Proposed Regulations Issued for ESBTs with NRA Potential Current Beneficiary Subject to Grantor Trust Rules

The IRS has moved to plug a potential loophole created when Congress changed the law in the Tax Cuts and Jobs Act (TCJA) to allow an electing small business trust (ESBT) to have a nonresident alien (NRA) potential current beneficiary (PCB).  In proposed regulations REG-117062-18 the IRS provides that if such an NRA would be treated as the owner of trust corpus under the grantor trust rules for such a trust, the grantor will not be treated as the owner of the S corporation portion of the ESBT.

In the preamble to the proposed regulations, the IRS points out that the committee reports related to the TCJA had stated that allowing NRAs to be PCBs of ESBTs did not pose a risk that the S corporation income would not be subject to U.S. tax, since tax is imposed on the trust and not the beneficiary for S corporation income when shares are held by an ESBT.

However, previously the IRS had taken the position that the grantor trust rules overrode the ESBT rules.  So if a trust elected ESBT status that was fully or partially a grantor trust, the deemed owner under the grantor trust rules would be treated as the owner of some or all of the S corporation shares and subject to tax on such income.  Now that an NRA can be a PCB of a electing small business trust, it is possible under a number of scenarios that the S corporation income could escape U.S. taxation if that treatment were permitted to continue.

To prevent this from happening, the IRS is proposing to add the following to Reg. §1.641(c)-1(b).  In Proposed Reg. §1.641(c)-1(b)(1)(ii) the IRS provides that, in such a case, “the items of income, deduction, and credit from that grantor portion must be reallocated from the grantor portion to the S portion … of the ESBT.”  In that case, the trust would pay tax directly on the income from the S corporation.

Example 6 is added at Proposed Reg. §1.641(c)-1(l)(6) to illustrate the application of this provision:

Example 6: NRA as potential current beneficiary. Domestic Trust (DT) has a valid ESBT election in effect. DT owns S corporation stock. The S corporation owns U.S. and foreign assets. The foreign assets produce foreign source income. B, an NRA, is the grantor and the only trust beneficiary and potential current beneficiary of DT. B is not a resident of a country with which the United States has an income tax treaty. Under section 677(a), B is treated as the owner of DT because, under the trust documents, income and corpus may be distributed only to B during B’s lifetime. Paragraph (b)(2)(ii) of this section requires that the S corporation income of the ESBT that otherwise would have been allocated to B under the grantor trust rules must be reallocated from B’s grantor portion to the S portion of DT. In this example, the S portion of DT is treated as including the grantor portion of the ESBT, and thus all of DT’s income from the S corporation is taxable to DT.

The regulations are proposed to apply to all ESBTs after December 31, 2017.