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Tax Law Update: June 2019

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

• Proposed regulations concerning ESBTs and nonresident aliens—The Treasury Department has issued REG-117062-18 (April 29, 2019) to amend regulations relating to electing small business trusts (ESBTs) that are grantor trusts deemed owned (in whole or in part) by nonresident aliens.

S corporations (S corps) restrict ownership to certain persons. An S corp must have one class of stock and must not have more than 100 shareholders. All shareholders must be individuals except for certain qualified trusts or organizations. And, under Internal Revenue Code Section 1361(b)(1)(C), a nonresident alien (NRA) isn’t permitted to be a shareholder.

An ESBT is one type of trust that’s a permitted S corp shareholder. For the purposes of determining whether the shareholder rules are violated, each potential current beneficiary (PCB) of an ESBT is treated as a shareholder. A PCB is each person who at any time is entitled to or may receive at the discretion of any person a distribution from the trust (excluding via exercise of a power of appointment). 

Wholly or partial grantor trusts may make ESBT elections. If so, the deemed owner of the grantor trust (or any part thereof) is also a PCB.  

As noted above, an NRA isn’t a permitted shareholder of an S corp. If an NRA became a PCB of an ESBT, under prior rules, the ESBT election would terminate, as well as the S corp status. However, recent changes to the statute altered the rule so that for purposes of IRC Section 1361(b)(1)(C)’s residency requirement only, you needn’t look through the ESBT to each PCB. Now, having an NRA as a PCB of an ESBT won’t cause the S corp election to terminate.  

However, this change caused a problematic potential consequence: If the ESBT is a grantor trust with an NRA as the grantor, the S corp income would flow through to the NRA and wouldn’t be subject to U.S. federal income tax (unless that income was U.S. source fixed or determinable or effectively connected with a U.S. trade or business). Typically, an ESBT is taxed on its S corp income, which would protect against tax avoidance, but the grantor trust rules override the ESBT provisions.  

The Treasury determined that the expansion of the statute to permit an NRA to be an ESBT PCB wasn’t intended to override the statutory goal of subjecting all S corp income to federal income tax. The proposed regulations close the gap by requiring that if a deemed owner of a grantor trust that’s elected to be an ESBT is an NRA, the portion of income otherwise allocable to the grantor must be reallocated to the ESBT. The regulations do so by amending Treasury Regulations Sections 1.641-(c)-1 and 1.1361-1 and are proposed to become effective for all ESBTs after Dec. 31, 2017.

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