Proposed Regulations Published on Electing Small Business Trusts

| 5/9/2019
The Tax Cuts and Jobs Act (TCJA) amended the IRC to allow an electing small business trust (ESBT) with a nonresident alien (NRA) potential current beneficiary (PCB) to be an eligible S-corporation shareholder. Generally, a PCB is any person who is entitled to or, at the discretion of any person, may receive a distribution from the principal or income of the ESBT. A PCB may include a deemed owner of a grantor trust that elects to be an ESBT. This amendment prevents the change in immigration status of an ESBT PCB from jeopardizing the S-corporation status of the entity in which the ESBT is a shareholder.

Current rules allow income from an S corporation with an ESBT shareholder to escape federal income tax if an NRA is the deemed owner (grantor) of the ESBT under the grantor trust rules. On April 19, 2019, the U.S. Department of the Treasury and the IRS published proposed regulations to make certain that S-corporation income remains subject to federal income tax in these situations. These rules are proposed to be effective retroactively for ESBTs after Dec. 31, 2017. Comments and requests for a public hearing are due June 3, 2019.

Background

Subchapter S of the IRC permits a corporation to elect to be treated as a small business corporation if it satisfies specific requirements, including the number and type of shareholders. Only specified types of trusts, including ESBTs, are eligible to be an S-corporation shareholder. Each PCB of an ESBT is treated as a separate S-corporation shareholder.

An ESBT that owns the stock of an S corporation or other property is treated as if there are two separate trusts – an S portion and a non-S portion. The S portion, consisting solely of S-corporation stock, is treated as a separate trust and taxed at the highest income tax rate applicable to trusts. The non-S portion of the ESBT also is treated as a separate trust and taxed at the rate applicable under the normal trust income taxation rules. If, however, a portion of an ESBT is treated as owned by a grantor of the ESBT, the grantor trust rules apply, and the grantor, rather than the trust, is taxable on the grantor portion of the ESBT.

Under these rules, if an NRA is the grantor with respect to the S portion of an ESBT, income from the S corporation passes through to the NRA rather than being taxed to the trust at the highest trust rate. Under certain circumstances, this situation could allow some S-corporation income, such as foreign-sourced income or income not effectively connected to a U.S. trade or business, to escape federal income tax when the income passes from a domestic ESBT to the NRA grantor. Additionally, if the NRA grantor is a resident of a country with which the United States has an income tax treaty, U.S. source income of the S corporation also might be exempt from tax or subject to a lower rate of tax.

Proposed regulations

The proposed regulations are intended to ensure that the TCJA amendments allowing an NRA to be a PCB of an ESBT do not result in S-corporation income escaping U.S. taxation. The proposed regulations provide that if an NRA is grantor of all or a portion of an ESBT, the grantor portion of the net income of the ESBT must be reallocated to the S portion of the ESBT. This results in the S-corporation income being taxed to the ESBT at the highest trust rate rather than passing through to the NRA and potentially escaping U.S. tax.

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