Increased Capital Gain Rate, Nonresident Aliens, and ESBTs

Compare and Contrast

Have you spoken to anybody about the infrastructure bill on which the Senate is about to vote? I know I haven’t, except to explain that Speaker Pelosi has stated the House will not consider the bill unless and until the Senate also adopts a budget resolution for the President’s tax and spending plans.

The primary concern among those with whom I have spoken is the proposed increase of the tax rate on long term capital gains. Interestingly, a number of these conversations have been with nonresident aliens[i] (“NRAs”) who are beneficiaries of certain U.S. trusts that hold shares of stock in S corporations.

In general, these folks could care less about the infrastructure bill; however, because of Ms. Pelosi’s stance, any discussion regarding the future taxation of capital gains necessarily draws in the infrastructure bill.

2021: Infrastructure

Speaking of which, it has been just over a week since Senate Majority Leader Chuck Schumer introduced the $1.2 trillion “Bipartisan Infrastructure Investment and Jobs Act.”[ii] In the ensuing days, we witnessed the Congressional equivalent of “herding cats” as hundreds of amendments were offered to the already 2,702-page bill.[iii] Instead of bringing the measure to a vote last week as he had hoped, Sen. Schumer found himself in the position of having to keep the Chamber in session for at least a few more days[iv] to complete its work on the bill, and the Senate will be voting on the measure in the next day or so.

Just as importantly, Sen. Schumer wants the Senate to consider and vote upon the budget resolution prepared by Senate Budget Committee Democrats, the passage of which is a prerequisite to using that Chamber’s reconciliation process later this year to enact the President’s $3.5 trillion spending plan, including the tax increases provided therein.[v]

1996: S corporations[vi]

Just over 25 years ago, I moved my practice from Manhattan to Long Island, New York. During that summer, I followed the evolution of what eventually was enacted – on a bipartisan basis – as the Small Business Job Protection Act of 1996.[vii] Among the provisions included in that legislation were certain changes that liberalized the criteria for qualifying as a “small business,” or “S”, corporation.[viii]

Perhaps the change most welcomed by the estate planning community was the introduction of the “electing small business trust,” or ESBT.[ix] Prior to the ESBT, trusts other than grantor trusts, certain testamentary trusts, and qualified subchapter S trusts (“QSST”)[x] could not be shareholders in an S corporation.[xi] These limitations prevented S corporation shareholders from engaging in some basic estate planning; for example, the creation of non-grantor trusts that provided for the accumulation of trust income, or that authorized the trustee to distribute (“sprinkle”) trust income and/or principal, as the trustee determined, among a class of beneficiaries, including NRAs.

ESBT

In response to these circumstances, and to facilitate family estate planning, Congress amended the Code to allow stock in an S corporation to be held by an ESBT.[xii]

For a trust to qualify as an ESBT, the trust must be a domestic trust,[xiii] all beneficiaries of the trust must be individuals, estates, or charitable organizations eligible to be S corporation shareholders, and no interest in the trust may be acquired by purchase.[xiv] A trust must elect to be treated as an electing small business trust.[xv] A grantor trust may elect to be treated as an ESBT.[xvi]

Each “potential current beneficiary” (PCB[xvii]) of the trust is counted as a shareholder for purposes of the 100-shareholder limitation (or if there were no PCBs, the trust would be treated as the shareholder).[xviii] A PCB means, with respect to any period, any person who is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust.[xix]

Separate Trusts 

An ESBT that owns stock of an S corporation, as well as other property, is treated as two separate trusts for purposes of computing the income tax attributable to the S corporation stock held by the trust, even though the ESBT is treated as a single trust for administrative purposes.[xx]

Specifically, the S portion, which consists solely of S corporation stock, is treated as a separate trust which is taxed on its share of the S corporation’s income at the highest rate of tax imposed on individual taxpayers.[xxi] This income – even if distributed by the ESBT – is not taxed to the beneficiaries of the ESBT.[xxii] The taxable income attributable to this portion includes (1) the items of income, gain, loss, or deduction allocated to it as an S corporation shareholder under the rules of subchapter S,[xxiii] and (2) the gain or loss from the sale of the S corporation stock.[xxiv]

In addition, both the S portion and the non-S portion of the ESBT can be treated as owned by a grantor under the grantor trust rules.[xxv]

Nonresident Aliens

Before 2018, an NRA could have been an “eligible beneficiary” of an ESBT.[xxvi] However, if the NRA ever became a PCB of the ESBT – and was thereby treated as a shareholder of the corporation for purposes of its qualification as an S corporation – the corporation’s “S” election would have terminated because an NRA is not an eligible shareholder.[xxvii]

In 2017, the Code was amended to allow NRAs to be PCBs of ESBTs.[xxviii] As amended, the Code[xxix] provides that NRA-PCBs will not be taken into account for purposes of the S corporation shareholder-eligibility requirement that otherwise prohibits NRA shareholders. As a result of that amendment, an NRA-PCB may receive a distribution of income from an ESBT without jeopardizing the corporation’s “S” election.[xxx]

While Congress expanded the scope of qualifying beneficiaries (PCBs) of ESBTs, it left unaltered the rule that an S corporation cannot have an NRA as a shareholder. Thus, a distribution of principal to an NRA-PCB from the ESBT – i.e., a distribution of shares of stock in an S corporation – will terminate the corporation’s “S” election.[xxxi]

Grantor Trust

Generally speaking, a grantor trust is a trust with respect to which the grantor has retained certain rights over the trust’s income or assets such that the income of the trust should be taxed to the grantor rather than to the trust which receives the income, or to the beneficiary to whom the income may be distributed. If a trust is a grantor trust, then (i) the grantor is treated as the owner of the assets, (ii) the trust is disregarded as a separate entity for federal income tax purposes, and (iii) all items of income, deduction, and credit are taxed to the grantor as the deemed owner.

Wholly or partially-owned grantor trusts can make an ESBT election, but the grantor trust taxation rules of the Code override the ESBT provisions; in other words, the income of the portion of an ESBT treated as owned by the grantor is taken into account by the deemed owner (rather than by the ESBT) in computing the deemed owner’s taxable income.[xxxii] Stated differently, an ESBT pays tax directly at the trust level on its S corporation income, except for the amount that is taxed to the owner of the grantor trust portion of the ESBT.

That said, the deemed owner of the grantor trust portion of an ESBT is treated as a PCB of the ESBT.[xxxiii] What if the deemed owner is an NRA?

Under the grantor trust rules,[xxxiv] the income of an irrevocable domestic trust is taxed to an NRA grantor if the only amounts distributable from such trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.[xxxv]

As enacted, the Act’s expansion of an ESBT’s permissible PCBs to include an NRA may have allowed S corporation income attributed to the grantor trust portion of an ESBT that is received by an NRA deemed owner of that portion, to escape federal income taxation.

For example, if an NRA grantor were a deemed owner of a domestic trust (a grantor trust) that elected to be an ESBT, and thus were to be allocated foreign source income of the S corporation, or income not effectively connected with the conduct of a U.S. trade or business, that NRA would not be required to include such S corporation items in income because the NRA would not be liable for federal income tax on such income.[xxxvi]

Regulations

The general rule of ESBT taxation subjects the ESBT to tax on its S corporation income at the trust level, rather than the beneficiary level. Because the ESBT must be domestic, this rule is “indifferent” to the citizenship or residence status of the ESBT’s beneficiaries.

However, the IRS realized that this general rule does not take into account the interaction between the ESBT and grantor trust regimes, which allows a trust to be an ESBT for S corporation qualification purposes while permitting all or a portion of the trust subject to the grantor trust rules to be taxed as a grantor trust, rather than as an ESBT. As described earlier, the taxable income of a grantor trust that elects to be an ESBT is treated as the taxable income of the deemed owner of the trust, regardless of whether the ESBT distributes the income.

The IRS observed that the ability of an NRA to be a PCB of an ESBT, in combination with the potential for a grantor trust portion of an ESBT to be owned by an NRA, could result in S corporation income passing without tax from the domestic ESBT to the NRA, thereby escaping federal income taxation.

In response to the risk arising from the unintended interplay of the ESBT and grantor trust rules, the IRS issued regulations[xxxvii] to ensure that, with respect to situations in which an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the S corporation income of the ESBT will continue to be subject to U.S. federal income tax.

Specifically, the regulations require that the S corporation income of the ESBT be included in the S portion of the ESBT if that income otherwise would be allocated to an NRA deemed owner under the grantor trust rules.[xxxviii]

Accordingly, such income will be taxed to the domestic ESBT by providing that, if the deemed owner is an NRA, the grantor portion of the trust’s net income must be reallocated from the grantor portion of the ESBT to the S portion of the trust.

Eliminating ESBT and Tax?

If all or a portion of an ESBT is treated as owned by an individual under the grantor trust rules, such owner is a potential current beneficiary in addition to persons described in the trust as beneficiaries.

Moreover, the grantor-deemed owner is treated as the owner of the S corp. stock and is taxed on its income.

If the grantor-deemed owner is an NRA, however, the ESBT itself is taxed on its share of the S corporation income to ensure that U.S. income tax is imposed on the gain from the sale.

What if the S corporation of which an ESBT is a shareholder – assume the only shareholder for our purposes – is planning to sell it assets, or if the ESBT itself is planning to dispose of its shares of stock in the S corporation?

The ESBT’s pro rata share of the gain from the corporation’s sale of the assets or the trust’s gain from the sale of the S corporation stock would be taxable to the ESBT, thereby reducing the net proceeds that may be distributed to the NRA.

The amount by which the proceeds are reduced may be greatly increased if the Administration’s proposed capital gain rate hike is enacted.

What might the NRA do to minimize the taxable gain from the sale and, thereby, the reduction in net proceeds distributable to the NRA?

Alternatives 

If the trust were treated as a grantor trust with respect to the sale of the stock, the NRA would be treated as having sold the stock. Assuming the corporation has not been a “U.S. real property holding corporation” during the five-year period ending with the date of the sale,[xxxix] and assuming the stock was not held for use in a U.S. trade or business, the gain from its sale would not be treated as U.S.-source income and, thus, would not be subject to U.S. income tax.

How then might the trust achieve grantor trust status for what is the S portion of the trust?

One option is to terminate the trust’s ESBT election, following which the S corporation portion of the trust would be treated as a grantor trust. Unfortunately, an ESBT election may be affirmatively revoked only with the consent of IRS.[xl]

That said, the corporation’s S election may be affirmatively revoked by its shareholders; in fact, the shareholders may even designate a prospective revocation date in the revocation statement. Because the ESBT would no longer own S corporation stock (the corporation having become a C corporation), the trust would cease to qualify as an ESBT; its last day as an ESBT would be the day before the date on which the trust failed to meet the definition of an ESBT.

The S election may also be terminated by having the ESBT dispose of all its S corporation stock to an ineligible shareholder; it would cease to be an ESBT on the first day following the disposition. For example, a distribution of the stock from the ESBT to an ineligible shareholder – such as a nonresident alien who happens to be a PCB – would result in the loss of “S” status for the corporation and ESBT status for the trust as of the day of transfer of the stock to the ineligible person; the last day as an S corporation and ESBT would be the day before the day of the transfer.

On the day of the sale, the trust will be a grantor trust, and the gain from the sale of the stock[xli] – stock of a C corporation at that point – will belong to the NRA-grantor. Because of the NRA’s status, no U.S. tax would be owing.

[i] Nonresident noncitizens for those who prefer the latter. See IRC Sec. 7701(b)(1)(B).

[ii] Who comes up with these names?

[iii] “I’ve seen sausage made, and it’s a prettier process and a lot easier,” Sen. Romney was quoted as saying. The Hill’s “Morning Report,” Monday, August 2, 2021.

[iv] A move that will further delay (and shorten) the Senate’s summer “recess,” which runs into Mid-September – about the same time the House returns from its vacation.

I guess the Senate has been given detention. Schumer blames the Republicans for delaying a vote, while Republicans blame Schumer for rushing into a vote without thoroughly vetting the bill.

[v] Of course, Ms. Pelosi – in a concession to the more progressive wing of her party – has stated very clearly that the House will not consider the infrastructure bill unless it is accompanied by the budget resolution, a position she reiterated last Friday.

[vi] Apologies, but I do not have a 1981 nuclear-powered DeLorean with a flux capacitator.

[vii] P.L. 104-188, which was enacted on August 20, 1996. The legislation was introduced by a Texas Republican (Rep. Bill Archer), was passed in the Senate by a vote of 76-22, was passed in the House by a vote of 354-72 and was signed into law by an Arkansas Democrat (Pres. Bill Clinton). The House membership included 230 Republicans, 204 Democrats, and 1 Independent; the Senate included 55 Republicans and 45 Democrats.

Someone please tell me how we got to where we are today.

[viii] For example, the Act increased the maximum number of eligible shareholders from 35 to 75 (the number is now set at 100, and there are some very liberal “counting rules” within the context of a family), expanded the post-death holding period for all testamentary trusts to two years, allowed an S corporation to own 80 percent or more of the stock of a C corporation, allowed an S corporation to own all the stock of a qualified subchapter S subsidiary, repealed the rule that treated an S corporation in its capacity as a shareholder of another corporation as an individual, reduced the stepped-up basis of S corporation stock acquired from a decedent by the extent to which the value of the stock is attributable to items constituting income in respect of a decedent, extended to S corporations the presumption that land will not be treated as ordinary income property solely by reason of being subdivided, and allowed certain tax-exempt organizations to be shareholders.

[ix] IRC Sec. 1361(e); Reg. Sec. 1.1361-1(m).

[x] IRC Sec. 1361(d); Reg. Sec. 1.1361-1(j). The QSST can have only one current income beneficiary (for life), any corpus distributed during the life of the beneficiary must be distributed to the beneficiary, the beneficiary’s income interest must terminate at the earlier of the beneficiary’s death or the termination of the trust, and if the trust terminates during the beneficiary’s life, the trust assets must be distributed to the beneficiary. All the income (as defined for local law purposes) must be currently distributed to that beneficiary.

[xi] IRC Sec. 1361(c): Reg. Sec. 1.1361-1(h).

[xii] IRC Sec. 1361(c)(2)(A)(v) and Sec. 1361(e). An ESBT may also hold other property.

[xiii] IRC Sec. 7701(a)(30)(E).

[xiv] For this purpose, “purchase” means any acquisition of property with a cost basis (determined under sec. 1012). Thus, interests in the trust must be acquired by reason of gift, bequest, etc.

[xv] IRC Sec. 1361(e)(3). The election is made by the trustee. By comparison, the QSST election is made by the beneficiary of the trust who will be treated as the deemed owner of the trust income and property for tax purposes under IRC Sec. 678.

[xvi] Reg. Sec. 1.641-1(c).

[xvii] Not polychlorinated biphenyl.

[xviii] Reg. Sec. 1.1361-1(e)(1).

[xix] No person is treated as a potential current beneficiary solely because that person holds any future interest in the trust. IRC Sec. 1361(c)(2)(B)(v); Reg. Sec. 1.1361-1(m)(4).

[xx] Reg. Sec. §1.641(c)-1(a).

[xxi] IRC Sec. 641(c). Currently 37% for ordinary income and 20% for long term capital gain.

[xxii] Accordingly, there is no distribution deduction for the trust.

[xxiii] IRC Sec. 1366.

[xxiv] This income is not included in the distributable net income (“DNI”) of the trust, and thus is not included in the beneficiaries’ income when distributed to them. No item relating to the S corporation stock could be apportioned to any beneficiary.

The non-S portion of the ESBT remains subject to the usual trust income taxation rules that govern simple and complex trusts. Subchapter J. In determining the tax liability with regard to this portion of the trust, the items taken into account by the Subchapter S portion of the trust are disregarded. Although distributions from the trust are deductible in computing the taxable income on this portion of the trust, the trust’s DNI does not include any income attributable to the S corporation stock.

[xxv] IRC Sec. 671 et seq. Reg. Sec. 1.1361-1(m)(4)(ii).

[xxvi] Reg. Sec. 1.1361-1(m)(1)(ii)(D).

[xxvii] IRC Sec. 1361(b)(1)(C); Reg. Sec. 1.1361-1(m)(5)(iii).

Similarly, a change in the immigration status of a PCB of an ESBT from a resident alien (a “U.S. person”) to an NRA would have terminated an ESBT election and, thus, also terminated the corporation’s “S” election.

This result would have occurred because, prior to the Act, the Code provided that each PCB of an ESBT had to be treated as a shareholder of the S corporation.

[xxviii] Tax Cuts and Jobs Act, P.L. 115-97, Sec. 13541.

[xxix] IRC Sec. 1361(c)(2)(B)(v).

[xxx] Effective January 1, 2018.

[xxxi] IRC Sec. 1361(b)(1)(C) and Sec. 1362(d)(2).

[xxxii] See §1.641(c)-1(c).

[xxxiii] If all or a portion of an ESBT is treated as owned by a person under the grantor trust rules, such owner is also treated as a PCB.

[xxxiv] IRC Sec. 672(f)(2)(A)(ii).

[xxxv] Subject to certain exceptions, the grantor trust rules apply only if they result in taxable income being attributed to a citizen or resident of the United States; in other words, the grantor trust rules will generally not cause a non-U.S. person to be treated as the owner of trust assets for income tax purposes.

The denial of grantor trust status to a trust that otherwise would be deemed owned by a foreign person does not apply to any portion of a trust if the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.

[xxxvi] Under IRC Sec. 871(a) or (b). In other words, the NRA deemed owner would not be subject to U.S. federal income tax on the S corporation income unless this income was U.S. source fixed or determinable income, or income effectively connected with a U.S. trade or business.

[xxxvii] T.D. 9868.

[xxxviii] Reg. Sec. 1.641(c)-1(b)(1)(ii) and 1.641(c)-1(b)(2)(ii).

[xxxix] IRC Sec. 897(c).

[xl] IRC Sec. 1361(e)(3); Reg. Sec. 1.1361-1(m)(6).

[xli] Directly or on its liquidation following an asset sale.