The IRS and Treasury have recently announced (see Notice 2020-69) their intention to issue regulations that would allow certain S corporations that have Global Intangible Low-Taxed Income (GILTI) to irrevocably elect into ‘entity treatment’ for purposes of determining GILTI inclusions. This election, in certain circumstances, could increase an S corporation’s capacity to make tax-free distributions to their shareholders.
GILTI is one of the anti-deferral provisions enacted in 2017 as part of the Tax Cuts and Jobs Act. When triggered, it requires certain U.S. shareholders of controlled foreign corporations (CFCs) to recognize currently certain offshore earnings, regardless of whether the income is distributed or retained offshore.
Pursuant to regulatory guidance issued in 2019, S corporation shareholders, and not the S corporation itself, are treated, as proportionally owning the stock of a controlled foreign corporation (CFC) owned by the S corporation. Under these rules, the S corporation does not have a GILTI inclusion, and GILTI is not included in a shareholder’s distributive share. Instead, the shareholders of the S corporation determine the GILTI inclusion at the individual level.
This treatment can lead to adverse consequences to shareholders. Specifically, under this ‘aggregate’ treatment, GILTI income does not increase the S corporation’s Accumulated Adjustments Account (AAA). For S corporations with prior C corporation earnings and profits, AAA reflects the previously taxed S corporation earnings that the S corporation can distribute to its shareholders tax-free. In circumstances where an S corporation distributes money for shareholders to pay taxes, including taxes attributable to their GILTI inclusions, this failure to increase AAA can result in a taxable distribution.
In response to this potential issue, the IRS and Treasury have issued Notice 2020-69, providing relief for certain S corporations with E&P via an irrevocable election that would allow the GILTI inclusion to be determined at the S corporation level, and allocated out to the shareholders as part of their distributive shares. This entity level treatment would allow the GILTI inclusion to increase AAA, and thus alleviate the possibility of S corporations having to make distributions from E&P to shareholders to pay the tax on GILTI income.
This treatment is not without potential consequences. Notably, the GILTI rules only require 10% U.S. shareholders of a CFC to include in their current income their share of GILTI income. Thus, if an S corporation shareholder was not considered a U.S. shareholder (i.e. they indirectly owned less than 10% of the S corporation’s stock) they would not have a GILTI inclusion under the aggregate GILTI rules outlined in the final regulations. However, if the S corporation were to elect into the entity treatment outlined in this Notice, that 10% shareholder would receive a distributive share of the S corporation’s GILTI income.
S corporations with ‘Transition A&EP’ – accumulated earnings and profits calculated as of Sept. 1, 2020, subject to certain reductions – can elect into entity treatment for their first taxable year ending on or after Sept. 1, 2020. Taxpayers also have the option to elect into this treatment for tax years beginning before Sept. 1, 2020, and ending after June 21, 2019, on a timely filed original return or on an amended return filed by March 15, 2021. Entity level treatment would continue until the S corporation’s earnings and profits had been exhausted.
Conclusion and Observation
Interestingly, the Notice leans heavily on the definition of Transition AE&P and its Sept. 1, 2020, measurement date. It appears that taxpayers who might otherwise elect into this regime for tax years ending before Sept. 1, 2020, could only do so if they have AE&P as of Sept. 1, 2020. This might limit the ability of taxpayers that made distributions prior to Sept. 1, 2020, to fully realize the benefits associated with entity treatment. It is unclear whether that was intentional.
With the extended due date for calendar year 2019 returns fast approaching, it would be prudent for S corporations tha