One of the many areas the Tax Cuts and Jobs Act (TCJA) impacts includes the treatment of nonresident aliens as potential current beneficiaries of an Electing Small Business Trust (ESBT). Historically, each potential current beneficiary of an ESBT had to be a U.S. citizen or resident for the trust to qualify as an ESBT. If you were a nonresident alien, you could not be a potential current beneficiary of an ESBT.
However, that has changed under the TCJA. Nonresident aliens who are potential current beneficiaries of an ESBT are no longer treated as ineligible shareholders of an S Corporation. It is important to note that a nonresident alien cannot own stock in any S Corporation directly either before or after the change made by the TCJA.
Individuals and their advisors need to be aware that the Treasury Department and IRS are applying these regulations retroactively to prevent abuse and may require action on the part of taxpayers.
What are the Benefits of Qualifying as an Electing Small Business Trust (ESBT)?
Let’s step back a moment and look at the ESBT more closely. A “small business corporation,” often referred to as an S Corporation, enjoys certain tax advantages over C Corporations. Namely, the income of an S Corporation is only taxed once at the shareholder level; whereas the income of a C corporation is taxed twice, once at the corporate and level and again at the shareholder level. Among other restrictions, S Corporation shareholders are restricted to individuals, estates, certain types of trusts and certain types of tax-exempt organizations. The types of individuals eligible to be S Corporation shareholders are further restricted to U.S. citizens or residents. One type of trust that qualifies to be an S Corporation shareholder is a domestic trust that qualifies and has elected to be an ESBT. The intent of allowing this type of trust to be an eligible S Corporation shareholder is to facilitate family financial planning.
At the time the original provision was enacted allowing nonresident aliens to be potential current beneficiaries of ESBTs, Congress did not believe this change would have an effect on federal revenues because generally an ESBT’s share of S Corporation income is taxed at the trust level at the highest rate of tax imposed on individual taxpayers. As a result, the residency status of the individual beneficiaries should not impact the tax calculation of the S Corporation income.
However, when analyzing the impact to federal revenues, Congress failed to consider the effect of the “grantor trust” rules. A grantor trust is one in which the individual who funded or is deemed to own the trust retains the power to control or direct the trust’s income or assets. If a trust is determined to be a grantor trust, the trust is disregarded as a separate entity for federal income tax purposes and income, deductions and credits are taxed directly to the person who funded or is the deemed owner of the trust. Furthermore, the grantor trust rules prevail over the general rule that S Corporation income is taxed at the ESBT level. A grantor trust is eligible to make an ESBT election.
If an ESBT is determined to be a grantor trust (in whole or in part), the income of the S Corporation is taxed at the individual grantor level instead of at the trust level. This could be problematic if an ESBT is a grantor trust with respect to a nonresident alien.
For example, if an ESBT is a grantor trust with respect to a nonresident alien and the S Corporation generated foreign source income or income not effectively connected with the conduct of a U.S. trade or business, those amounts would not be subject to U.S. federal income tax. To further aggravate matters, if the nonresident alien is a resident of a country that has an income tax treaty with the U.S., the S Corporation’s U.S. source income might be exempt from U.S. federal income tax or eligible for a lower U.S. federal income tax rate. Nonresident aliens eligible for grantor trust treatment would only be subject to U.S. federal income tax on the S Corporation income that is U.S. source fixed or determinable income, or income effectively connected with a U.S. trade or business.
The Treasury Department and IRS believe Congress did not intend for this result when it changed the statute to allow nonresident aliens to be potential current beneficiaries of ESBTs. As a result, on June 18, 2019, the Treasury Department and IRS finalized regulations requiring S Corporation income that would otherwise be taxed at the individual level of a nonresident alien under the grantor trust rules to continue to be taxed at the trust level of an ESBT — ensuring that all of the S Corporation’s income remains subject to U.S. federal income tax. These regulations were effective January 1, 2018.
Retroactive Applications and Actions
As mentioned, the Treasury Department and IRS are applying these regulations retroactively to prevent abuse. As a result, a 2018 tax return that has already been filed inconsistent with these regulations will need to be amended and 2019 estimated tax payments may need to be adjusted to avoid underpayment penalties.
Contact Michael Boncher at firstname.lastname@example.org, Alane Boffa at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.