By Anthony Diosdi
As part of the complex U.S. tax law, certain domestic corporations can make an election to be taxed as an “S” corporation. An “S” corporation is only permitted to have certain types of shareholders which are generally limited to individuals who are U.S. persons and certain trusts and estates. The result is that the corporation is not subject to income tax, but its taxable income is instead taxed directly to shareholders. In the case of a “C” corporation, the corporation is subject to income tax but there is a second tax at the individual level upon the receipt of corporate dividends.
Among the technical requirements of an “S” corporation is that such corporation cannot have a nonresident alien as a shareholder. Unfortunately, many tax practitioners who may not be familiar with international provisions of the Internal Revenue Code interpret that limitation to conclude that an alien who is not a lawful permanent resident (e.g. a “Green Card Holder”) cannot be an “S” corporate shareholder. As used in the “S” provisions of the Internal Revenue Code, a tax rather than an immigration test is applied and so long as an alien constitutes a U.S. income tax resident alien under the Substantial Presence Test or the alien is a Green Card Holder, the alien can be an “S” corporation shareholder. The result could be undesirable double taxation or the increase audit risk where a “C” corporation generates deductions for compensation. These risks are even greater when the alien does not possess the appropriate immigration visa to receive compensation in the U.S.
For those aliens who cannot satisfy the Green Card Test or Substantial Presence Test, under the Tax Cuts and Jobs Act of 2018, effective January 1, 2018, nonresident aliens may also elect be taxed somewhat similar “S” corporation shareholders for U.S. tax purposes. The Tax Cuts and Jobs Act of 2018 opens up major potential planning opportunities nonresident aliens by allowing such individuals to be potential Electing Small Business Trust (“ESBT”) beneficiaries. Generally, the eligible beneficiaries of an ESBT include individuals, estates, and certain charitable organizations eligible to hold “S” corporation stock directly. A trust is eligible to be classified as an ESBT if: 1) the trust’s beneficiaries are limited to individual (whether resident aliens or nonresident aliens), estates or certain types of charitable organizations; 2) no interest in the trust was acquired by purchase; 3) an election is timely made by the trustee to treat the trust as an ESBT; and 4) the trust is a domestic trust for U.S. tax purposes.
In exchange for the flexibility of an ESBT, there are certain U.S. income tax rules to consider. In general, an ESBT’s tax attributes consist of an “S” portion, a non-”S” portion, and in some instances a grantor portion. In general, the “S” portion of the trust is subject to U.S. income tax at the highest income tax rate (currently 37 percent), unless the income is capital gains income (e.g., sale of the “S” corporation’s stock) which in such case general applicable capital gains rates would apply (e.g., long-term rates up to 20 percent). There are other rules which limit deductions and credits allocable to the “S” portion of the trust and which limit the use of capital losses.
From a U.S. income tax perspective, ESBT beneficiaries would be taxed differently on the “S” corporation’s income and profits than the “S” corporation’s direct U.S. person shareholders. The biggest difference is U.S. income taxation of the “S” corporation shareholder profits. The trust would pay U.S. income taxes at a fixed 37 percent rate while the direct “S” corporation shareholders would pay U.S. income tax at graduated rates ranging from 10 percent to 37 percent (it would take approximately $600,000 of taxable income before direct U.S. person shareholders pay a 37 percent rate of tax on their respective shares of the “S” corporation income). In all other aspects, the U.S. taxation of an ESBT as compared to the direct U.S. person shareholders principally remains the same. In other words, the same capital gains rates generally apply if the “S” corporation shares were sold or the “S” corporation produced capital gains income from the sale of the “S” corporation assets. In addition, there is only one level of U.S. income tax (i.e., the “S” corporation pays no U.S. income tax- the shareholders of the “S” corporation report and pay their respective share of net income from the company on their individual income tax returns). The main advantage of ESBT (besides avoiding double taxation and decreasing the risk of IRS audits) is that its alien beneficiaries could be insulated from the U.S. estate tax altogether while aliens investing directly in the U.S. or investing through a U.S. corporation could be subject to the U.S. estate tax.
Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.