IRS Finalizes Regs on ESBTs with Nonresident Aliens as Potential Current Beneficiaries

(Parker Tax Publishing June 2019)

The IRS issued final regulations on the statutory expansion in the Tax Cuts and Jobs Act of 2017 of the class of permissible potential current beneficiaries of an electing small business trust (ESBT) to include nonresident aliens (NRAs). In particular, the final regulations ensure that the income of an S corporation will continue to be subject to U.S. federal income tax when an NRA is a deemed owner of a grantor trust that elects to be an ESBT. T.D. 9868.

Background

In order to qualify as an S corporation, Code Sec. 1361(b)(1) provides that the corporation cannot have a nonresident alien (NRA) as a shareholder. The Tax Cuts and Jobs Act of 2017 (TCJA) amended the Code to allow NRAs to be potential current beneficiaries (PCBs) of electing small business trusts (ESBTs). As a result, Code Sec. 1361(c)(2)(B)(v) now provides that NRA PCBs are not taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders.

Generally, only certain types of trusts are permitted to be S corporation shareholders. ESBTs were added to the list of permitted S shareholders in 1996 to facilitate family financial planning. For purposes of determining whether a corporation is an S corporation, each PCB of an ESBT is treated as a separate S corporation shareholder. 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 (determined without regard to any power of appointment to the extent such power remains unexercised). 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 income tax purposes, even though the ESBT is treated as a single trust for administrative purposes.

Wholly or partially owned grantor trusts can make an ESBT election but the grantor trust taxation rules 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 items of income, deduction, and credit of the portion of an ESBT treated as owned by a grantor or other person under the grantor trust rules are taken into account by the deemed owner (rather than the ESBT) under Code Sec. 671 in computing the deemed owner's taxable income. Therefore, a wholly-owned grantor trust can be an ESBT, but with no immediate change to the grantor trust's taxation. While an ESBT may be divided into a non-S portion, an S portion, and a grantor trust portion, the statutory definitions of an ESBT and of a PCB focus on all the persons who are beneficiaries or PCBs of the entire trust, rather than beneficiaries of only the S portion. The deemed owner of the grantor trust portion is treated as a PCB of the ESBT.

Final Regulations

In mid-April, the IRS issued proposed regulations under Code Sec. 641 and Code Sec. 1361. The proposed regulations were aimed at ensuring 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. Those proposed regulations have now been finalized in T.D. 9868 without modification. Like the proposed regulations, the final regulations modify the allocation rules under Reg. Sec. 1.641(c)-1 to require that the S corporation income of an 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 final regulations also make conforming revisions to Reg. Sec. 1.1361-1(m). For example, the regulations update the description of PCBs in Reg. Sec. 1.1361-1(m)(4)(i) to reflect the ability of NRAs to be PCBs of ESBTs. The regulations also update other provisions in Reg. Sec. 1.1361-1(m) to reflect that ability.

According to the IRS, without these regulations, 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 an NRA deemed owner of that portion, to escape federal income tax, contrary to Congressional intent.

Effective Date

To prevent abuse of Code Sec. 641 and Code Sec. 1361, and the regulations thereunder, the regulations apply to all ESBTs after December 31, 2017.

For a discussion of the taxation of ESBTs, see Parker Tax ¶30,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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