The Section 965 transition tax is a one-time federal tax on the accumulated foreign earnings that U.S. shareholders of certain foreign corporations had never brought home or paid U.S. tax on. Enacted as part of the Tax Cuts and Jobs Act of 2017, it forced those untaxed profits into income for the last tax year beginning before January 1, 2018, at effective rates of 15.5% on cash and cash-equivalent earnings and 8% on earnings tied up in non-cash assets. By 2026, most taxpayers who elected the eight-year installment plan have finished paying. The group still exposed is S-corporation shareholders who deferred their liability under Section 965(i), who continue to carry an annual reporting obligation and remain at risk of acceleration.
Who the Tax Applied To
The tax reached any “United States shareholder” of a “specified foreign corporation.” Under Section 951(b), a U.S. shareholder is a U.S. person — citizen, resident, domestic partnership, or domestic corporation — who owns at least 10% of the vote or value of a foreign corporation, directly or through attribution.1Office of the Law Revision Counsel. 26 US Code 951 – Amounts Included in Gross Income of United States Shareholders
A specified foreign corporation is either a controlled foreign corporation (broadly, one where U.S. shareholders collectively own more than 50% of the vote or value) or any other foreign corporation with at least one domestic corporation as a U.S. shareholder. Passive foreign investment companies that are not also controlled foreign corporations are excluded.2Office of the Law Revision Counsel. 26 USC 965 – Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation The 10% floor kept small passive investors out of scope.
How the Bill Was Calculated
The base was the foreign corporation’s accumulated earnings and profits going back to 1986 that had never been subject to U.S. tax. The statute measured that pool on two dates — November 2, 2017, and December 31, 2017 — and used whichever produced the larger figure, blocking any attempt to shift profits out between them.2Office of the Law Revision Counsel. 26 USC 965 – Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation
That inclusion was then split into two buckets. Cash and cash equivalents — bank deposits, receivables, short-term securities — were effectively taxed at 15.5%. Everything else, meaning earnings reinvested in factories, equipment, and other illiquid business assets, was effectively taxed at 8%. The mechanic that produced those numbers was a deduction under Section 965(c) applied against a corporate rate, not a headline rate in the statute. The taxpayer’s “aggregate foreign cash position” drew the line between the two buckets.
Why the Foreign Tax Credit Didn’t Fully Offset the Bill
Taxpayers who had already paid foreign income tax on the same earnings could not use the full foreign tax credit against their Section 965 liability. Section 965(g) disallows a portion of the credit proportional to the Section 965(c) deduction — roughly 77% of the credit on cash earnings and 56% on non-cash earnings is lost.2Office of the Law Revision Counsel. 26 USC 965 – Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation The reasoning: if the deduction sheltered part of the income from U.S. tax, the credit tied to that sheltered slice had to shrink too. For shareholders in high-tax jurisdictions, this was where the transition tax stung most.
The Eight-Year Installment Schedule
Section 965(h) let taxpayers spread the liability over eight years, back-loaded:
- Years 1 through 5: 8% each year
- Year 6: 15%
- Year 7: 20%
- Year 8: 25%
No interest accrued on the deferred balance as long as installments stayed current. For the typical 2017 inclusion year, the first payment was due with the 2017 return in April 2018, and the final 25% payment was generally due by April 15, 2025.3Internal Revenue Service. General Section 965 Questions and Answers Including Transfer and Consent Agreements Most taxpayers on this schedule have finished paying by 2026.
Events That Accelerate What’s Left
If you are still on the installment plan, several events collapse the remaining balance into an immediate obligation. Missing an installment is the obvious one. Treasury regulations also accelerate the balance when the taxpayer sells substantially all assets (including through bankruptcy); an entity ceases business operations; a taxpayer stops being a U.S. person (for example, a resident alien becoming a nonresident); the taxpayer joins or leaves a consolidated group in ways the regulations specify; or an individual taxpayer dies without the estate or successor properly assuming the liability. The IRS Commissioner can also accelerate the balance on specific compliance grounds.
When acceleration hits, the balance is due as if the installment election had never existed. The failure-to-pay penalty of 0.5% per month (capped at 25%) then runs on anything unpaid past the accelerated due date, along with interest at the federal underpayment rate.4Internal Revenue Service. Topic No. 653, IRS Notices and Bills, Penalties and Interest Charges
S-Corporation Shareholders and the Section 965(i) Deferral
S-corporation shareholders got a different, more generous option. Because S corporations push income through to owners who might not have any way to reach the cash sitting overseas, Section 965(i) let an S-corp shareholder defer the entire net tax liability indefinitely, with no installment payments, until a triggering event.5Internal Revenue Service. Section 965 Transition Tax This is the piece of Section 965 most likely to still be live in 2026.
Triggering events include the corporation losing its S-corp status, the shareholder transferring any of the S-corp stock, a liquidation or cessation of business, and the shareholder ceasing to be a U.S. person. Once triggered, the deferred amount generally becomes due, and the shareholder can then elect the eight-year installment schedule under Section 965(h) starting from that point.
Stock transfers have a specific escape route. If the shareholder transfers S-corp stock to an eligible transferee, both parties can file Form 965-D within 30 days of the transfer to move the deferred liability to the new owner. The transferee must be a U.S. individual (not a foreign entity or a domestic pass-through), must show ability to pay, and both parties become jointly and severally liable.6Internal Revenue Service. Instructions for Form 965-D The 30-day deadline is absolute; no extensions. If the transferor dies, the deadline shifts to the due date of the decedent’s final tax return.
Annual Reporting While a Deferral Is Live
A shareholder with an active 965(i) deferral has to report the outstanding balance on their tax return every year until the liability is fully paid. Skipping the report triggers an automatic addition to tax equal to 5% of the deferred amount for that year.7Federal Register. Guidance Regarding the Transition Tax Under Section 965 and Related Provisions As 2017 recedes, this is the trap: shareholders forget the deferral exists and drop the annual filing.
Individual taxpayers and pass-through entities track their net liability and installment payments on Form 965-A. Corporations and real estate investment trusts use Form 965-B for the same purpose.8Internal Revenue Service. About Form 965-A, Individual Report of Net 965 Tax Liability Anyone with a live installment election or a 965(i) deferral needs to keep filing the applicable form each year until the liability is fully satisfied.5Internal Revenue Service. Section 965 Transition Tax
Stock Basis Before You Sell or Take a Distribution
Paying the transition tax on a foreign corporation’s accumulated earnings and then having those same earnings taxed again on a later distribution or sale is the double-tax problem the regulations were meant to address. Treasury regulations under Section 965 allow a stock basis increase to reflect amounts already included under the transition tax, with final rules issued in February 2019. If you paid the tax but never confirmed a basis adjustment was made, check before selling the shares or taking a distribution from the foreign corporation. It’s the cleanup step that most often gets missed.