the foreign corporation.

• The rules are complex, and the benefits depend on your specific situation.

• Consult with a qualified CPA or international tax advisor before making a Section 962 election.

  
  

Bottom Line: If you’re a U.S. individual with a foreign corporation, Section 962 is a valuable tool to consider—but it’s not a one-size-fits-all solution. Weigh the immediate tax savings against the potential for future tax and complexity, and always seek professional advice tailored to your circumstances.

This post is for informational purposes only and does not constitute tax advice. Please consult a qualified tax professional for advice specific to your situation.