The IRS released guidance on Sept. 1 (Notice 2020-69) offering relief for S corporations with accumulated earnings and profits (AE&P) after a conversion from a C corporation and addressing the treatment of qualified improvement property (QIP) for global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) calculations.
Notice 2020-69 provides that the IRS intends to issue future regulations under the GILTI rules of Section 951A and the Subpart F rules under Section 951 to address certain S corporations with AE&P. The guidance helpfully offers S corporations the ability to elect entity treatment for certain GILTI and FDII calculations, but there can be drawbacks, particularly for minority shareholders. The notice also addresses the impact of retroactive changes to qualified improvement property (QIP) on the computation of qualified business asset investment (QBAI) for purposes of FDII under Section 250 and GILTI under Section 951A.
The notice provides helpful guidance in these two previously uncertain areas, but timely action may be required in certain areas for taxpayers to benefit.
S corporations and AE&P
Generally, U.S. shareholders must include their pro rata share of Subpart F income and GILTI inclusion for any given taxable year. S corporations are treated in the same manner as domestic partnerships for purposes of Sections 951 and 951A. Accordingly, in some cases, an S corporation is not treated as owning stock of a foreign corporation but instead, each S corporation shareholder is treated as proportionately owning the stock of the S corporation-owned controlled foreign corporation (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.
For an S corporation that converted from C corporation, the C corporation transfers its AE&P to the S corporation when the S election is made. The S corporation’s accumulated adjustments account (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 an AAA, thus preserving a single-level-of-tax to S corporation shareholders.
When a deemed income inclusion occurs under the rules discussed above, it does not result in a positive adjustment to the AAA because the inclusion amounts arise at the shareholder level, rather than at the S corporation level. Therefore, if an S corporation with AE&P distributes property to its shareholders, the S corporation would need an AAA equal to the distribution amount to prevent the distribution from being included in such shareholder’s gross income to the extent of AE&P and taxed as a dividend. As a result, there is a disconnect between the two systems, “aggregate” for certain deemed inclusions and “entity” for AE&P, creating issues and unexpected tax consequences for certain S corporation shareholders.
Notice 2020-69 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 GILTI and the Section 250 FDII deduction. Entity treatment means that an S corporation that owns stock of a CFC picks up the deemed inclusions under Sections 951A and 951, thus allowing the S corporation to determine its GILTI and Subpart F inclusions, with its shareholders then taking into account their distributive share of that amount. This allows the S corporation to treat the deemed inclusions as an item of income to increase its AAA. Moreover, this increase 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, the election does come with some added complexity and tracking. S corporations making such an election must track a new quantity, “transition AE&P,” that 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 an transition AE&P amount is exhausted, then S corporations are transitioned to the aggregate treatment as provided in the final GILTI regulations.
Grant Thornton Insight:
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. However, under the entity approach, 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% owners to tax on the GILTI income that might have otherwise been avoided had the election not been made.
With respect to the first taxable 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 taxable 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 returns or on amended returns filed by March 15, 2021.
For taxable 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 Treas. Reg. Sec. 1.951A-5, in their entirety, for taxable years that ended before June 22, 2019. Given the availability of entity treatment under those rules, the election is not necessary for such periods.
QBAI rules for FDII and GILTI
The guidance settles some uncertainty in the QBAI calculation caused by the retroactive nature of a change in depreciation for QIP. QIP includes a broad category of improvements to the interior of nonresidential real property, and was intended to have a 15-year recovery period under the general depreciation system and a 20-year recovery period under the alternative depreciation system (ADS). However, a drafting error in the TCJA left QIP off the list of eligible 15-year property. The CARES Act fixed this error retroactive for property placed in service after Dec. 31, 2017 (see our coverage of the QIP correction).
The uncertainty arose because Section 951A(d)(3) requires a taxpayer to calculate QBAI by determining the adjusted basis of property using the ADS rules under Section 168(g) “notwithstanding any provision of this title (or any other provision of law) which is enacted after the date of the enactment of [Section 951A].” The regulations under Section 951A further provide that the adjusted basis in specified tangible property is determined without regard to any provision of law enacted after Dec. 22, 2017, unless such later enacted law specifically and directly amends the definition of QBAI. This definition of QBAI also applies for the purposes of determining deemed tangible income return under Section 250. Because the CARES Act did not specifically and directly amend the definition of QBAI under Section 951A, there was uncertainty as to its application when determining QBAI.
The notice clarifies that the technical amendment to Section 168 enacted as part of the CARES Act was intended to apply as if it had been enacted as part of the Tax Cuts and Jobs Act (TCJA). The notice further states that the IRS has determined that this clarification is consistent with congressional intent that the provisions of the technical amendment be given effect as if included in TCJA. The guidance provides certainty to taxpayers who have placed QIP into service after Dec. 31, 2017, and are required to compute QBAI for Sections 951A or 250.
Grant Thornton Insight:
The guidance may be favorable or unfavorable depending upon a taxpayer’s particular circumstances. In a GILTI context, accelerated depreciation for QBAI may adversely impact deemed tangible income return, thereby increasing the overall GILTI inclusion. In a FDII context, the change would typically reduce QBAI, which should produce increased deemed intangible income, and thereby increase the FDII deduction.
The forthcoming QIP-QBAI regulations will apply to taxable years of foreign corporations beginning after Dec. 31, 2017. Before the issuance of the forthcoming regulations, U.S. shareholders and domestic corporations may rely on the rules, provided that the taxpayer consistently applies them for purposes of FDII and GILTI to such taxable year and all subsequent taxable years.
Notice 2020-69 intends to provide relief to S corporations by transitioning to a temporally limited entity treatment regime. Taxpayers should evaluate the ability to elect to compute subpart F and GILTI utilizing the entity treatment, weighing the pros and cons of such an election. Additionally, the clarification of QIP useful life may provide benefit to multinational taxpayers. Taxpayers have the opportunity to retroactively apply both the QIP rules and the S corporation entity treatment election and should consider whether to do so on amended returns.
David E. Sites
National Managing Partner, International Tax Services Practice Leader
David leads the firm's International Tax practice, which focuses on global tax planning, cross border merger and acquisition structuring, and working with global organizations in a variety of other international tax areas.
Washington DC, Washington DC
- Technology and telecommunications
- Retail and consumer products
- International tax
Washington DC, Washington DC
- Technology and telecommunications
- Private equity
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