Before the Tax Cuts and Jobs Act (TCJA) a nonresident alien (NRA) could not own stock in a US S corporation. In fact, if a shareholder of an S corporation became an NRA the benefits of the S corporation flow through tax treatment was terminated for all shareholders. This occasionally happened even where the S corporation stock was owned by an electing small business trust (ESBT) and one of the shareholders married an NRA in a community property state or country. The termination of the S corporation resulted in unforeseen tax consequences to all the shareholders and could upset family held business relationships. This has now changed effective January 1, 2018.
Background on ESBTs
An election can be made for a trust (including a grantor trust) to be treated as an ESBT. The election must be made within the first two- and one-half months of the beginning of the trust year. The result is that the ESBT will pay tax at the trust level at the highest rate for individuals (37%). The IRS just issued regulations to make sure this is the situation since there is concern that an NRA that might be difficult to tax actually pays the US tax on his or her share of the S corporation income.
There are several requirements for a trust to be an ESBT, but nothing prevents an ESBT from holding S corporation stock as well as other property or from accumulating trust income. In addition, a potential current beneficiary (PCB) may be one of multiple beneficiaries of an ESBT.
A PCB, with respect to any period, is any person who at any time during such period is entitled to receive, or at the discretion of any person may receive, a distribution from the principal or income of the ESBT. 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 — even though the ESBT is treated as a single trust for administrative purposes.
The proposed regulations would 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 would continue to be subject to U.S. federal income tax.
Specifically, the allocation rules would be modified 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.
A trust must elect to be treated as an ESBT (and pay the applicable US tax) for the tax year for which the election is made and all subsequent tax years, unless it is revoked with the consent of the IRS. Only one election is needed for a trust, regardless of the number of S corporations it owns. The trustee with authority to legally bind the trust must make the election by signing and filing a statement with the IRS Service Center where the S corporation files its income tax return. The statement must include some of the following:
- Name, address and taxpayer identification number of all potential current beneficiaries (PCB), the trust and the S corporation(s). This will require the NRA to obtain an ITIN (no easy task anymore!).
- Specify the effective date of the election (not earlier than 15 days and two months before the date on which the election is filed).
- The date(s) on which the stock of each S corporation was transferred to the trust.
- Certain other representations.
The election must generally be filed within two months and 16 days of the day that the S corporation stock is first transferred to the trust.
Impact and Developments
This is a favorable change to the S corporation rules and might even offer an opportunity to seek offshore equity funding from foreign individuals. It is also a favorable development for family office planning involving both US and non-US family members. MSDM has both the international and S corporation expertise to help you review how this might be beneficial for your particular situation. Please contact us to discuss this further.