Nonresident Aliens now Potential Beneficiaries of Electing Small Business Trusts
The IRS has recently issued proposed regulations (REG-117062-18), as guidance under The Tax Cuts and Jobs Act (TCJA), enacted in December 2017, that will expand the class of permissible current beneficiaries of an electing small business trust (ESBT) to include nonresident aliens as potential current beneficiaries.
The intention of the proposed regulations is that the income of the S corporation would continue to be subject to U.S. federal income tax when a nonresident alien is a deemed owner of a grantor trust that elects to be an ESBT.
Background on ESBT
Only certain trusts are permitted to be S corporation shareholders. One such permitted trust is an ESBT. There are several requirements for a trust to be an ESBT, however, there is nothing that prevents an ESBT from holding S corporation stock, as well as other property, or from accumulating trust income. In addition, a potential current beneficiary may be one of multiple beneficiaries of an ESBT, and a grantor trust may elect to be an ESBT.
What qualifies as a potential current beneficiary (PCB)?
- Anyone who’s entitled to distributions from the ESBT or who, at the discretion of any person, may receive a distribution.
- The deemed owner of a grantor trust that elects to be an ESBT.
An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts (S portion and non-S portion, respectively) even though the ESBT is treated as a single trust for administrative purposes.
Wholly or partially-owned grantor trusts can make an ESBT election. An ESBT pays tax directly at the trust level on its S corporation income and that income is not passed through to the beneficiaries, except for the amount that is taxed to the owner of the grantor trust portion. The deemed owner of the grantor trust portion is treated as a potential current beneficiary of the ESBT. A potential shortcoming of the ESBT is that the S corporation income will be taxed at the top ordinary income tax rate (currently 37%).
Change Arising from The Tax Cuts and Jobs Act
- Prior to the TCJA, nonresident alien individuals were not permitted to be a potential current beneficiary. Let’s say there was a change in immigration status of a potential current beneficiary of an ESBT that owns S corporation stock from resident alien to nonresident alien – this would cause a termination of the ESBT election, and therefore also possibly terminate the corporation’s S-election.
- The TCJA amendment now permits nonresident alien individuals to be potential current beneficiaries.
The proposed regulations intend, with respect to situations in which a nonresident alien is a deemed owner of a grantor trust that has elected to be an ESBT, the S corporation income of the ESBT would continue to be subject to U.S. federal income tax.
The proposed regulations specifically would modify the allocation rules to require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would have been allocated to a nonresident alien-deemed owner under the grantor trust rules. Accordingly, this income would be taxed to the domestic ESBT by providing that, if the deemed owner is a nonresident alien, the grantor portion of net income must be reallocated from the grantor portion of the ESBT to the ESBT’s S portion.
The proposed regulations apply to all ESBTs after Dec. 31, 2017. The IRS notes that under section 7805(b)(3) a regulation may take effect or apply retroactively to prevent abuse.
For more information, please contact a member of the Herbein tax team, or email us at firstname.lastname@example.org.
Article prepared by Stacy A. Weller.