Letters, acronyms, initialisms[i] – they seem to slip into every post these days.
It has always been a goal of U.S. tax policy to ensure that taxable income sourced in the U.S. does not escape the federal income tax.
In general, this income and the scenarios in which it arises are easily identifiable. However, there are occasions where the IRS, in interpreting Congressional policy, has to address a not-so-obvious gap in legislation.
Regulations recently issued in response to one of the 2017 federal tax changes[ii] to the S corporation rules provide an example of one such scenario.
“S corporations?” you say.
C Corps and Partnerships
Yes, the C corporation may have been the principal beneficiary of the Act, especially when one considers the much reduced federal rate at which its profits are taxed;[iii] and yes, partnerships offer more flexibility than any other business entity insofar as the economic arrangements among its owners are concerned.[iv]
The fact remains, however, that the earnings of a C corporation are subject to so-called “double taxation.”[v] While this may not present an issue to a business that is reinvesting its profits, rather than paying them out as dividends,[vi] it is a serious consideration for the individual business owner who plans to sell that business one day – timing is everything – and who recognizes that most buyers will prefer to acquire the assets of the business rather than its issued and outstanding shares.[vii]
The fact also remains that the individual owners of a partnership that is engaged in an active trade or business[viii] will be subject to self-employment tax on their distributive shares of the partnership’s ordinary business income.[ix]
What about the S corporation?
Don’t Forget the S Corp
In general, a “small business corporation,” the shareholders of which have made an “S” election,[x] is not itself subject to federal income tax, either on its ordinary business income or on the gain from the sale of its assets.[xi] Instead, the corporation’s profits flow through to its shareholders (whether or not distributed), who report them on their personal income tax returns, and adjust their stock basis accordingly.[xii]
Because of these stock basis adjustments, the subsequent distribution of these profits is generally not subject to tax in the hands of the shareholders.[xiii]
Thus, only one level of federal income tax is imposed on the corporation’s profits. In addition, these profits are not subject to self-employment tax in the hands of the shareholders.[xiv]
Yes, there are a number of requirements – limitations, really – that a domestic corporation must satisfy in order to qualify as a small business corporation; it cannot have: (i) more than 100 shareholders, (ii) as a shareholder a person (other than an estate and certain trusts) who is not an individual, (iii) a nonresident alien (“NRA”) as a shareholder,[xv] and (iv) more than one class of stock.[xvi]
However, in the case of most closely held businesses, these limitations have little practical effect. What’s more, in many cases, some of the obstacles they present may be addressed through the judicious use of a partnership.[xvii]
That being said, there have been legislative efforts over the years to “modernize” the rules applicable to S corporations by scaling back some of the limitations – especially where the the underlying tax policy is not sacrificed or compromised – in order to prevent them from becoming punitive with respect to the individual shareholders of an S corporation.[xviii]
One example of a measure that modernized the S corporation rules was the introduction of the electing small business trust (“ESBT”) in 1996.[xix] Prior to that legislation, only grantor trusts, voting trusts, certain testamentary trusts, and qualified subchapter S trusts could be shareholders in an S corporation.[xx]
Congress recognized that, in order to facilitate family estate and financial planning, an individual who owned shares of stock in an S corporation should be allowed to contribute their shares to a non-grantor trust that provides for the distribution of trust income to, or its accumulation for, a class of individuals; for example, a trust that authorizes the sprinkling of income among the contributing shareholder’s family members who are beneficiaries of the trust, at such times, and in such amounts, as may be determined by a trustee.[xxi]
And, so, the ESBT was born.
An ESBT is a domestic trust[xxii] that satisfies the following requirements: (i) The trust does not have as a beneficiary any person other than an individual, an estate, or certain exempt organizations; (ii) no interest in the trust was acquired by purchase;[xxiii] and (iii) the trustee has made an election with respect to the trust.[xxiv] A grantor trust may elect to be an ESBT.
The term “potential current beneficiary” means, with respect to any period, 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 trust.[xxvii] In general, a PCB is treated as a shareholder of the corporation for purposes of determining whether the corporation qualifies as an S corporation.[xxviii] No person is treated as a PCB solely because that person[xxix] holds any future interest in the trust.
If all or a portion of an ESBT is treated as owned by a person under the grantor trust rules, such owner is also treated as a PCB.[xxx]
NRAs as PCBs
Before 2018, an NRA could have been an “eligible beneficiary” of an ESBT.[xxxi] However, if the NRA ever became a PCB of the ESBT[xxxii] – and was thereby treated as a shareholder of the corporation for purposes of its qualification as an S corporation – the corporation’s “S” election would have terminated because an NRA is not an eligible shareholder.[xxxiii]
Similarly, a change in the immigration status of a PCB of an ESBT from a resident alien (a “U.S. person”) to an NRA would have terminated an ESBT election and, thus, also terminated the corporation’s “S” election.[xxxiv]
Then, in late 2017, the Act amended the Code to allow NRAs to be PCBs of ESBTs. As amended, the Code[xxxv] provides that NRA-PCBs will not be taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders. As a result of that 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 terminate its “S” election. What’s more, an NRA-PCB may receive a distribution of income from an ESBT without jeopardizing the corporation’s “S” election. Of course, a distribution of principal to an NRA-PCB from the ESBT – i.e., a distribution of shares of stock in an S corporation – will terminate the “S” election.[xxxvi]
While Congress expanded the scope of qualifying beneficiaries (PCBs) of ESBTs, it left unaltered the rule that an S corporation cannot have an NRA as a shareholder.
An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts (an S portion and a non-S portion, respectively) for purposes of the federal income tax, even though the ESBT is treated as a single trust for administrative purposes.[xxxvii]
Specifically, the S portion, which consists solely of S corporation stock, is treated as a separate trust; in general, it is taxed on its share of the S corporation’s income at the highest rate of tax imposed on individual taxpayers.[xxxviii] This income – whether or not distributed by the ESBT – is not taxed to the beneficiaries of the ESBT.[xxxix]
The non-S portion of the ESBT remains subject to the usual trust income taxation rules that govern simple and complex trusts.
In addition, the S portion or the non-S portion of the trust (or both) can be treated as owned by a grantor (the “grantor portion”) under the grantor trust rules.[xl]
Generally speaking, a grantor trust is a trust with respect to which the grantor has retained certain rights over the trust’s income or assets such that the income of the trust should be taxed to the grantor rather than to the trust which receives the income, or to the beneficiary to whom the income may be distributed. If a trust is a grantor trust, then (i) the grantor is treated as the owner of the assets, (ii) the trust is disregarded as a separate entity for federal income tax purposes, and (iii) all items of income, deduction, and credit are taxed to the grantor as the deemed owner.
Wholly or partially-owned grantor trusts can make an ESBT election, but the grantor trust taxation rules of the Code override the ESBT provisions; in other words, the income of the portion of an ESBT treated as owned by the grantor is taken into account by the deemed owner (rather than by the ESBT) in computing the deemed owner’s taxable income.[xli] Stated differently, an ESBT pays tax directly at the trust level on its S corporation income, except for the amount that is taxed to the owner of the grantor trust portion of the ESBT.
As indicated above, the deemed owner of the grantor trust portion of an ESBT is treated as a PCB of the ESBT. What if the deemed owner is an NRA?
Under the grantor trust rules,[xlii] the income of a domestic trust is taxed to an NRA grantor if the only amounts distributable from such trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.
As enacted, the Act’s expansion of an ESBT’s permissible PCBs to include an NRA may have allowed S corporation income attributed to the grantor trust portion of an ESBT that is received by an NRA deemed owner of that portion, to escape federal income taxation.
For example, if an NRA grantor were a deemed owner of a domestic 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, that NRA would not be required to include such S corporation items in income because the NRA would not be liable for federal income tax on such income.[xliii] In other words, the NRA deemed owner would not be subject to U.S. federal income tax on the S corporation income unless this income was U.S. source fixed or determinable income, or income effectively connected with a U.S. trade or business.
The IRS Reacts
The general rule of ESBT taxation subjects the ESBT to tax on its S corporation income at the trust level, rather than the beneficiary level. Because the ESBT must be domestic, this rule is “indifferent” to the citizenship or residence status of the ESBT’s beneficiaries.
However, the IRS realized that this general rule does not take into account the interaction between the ESBT and grantor trust tax regimes, which allows a trust to be an ESBT for S corporation qualification purposes while permitting all or a portion of the trust subject to the grantor trust rules to be taxed as a grantor trust, rather than as an ESBT. As described earlier, the taxable income of a grantor trust that elects to be an ESBT is treated as the taxable income of the deemed owner of the trust, regardless of whether the ESBT distributes the income.
According to the IRS, Congress assumed that the taxation of income at the ESBT level would protect against potential tax avoidance that might otherwise result from permitting an NRA to be a PCB of an ESBT.
However, the IRS observed that the post-Act ability of an NRA to be a PCB of an ESBT, in combination with the potential for a grantor trust portion of an ESBT to be owned by an NRA, could result in S corporation income passing without tax from the domestic ESBT to the NRA, thereby escaping federal income taxation.
The IRS determined that, by allowing an NRA to be a PCB of an ESBT, Congress did not intend to override statutory provisions that have operated to ensure that all of S corporation income remains subject to federal income tax.
The New Regulations
In response to the risk arising from the unintended interplay of the ESBT and grantor trust rules, the IRS issued regulations that were just recently finalized.[xliv] These regulations 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 will continue to be subject to U.S. federal income tax.
Specifically, the regulations require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would be allocated to an NRA deemed owner under the grantor trust rules.
Accordingly, such income will be taxed to the domestic ESBT by providing that, if the deemed owner is an NRA, the grantor portion of the trust’s net income must be reallocated from the grantor portion of the ESBT to the S portion of the trust.
These proposed regulations are proposed to apply to all ESBTs after December 31, 2017.
What to Do?
The addition of NRAs as PCBs of an ESBT[xlv] comes at a time when many U.S. individuals are studying, living or working overseas. These individuals may already be, or may one day become, shareholders of an S corporation. Of course, many of these individuals may develop close relationships with NRAs, and eventually seek to share some of their wealth with these NRAs; for example, by making them beneficiaries of their estates, whether outright or through trusts like ESBTs.
Notwithstanding the change in the Code to permit NRA-PCBs, and speaking generally, the shareholders of an S corporation have a duty to one another to preserve their corporation’s “S” election.[xlvi]
This “obligation” is most often (if ever) memorialized in a shareholders’ agreement under which the owners of the S corporation agree not to transfer their shares to a person that is not eligible to be a shareholder of an S corporation. In many cases, the concept of a “transfer” will be interpreted broadly by the agreement to include, for example, not only the initial transfer into a trust, but also all subsequent transfers or distributions from the trust, including any that are contingent – we don’t want our NRA-PCB eventually becoming a shareholder.
In other agreements, the shareholders go so far as to require the disclosure of their estate plans to the corporation[xlvii] so as to avoid any surprises upon the passing of a shareholder. For example, if a shareholder’s only potential beneficiaries are NRAs, it would behoove the corporation and the other shareholders to be aware of that fact in advance.[xlviii] In that instance, the shareholders and the corporation will want to provide and plan for the eventual mandatory buyout of that shareholder’s interest.[xlix]
As in all things, it pays to be prepared.
[i] Yes, it is a word.
[ii] Tax Cuts and Jobs Act; P.L. 115-97. The Act.
[iii] 21-percent; IRC Sec. 11. Down from a maximum graduated rate of 35-percent.
Of course, the Act gave pass-through entities, including partnerships and S corporations, the Sec. 199A deduction as a consolation prize.
[iv] “All” that is required is that the allocation of income among the partners have substantial economic effect. IRC Sec. 704(b); otherwise, the owners are relatively free to share the economic pie as they see fit.
[v] Once at the level of the corporation, and again when distributed to its shareholders as a dividend. In the case of individual shareholders, the dividend is subject to a federal tax rate of 20-percent (assuming a “qualified” dividend) and a federal surtax of 3.8-percent (as net investment income). IRC Sec. 1(h); IRC Sec. 1411. A combined federal rate of 39.8-percent.
[vi] Subject always to the accumulated earnings tax. IRC Sec. 531.
[vii] An asset purchase is less expensive for a buyer because it enables the buyer to recover its purchase price through depreciation, amortization, and expensing of its investment. IRC Sec. 168 and 197.
[viii] As opposed to an “investment partnership” that invests for its own account.
[ix] IRC Sec. 1401 and 1402.
[x] IRC Sec. 1362.
[xi] IRC Sec. 1363. There are exceptions; for example, the built-in gains tax under IRC Sec. 1374, and the excise tax under IRC Sec. 1375.
[xii] IRC Sec. 1366 and 1367. The maximum federal income tax rate on the ordinary income of an individual shareholder is 37-percent. However, if an individual shareholder does not materially participate in the business of the S corporation, their share of its income may also be subject to the 3.8-percent federal surtax on net investment income under IRC Sec. 1411.
[xiii] IRC Sec. 1367 and 1368. We assume for our purposes that the S corporation has no E&P from C corporation tax years (whether its own or the E&P of a corporation that it acquired on a “tax-free” basis).
[xiv] Of course, any shareholder who provides services to the S corporation should be paid a reasonable salary in exchange for such services; this salary will be subject to employment tax.
[xv] An NRA is an individual who is neither a citizen nor a resident of the U.S.[xv] In general, an alien individual is treated as a resident of the U.S. with respect to any calendar year if such individual[xv] (i) is a lawful permanent resident of the U.S. at any time during such calendar year;[xv] or (ii) meets the so-called “substantial presence test.”[xv] IRC Sec. 7701(b)(1) and Sec. 7701(b)(3).
[xvi] IRC Sec. 1361(b).
[xvii] See, e.g., Reg. Sec. 1.701-2(d), Ex. 2.
[xviii] One has to recall that, before the introduction of the LLC, S corporations were the most popular “corporate” entity for small businesses. There are a lot of S corporations out there. These corporations cannot convert into LLCs without triggering tax liability for their shareholders.
[xix] IRC Sec. 1361(e). Small Business Job Protection Act of 1996; P.L. 104-188; Sec. 1302(a), effective for tax years beginning after December 31, 1996. See Reg. Sec. 1.1361-1(m).
[xx] IRC Sec. 1361(c).
[xxi] Sometimes referred to as a “pot trust.”
[xxii] IRC Sec. 7701(a)(30)(E); meaning a domestic court exercises primary supervisions over the administration of the trust, and one or more U.S. persons have the authority to control all substantial decisions of the trust.
[xxiii] I.e., with a cost basis. IRC Sec. 1012.
[xxiv] Once made, the election applies to the year for which it is made and all subsequent years.
[xxv] Compare to a QSST. IRC Sec. 1361(d).
[xxvi] Not Polychlorinated biphenyl.
[xxvii] IRC Sec. 1361(e)(2).
[xxviii] IRC Sec. 1361(c)(2)(B)(v); Reg. Sec. 1.1361-1(m)(4)(i).
[xxix] Including an NRA.
[xxx] Reg. Sec. 1.1361-1(m)(4).
[xxxi] Reg. Sec. 1.1361-1(m)(1)(ii)(D).
[xxxii] See what I mean about acronyms and initialisms?
[xxxiii] Reg. Sec. 1.1361-1(m)(5)(iii).
[xxxiv] This result would have occurred because, prior to the Act, the Code provided that each PCB of an ESBT had to be treated as a shareholder of the S corporation.
[xxxv] IRC Sec. 1361(c)(2)(B)(v).
[xxxvi] IRC Sec. 1361(b)(1)(C) and Sec. 1362(d)(2).
[xxxvii] Reg. Sec. §1.641(c)-1(a).
[xxxviii] IRC Sec. 641(c). The maximum rate is 37-percent after the Act.
[xxxix] Accordingly, there is no distribution deduction for the trust.
[xl] IRC Sec. 671 et seq.
[xli] See §1.641(c)-1(c).
[xlii] IRC Sec. 672(f)(2)(A)(ii).
[xliii] Under IRC Sec. 871(a) or (b). Likewise, if the NRA is a resident of a country with which the U.S. 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 tax, in the hands of that NRA.
[xliv] T.D. 9868.
[xlv] It’s anything but poetic.
[xlvi] I know, “Lou, what do you have against love?” To which I respond, “What’s love got to do, got to do with it?”
[xlvii] Usually the board of directors.
[xlviii] I hate surprises. And the process of requesting reinstatement of an S election after an “inadvertent” termination is not always as straightforward as some may believe.
[xlix] Perhaps by purchasing life insurance on that shareholder’s life.