The IRS has issued proposed regs that would ensure that the income of an S corporation will continue to be subject to U.S. income tax even when a nonresident alien (NRA) is a deemed owner of a grantor trust that elects to be an electing small business trust (ESBT). Let’s look at the details.
Background on Electing Small Business Trusts (ESBTs)
Under the Internal Revenue Code, an S corporation cannot have an NRA as a shareholder. In addition, there are limits on the types of trusts that can be S corporation shareholders. One such permitted trust is an ESBT.
There are several requirements for a trust to be an ESBT, but nothing prevents an ESBT from holding S corporation stock as well as other property or from accumulating trust income. In addition, a potential current beneficiary (PCB) may be one of multiple beneficiaries of an ESBT, and a grantor trust may elect to be an ESBT.
A PCB, with respect to any period, is any person who at any time during such period is entitled to receive, or at the discretion of any person may receive, a distribution from the principal or income of the ESBT. A PCB also can be the deemed owner of a grantor trust that elects to be an ESBT.
An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts — S portion and non-S portion — even though the ESBT is treated as a single trust for administrative purposes. The S portion or non-S portion (or both) can be treated as owned by a grantor, referred to as the “grantor portion.”
Wholly or partially owned grantor trusts can make an ESBT election, but the grantor trust taxation rules of the Internal Revenue Code override the ESBT provisions. Therefore, an ESBT pays tax directly at the trust level on its S corporation income, and that income isn’t passed through to the beneficiaries except for the amount taxed to the owner of the grantor trust portion. The deemed owner of the grantor trust portion is treated as a PCB of the ESBT.
The Tax Cut and Job Act’s impact
Before the Tax Cuts and Jobs Act (TCJA), if an ESBT owned S corporation stock, a change in the immigration status of one of its PCBs from resident alien to NRA would have terminated the ESBT election. Therefore, the status change would have also terminated the corporation’s election as an S corporation.
Why would this have occurred? Before a TCJA-enacted exception to the Internal Revenue Code (IRC), the eligible-shareholder requirement provided, in part, that each PCB of an ESBT must be treated as a shareholder of the S corporation. And, as mentioned earlier, an NRA can’t be an S corporation shareholder.
The TCJA amended the IRC to provide that the rule treating each PCB of an ESBT as a shareholder doesn’t apply for purposes of the eligible-shareholder requirement. Because of that TCJA amendment, if a resident alien PCB of an ESBT holding S corporation stock becomes an NRA, the status of that PCB as an NRA won’t cause the S corporation’s S election to be terminated.
Before the TCJA, only individuals subject to federal income taxation could receive an ESBT’s share of S corporation income, because a grantor trust that elected ESBT status couldn’t have had a deemed owner who was an NRA. The TCJA’s expansion of an ESBT’s permissible PCBs to include an NRA would allow S corporation income attributed to the grantor portion of an ESBT that’s received by an NRA deemed owner of that portion to escape federal income taxation.
For example, let’s say an NRA was a deemed owner of a grantor trust that elected to be an ESBT, and thus was to be allocated foreign source income of the S corporation or income not effectively connected with the conduct of a U.S. trade or business under the IRC. In such a case, that NRA wouldn’t be required to include such S corporation items in income because the NRA wouldn’t be liable for federal income tax on such income.
Additionally, if that NRA was a resident of a country with which the United States had an income tax treaty, U.S. source income of the S corporation also might be exempt from tax or subject to a lower rate of federal income tax in the hands of that NRA.
The proposed regs would ensure that, with respect to situations in which an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the S corporation income of the ESBT would continue to be subject to U.S. federal income tax.
Specifically, the proposed regs would modify the allocation rules to require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would have been allocated to an NRA deemed owner under the grantor trust rules. The proposed regs are proposed to apply to all ESBTs after December 31, 2017.
Impact and developments
If it’s possible you might be affected by these proposed regulations, consult your CPA. He or she can help you determine their impact and keep you apprised of developments.