Highlights
- The
U.S. Tax Cuts and Jobs Act (the TCJA), which was enacted at the end of 2017, dramatically changed theU.S. cross-border tax regime, including many reforms that focus on multinational corporations. However, some lesser known TCJA provisions apply to foreign individuals. -
This
Holland & Knight alert addresses a change to theU.S. "S" corporation rules that presents interesting opportunities for foreign individuals who wish to restructure their investments inU.S. real estate or operating businesses. -
This alert also includes a case study that demonstrates, in general terms, key
U.S. income tax savings that can be obtained by converting from a "C" corporation structure to an "electing small business trust" (ESBT)/S corporation structure.
The
This
S Corporation Regime
An S corporation, in many (but not all) respects, is treated as a "pass-through" entity. That is, the S corporation itself (with some exceptions) is not subject to corporate level tax. Rather, all items of income, deduction, loss, credit, etc., "pass through" to the shareholders. This is unlike the "double tax" "C" corporation regime, where the entity itself is subject to corporate income tax and then dividends from the corporation are taxed to the shareholders.
A number of requirements must be met in order for a corporation to be eligible to elect to be an S corporation. For example, the corporation may have no more than 100 shareholders, it may have only one class of stock and it may not be owned by certain types of shareholders.
One of the types of shareholders who may not own stock in an S corporation is an individual who is not a
ESBT Rules
Certain specific types of trusts that are classified as "domestic" trusts for
A trust is classified as an ESBT if no interest in the trust was acquired by purchase, if all of its beneficiaries are individuals, estates or charitable organizations, and if the trust makes an affirmative election with the
In general, for purposes of determining whether a corporation is an S corporation, each "potential current beneficiary" of an ESBT is treated as a shareholder of the corporation. Thus, a corporation owned by an ESBT may be an S corporation only if all of the potential current beneficiaries of the trust are eligible shareholders.
Under those rules, prior to the TCJA, a corporation whose shareholders include an ESBT could be an S corporation only if none of the potential current beneficiaries of the trust were nonresident aliens. The TCJA removed that rule. Under the TCJA, a potential current beneficiary of an ESBT is not treated as a shareholder in determining whether a corporation is an S corporation for purposes of the nonresident alien shareholder prohibition.
As discussed below, this change in the law presents some interesting planning opportunities for nonresident aliens to restructure their investments in
Case Study
The following case study demonstrates one instance in which TCJA's change to the S corporation rules described above presents a beneficial restructuring opportunity for a nonresident alien family.
Assume the following facts:
- Mr. X and his children are nonresident aliens. They reside in a country that is not a party to an income tax treaty with
the United States . (For example, most Latin American countries are not parties to income tax treaties with theU.S. ) -
Mr. X owns 100 percent of the stock of a foreign corporation (
Foreign Corp ). The use of a foreign corporation allows Mr. X to avoid theU.S. federal estate tax if he were to die while owning his interest in theU.S. business described below. Foreign Corp owns 100 percent of the stock of aU.S. corporation (U.S. Corp ).U.S. Corp is classified as a C corporation. (Under the rules mentioned above, a foreign corporation may not own stock in an S corporation.)U.S. Corp owns a number of separateU.S. limited liability companies (the "LLCs).Each LLC owns a building inFlorida that it leases to tenants. (Having each building owned by a separate LLC is helpful for non-tax liability protection purposes.)- The fair market of each building is significantly higher than its tax basis.
-
Each of the LLCs is classified as a "disregarded entity" for
U.S. federal tax purposes. This means that even though the LLC exists for non-tax law purposes, it does not exist forU.S. federal tax purposes. All of the activities, income, losses, etc. of the LLCs "consolidate" onto theU.S. federal corporate income tax return ofU.S. Corp. Losses from one LLC may be used to offset income from another LLC. - The LLCs generate significant annual cash flow from these activities. Mr. X wishes to use this cash flow for other business activities that he conducts in his home country.
- It is not anticipated that any of the LLCs will sell its real estate within the next five years.
Consequences Under Current Structure
Under the current structure,
The
In addition,
Therefore, for example, if
U.S. Corp will be subject toU.S. federal andFlorida corporate income tax of$2.5 million ($10 million x 25 percent).U.S. Corp will have$7.5 million left to distribute toForeign Corp as a dividend ($10 million –$2.5 million ).-
The
$7.5 million distributed byU.S. Corp toForeign Corp as a dividend will be subject to aU.S. dividend withholding tax of$2.25 million ($7.5 million x 30 percent). -
As a result, the overall effective of
U.S. income tax rate onU.S. Corp's taxable income is 47.5 percent (($2.5 million +$2.25 million ) ÷$10 million ).
This high overall effective tax rate is due to the "double taxation" regime applicable to C corporations (corporate level tax and then shareholder level tax). Mr. X may consider liquidating the corporation structure. However, this gives rise to a host of issues, not the least of which is that the liquidation itself will trigger corporate level tax on the excess of the fair market value of the assets over their tax basis.
Potential Restructuring
Under the TCJA, Mr. X can potentially reduce the overall
For example, Mr. X could form an irrevocable
Mr. X could then arrange for
After the restructuring, the following
- The LLCs' annual rental income should be subject to a single level of
U.S. federal income tax. TheU.S. federal income tax will be imposed on theDelaware Trust (rather thanU.S. Corp ), at graduated rates of up to 37 percent. There will be no additionalU.S. withholding tax. Furthermore, if and to the extent that certain conditions are met,U.S. Corp may qualify for the 20 percent "qualified business income" deduction enacted by the TCJA. This deduction results in a tax rate of 29.6 percent. (Note that this article does not address the additional "Medicare surtax" that in some cases may apply.) -
The
Florida income tax will not be imposed on the earnings of the LLCs.Florida imposes an income tax only on C corporations, not on individuals, trusts or S corporations. -
If an LLC sells its property, the
Delaware Trust will be subject toU.S. federal income tax on the gain at a rate of 20 percent. (This assumes that the five-year "built-in gains" tax does not apply – see below.)
Therefore, the use of the ESBT/S corporation structure can result in meaningful
Technical Considerations
The discussion above demonstrates, in general terms, some of the key
While a thorough discussion of all of these rules is beyond the scope of this article, the following are some of the key rules that must be addressed by competent
- The trust must be drafted so that it is a domestic trust for
U.S. federal income tax purposes. Even a trust that is governed byU.S. law (such as aDelaware trust) may be classified as a foreign trust if not structured and drafted properly. - The trust must be drafted so that it provides estate tax protection for Mr. X and his family.
-
The reorganization of
Foreign Corp intoU.S. Corp may, in certain specific cases, be subject to tax under theForeign Investment in Real Property Tax Act (FIRPTA). Furthermore, even if the reorganization is potentially tax-free under FIRPTA, certainIRS filings must be made under FIRPTA in order for the reorganization to qualify for tax-free treatment. -
If a property owned by one of the LLCs is appreciated at the time of the S corporation election and is sold within five years of the election,
U.S. Corp will be subject toU.S. corporate income tax on the built-in gain existing at the time of the election (often referred to as the "built-in gain tax"). -
Certain adverse tax consequences may apply in some cases where a C corporation that has accumulated "earnings and profits" converts to an S corporation. These consequences can include additional tax liabilities and even potential loss of S corporation status, sometimes referred to as "
sting " taxes. Careful planning must be undertaken to ensure that these adverse tax consequences do not apply.
Conclusion
The TCJA has allowed nonresident alien individuals to avail themselves of the benefits of S corporation treatment through the use of an ESBT structure. This can allow meaningful tax-efficient planning. However, numerous detailed
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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