The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has received significant media attention over the past year. However, one component of the law that has remained largely under the radar is the TCJA's liberalizing of the S corporation rules, particularly with respect to non-U.S. ownership. The TCJA revised the long-standing prohibition on a nonresident alien's being a potential current beneficiary of an electing small business trust (ESBT). This change was effective Jan. 1, 2018.
For the first time, a nonresident alien can take an equity stake in an S corporation, albeit indirectly as a trust beneficiary, without terminating the ESBT and S corporation statuses. This change presents a new opportunity for a nonresident alien to invest in an S corporation without compromising the entity's S corporation status. To be clear, the long-standing prohibition on a nonresident alien's being a direct S corporation shareholder (Sec. 1361(b)(1)(C)) was left intact. Accordingly, it is still necessary to ensure that under no circumstance could the trust distribute S corporation shares to a nonresident alien beneficiary, as such a distribution would jeopardize the trust's status as an ESBT as well as the S corporation status.
What are ESBTs, potential current beneficiaries, and nonresident aliens?
ESBT: Congress introduced the ESBT in the Small Business Job Protection Act of 1996 (1996 Act), P.L. 104-188, as a new type of qualifying S corporation shareholder. The 1996 Act's liberalization of the S corporation rules continued a trend that can also be seen in other concessions such as the steady increase in the allowable number of shareholders of an S corporation to 100 (Sec. 1361(b)(1)(A)) and in broadly defining "family" and treating all family members as one shareholder for purposes of this numerical limitation (Secs. 1361(c)(1)(A) and (B)).
The 1996 Act also continued the trend toward permitting trusts as S corporation shareholders, which had started with the qualified Subchapter S trust (QSST). Sec. 1361(e) defines an ESBT as a trust that meets the following requirements: (1) The trust must have only individuals, estates, certain charitable organizations, or certain U.S. governmental entities as beneficiaries (but a U.S. governmental entity may not be a potential current beneficiary); (2) no interest in the trust may have been acquired by purchase, i.e., where basis is determined under Sec. 1012; (3) the trustee must elect for the trust to be treated as an ESBT; and (4) the trust may not be (a) a QSST, (b) a tax-exempt trust, (c) a charitable remainder annuity trust, or (d) a charitable remainder unitrust.
The ESBT itself is treated as the S corporation shareholder for the purpose of the consent requirement for the S corporation election (Regs. Sec. 1.1362-6(b)(2)(iv)). Each potential current beneficiary, however, is treated as a shareholder for purposes of the 100-shareholder maximum under Sec. 1361(b)(1)(A). It should be noted that the ESBT is unique to S corporations (see, e.g., IRS Letter Ruling 200817007, in which the IRS ruled that ESBT elections would be wholly unnecessary for trust shareholders of a C corporation for purposes of the small business corporation exception to Sec. 280G).
Potential current beneficiary: The concept of a potential current beneficiary plays a unique role with ESBTs. Sec. 1361(e)(2) defines a potential current beneficiary as, with respect to any period, any person who during that period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the ESBT. Under Regs. Secs. 1.1361-1(m)(4)(i) and (v) and IRS Letter Ruling 200522003, a future or contingent interest holder is not a potential current beneficiary and becomes a potential current beneficiary only upon the occurrence of the future or contingent event, e.g., the death of another person.
Prior to the TCJA, if the contingent beneficiary was a nonresident alien, this would risk invalidating the ESBT status if the trust did not dispose of all of the S corporation's stock within one year of the realization of the contingency (see Regs. Sec. 1.1361-1(m)(4)(iii)). Otherwise, additional costly and time-consuming remedies might have been required to preserve the ESBT status, such as obtaining a court order to modify the trust so that it could not make distributions to any potential current beneficiary who is a nonresident alien, just in case a resident alien potential current beneficiary should happen to become a nonresident alien (see IRS Letter Ruling 200913002). The TCJA simplified estate planning in this regard by allowing a nonresident alien to be a potential current beneficiary, thus providing for greater ease and flexibility in estate planning where a nonresident alien and an S corporation are involved.
Nonresident alien: Sec. 7701(b)(1)(B) defines a nonresident alien in the negative as an individual who is neither a U.S. citizen nor a resident alien. Under Secs. 7701(b)(1)(A)(i)-(iii), resident aliens include: (1) lawful permanent residents; (2) individuals who meet a substantial presence test; and (3) those who are able to and do elect to be treated as such in certain limited circumstances. Essentially, a nonresident alien is an individual who is not a U.S. taxpayer; however, as IRS Letter Ruling 200913002 illustrates, even a resident alien can potentially become a nonresident alien, i.e., his or her status of residence can change.
Overview of ESBT taxation
ESBT taxation can be complex. An ESBT may consist of up to three separate trust types or portions: (1) an S portion; (2) a non-S portion; and (3) a grantor portion. The taxation of an ESBT (and its beneficiaries) depends on the portion to which income is attributed.
S portion: In situations where no portion of the trust is treated as a grantor trust, an ESBT is typically treated as consisting of two separate trusts: (1) the S portion, which holds S corporation stock, and (2) the non-S portion, which holds all other trust assets (Sec. 641(c)(1)(A) and Regs. Sec. 1.641(c)-1(a)). The S portion is taxed as a separate trust, the tax attributes of which may not be commingled with those of the non-S portion. The S portion takes into account items of income, deduction, gain, loss, and credit reported to the trust on the S corporation's Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. (Regs. Secs. 1.641(c)-1(d)(1) and (2)). State, local, and non-U.S. taxes, as well as administrative expenses, that relate to both the S portion and the non-S portion must be allocated on a reasonable basis (Regs. Sec. 1.641(c)-1(h)(1)). The S portion is taxed at the highest individual rate on ordinary income (Regs. Sec. 1.641(c)-1(e)(1)).
This is the crux of the ESBT tax regime: The income is fully taxed at the trust level, so a potential current beneficiary receiving a distribution from the trust (which originated from the S corporation) does not pay tax on the distribution. This treatment may also have helped Congress become comfortable with allowing nonresident aliens to be potential current beneficiaries because it obviates the need for tax collection against a nonresident alien, over whom the IRS may not easily exercise personal jurisdiction. The S portion's basis in the S corporation's stock increases by income and decreases by distributions and deductions, in the same manner as for an individual shareholder (Regs. Sec. 1.641(c)-1(f)). When an ESBT sells S corporation stock, the S portion is taxed on any gain or loss on the sale of the S corporation's stock (Regs. Sec. 1.641(c)-1(d)(3)(i)).
Non-S portion: The non-S portion of an ESBT is taxed on all of the non-S corporation income. Taxable income is determined by taking into account all items of income, deduction, and credit except for those attributable to the S portion (Regs. Sec. 1.641(c)-1(g)(1)). The non-S portion may deduct all state, local, and non-U.S. taxes, as well as administrative and other expenses, directly related to income from other assets or allocated to the non-S portion on a reasonable basis (Regs. Sec. 1.641(c)-1(h)). Income from the sale of the S corporation's stock reported on the installment method is includible in the S portion. However, the interest on the installment obligation is includible in the non-S portion (Regs. Sec. 1.641(c)-1(g)(3)). It should be apparent that if there is no non-S corporation income, i.e., the sole purpose/activity of the trust is holding the S corporation's stock, then there would be no non-S portion and no attendant tax.
Grantor portion: The rules of Subpart E govern any grantor portion of an ESBT (Regs. Sec. 1.641(c)-1(c)). These grantor trust rules provide that the trust income is taxed to the deemed owner of the trust, i.e., the grantor, on his or her individual income tax return (Sec. 671). This treatment would cause tax leakage from Treasury's perspective in the case of a nonresident alien who is a grantor of a portion of an ESBT, in that taxable income flowing through to the nonresident alien grantor might escape U.S. taxation. Treasury is drafting proposed regulations to prevent nonresident aliens who are potential current beneficiaries from avoiding U.S. tax on certain types of S corporation income when these nonresident aliens are owners of grantor trusts electing to be ESBTs. As of this writing, however, these proposed regulations were still forthcoming.
A relaxing of S corporation ownership rules
The TCJA fundamentally relaxed the rules on S corporation ownership by allowing nonresident aliens to be potential current beneficiaries of ESBTs and, therefore, indirect S corporation shareholders. This presents a planning opportunity for a nonresident alien who wants to invest in an S corporation and/or for an S corporation seeking non-U.S. capital, without terminating the S corporation election. This change is only the most recent in a trend to liberalize S corporation requirements and allow greater flexibility in structuring S corporations and their ownership. The flowthrough income tax treatment of S corporations, coupled with a gradual relaxing of the S corporation requirements, has allowed S corporations to proliferate and achieve their status as the most popular U.S. business entity.
According to the IRS's Statistics of Income, for example, only 1.6 million Forms 1120, U.S. Corporation Income Tax Return, were filed for the 2013 tax year by C corporations, while over 4.3 million Forms 1120S, U.S. Income Tax Return for an S Corporation, were filed by S corporations for the same year (IRS Statistics of Income, Corporation Income Tax Returns Complete Report, 2013). It remains to be seen whether the TCJA's reduced corporate tax rate of 21% will cause more corporations to forgo Subchapter S status. One thing that is clear is that, given the S corporation's popularity, it is here to stay, and there will continue to be those who will push for further changes to S corporation requirements on permissible shareholders and classes of stock to allow for even greater flexibility. Perhaps, someday, individual retirement accounts may become permissible S corporation shareholders.
Mo Bell-Jacobs, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.