Proposed regulations issued on ESBTs with nonresident beneficiaries

Tax Hot Topics newsletterThe 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.
Bryan Keith
Managing Director
Washington National Tax Office
T +1 202 861 4116

Brad Roe
Managing Director
Houston Office
T +1 832 476 5080

Jack Stringfield
Senior Associate
Washington National Tax Office
T +1 202 521 1518
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