United States

Proposed regulations address ESBTs with foreign beneficiaries

TAX ALERT  | 

Treasury issued proposed regulations on April 17 to help ensure that S corporation income allocated to an electing small business trust (ESBT) does not escape U.S. federal income taxation when a nonresident alien (NRA) is a potential current beneficiary of the ESBT. The regulations are proposed to be effective retroactive to Jan. 1, 2018.

The problem

The Tax Cuts and Jobs Act of 2017 P.L. 115-97 (TCJA) amended the S corporation eligibility rules to provide that ESBTs could have NRAs as potential current beneficiaries, effective Jan. 1, 2018.  This was a welcome change because: a) it expanded the universe of corporations that could qualify for subchapter S status to include those with trusts as shareholders where NRAs were potential current beneficiaries, and b) it helped ensure that a change in a trust beneficiary’s tax status, for example from resident alien to nonresident alien, would not terminate an existing S corporation’s tax status.

From Congress’s perspective, the change also appeared to carry little risk of tax leakage because the tax regime applicable to ESBTs typically ensures that the trust – not the beneficiary – pays tax on the S corporation’s income. The problem, however, was that the TCJA did not address that fact that grantor trusts, i.e., trusts where the deemed owner is treated as the owner of the assets, can make ESBT elections.

The fix

The proposed regulations address this issue by requiring in situations where an NRA is a deemed owner of a grantor trust, and the trust makes an ESBT election, that the trust rather than the deemed owner be subject to tax on the S corporation income. These rules would require that the parties effectively ignore the trust’s grantor trust status with respect to its share of S corporation income.

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