How Foreigners Can Become S Corp Shareholders

How Foreigners Can Become S Corp Shareholders

The Tax Cuts and Jobs Act brings some excellent news to nonresident aliens who want to (indirectly) own S corp shares.

Nonresidents Aliens

Not a U.S. CitizenNot a resident alien
Lawful permanent resident of the U.S.A.
Those who meet the so-called substantial presence test
Those who can and elect to be treated as resident aliens in certain circumstances

Apart from the above, a nonresident alien is not a U.S. taxpayer although a resident alien can become a nonresident alien if her status changes.

Up until January 1st, 2018, a nonresident alien was not allowed to be a (potential) current beneficiary of an electing small business trust (ESBT).

Electing Small Business Trust [ESBT]

Created by Congress in 1996 with the Small Business Protection ActCreated it as a new type of qualifying S corporation shareholderFour requirements were set to define an ESBT as a trust.
Only individuals, estates, specific charitable organizations or specified governmental entities are allowed to become beneficiariesNo interest in the trust may have been acquired by purchase (where the basis is determined by Sec 1012)The trustee must elect for the trust to be treated as an ESBT.
The trust may not be a:QSSTTax Exempt trust
Charity remainder annuity trust Charitable remainder trust

This has changed, and now a nonresident alien can invest (indirectly) in an S corporation without terminating its ESBT and S corporation status.

The ESBT is treated as an S corporation shareholder for purposes of the consent requirement. Each potential current beneficiary is treated as a shareholder in terms of the 100-shareholder maximum prescribed in Section 136(b)(1)(A).

Potential Current Beneficiary

Plays a crucial role with ESBTs.

The TCJA simplified estate planning by allowing a nonresident alien to be a potential current beneficiary

Defined as any person who is entitled to or who may receive a distribution from the principle income of the ESBT.Excludes any future or contingent interest holders – only becomes potential current beneficiaries when contingency becomes fact or when the date arrives.

ESBT Taxation

ESBT taxation is differentiated by three trust types or portions

S PortionNON-S PortionGrantor Portion
Holds the S corporation stocksHolds all trust assets except S corporation stockWhen a trust is NOT treated as a grantor trust, it is treated as a combination S portion and non-S portion trust
Treated as a separate trust – tax attributes of which may not be comingled with the non-S portion trust and takes account of:Taxed on all the non-S portion income taking into account:Trust income is taxed to the deemed owner of the trust, the grantor, on his/her own individual income tax return
CreditState, local and non-US taxes and administration expenses that relate to both S portion and non-S portion trusts must be reasonably allocated
Income relatable to the sale of S corp stock reported on the installment method

State, local and non-US taxes and administration expenses that relate to both S portion and non-S portion trusts must be reasonably allocated

Interest on the installment obligation is included here.If there is no non-S Corporation income and it only holds stock, there will be no non-S portion and no attendant tax
In the view of the treasury, this causes tax leakage in the event of a nonresident alien who is a grantor of a portion of an ESBT because some of the income that flows through to the nonresident alien would escape US taxation. Proposed regulations are underway to stem this.

By relaxing the rules set out above, a planning opportunity is created for nonresident aliens who want to invest in S corporations and for S corporations seeking non-US capital without terminating the S corporation election.

The flow through income tax treatment of S corporation, along with the relaxation of the rules causes a proliferation of S corporations as the most popular US entity.

S corporations are here to stay, and ongoing pressure to change S corporation requirements and permissible shareholders and classes of stock will bring about even more flexibility.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.

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