The 2017 Tax Cuts and Jobs Act (TCJA) has made C-Corporation status much more attractive to business owners, and the 21% flat tax rate has caused many to consider whether converting to a C-Corporation may be worth the switch. For some, however, the administrative burdens that come with incorporating don’t seem worth the trouble. Before dismissing the idea of incorporating, individuals should consider other factors that have come with the passing of the TCJA. For entities that export goods or services to foreign customers, one of the most important factors is the Foreign Derived Intangible Income (FDII) deduction. This deduction, available only to C-Corporations, might cause some U.S. exporters to revisit the idea of restructuring to take advantage of the tax savings it could bring.
What is the FDII deduction?
The FDII deduction allows a portion of a corporation’s income—the portion deemed to be “foreign-derived intangible income”—to be taxed at an effective rate of just 13.125%. “Foreign derived intangible income,” for the purposes of this deduction, is income in excess of 10% of a taxpayer’s Qualified Business Asset Investments (QBAI). For reference, QBAI is equal to a company’s depreciable assets, not including intangible property.
Who gets it?
The deduction is available only to U.S. C-Corporations who export goods or services to foreign customers. If your business is a non-C-Corporation with a foreign customer base and a relatively insignificant amount of fixed assets, then a switch to C-corporation status may provide you with significant tax savings.
How is FDII calculated?
The FDII calculation is fairly complex, but when broken down into steps it can be better understood. It is important to note, the deduction cannot reduce taxable income below zero. Similarly, there is no benefit if deemed intangible income is zero or less. These seven steps outline the calculation:
- Determine Deduction Eligible Income (DEI). This is the gross income less deductions allocable to the gross income, such as amounts included in Subpart F income and dividends received from controlled foreign corporations.
- Determine the foreign portion of deduction eligible income, or Foreign-derived Deduction Eligible Income (FD DEI). This is defined as any income from sales to a foreign person for foreign use.
- Determine QBAI exemption (10% of QBAI)
- Determine Deemed Intangible Income (DII). This is the excess of the corporation’s DEI over 10% of its QBAI.
- Calculate Foreign Derived Intangible Income (FDII). This is Deemed Intangible Income multiplied by the percentage that represents the ratio of the corporation’s Foreign-derived Deduction Eligible Income to its total Deduction Eligible Income.
- Deduct FDII by 37.5% to determine Taxable FDII.
- Calculate tax due
To best understand the potential benefit of the FDII Deduction, follow the above steps in the example provided below.
|1. Deduction Eligible Income||500,000||(DEI Separately Calculated)|
|2. Foreign-derived Deduction Eligible Income||100,000||(FD DEI Separately Calculated)|
|3. QBAI exemption (QBAI = $400,000)
QBAI * 10%
|400,000 * 10%
|(QBAI Separately Calculated)|
|4. Deemed Intangible Income (DII)
less QBAI exemption
|5. Foreign Derived Intangible Income (FDII)
DII * (FD DEI / DEI)
|6. Calculate taxable FDII
Less FDII deduction (FDII * 37.5%)
|7. Tax due at corporate rate (21%)
Tax due at FDII effective rate (13.125%)
As the example illustrates, although presented on a small scale of income, C-Corporations may be eligible to receive substantial benefits by taking advantage of the FDII deduction. If your business isn’t currently eligible for this deduction, you may want to consider if operations could be restructured to take advantage of the opportunity. It should be noted that the 13.125% effective tax rate provided by this deduction will increase to 16.406% in 2026, so it would be beneficial to take advantage of the deduction sooner rather than later in order to maximize savings.
There are a number of factors a business owner would need to consider when contemplating a change in structuring, Clayton & McKervey can assist with an analysis to determine what tax savings opportunities may be available.