Editor: Mark G. Cook, CPA, CGMA
One requirement for an S corporation is that it cannot have a nonresident alien as a shareholder (Sec. 1361(b)(1)(C)). This requirement seems easy to apply; however, when it comes to an eligible small business trust (ESBT), unforeseeable situations may unexpectedly terminate the S election — such as when a nonresident alien becomes a potential current beneficiary of an ESBT or a deemed owner of a grantor trust that elects to be an ESBT. The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, provides a way to avoid the unexpected termination of the S election when one of these situations arises.
Sec. 7701(b)(1)(B) defines a nonresident alien as an individual who is neither a citizen nor a resident of the United States within the meaning of Sec. 7701(b)(1)(A). 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) that individual either (1) is a lawful permanent resident of the United States at any time during that calendar year (the green card test); (2) meets the substantial-presence test of Sec. 7701(b)(3); or (3) makes the first-year election provided in Sec. 7701(b)(4).
An ESBT is one of the few trusts that qualifies as an S corporation shareholder. An ESBT allows multiple beneficiaries and the accumulation of income, which can facilitate families' financial planning. To be an eligible S corporation shareholder, the ESBT must be a domestic trust that (1) does not have as a beneficiary any person other than an individual, an estate, or certain exempt organizations; and (2) no interest in the trust was acquired by purchase. The trustee also must have made a valid ESBT election for the trust (Secs. 1361(c)(2)(A)(v) and 1361(e)).
Each potential current beneficiary of the ESBT is counted as a shareholder for the S corporation 100-shareholder limitation. If there are no potential current beneficiaries, the trust is treated as the shareholder (Regs. Sec. 1.1361-1(e)(1)). A potential current beneficiary generally is any person or charity that is entitled to, or at the discretion of the trustee may, receive a distribution from the principal or income of the trust. A person entitled to receive a distribution only after a specified time or when a specified event occurs (such as the death of the holder of a power of appointment) is not a potential current beneficiary until the time arrives or the event occurs (Regs. Sec. 1.1361-1(m)(4)(v)).
Before Jan. 1, 2018, the existence of a potential current beneficiary who was a nonresident alien would terminate the S election, since an S corporation cannot have a nonresident alien as a shareholder. Family trusts are often set up to cover many years. With families becoming increasingly globalized, some descendants will more likely become nonresident aliens.
Example 1: An ESBT's governing instrument provides for discretionary distributions of income or principal to A for life, and upon A's death, for the trust assets to be divided into separate trusts for A's children. The intended beneficiaries of the original ESBT are A and A's children. If one of the children is a nonresident alien, upon A's death, the nonresident alien child becomes a potential current beneficiary. At that time (if before Jan. 1, 2018), the S election would have been inadvertently terminated. To avoid this problem, the trust instrument must have provided that no distribution may be made to a nonresident alien or other nonqualifying beneficiary.
However, not all trust instruments have such a provision, especially family trusts that were written decades ago and have not been revised since. The TCJA provided a way out by amending Sec. 1361(c)(2)(B)(v) to provide that a nonresident alien is not treated as a shareholder for purposes of the prohibition on nonresident aliens as shareholders under Sec. 1361(b)(1)(C). In other words, the rule of treating each potential beneficiary of an ESBT as an S corporation shareholder will not apply for purposes of the rule that disqualifies S corporations for having nonresident aliens as shareholders. As such, nonresident aliens are now eligible to be potential current beneficiaries of an ESBT, and the S election will not be thereby terminated (Regs. Secs. 1.1361-1(m)(4)(i) and 1.1361-1(m)(1)(ii)(D)). Referring back to Example 1, when the nonresident alien child becomes a potential current beneficiary (on or after Jan. 1, 2018), the S election is not inadvertently terminated.
An ESBT can provide that income will be distributed to (or accumulated for) one or more beneficiaries. Thus, an individual can establish a trust to hold S corporation stock and split income among family members or others who are trust beneficiaries. However, there is a price to pay: The trust (not the beneficiaries) is taxed on the income attributable to the S corporation stock at the highest trust rate (37% for 2018 through 2025), unless the income qualifies as long-term capital gain, in which case a capital gain rate applies (Sec. 641(c)(2)(A)). Thus, none of the potential current beneficiaries (including nonresident alien potential current beneficiaries) will be taxed on the S corporation income.
A grantor trust may elect to be an ESBT (Regs. Sec. 1.641(c)-1). In a grantor trust, the grantor (or some other person) retains control over the trust to an extent that the grantor (or the other person), rather than the fiduciary or beneficiary, is treated for federal income tax purposes as the owner of all or part of the trust and is therefore taxed directly on the income and/or other tax attributes of the trust (Sec. 674(a)). Grantor trusts include, but are not limited to, a revocable trust (also known as a living trust), a grantor retained annuity trust, a qualified personal residence trust, and an intentionally defective grantor trust. The deemed owner of the grantor trust portion of an ESBT is treated as a potential current beneficiary.
Before the TCJA, under Sec. 1361(c), ownership of stock by a grantor trust deemed owned by a nonresident alien would preclude the corporation from qualifying as a small business corporation eligible to be an S corporation, because the nonresident alien owner, as a potential current beneficiary of the trust, would be treated as a shareholder in the S corporation. Sec. 1361(c)(2)(B)(v), as amended by the TCJA, provides that the rule treating each potential current beneficiary of an ESBT as a shareholder does not apply for purposes of the eligible-shareholder requirement of Sec. 1361(b)(1)(C). Therefore, ownership of stock by a grantor trust deemed owned by a nonresident alien now will not prohibit the trust from being a shareholder in an S corporation if it validly elects to be an ESBT.
When all or part of the ESBT is treated as a grantor trust, the items of income, deductions, and credits attributable to the grantor portion are taxed to the deemed owner under the regular grantor trust rules. As such, the S corporation income would be allocated to the deemed owner rather than be taxed to the trust. However, if a nonresident alien is a deemed owner of a grantor trust that has elected to be an ESBT, the final regulations under the TCJA amendments require that the S corporation income of the ESBT, as well as the grantor portion of the ESBT, be reallocated from the grantor portion to the S portion of the ESBT instead. Accordingly, that income will be taxed at the trust level, not to the nonresident alien (Regs. Secs. 1.641(c)-1(b)(1)(ii) and (2)(ii)).
Example 2: An ESBT owns S corporation stock. The S corporation owns U.S. and foreign assets. The foreign assets produce foreign-source income. A nonresident alien is the grantor and the only trust beneficiary and potential current beneficiary of the ESBT. The nonresident alien is not a resident of a country with which the United States has an income tax treaty. Under Sec. 677(a), the nonresident alien is treated as the owner of the ESBT because, under the trust documents, income and corpus may be distributed only to the nonresident alien during his or her lifetime. The S corporation income of the ESBT that otherwise would have been allocated to the nonresident alien under the grantor trust rules must be reallocated from the nonresident alien's grantor portion to the S portion of the ESBT. Thus, the ESBT will pay tax on all the S corporation income (Regs. Sec. 1.641(c)-1(l), Example (6)).
The TCJA permits the S election to remain valid in situations where a nonresident alien becomes a potential current beneficiary of an ESBT or a deemed owner of a grantor trust that elected to be an ESBT. Although the TCJA helps avoid unexpected termination of the S election in these situations, careful planning is still needed regarding who is taxed on the S corporation income and the grantor portion of the income of an ESBT involving a nonresident alien potential current beneficiary, and how much that tax liability will be.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
All contributors are members of SingerLewak LLP.