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Final Regulations Issued Regarding Partnerships and S Corporations that Hold Controlled Foreign Corporations

Final Regulations Issued Regarding Partnerships and S Corporations that Hold Controlled Foreign Corporations

By Anthony Diosdi

On January 25, 2022, the United States Department of Treasury (“Treasury”) and Internal Revenue Service (“IRS”) published final regulations related to the treatment of domestic partnerships and S corporations that hold stock in a controlled foreign corporation (“CFC”) for purposes of determining amounts included in the gross income of their partners and shareholders with respect to the CFCs. The regulations finalize a portion of the proposed regulations published on June 21, 2019.

The final regulations provide pass-through entities such as partnership and S corporations consistent treatment for subpart F income, GILTI, and Section 956 inclusions. The guidance provided in the regulations represent a shift in the way pass-through entities are taxed on foreign source income. Since 1962, U.S. partnerships have been treated as separate entities for purposes of determining a shareholder’s subpart F taxable inclusion. A continued shift guidance provided by the Treasury and the IRS through promulgated regulations towards an aggregate approach in the reporting of foreign income will significantly impact nearly all pass-through entities that hold CFCs.

A Discussion Regarding the Final Regulations Issued By the Treasury and IRS

Internal Revenue Code Section 957(a) defines a CFC as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned, directly, indirectly or constructively under the Section 958 ownership rules, by a United States shareholder (a “U.S. shareholder”) on any day during the foreign corporation’s tax year. Internal Revenue Code Section 951(b) defines a “U.S. shareholder as a U.S. citizen, resident alien, corporation, partnership, trust or estate who owns, or is considered as owning at least 10 percent of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. The Internal Revenue Code provides that a U.S. shareholder of a CFC is subject to tax on the CFC’s subpart F income, GILTI inclusions, and CFC’s investment in U.S. property under the provisions of Internal Revenue Code Section 956. For purposes of Section 956, U.S. property includes most tangible and intangible property owned by a CFC that has a U.S. situs such as tangible property located in the United States; stock of a domestic corporation; an obligation of a U.S. person; and a right to use a patent, copyright, or other forms of intellectual property in the United States if acquired or developed by the CFC for that use.

The final regulations adopt an aggregate approach to U.S. partnerships for purposes of determining the person that must take into account a GILTI inclusion, subpart F and Section 956 inclusions with respect to CFC stock held by a U.S. partnership and any provision that applies by reference to a GILTI inclusion. These rules apply equally to shareholders of S corporations. For purposes of this rule, a U.S. partnership is not treated as owning stock in a foreign corporation within the meaning of Internal Revenue Code Section 958(a). This means, a U.S. partnership cannot have a subpart F or Section 956 inclusion. Instead, domestic partners of a U.S. partnership are treated as owning proportionately the stock of the CFC owned by the partnership, and a partner that is a U.S. shareholder with respect to a CFC determines its pro rata share of the subpart F, GILTI inclusions, and Section 956 inclusion. These rules also apply to shareholders of S corporations.

The final regulations continue to treat partnership as entities for purposes of applying Section 1248. Internal Revenue Code Section 1248 prevents U.S. shareholders from “cashing in” on and realizing the economic benefit of accumulated earnings of a CFC at long-term capital gains tax rates. The capital gain result could be accomplished by selling stock of a CFC at a price that would reflect the accumulated earnings of the CFC. It could also be achieved by liquidating the CFC. In either event, the excess of the amount realized upon the sale or liquidation by the U.S. shareholder had repatriated the foreign earnings through dividend distributions, the earnings would have been taxed at ordinary rates. Internal Revenue Code Section 1248 prevents this result, under specified circumstances, treating the gain recognized on the sale or exchange (or through liquidation or redemption) of the U.S. shareholder’s stock as a dividend to the extent that the gain reflects the shareholder’s interest in undistributed earnings attributable to the stock sold or exchanged. Thus, gain recognized by a domestic partnership from the sale of a CFC’s stock may be subject to Section 1248 even though none of its partners are U.S. shareholders.

As a result of these rules, partners of U.S. partnership or shareholders of S corporation are not required to file Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, if 1) the domestic partnership or S corporation is a U.S. Shareholder of a CFC; and 2) the domestic partnership or S corporation files the form. Instead, the partners of a domestic partnership or shareholders of an S corporation compute their flow through income inclusions through a Schedule K-2, “Partners” Distributive Share Items – International” and Schedule K-3, “Partner’s Share of Income, election.” 

Specific Treatment of S Corporations Under the Regulations

The Treasury and the IRS announcement in Notice 2020-69 was promulgated to assist in the transition of S corporations with accumulated earnings and profits. In certain circumstances, an S corporation may have an accumulated adjustment account and accumulated earnings and profits of a C corporation predecessor. The aggregate approach may cause certain distributions by those S corporations to be considered taxable dividends from the accumulated earnings and profits, rather than a non-taxable distribution from accumulated adjustment accounts even when shareholders have included subpart F or GILTI inclusions from CFCs owned by the S corporation.

Notice 2020-69 allowed certain S corporations to elect an entity-treatment rule to mitigate this result. Electing S corporations calculated a GILTI inclusion amount at the corporate level, and each shareholder of the S corporation had to include its distributive share of that amount in gross income, even if the shareholder itself was not a U.S. Shareholder. The proposed regulations would adopt the election provided in Notice 2020-69 for qualifying S corporations and their shareholders that elect entity treatment for subpart F and GILTI inclusions purposes on an originally filed or amended return.

To qualify, an S corporation must have 1) made its S corporation election before June 22, 2019; 2) been considered to own stock of a CFC within the meaning of Section  958(a) or June 22, 2019; 3) had accumulated earnings and profits balance on September 1, 2020, or on the first day of any subsequent tax year; and 4) maintained sufficient records to support an accumulated earnings and profits determination. Once a qualified S corporation electing entity treatment under the rule exhausted its accumulated earnings and profits balance, the S corporation would, like a domestic partnership, default to the aggregate treatment described previously.

Under this elective entity treatment, an S corporation that owns stock of a CFC would be treated as owning, within the meaning of Section 958(a), a foreign corporation, such that the S corporation would have CFC inclusions. The effect of the election would be to treat an applicable CFC inclusion as an item of income of the S corporation itself, increasing the S corporation’s accumulated adjusted account and decreasing distributions from accumulated earnings and profits. See KPMG report: Regulations Addressing Tax Treatment of U.S. Partnerships and S Corporations That Own Stock of CFCs and PFICs, January 28, 2022.


The final regulations merit careful study by any U.S. partnership or S corporation that owns a 10 percent or more interest in a foreign corporation. In many cases, extending the aggregate approach to domestic partners of U.S. partnership and shareholders of S corporations to hold CFCs will impose additional administrative burdens.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.