S corporations: planning for FTCs.

• Author: Beaumont, Simon J.
• Position: Foreign tax credits

The increasingly global marketplace has caused many U.S. corporations-including electing S corporations--to establish sales, marketing and manufacturing operations in various foreign jurisdictions. As these activities generally subject the U.S. taxpayer to foreign taxation, the U.S. foreign tax credit (FTC) mechanism plays an important role in avoiding double taxation. Limitations placed on S corporations' use of FTCs make it especially important to carefully plan an S corporation's expansion into the global marketplace.

There are a number of constraints applying to S corporations that may help determine the appropriate foreign structure. An S corporation cannot own 80% or more of another corporation (Sec. 1361(b)). Additionally, an S corporation, unlike a regular corporation, is not entitled to deduct or claim foreign taxes as a credit. Any foreign income taxes directly paid by an S corporation (such as withholding or branch taxes) are passed through to the shareholders who can either elect to deduct the taxes or claim the amounts as an FTC on their individual returns (Secs. 1363(c)(2)(B), 1366(a)i)) and 1373, and Regs. Sec. 1.702-1(a)(6)). The shareholder combines the foreign taxes passed through from the S corporation with other available FTCs. The shareholder may elect to claim the credit on an accrual basis even though the taxpayer is on the cash basis of accounting (Regs. Sec. 1.905-1).

An even more important limitation is that an S corporation cannot pass through so-called "deemed paid" FTCs under Sec. 902. When a dividend is received from a foreign corporation, a domestic C corporation may claim an FTC to the extent of the underlying foreign taxes paid by the foreign corporation on the earnings that gave rise to the dividend (Sec. 902). Deemed paid credits are not available to noncorporate taxpayers.

Sec. 1373 specifically provides that an S corporation is treated as a partnership for purposes of the FTC, subpart F and international boycott provisions, and that S shareholders will be treated as partners of such partnerships. Partnerships are not entitled to claim FTC and only foreign taxes directly paid by the partnership flow through to the partners (Sec. 702(a)(6)).

The fact that an S corporation or its shareholders cannot take advantage of the deemed paid FTC will greatly influence the manner in which an S corporation structures its foreign operations. The establishment of a foreign corporation owned directly by the shareholders...