IRS provides guidance on application of Section 965 to excise tax on private foundation net investment income

New Federal Tax Developments from Grant Thornton’s not-for-profit practice

The IRS’s recent proposed regulations on the new transition tax under Section 965 provide guidance on how the mandatory income inclusions will affect the excise tax on the net investment income of private foundations under Section 4940. The IRS has not yet clarified how the new Section 965 will impact an organization’s unrelated business taxable income (UBTI).

Background The Tax Cuts and Jobs Act amended Section 965 to create a one-time transition tax on previously unrepatriated foreign earnings. The tax operates by requiring certain U.S. owners of controlled foreign corporations to include in taxable income, under Subpart F, their share of net post-1986 earnings and profits (E&P) for the last taxable year of the foreign corporation beginning before Jan. 1, 2018. A corresponding deduction generally provides an effective corporate rate on the income of 15.5% for earnings attributable to cash and cash equivalents and 8% for other assets. The law allows some additional relief by permitting taxpayers to make an election to spread their liability from the tax over an eight-year period.

Impact on Section 4940 excise tax on net investment income Section 4940 imposes an excise tax of either 1% or 2% on the net investment income (NII) of most domestic tax-exempt private foundations. Subpart F income is generally included in the computation of a private foundation’s Section 4940 excise tax liability as a dividend, and the new Section 965(a) income inclusion under the one-time tax is subject to the Section 4940 excise tax. The proposed regulations then specifically provide that:

  • The deduction under Section 965(c) that reduces the effective rate of the one-time tax for corporations does not apply for purposes of the Section 4940 excise tax and will not reduce private foundation NII.
  • The ability to spread the liability from the one-time tax over eight years does not apply to the Section 4940 tax.

In effect, private foundations pay the full 1% or 2% tax under Section 4940 on all of the Section 965(a) income, with no deduction under Section 965(c) for a reduced rate, and without the ability to spread the additional liability over eight years. 

The proposed regulations do not address whether the new Section 965 income inclusion should be considered UBTI. There is some pre-existing administrative guidance and legislative history that may support the idea that because Subpart F income is a dividend, the Section 965(a) inclusion is not UBTI absent debt financing, but the IRS has not yet provided any explicit guidance on the issue.

Grant Thornton Insight: Private foundations holding alternative investments should carefully review their information reporting documents (e.g. Schedules K-1) to ensure the proper treatment of Section 965(a) income (as either net investment income or unrelated business income). In addition, it is important to note that the Schedule K-1 discloses the corresponding Section 965(c) deduction as a deductible expense for income tax filers, but private foundations pay excise taxes and are unable to take advantage of the Section 965(c) deduction to offset their net investment income. Carefully analyze Schedules K-1 accordingly and consult a tax advisors for the appropriate guidance.

For more information contact: Frank Giardini
Practice Leader, Not-for-Profit Health Care Tax, Grant Thornton LLP
T +1 215 656 3060

Michelle Weber
Partner, Not-for-Profit Tax Practice, Grant Thornton LLP
T +1 414 277 1536

Scott Thompsett
Managing Director, Not-for-Profit Tax Practice, Grant Thornton LLP
T +1 631 577 1867

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