The IRS has finalized regulations (TD 9868) regarding the addition of nonresident aliens (NRAs) to the class of permissible potential current beneficiaries of an electing small business trust (ESBT).

Adopting in their entirety proposed regulations (REG-117062-18; Tax Alert 2019-0834) issued in April 2019, the final regulations implicitly confirm that a grantor trust deemed to be owned by an NRA may own stock in a corporation without causing the corporation to not qualify as an S corporation, as long as the trust validly elects to be an ESBT. The regulations ensure that an S corporation's income 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

A small business corporation may not have an NRA as a shareholder. Only a small business corporation may elect and maintain S corporation status. Certain trusts, including certain grantor trusts and ESBTs, may be S corporation shareholders. 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.

The Tax Cuts and Jobs Act of 2017 (TCJA) amended Section 1361(c)(2)(B)(v) to allow NRAs to be PCBs of ESBTs. The code now provides that "NRA PCBs will not be taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders," the Preamble explains.

The final regulations

After releasing the proposed regulations under Sections 641 and 1361, the IRS received no comments and therefore has finalized the regulations unchanged.

When an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the final regulations provide that the ESBT's S corporation income continues to be subject to US federal income tax. To reach this result, the regulations change the allocation rules under Reg. Section 1.641(c)-1 to require the ESBT's S corporation income to be included in the S portion of the ESBT if the grantor trust rules would have otherwise allocated the income to an NRA-deemed owner.

As conforming revisions, the regulations also update the description of PCBs found in various provisions of the Section 1361 regulations to reflect that NRAs may be PCBs of ESBTs.

Applicability date

Although final regulations are typically not effective until after being 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. The final regulations state that "to prevent abuse" of Sections 641 and 1361 and the regulations under these sections, "the final regulations apply to all ESBTs after December 31, 2017."

Implications

The goal of these regulations is to prevent non-US source income from flowing through an S corporation and escaping US taxation in the hands of an NRA. Given there were no comments on the regulations, they may have been the least controversial regulations package to date on a TCJA amendment.

Given how rarely the government promulgates regulations on ESBTs, it was a little unfortunate that the government did not use this guidance package to update the existing regulations for other TCJA impacts, such as the revision to the charitable deduction rules for the S-portion of an ESBT, or allowing interest expense incurred on the acquisition of S corporation stock to be deductible on the S-portion dating back to the Small Business and Work Opportunity Act of 2007.

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