Preamble to Prop Reg REG-117062-18; Prop Reg §1.641(c)-1, Prop Reg §1.1361-1
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 when a nonresident alien (NRA) is a deemed owner of a grantor trust that elects to be an electing small business trust (ESBT).
Background—ESBTs generally. An S corporation cannot have an NRA as a shareholder. (Code Sec. 1361(b)(1)(C))
Only certain trusts are permitted to be S corporation shareholders. One such permitted trust is an ESBT. (Code Sec. 1361(c)(2)(A)(v)) there are several requirements for a trust to be an ESBT. (Code Sec. 1361(e)(1)) However, there is nothing that prevents an ESBT from holding S corporation stock as well as other property or from accumulating trust income. In addition, (i) a potential current beneficiary (PCB) may be one of multiple beneficiaries of an ESBT, and (ii) 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, or at the discretion of any person may receive, a distribution from the principal or income of the ESBT. (Code Sec. 1361(e)(2)) 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, respectively) for purposes of chapter 1 of subtitle A of the Code, even though the ESBT is treated as a single trust for administrative purposes. (Reg. §1.641(c)-1(a)) The S portion or non-S portion (or both) can be treated as owned by a grantor under Reg. §1.641(c)-1(b)(1), 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 Code override the ESBT provisions. Therefore, an ESBT pays tax directly at the trust level on its S corporation income and that income is not passed through to the beneficiaries, except for the amount that is 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.
Background—Tax Cuts and Jobs Act change. Prior to the enactment of the Tax Cuts and Jobs Act (TCJA, PL 115-97, 2017), a change in the immigration status of a PCB of an ESBT that owns S corporation stock from resident alien to NRA would have terminated an ESBT election, and therefore also terminated the corporation’s election as an S corporation. This result would have occurred because, prior to the TCJA-enacted exception to the Code Sec. 1361(b)(1)(C)eligible-shareholder requirement (see below), Code Sec. 1361(c)(2)(B)(v) provided, in relevant part, that each PCB of an ESBT must be treated as a shareholder of the S corporation.
Section 13541(a) of the TCJA amended Code Sec. 1361(c)(2)(B)(v) to provide that the rule treating each PCB of an ESBT as a shareholder does not apply for purposes of the eligible-shareholder requirement of Code Sec. 1361(b)(1)(C). As a result of that TCJA amendment, if a resident alien PCB of an ESBT becomes an NRA, the status of that PCB as an NRA will not cause the S corporation of which the ESBT is a shareholder to fail the requirement in Code Sec. 1361(b)(1)(C), which otherwise would terminate its S election.
Prior to 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 could not 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 is received by a NRA deemed owner of that portion, to escape Federal income taxation, contrary to Congressional intent as expressed in H. Rept. 115-466 at p. 517 (2017). For example, if an NRA were to be a deemed owner of a grantor trust that elected to be an ESBT, and thus were 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 Code Sec. 864(c)(4)(B), that NRA would not be required to include such S corporation items in income under Code Sec. 671 because the NRA would not be liable for Federal income tax on such income under Code Sec. 871(a) or Code Sec. 871(b). Additionally, if that NRA is a resident of a country with which the United States has 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.
Proposed regs. 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 under Reg. §1.641(c)-1 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. (Prop Reg §1.641(c)-1(b)(1)(ii))