Bridging the gap: GILTI and AAA

Editor: Greg A. Fairbanks, J.D., LL.M.

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, disrupted many traditional international tax norms, including the treatment of passthrough entities as separate when determining certain inclusions generated by foreign investments. For decades, domestic passthroughs were treated as separate entities when determining an investor’s Subpart F inclusion related to investments in controlled foreign corporations (CFCs). However, in 2019, the IRS changed course in final (T.D. 9866) and proposed (REG-101828-19) regulations addressing the treatment of owners of passthrough entities. Although the IRS then finalized the portions of the proposed regulations (T.D. 9902), the rules regarding the treatment of domestic partnerships remain proposed as of this writing. These regulations provide rules that look to treat passthroughs as an aggregate of their owners, rather than as entities, when determining global intangible low-taxed income (GILTI) or Subpart F income inclusions (deemed inclusions). This cosmic shift created a gap between pre-TCJA systems applying an entity approach and the post-TCJA system of computing deemed inclusions applying an aggregate approach.

One of the most important consequences affects an S corporation’s computation of its accumulated adjustments account (AAA). The AAA tracks the corporation’s ability to make tax-free distributions to shareholders. The AAA offers several benefits. S corporation distributions are sourced first out of the AAA before accumulated earnings and profits (AE&P). AE&P are earnings and profits that accumulated when the S corporation was formerly a C corporation and are taxed as dividends when ultimately distributed.

The aggregate approach to deemed inclusions prevents an increase of the AAA at the S corporation level, despite the previously taxed but undistributed earnings of the S corporation. The gap in systems created adverse consequences for many shareholders of S corporations with AE&P. However, the IRS provided temporary relief with guidance released on Sept. 1, 2020 (Notice 2020-69). Notice 2020-69 provides a new entity election that allows an S corporation to compute the deemed inclusions at the entity level, as opposed to at the shareholder level, allowing the deemed inclusions to increase the AAA. This item provides background on the new entity election, illustrates its effects, and highlights opportunities and traps to consider when contemplating the election.

Background

Generally, U.S. shareholders must include their pro rata share of the deemed inclusions for any given tax year. S corporations are treated in the same manner as domestic partnerships for purposes of Secs. 951 and 951A. Accordingly, in some cases, an S corporation is not treated as owning stock of a foreign corporation. Instead, each S corporation shareholder is treated as proportionately owning the stock of the S corporation-owned CFC. Under this aggregate treatment, the U.S. shareholder determines its GILTI inclusion (or Subpart F inclusion, if early-adopting certain proposed regulations) with respect to the S corporation–owned CFC.

The AAA includes the earnings of the corporation that have been previously taxed to shareholders for all years in which an S election is in effect, less any amounts distributed. For an S corporation that converted from a C corporation, the C corporation transfers its AE&P (i.e., the untaxed and undistributed earnings and profits accumulated during its tenure as a C corporation) to the S corporation when the S election is made. The S corporation’s AAA does not increase by the amounts included in AE&P and is limited to income generated by the corporation during its status as an S corporation. Future distributions are prioritized out of the AAA, thus preserving a single level of tax to S corporation shareholders. For example, if an S corporation with AE&P distributes property to its shareholders, the distributions will generally be tax-free to the extent of the AAA, and then the shareholders will recognize dividends to the extent the distribution exceeds the AAA and is made out of AE&P.

When deemed inclusions occur under the rules above, they do not result in a positive adjustment to the AAA because the deemed inclusion amounts arise at the shareholder level rather than at the S corporation level. As a result, there is a disconnect between the two systems (“aggregate” for deemed inclusions and “entity” for AE&P and the AAA), creating issues and unexpected tax consequences for certain S corporation shareholders.

The notice provides relief and attempts to temporarily align the two systems until the S corporation no longer has AE&P as of a certain date (discussed further below — note that such AE&P is modified into a new transitional amount to reflect this temporary system until it is exhausted). The notice states that the IRS intends to allow S corporations with AE&P and their shareholders to make an election to apply entity treatment for purposes of deemed inclusions. Entity treatment means that an S corporation that owns stock of a CFC will compute the deemed inclusions under Secs. 951A and 951 at the entity level, thus allowing the S corporation to determine its deemed inclusions, with its shareholders then taking into account their distributive share of that amount (see the illustration below). This enables the S corporation to treat the deemed inclusions as an item of income to increase its AAA.

The AAA created by the deemed inclusions allows the S corporations to distribute property to shareholders and avoid dividend treatment to the extent of the AAA created by the deemed inclusions. However, electing entity treatment is not without its drawbacks, including its impact on minority shareholders. Minority shareholders that own less than a 10% interest in the underlying CFC may not have deemed inclusions under the aggregate approach. Under the entity approach, however, all shareholders include in gross income their allocable share of the S corporations’ deemed inclusions. In other words, the election may subject less-than-10% shareholders to tax on the deemed inclusions that might have otherwise been avoided had the election not been made.

The election also comes with some added complexity and tracking. S corporations making such an election must track a new quantity, “transition AE&P,” which is meant to lock in and track AE&P as of Sept. 1, 2020, and provide a transition by providing limited entity treatment to the S corporation. Once a transition AE&P amount is exhausted, S corporations are transitioned back to the aggregate treatment as provided in the final GILTI regulations.

The entity election provided by the notice is generally available if the S corporation:

• Makes the election in accordance with the procedures in the notice;
• Elected S corporation status before June 22, 2019;
• Would be treated as owning stock of a CFC on June 22, 2019, within the meaning of Sec. 958(a), if entity treatment applied, has transition AE&P on Sept. 1, 2020, or on the first day of any subsequent tax year; and
• Maintains records supporting the S corporation’s determination of transition AE&P.

With respect to the first tax year ending on or after Sept. 1, 2020, an S corporation may irrevocably elect to apply entity treatment on a timely filed (including extensions) original Form 1120-S, U.S. Income Tax Return for an S Corporation. For tax years of an S corporation ending before Sept. 1, 2020, and after June 21, 2019, the S corporation and all its shareholders may irrevocably elect the entity treatment on timely filed (including extensions) original or amended returns filed by March 15, 2021.

For tax years that ended before June 22, 2019, the IRS issued previous guidance (Notice 2019-46) announcing its intent to issue regulations that would permit certain domestic partnerships or S corporations to apply the 2018 proposed GILTI regulations, including the hybrid approach in proposed Regs. Sec. 1.951A-5, in their entirety for tax years that ended before Jun. 22, 2019. Given the availability of entity treatment under those rules, the election is not necessary for such periods.

To illustrate the impact of the new entity election, a few simple fact patterns are examined:

Example 1: S is an S corporation with two U.S. shareholders, A and B, who respectively own 9% and 91% of S’s stock. S wholly owns FC, a CFC. Neither A nor B is considered a Sec. 958(a) shareholder with respect to any other CFCs. On Jan. 1, S has AE&P of $150 and AAA of $0. S makes the entity election to apply the transition rules allowing for entity treatment of deemed inclusions. During the tax year, S has no taxable income or loss, and FC has $100 of tested income (within the meaning of Regs. Sec. 1.951A-2(b)(1)). FC has no tax basis in tangible assets, and thus there is no net deemed tangible income return (within the meaning of Regs. Sec. 1.951A-1(c)(3)). On Dec. 31, S distributes $150 to its shareholders, A and B.

S’s GILTI inclusion for the tax year is $100. Because S computes its income as an individual under Sec. 1363(b), it cannot take a Sec. 250 deduction for any GILTI inclusion amount. Due to S’s making the entity election, S will increase its AAA by the GILTI inclusion amount of $100. A and B will then include their pro rata share of S’s GILTI inclusion within gross income, which is $9 ($100 × 9%) and $91 ($100 × 91%), respectively. Although A is a minority shareholder of S, electing the entity treatment requires all U.S. shareholders to include their pro rata share of S’s GILTI inclusion irrespective of whether they are themselves a U.S. shareholder in S’s CFC.

S’s distribution of $150 to its shareholders is first treated as tax-free to the extent of the AAA ($100). The shareholders recognize dividends to the extent the distribution exceeds AAA and is made out of transition AE&P ($50). S’s new balance in the transition AE&P account is $100 ($150 – $50), and S will be able to continue to apply the entity treatment until the remainder of the transition AE&P is depleted (see the table below).

As seen in the table above, the election significantly reduces the overall tax paid by the shareholders in the year of the distribution. However, in doing so, the election increases the tax incurred by A due to the inclusion of its pro rata share of GILTI.

By utilizing the entity treatment election, S corporations are provided the benefit of temporary increases to AAA that can be used to create a tax-free distribution of property to their U.S. shareholders. The election may allow for more tax-efficient distributions of excess domestic cash or property utilizing the AAA created by foreign earnings. This scenario is illustrated below in Example 2.

Example 2: B and W are U.S. shareholders who each own a 50% interest in an S corporation, L. L wholly owns T, a CFC. Neither B nor W is considered a Sec. 958(a) shareholder with respect to any other CFCs. As of Jan. 1, L does not have a balance within its AAA, as a result of previous distributions, and has AE&P of $200. L has excess cash generated by domestic operations. L makes the entity election to apply the transition rules allowing for entity treatment of deemed inclusions. During the tax year, L has $10 of ordinary income, and T has $75 of tested income (within the meaning of Regs. Sec. 1.951A-2(b)(1)). T has no tax basis in tangible assets, and thus there is no net deemed tangible income return (within the meaning of Regs. Sec. 1.951A-1(c)(3)). On Dec. 31, L distributes $75 of the excess cash to its shareholders, B and W.

L generates a GILTI inclusion of $75 for the tax year. Because L computes its income as an individual under Sec. 1363(b), it cannot take a Sec. 250 deduction for any GILTI inclusion amount. Due to L’s making the entity election, L will increase its AAA by the GILTI inclusion amount of $75. B and W will then include their pro rata share of L’s GILTI inclusion within gross income, which is $37.5 ($75 × 50%).

L’s distribution of $75 to its shareholders is treated as tax-free to the extent of the AAA ($85), which resulted, in part, from the entity election. L’s balance in the transition AE&P account remains $200 ($200 – $0), and L will be able to continue to apply the entity treatment until the remainder of the transition AE&P is depleted (see the table below).

Similar to Example 1, L is able to increase its AAA by the GILTI inclusion of $75, and both shareholders will include their pro rata share of the deemed inclusion in gross income. This increases the AAA created by the domestic earnings ($10) by the GILTI inclusion ($75), resulting in total AAA of $85 prior to distributions. As seen in the table above, without the election, B and W would have to pay tax on their GILTI inclusion, ordinary income, and the distribution out of AE&P in excess of the AAA without GILTI. However, the entity election allows L to increase its AAA by the deemed inclusions and provides L with the ability to distribute additional tax generated by the domestic operations. Thus, even if L intends on reinvesting T’s offshore earnings, it may nevertheless use the AAA created by such earnings to efficiently access domestic cash or property.

Opportunities and next steps

S corporations with AE&P and their tax professionals should consider the effects of the notice and any subsequent regulations. The election creates another earnings pool to track but can provide temporary relief to S corporations when computing the AAA. S corporation shareholders often look to maximize the AAA in order to minimize the amount of distributions in excess of the AAA classified as a dividend from AE&P. This is another tool in the toolbox to accomplish this and can be used to access cash unrelated to the foreign operations.

In addition to the above implications, S corporations may see other benefits from making this election. For example, it may alleviate the mismatch of inside and outside tax basis. Currently, the aggregate computation of the deemed inclusions results in an increase in basis of the property held by the shareholder with the inclusion (i.e., the stock in the S corporation, commonly referred to as the outside basis in the S corporation). However, pending any future guidance by the IRS, there does not appear to be a corresponding adjustment to the stock of the CFC in the hands of the S corporation (i.e., the stock of the CFC, referred to as the inside basis). If an S corporation makes the entity election, the S corporation’s basis in its CFC will be increased by the deemed income inclusions creating inside basis, and the allocation of income to the S corporation shareholders may also create outside basis — alleviating the mismatch.

Making the entity election may provide significant benefits to applicable S corporations. But, as illustrated above, it’s not without its traps and may increase the tax of certain shareholders. As a result, taxpayers should carefully evaluate and model the impacts of the entity election, weighing its pros and cons.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.