The IRS has issued proposed regulations (REG-117062-18) providing rules on the recent statutory expansion of the class of permissible potential current beneficiaries (PCBs) of an electing small business trust (ESBT) to include nonresident aliens (NRAs). The proposed regulations implicitly confirm that a grantor trust deemed owned by an NRA may now own stock in a corporation without causing the corporation to not qualify as an S corporation, provided that the trust validly elects to be an ESBT. The focus of the proposed regulations is to ensure that the income of an S corporation will continue to be subject to US federal income tax when an NRA is a deemed owner of a grantor trust that elects to be an ESBT.

Background

Only a small business corporation can elect and maintain S corporation status.¹ A small business corporation may not have an NRA as a shareholder.² Certain trusts are permissible S corporation shareholders, including certain grantor trusts and ESBTs.³ Generally, the deemed owner of a grantor trust and each PCB of an ESBT is treated as a shareholder for purposes of determining if a corporation qualifies as a small business corporation.⁴ Thus, prior to a change enacted by the Tax Cuts and Jobs Act of 2017 (TCJA), the ownership of stock by a grantor trust deemed owned by an NRA or by a trust with an NRA as a PCB would preclude the corporation from qualifying as a small business corporation eligible to be an S corporation. The TCJA amended the rule treating each PCB as a shareholder to provide that this rule does not apply for purposes of the rule prohibiting an NRA from being a shareholder in an S corporation.⁵

In the case of an ESBT, the portion of the trust consisting of S corporation stock (the S portion) is treated as a separate trust for purposes of determining the trust's liability for US federal income tax.⁶ Generally, an S corporation's items of income, gain, deduction, loss and credit (S items) are taken into account by the S portion of the trust and taxed at the trust level.⁷ However, if the ESBT is also a grantor trust, S items allocated to the grantor trust portion of the trust are, for US federal income tax purposes, taken into account by the grantor, and not the trust.⁸ In other words, when an ESBT is also a grantor trust, the grantor trust rules override the ESBT rules so the grantor of the grantor trust portion is taxed on the trust's income.

The proposed regulations

As noted above, the TCJA amended the rule treating each PCB of an ESBT as a shareholder for purposes of the S corporation eligibility requirements, to provide that this rule does not apply for purposes of the prohibition of NRAs as shareholders. To ensure that all S corporation income remains subject to US federal income tax, the proposed regulations provide that when an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, S corporation items allocated to the grantor portion of the trust must be reallocated to the S portion of the trust and taxed at the trust level.⁹

Effective/applicability date

Although proposed regulations are typically not effective until after their successor final regulations are published in the Federal Register, regulations issued within 18 months of the enactment of new statutory provisions may take effect or apply retroactively to prevent abuse. Viewing this as such a case, the IRS proposes that these regulations apply to all ESBTs after December 31, 2017.

Implications

Prior to the issuance of these proposed regulations, many practitioners questioned whether a grantor trust with an NRA as a deemed owner could be a permissible S corporation shareholder by making an ESBT election. This is because although the change enacted by the TCJA permits an NRA to be a PCB of an ESBT, it did not eliminate the general prohibition on NRAs as shareholders, and in the case of a grantor trust, the deemed owner of the trust is considered a shareholder. Neither the preamble nor the proposed regulations explicitly addressed this concern, but by providing specific rules addressing the taxation of S corporation items allocated to a grantor trust deemed owned by an NRA, it is implicit in the proposed regulations that ownership of stock by a grantor trust with an NRA as a deemed owner will not preclude a corporation from qualifying as a small business corporation if the trust validly elects to be an ESBT.

Ultimately, the goal of these proposed regulations is to prevent non-US source income from flowing through an S corporation and escaping US taxation in the hands of an NRA. The universe of individuals who may be impacted by these proposed regulations is fairly narrow because: (1) the trust must be a domestic trust for US tax purposes, meaning that the trust must satisfy the court and control tests under IRC Section 7701(a)(30)(E), and (2) the trust is a grantor trust to the NRA because distributions may only be made to the grantor or grantor's spouse during the NRA grantor's lifetime. Interestingly, by utilizing the definition of NRA in IRC Section 7701(b)(1)(B), these proposed regulations do not appear to apply to an individual that is treated as a non-US resident pursuant to a US income tax treaty.

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ENDNOTES

¹ IRC Section 1361(a)(1).

² IRC Section 1361(b)(1)(c).

³ See IRC Section 1361(b)(1)(B) and IRC Section 1361(c)(2)(A).

⁴ IRC Section 1361(c)(2)(B)(i) and (v).

⁵ IRC Section 1361(c)(2)(B)(v), last sentence.

⁶ IRC Section 641(c)(1).

⁷ IRC Section 641(c)(2) and (3).

⁸ Regulation Section 1.641(c)-1(c) and (d).

⁹ Proposed Regulation Section 1.641(c)-1(b)(1)(ii) and 1.641(c)-1(b)(2)(iii) [sic].