Introduction: Why the Transition Tax Still Matters in 2026
The transition tax is the one-off US charge, created by section 965 of the Internal Revenue Code in December 2017, that taxed American shareholders on years of profit their foreign companies had kept and never paid out. For an American who owned a British company at the end of 2017, it turned retained earnings sitting in a London bank account into US taxable income overnight. No cash moved. Nevertheless, the bill was real, and for many owners it is still unpaid.
Most guides to the transition tax were written in 2018 and 2019 for corporate groups and their advisers. Consequently, they assume a timely return, a neat installment election and a finance team that tracked every payment. However, the owners we meet in Britain look nothing like that. They are founders, consultants, dual nationals and accidental Americans who ran a UK limited company for years, filed every UK return on time and never filed a US return at all. For them, the transition tax is not history. Instead, it is an open liability with interest compounding since 2018 or 2019.
At TaxYork, we prepare US and UK returns for American company owners, investors and senior executives across Britain. In our experience, the transition tax is the single largest number that appears when an owner with missed US tax returns finally brings their history up to date. This guide explains who owed it, why a March year-end company changes the arithmetic, what the IRS is doing about it in 2026 and how you resolve it properly.
What the Transition Tax Actually Taxed
The transition tax taxed your share of a foreign company's accumulated post-1986 earnings and profits that had never been taxed in America. Specifically, section 965 required each US shareholder to include those earnings in income for the company's last tax year beginning before 1 January 2018. The earnings were measured on two dates, 2 November 2017 and 31 December 2017, and the higher figure applied. Furthermore, the statutory text of section 965 then allowed a deduction that brought the effective rate down to a lower level, split between cash and everything else.
Congress designed the charge as a bridge. Before 2018, a US shareholder generally paid no US tax on a foreign company's active trading profits until they were distributed. After 2017, the new regime taxed many of those profits annually, first as GILTI and now as net CFC tested income. Therefore, the transition tax swept up everything accumulated under the old deferral system in a single inclusion, so that nothing escaped the change.
Why UK Company Owners Were Hit Hardest
British companies are an obvious target because so many Americans in Britain trade through a limited company. A consultancy, a design studio, a fund management boutique or a family property company could easily build up hundreds of thousands of pounds of retained profit over a decade. Moreover, UK owners often keep profits inside the company deliberately, because extracting them as dividends triggers UK income tax at up to 39.35% today. That sensible British planning created exactly the untaxed pool that section 965 was written to reach.
Who Owed the Transition Tax on a UK Company
You owed the transition tax only if two tests were met at the end of 2017. First, you had to be a US shareholder, which at the time meant a US person owning at least 10% of the company's voting power, directly, indirectly or by attribution. Second, the company had to be a specified foreign corporation, which means a controlled foreign corporation or a foreign company with at least one American corporate shareholder. The IRS practice unit on the transition tax sets out both tests and the order in which examiners apply them.
The Controlled Foreign Corporation Test
A UK company is a controlled foreign corporation when US shareholders together own more than 50% of its vote or value. Consequently, an American who owns 100% of a London consultancy is plainly caught. Similarly, two American partners who each own 30% are both caught, because together they exceed 50%. In contrast, an American who owns 30% of a company whose other 70% belongs to British shareholders is usually outside the transition tax altogether, provided no American corporation holds shares. That company is not a controlled foreign corporation, so it is not a specified foreign corporation either.
The Non-US Spouse Point Most Owners Miss
Family ownership changes the answer more often than owners expect. The constructive ownership rules in section 958(b) do not attribute shares owned by a nonresident alien spouse to an American spouse. Therefore, a company owned 50/50 by an American and a British spouse who is not a US person has only 50% American ownership, which does not exceed 50%. In our experience, that genuine 50/50 split takes many family companies outside the transition tax entirely. However, the split must be real in both vote and value, and the share register at 31 December 2017 is the evidence that decides it.
Accidental Americans and Dual Nationals
Citizenship, not residence, decides US shareholder status. Consequently, a British-born director with a US passport, or an accidental American who has never lived in the United States, was a US shareholder in 2017 just as much as a New Yorker on secondment. Many dual national US UK owners only discover this when a bank's FATCA letter or a planned sale forces a review. By then, the 2017 or 2018 inclusion year is long past, and the transition tax has been accruing interest in silence. Our guide to US tax returns for dual nationals and accidental Americans explains how we rebuild that history from UK records.
How the Transition Tax Was Calculated for Individuals
The transition tax was built for corporations, and individuals were bolted on. The section 965(c) deduction was calibrated so that a corporation paid 15.5% on the part of the inclusion matched by cash and liquid assets and 8% on the rest. However, the deduction percentage was set by reference to the top corporate rate, while an individual paid tax on what was left at individual rates. As a result, the effective rate for an American owner depended heavily on which year the inclusion fell into.
The Cash Position and the Two Rates
The cash slice of the inclusion is set by your share of the company's aggregate foreign cash position. That figure is the greater of the company's cash and liquid assets at the end of its 2017 inclusion year and the average of the positions at the end of the two prior years. Cash includes bank balances, short-term deposits, listed securities and net receivables. Consequently, a UK company that holds its reserves as cash, which is typical for a profitable consultancy, usually sees most of its inclusion taxed at the higher cash rate.
The 2017 Versus 2018 Inclusion Year
This is the point almost every guide misses for British companies. The inclusion arises in your tax year in which the company's last tax year beginning before 2018 ends. For a calendar-year company, that is 2017. However, many UK companies use a 31 March year-end. Their last year beginning before 2018 runs from 1 April 2017 to 31 March 2018, so the transition tax falls on your 2018 US return instead.
That shift matters because the top corporate rate fell from 35% in 2017 to 21% in 2018. For a 2017 inclusion, an individual in the 39.6% bracket paid roughly 17.5% on the cash slice and roughly 9.1% on the rest. For a 2018 inclusion, the smaller corporate deduction left an individual in the 37% bracket paying roughly 27.3% on cash and 14.1% on the remainder. Therefore, an American owner of a March year-end UK company faced a transition tax rate around 10 points higher than a calendar-year owner with identical profits.
Why Your UK Corporation Tax Did Not Help
A UK company paid corporation tax at 20% to March 2017 and 19% from April 2017, as the HMRC corporation tax rates tables record. A US corporation owning that company could claim a deemed-paid credit for part of that UK tax. An individual, however, gets no indirect credit for corporation tax paid by a company. Consequently, an American who simply reported the inclusion on Form 1040 paid the full transition tax with no relief for the British tax the company had already paid. The only route to that credit runs through the section 962 election, which we cover below.
The Section 962 Election and the Transition Tax
Section 962 lets an individual US shareholder elect to be taxed on a CFC inclusion as if they were a domestic corporation. For the transition tax, that election delivered two benefits at once. First, the inclusion was taxed at the corporate-equivalent rates of 15.5% and 8% rather than the higher individual figures. Second, the electing individual could claim a deemed-paid credit for UK corporation tax under section 960, which corporations enjoy and individuals normally do not. The text of section 962 sets out the mechanism.
The Section 965(g) Haircut on the UK Credit
The credit is not full. Section 965(g) disallows a fixed percentage of the foreign tax attached to the inclusion, mirroring the deduction. Specifically, 55.7% of the UK tax attached to the cash slice and 77.1% of the tax attached to the non-cash slice cannot be credited. Nevertheless, a UK company that paid 19% or 20% corporation tax on its profits usually carries enough credit to cut the 962 transition tax sharply. In many of our cases the electing owner's bill falls by two thirds or more compared with the non-electing figure.
Can You Still Make a 962 Election on a Late Return?
Timing is the hard question. The final GILTI regulations issued in 2020 (Treasury Decision 9901) stated in their preamble that, until further guidance, an individual may make an otherwise valid section 962 election on an amended return for 2018 and later years, provided the government's interests are not prejudiced by the delay. Consequently, an owner whose transition tax fell in 2018, because of a March year-end, has a stronger argument for a late 962 election than an owner with a 2017 inclusion. For 2017 inclusion years, the position is less settled, and we assess the evidence and the risk case by case before filing.
The Second Layer of Tax Later
A 962 election is not free. When the company later pays out the earnings that the electing owner included, section 962(d) taxes the distribution again to the extent it exceeds the US tax already paid. A qualified dividend from a UK company can attract 20% plus the 3.8% net investment income tax. Therefore, the election saves the most when the owner plans to leave the profits in the company, or to sell the shares, rather than strip the cash out as dividends soon afterwards.
Paying the Transition Tax: Installments, Deadlines and Acceleration
Congress softened the transition tax with an eight-year payment plan under section 965(h). An owner who elected could pay 8% of the net liability in each of the first five years, 15% in the sixth, 20% in the seventh and 25% in the eighth, with no interest on the deferred amounts. The Treasury regulations at section 1.965-7 set out the schedule, the election statement and the events that end it.
When the Installments Ran Out
For a 2017 inclusion, the first installment was due on 15 April 2018 and the eighth on 15 April 2025. For a 2018 inclusion, the schedule ran one year later, so the final 25% installment fell due on 15 April 2026. Consequently, any owner of a March year-end UK company who elected in time has only just finished paying, and each year's payment was tracked on Form 965-A. Moreover, the installment due dates ignore the automatic two-month filing extension for Americans abroad, so a payment made in June was already late.
Why a Missed Return Means No Installment Plan
This is the critical point for anyone with missed US tax returns. The installment election must be made by the due date of the return, including extensions, and the regulations state plainly that relief under the general late-election rules in sections 301.9100-2 and 301.9100-3 is not available. Therefore, an owner who never filed a 2017 or 2018 return cannot elect installments now. Instead, the entire transition tax was due on the original deadline, and interest has run on the full amount ever since.
The IRS questions and answers on section 965 reporting confirm that elections follow the return deadline and that an owner who filed without the election could only cure it by amending before that deadline passed. Furthermore, the statute protects timely electors in another way. Under section 965(h)(4), a later deficiency is spread across the remaining installments, unless it results from negligence, intentional disregard of the rules or fraud. Late filers lose that protection too.
Acceleration When You Leave the US System
An installment plan ends early if certain events occur. These include missing an installment and incurring a penalty, selling substantially all your assets, death and, importantly for Americans in Britain, any event that makes you no longer a US person. Consequently, an owner who renounced US citizenship, or a green card holder who abandoned residence, while installments remained outstanding found the whole unpaid balance due on that date. In our experience, several British clients who renounced between 2019 and 2024 never realised that their exit accelerated a transition tax balance they had not reported in the first place.
The IRS Section 965 Campaign and the Open Statute
The IRS has not forgotten the transition tax, and the courts have confirmed its validity. In June 2024, the Supreme Court upheld the charge in Moore v. United States, a case brought by American shareholders of an Indian company who argued it taxed income they never received. Meanwhile, its Large Business and International division runs a dedicated "IRC Section 965 for Individuals" compliance campaign alongside its corporate 965 campaign. On 8 September 2026, the IRS reissued interim guidance to its examiners in memorandum LB&I-04-0926-0006, which applies to any case where the taxpayer miscalculated the liability or failed to report a section 965 inclusion, deduction or tax. The memorandum expires on 4 January 2027 unless it is extended or folded into the Internal Revenue Manual.
The Six-Year Rule in Section 965(k)
Normally, the IRS has three years from filing to assess additional tax. However, section 965(k) provides that the period for assessing the net transition tax liability does not expire before six years after the return for the inclusion year was filed. The 2026 memorandum confirms that this longer period covers only the section 965 liability, not the rest of the return. Consequently, examiners may let the ordinary three-year period lapse on other items while still pursuing the 965 amount. For an owner who filed a 2018 return in October 2019 that omitted the inclusion, the 965(k) window stayed open until October 2025, and a separate six-year rule for substantial omissions can keep the whole return open longer.
Never Filed Means Never Closed
For owners who filed nothing, the analysis is simpler and harsher. The assessment period never starts until a return is filed. Furthermore, a missing Form 5471 keeps the entire return open under section 6501(c)(8) until the form is supplied. On top of that, the failure-to-file penalty can reach 25% of the unpaid tax. Therefore, an unfiled 2017 or 2018 return carrying a transition tax liability remains assessable indefinitely, with interest and penalties accruing all the while. The IRS page on Form 5471 explains the filing categories that a UK company owner falls into.
How Section 965 Fits With a Wider Catch-Up
Most owners in this position also have missed FBARs, missed Forms 5471 for later years and unreported NCTI or GILTI inclusions. Each of those years also needed an FBAR filed with FinCEN for the company and personal accounts. Consequently, the transition tax is rarely the only problem. However, it is usually the oldest liability and often the largest. In our experience, the right sequence is to quantify the 2017 or 2018 position first, because it shapes the share basis, the previously taxed earnings and the payment plan for everything that follows. Our team handles missed FBAR and FATCA reporting in the same engagement, so the foreign account filings agree with the corporate figures.
The UK Side: HMRC and the Transition Tax
Britain never recognised the transition tax. HMRC does not tax a shareholder on a company's undistributed profits, so the 2017 deemed inclusion produced no UK tax and no UK return entry. Instead, the British charge arrives only when the company actually pays a dividend, at the UK dividend tax rates of 10.75%, 35.75% and 39.35% for 2026/27. That mismatch in timing is the source of most of the cross-border difficulty.
Previously Taxed Earnings When the Dividend Finally Comes
Earnings already taxed under section 965 become previously taxed earnings and profits. When the UK company later distributes them, the US generally does not tax the dividend again, unless a 962 election was made. However, HMRC taxes the full dividend in the year you receive it. Consequently, a UK-resident owner can pay up to 39.35% in Britain on a dividend that the US treats as tax-free, while the US tax on those same profits was paid years earlier with no UK credit. Our detailed guide to PTEP distributions from a UK company explains the ordering rules and the section 986(c) currency gain that hides inside them.
Why the Foreign Tax Credit Rarely Rescues You
You might expect the UK dividend tax to generate a US foreign tax credit. In practice, it rarely helps, because the US charges no tax on the PTEP dividend for the credit to offset. Moreover, section 965(g) and its regulations disallow the same applicable percentage of foreign taxes attributable to distributions of section 965 earnings. Similarly, HMRC's credit rules look for US tax on the same income in a corresponding period, and a US charge from 2018 or 2019 rarely matches a UK dividend paid in 2026. Therefore, careful timing of extraction matters, and our treaty and foreign tax credit work models both sides before any dividend is declared.
Selling or Liquidating the Company
The same mismatch affects a sale or a members' voluntary liquidation. Section 965 inclusions increase your US basis in the shares under section 961, which reduces the US gain on a later sale. In contrast, HMRC computes the UK gain on the original base cost, and Business Asset Disposal Relief may apply on the British side. Consequently, the US and UK gains on the same exit can differ by the whole 2017 inclusion, which affects how much UK capital gains tax is available as a credit against the US gain.
Case Study: A March Year-End Consultancy in Marylebone
James is a US citizen who moved to London in 2009 and set up a management consultancy as a UK limited company with a 31 March year-end. He owns 100% of the shares. He filed every UK company and personal return on time, but he filed no US returns between 2014 and 2024. In early 2026, a buyer approached him about acquiring the business, and its due diligence team asked for his US filing history.
What We Found
The company's last tax year beginning before 1 January 2018 ran from 1 April 2017 to 31 March 2018, so James's inclusion fell in his 2018 US tax year. His accumulated post-1986 earnings measured at 31 December 2017 were £1,200,000, or about $1,620,000 at the year-end exchange rate of roughly $1.35. The company's cash position was £800,000, about $1,080,000, leaving $540,000 in the non-cash slice. Furthermore, the company had paid UK corporation tax at 19% and 20% on its profits throughout.
The Numbers Without and With a 962 Election
Reported on an ordinary Form 1040 at the 37% top rate, James's transition tax came to about $294,900 on the cash slice and about $76,100 on the rest, a total of roughly $371,000. Because he had filed nothing, no installment election was available, and the full amount was due on 15 April 2019. Interest at the IRS quarterly underpayment rates since then adds roughly 45% by late 2026, taking the exposure above $535,000 before any penalties.
With a section 962 election on his 2018 return, the corporate-equivalent rates of 15.5% and 8% applied instead, producing about $210,600 before credits. After the deemed-paid credit for UK corporation tax, reduced by the 965(g) haircut, and the related gross-up, his net transition tax fell to roughly $98,000. With interest, that is closer to $142,000, a saving of nearly $400,000 compared with the non-electing route. However, the election carries the second-layer tax on future distributions of those earnings, so we modelled the sale proceeds and the timing of a pre-sale dividend before recommending it.
How We Resolved It
We prepared James's missing returns, his Forms 5471 for every year with the 2018 Schedule P and the section 965 transition tax statement, and his missed FBARs. We documented the facts supporting non-wilful conduct and the 962 election position under the TD 9901 preamble. Finally, we coordinated the US share basis with his UK accountant so that the sale agreement, the UK capital gains computation and the US Form 8949 all told the same story. The buyer's due diligence closed with a clean disclosure schedule, and the deal completed in September 2026.
How TaxYork Can Help
We prepare comprehensive US and UK tax returns for American owners of British companies, from the first missed year to the current one. For the transition tax, that means reconstructing 2017 earnings and profits from UK statutory accounts, applying the correct measurement dates and exchange rates, testing whether your company was ever a specified foreign corporation and modelling the 962 election before anything is filed. Furthermore, we prepare the Forms 5471, the FBARs and Forms 8938 alongside the income tax returns, so every figure reconciles.
Our team also handles the UK side, so your dividend timing, your Self Assessment and any sale or liquidation are planned with the US position in view. Consequently, you deal with one team that understands both HMRC and the IRS. Our cross-border tax planning for company owners covers exits, restructurings and extraction strategies where the US and UK rules pull in different directions.
Conclusion
The transition tax looks like a closed chapter from 2017, but for Americans who owned UK companies and missed their US tax returns it remains a live and growing debt. The installment plan is gone for late filers, the assessment period never started for unfiled years, and the IRS has an active individual campaign in 2026. Moreover, a March year-end can push the charge into 2018 and raise the rate by around ten points.
However, the position is rarely as bad as the headline figure suggests. Ownership tests, the non-US spouse rule, the cash position calculation and a well-supported 962 election can each reduce the bill substantially. Therefore, the right first step is a careful reconstruction of your 2017 position before you file anything, so that your catch-up filings, your future dividends and any eventual sale all rest on a correct foundation.
Contact Us
If you owned 10% or more of a UK company in 2017 and you are not certain your US returns dealt with section 965, speak to us before the IRS raises it. Email hello@taxyork.com or call 020 3488 8606, or book a consultation with our US-UK tax specialists. We will review your company's records, quantify the exposure and set out a filing plan that covers both sides of the Atlantic.
Disclaimer
This article is for general information only and does not constitute tax, legal or financial advice. Tax rules in the United States and the United Kingdom change frequently, and their application depends on your individual circumstances, including your company's ownership history, year-end and records. The figures in the case study are illustrative and rounded. You should obtain professional advice tailored to your situation before acting on any information in this article. TaxYork accepts no liability for any loss arising from reliance on this content.