Due to the complexity of these rules, the effective tax rate computed here undoubtedly contains errors and omissions. Many explicit and implicit assumptions have been made in the computations.

You should consult a tax professional for individual advice regarding your own situation. This analysis, and the commentary related to this analysis, should not be relied upon for any purpose whatsoever.

General Assumptions:

• The owner is a U.S. individual.
• The individual is taxed at the highest marginal U.S. income tax rate on ordinary income (37%).
• The individual is subject to the net investment income tax of 3.8%.
• The individual resides in the U.S.
• The foreign entity is classified as a corporation (and not as a flow-thru entity) in its home country. In other words, the foreign income tax is imposed on the entity itself and is not imposed on the owners of the entity.
• The foreign entity is on the accrual method of accounting and it accrues its foreign income taxes.
• The foreign year end of the foreign entity is the same as the U.S. year end of the foreign entity.
• The foreign income taxes are creditable foreign income taxes.
• Pre-tax income under U.S. tax principles equals taxable income under foreign tax principles. This assumption may not be realistic. See the book-to-tax adjustments discussion for Scenario 1.
• U.S. state income taxes are not considered.
• Current year profits are distributed on a current year basis so that dividend withholding taxes (if any) are imposed each year.

Assumptions about the foreign entity (when classified as a flow-thru entity):

• The foreign entity is not a per se corporation. See Treas. Reg. §301.7701-2(b)(8).
• If all members of the foreign entity have limited liability, a U.S. entity classification election has been made on Form 8832 to classify the entity as either a partnership or a disregarded entity. See Treas. Reg. §301.7701-3(b)(2).
• All of the income earned through the foreign entity is self-employment income.
• The individual has sufficiently high earnings so that self-employment income earned through the foreign entity is subject to only the 3.8% Medicare portion (2.9% + 0.9%) of the self-employment tax.

The net investment income tax applies to income from a trade or business where the trade or business is a passive activity with respect to the taxpayer within the meaning of Code §469. Code §1411(c)(2)(A) and Treas. Reg. §§1.1411-4(a)(1)(ii) and 1.1411-5.

"Passive activity" means a trade or business in which the taxpayer does not "materially participate." Code §469(c). A taxpayer is treated as materially participating in an activity only if the taxpayer's involvement in the operation of the activity is regular, continuous, and substantial. Code §469(h)(1). Temp. Treas. Reg. §1.469-5T provides that a taxpayer materially participates in an activity if the taxpayer meets at least one of seven tests. The first of these tests is that the individual participates in the activity for more than 500 hours during such year.

The income flowing through a foreign entity to a U.S. owner will not be subject to the net investment income tax if the U.S. owner materially participates in the business of the foreign entity. However, if the U.S. owner is located in the U.S. and the U.S. owner spends a substantial amount of time participating in the foreign entity's business, the foreign entity itself may be engaged in a U.S. trade or business. If the foreign entity is engaged in a U.S. trade or business, the foreign entity and any foreign owners of the entity may be required to file U.S. tax returns. Therefore, the U.S. owner should consider these implications before claiming that they materially participate in the activities of a foreign flow-thru entity.

Although the law in this area is not yet clear, some U.S. income tax treaties may allow a foreign tax credit against the net investment income tax.

In the flow-thru context, if the foreign country imposes a dividend withholding tax on distributions by the foreign entity to the U.S. owner, failure to make regular distributions out of the foreign entity may create excess foreign tax credits that cannot be utilized.

For example, assume that:

• The foreign entity income tax rate is 30%,
• The foreign dividend withholding tax rate is 15%, and
• The U.S. ordinary income tax rate is 37%.

If the foreign entity earns 100 of pre-tax income each year and if it makes no distributions until the 5th year, during the first 4 years, the U.S. tax before foreign tax credits will be 37 and the foreign tax credits available will be 30. The U.S. income tax after foreign tax credits will be 7 (37 - 30) for the first 4 years.

If the profits from the first 5 years are distributed in the 5th year, the dividend withholding tax in year 5 will be 52.5 (([100 - 30] X 5) X 15%). Thus, the allowable foreign tax credits in year 5 will be the income tax imposed of 30, plus the dividend withholding tax of 52.5. Total creditable foreign income taxes in year 5 will be 82.5 (30 + 52.5). However, due to the foreign tax credit limitation, only 37 of this amount can be claimed as foreign tax credits in year 7, resulting in excess foreign tax credits of 45.5 (82.5 - 37). Of this amount, 7 can be carried back one year and claimed as foreign tax credits in year 4. The remaining excess foreign tax credits of 38.5 can be carried forward for 10 years.

In this circumstance, the U.S. owner paid 7 of U.S. tax for the first three years. Those U.S. taxes could have been avoided if distributions were made in earlier years. If the excess foreign tax credits carried forward expire after 10 years, the 21 (7 X 3) of U.S. taxes paid in the first 3 years resulted in unnecessary double taxation.

The rules for losses with respect to the foreign tax credit limitation are complex. The discussion below merely touches on these rules.

The foreign tax credit limitation applies separately to several categories of foreign income. These categories are often called "baskets" and include the GILTI basket, the foreign branch basket, the passive basket, the general basket, and the income resourced by treaty basket. Code §904(d)(1) and (d)(6). If a taxpayer sustains a loss in one basket, the loss is allocated on a proportionate basis among (and operates to reduce) income in the other baskets for the year. Code §904(f)(5) and Treas. Reg. §1.904(f)-7. If such a loss occurs and there is income in the same basket in a later year, then the income is recharacterized (recaptured) as income from the other baskets that were reduced in the prior year. Treas. Reg. §1.904(f)-8.

When a loss in one basket occurs, the regulations require that separate limitation loss ("SLL") accounts be created. Treas. Reg. §1.904(f)-7(c). The balance in a separate limitation loss account represents the amount of the separate limitation loss that is subject to recapture in a given taxable year. Id.

In addition, special rules apply if the taxpayer has an overall foreign loss ("OFL") or an overall domestic loss ("ODL"). Code §904(f) and (g).

U.S. tax law generally limits the foreign tax credit to the U.S. tax on foreign income. Code §904(a). However, the limitation applies separately to several categories of foreign income. Code §904(d). These categories are often called "baskets" and include the GILTI basket, the foreign branch basket, the passive basket, the general basket, and the income resourced by treaty basket. Code §904(d)(1) and (d)(6). While exceptions exist, the passive basket typically includes investment-type income, such as dividends, interest, rents, and royalties, and gains on assets that generate those types of income. Code §§904(d)(2)(B) and 954(c).

Business income earned through a foreign flow-thru entity that is not passive income is typically foreign branch basket income. Code §904(d)(2)(J) and Treas. Reg. §1.904-4(f). A separate foreign tax credit limitation must be computed (on Form 1116) for the foreign branch basket income.

Very generally, when a taxpayer owns a qualified business unit ("QBU") with a functional currency other than the U.S. dollar, the QBU's taxable income or loss is first determined in its functional currency and then translated into U.S. dollars using the average exchange rate for the year. Code §987. In addition, currency gain or loss is recognized under Code §987 when the QBU distributes property to (i.e., makes a remittance to) the owner of the QBU. Id.

The regulations under Code §987 are complex and voluminous. See Treas. Reg. §1.987-1, et. seq. The Code §987 rules typically apply to activities of foreign flow-thru entities (including the activities of foreign partnerships).

This model assumes that the individual is resident in the U.S. Therefore, no totalization agreement would apply to reduce U.S. social security taxes.

U.S. citizens generally must pay a 15.3% self-employment tax on their self-employment income. Code §1401(a) and (b), and Code §1402(b). U.S. self-employment taxes, along with other FICA taxes, fund U.S. social security.

Self-employment income generally includes income derived from a trade or business carried on by an individual. Code §1402(a). However, self-employment income also includes a partner's distributive share of income from a trade or business carried on by a partnership of which he is a member. Id.

The 15.3% rate is made up of two components: 12.4% for OASDI and 2.9% for hospital insurance. The 2.9% hospital insurance applies to all self-employment income. However, the 12.4% rate for OASDI is capped at $176,100 (for 2025; the amount is adjusted for inflation each year).

For high-income taxpayers, the hospital insurance rate is increased from 2.9% to 3.8%. Code §1401(b)(2).

This model assumes that the individual owning the foreign flow-thru entity is a high-income individual who has already exceeded the OASDI cap for the year. Thus, this model assumes that only the incremental cost of the 3.8% hospital insurance (2.9% + 0.9%) is imposed on the self-employment income flowing through the foreign entity. If the individual has not already exceeded the OASDI cap, the self-employment income tax rate could be as high as 15.3%.

Also, an above-the-line deduction is generally allowed for one-half of the self-employment tax. Code §164(f). These effective tax rate calculations do not consider that above-the-line deduction.

If a foreign entity elects to change its classification from flow-thru status (either partnership or disregarded entity) to corporate status, the change creates a deemed contribution to a foreign corporation. Treas. Reg. §301.7701-3(g)(1)(i) and (iv). Although contributions to domestic corporations can generally be accomplished in a tax-free manner under Code §351, contributions to foreign corporations generally trigger gain recognition. Code §367(a). In addition, transfers of intangible property to a foreign corporation in a Code §351 exchange are subject to special deemed royalty rules. Code §367(d) and Treas. Reg. §1.367(d)-1T.

If a decision is made to change from flow-thru status to corporate status, understanding that gain will be recognized, it is important to identify all the assets that will be deemed transferred. Assets that may not be currently shown on the balance sheet may need to be valued (such as goodwill and other intangible assets). If an appraiser is used, values determined by the appraiser should be confirmed for reasonableness. A decision to change classification should not be taken lightly.

Because the U.S. tax cost of changing classification can create significant current U.S. tax, it is important to select the preferred classification (corporation or flow-thru) when the foreign entity is initially formed.

The effective tax rate analysis differs for U.S. citizens or green card holders who live outside the U.S. and own an interest in a flow-thru foreign entity.

First, dividend distributions from the foreign entity are likely not subject to a flat foreign dividend withholding tax rate. Instead, dividends from the foreign entity are likely taxed in the foreign country at graduated rates, or a preferential rates.

Second, the net investment income tax may not apply because it may be a social security tax that is covered by a totalization agreement, if the foreign country has a totalization agreement with the U.S. (the law in this area is not yet clear). In addition, it may be easier to claim that the owner material participates in the activities of the foreign entity without triggering a U.S. taxable presence.

Third, U.S. self-employment tax may not apply because it may be covered by a totalization agreement (if the foreign country has a totalization agreement with the U.S.).

When a U.S. individual directly owns a foreign disregarded entity, Form 8858 is generally required to be filed annually. Schedule C of Form 8858 reports income, expenses, and net income of the disregarded entity. Business income of the disregarded entity is generally reported on Form 1040, Schedule C. Investment income earned by the disregarded entity is generally reported on Form 1040, Schedules B and D.

When a U.S. individual directly owns an interest in a foreign entity classified as a partnership, Form 8865 is often required. If required, the Form 8865 generally includes Forms K-1 and K-3, which report the information to be included on Form 1040. Distributive share of partnership ordinary income is generally reported on Form 1040, Schedule E (page 2). If no Form 8865 is required (for example, where the U.S. individual owns less than 10% of the foreign partnership), it may be helpful to prepare a substitute K-1/K-3 for the partner.

The FBAR and Form 8938 may also be required.

It is also important to remember that foreign entities that have limited liability for all members default to be classified as corporations for U.S. tax purposes. U.S. tax advisors that do not typically deal with foreign entities often mistakenly believe that foreign LLCs default to be flow-thru entities. Although U.S. LLCs do default to flow-thru status, foreign LLCs must elect (on Form 8832) to be classified as a flow-thru entity. Treas. Reg. §301.7701-3(b) and (c).