Proposed ESBT Regs Clarify Tax Treatment of TCJA Changes

(Parker Tax Publishing April 2019)

The IRS issued proposed regulations relating to the expansion by the Tax Cuts and Jobs Act of 2017 of the class of permissible potential current beneficiaries (PCBs) of an electing small business trust (ESBT). In particular, the proposed regulations would ensure that the income of an S corporation will continue to be subject to U.S. federal income tax when a nonresident alien is a deemed owner of a grantor trust that elects to be an ESBT. REG-117062-18.

Background

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

Code Sec. 7701(b)(1)(B) defines an NRA as an individual who is neither a citizen of the United States nor a resident of the United States, within the meaning of Code Sec. 7701(b)(1)(A). Code Sec. 7701(b)(1)(A) provides that an alien individual is treated as a resident of the United States with respect to any calendar year if (and only if) such individual (1) is a lawful permanent resident of the United States at any time during such calendar year; (2) meets the substantial presence test of Code Sec. 7701(b)(3); or (3) makes the first-year election provided in Code Sec. 7701(b)(4).

ESBTs

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. An ESBT is any domestic trust that satisfies the following requirements: (1) the trust does not have as a beneficiary any person other than an individual, an estate, or an organization described in Code Sec. 170(c)(2) through (5), or an organization described in Code Sec. 170(c)(1) that holds a contingent interest in such trust and is not a PCB; (2) no interest in the trust was acquired by purchase; and (3) an election has been made under Code Sec. 1361(e) with respect to the trust. An ESBT may hold S corporation stock as well as other property, and may accumulate trust income. In addition, a PCB may be one of multiple beneficiaries of an ESBT, and a grantor trust may elect to be an ESBT.

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.

TCJA Changes

Before the TCJA, a change in the immigration status of a PCB of an ESBT that owns S corporation stock from resident alien to an 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, before the TCJA-enacted exception to the Code Sec. 1361(b)(1)(C) eligible-shareholder requirement that allows an NRA to be a PCB, Code Sec. 1361(c)(2)(B)(v) provided that each PCB of an ESBT must be treated as a shareholder of the S corporation. As previously mentioned, if a purported S corporation had an NRA shareholder, such S corporation would fail the qualification requirements listed in Code Sec. 1361(b)(1), resulting in the termination of its status as an S corporation. Additionally, before TCJA, only individuals subject to federal income tax 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.

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 in Code Sec. 1361(b)(1)(C). As a result, 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. While Congress amended Code Sec. 1361(c)(2)(B)(v) to expand the scope of qualifying beneficiaries of ESBTs, Congress left unaltered the rule under Code Sec. 1361(b)(1)(C) that an S corporation cannot have an NRA as a shareholder.

Proposed Regulations

In mid-April, the IRS issued proposed regulations under Code Sec. 641 and Code Sec. 1361. The proposed regulations are 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. Specifically, the proposed regulations would modify the allocation rules under Reg. Sec. 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.

The proposed regulations are also aimed at implementing Congress' amendment to Code Sec. 1361(c)(2)(B)(v) by making conforming revisions to Reg. Sec. 1.1361-1(m). For example, the proposed regulations would 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 proposed regulations similarly would update other provisions in Reg. Sec. 1.1361-1(m) to reflect that ability.

According to the IRS, without these proposed 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. 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, the IRS said, 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.

Effective Date

According to the IRS, to prevent abuse of Code Sec. 641 and Code Sec. 1361 and the regulations thereunder, these regulations are proposed to 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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