The IRS recently issued proposed regulations (REG-117062-18
) regarding electing small business trusts (ESBTs) with nonresident alien (NRA) potential current income beneficiaries (PCBs). The proposed regulations ensure that income of an S corporation continues to be subject to federal income tax when an NRA is a deemed owner of a grantor trust that elects to be an ESBT.
Prior to the Tax Cuts and Jobs Act (TCJA), all PCBs of an ESBT that held S corporation stock were treated as shareholders of that S corporation. S corporations are not permitted to have NRAs as shareholders. If a PCB of the ESBT was an NRA, this would terminate the corporation’s subchapter S election.
The TCJA amended Section 1361(c)(2)(B) so that an NRA who is a PCB of an ESBT that holds S corporation stock is not treated as a shareholder of the S corporation for purposes of the eligible S corporation shareholder requirement. As a result of this change, NRAs are now permitted to be PCBs of an ESBT that holds S corporation stock.
The new statute did not, however, address situations where an NRA is the grantor of a portion of an ESBT that is also a grantor trust. In general, the ESBT rules provide that portion of the trust consisting of S corporation stock is treated as a separate trust. This “S portion” is taxed on S corporation items of income at the trust level. There is an exception to this general rule when an ESBT is also a grantor trust. Under the exception, the grantor of the grantor trust, not the S portion of the trust, is taxed on the S corporation’s items of income. Thus, the grantor trust rules must be applied notwithstanding the fact that the trust made an ESBT election.
The IRS acknowledged in the preamble to the proposed regulations that the combination of the TCJA amendment to Section 1361 and the grantor trust rules could result in a potentially abusive outcome. If an NRA is a PCB of an ESBT that is also a grantor trust, S corporation items of income allocated to the NRA as the grantor of the trust have the potential to escape U.S. federal income taxation.
The IRS recognized that Congress did not intend for this result. The proposed regulations provide for special rules in situations where an NRA is a grantor of a grantor trust that has elected to be an ESBT. The proposed regulations provide that if a grantor trust elects to be an ESBT and the grantor is an NRA, then any S corporation items of that ESBT will not be allocated directly to the grantor. Instead, those S corporation items must be allocated to the S portion of the trust and taxed at the trust level.
The proposed regulations apply to all ESBTs after Dec. 31, 2017. The IRS notes that under section 7805(b)(3) a regulation may take effect or apply retroactively to prevent abuse.
Washington National Tax Office
+1 202 861 4116
+1 832 476 5080
Washington National Tax Office
+1 202 521 1518
Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.