- The U.S. Tax Cuts and Jobs Act (the TCJA), which was enacted at the end of 2017, dramatically changed the U.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 the U.S. "S" corporation rules that presents interesting opportunities for foreign individuals who wish to restructure their investments in U.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 U.S. Tax Cuts and Jobs Act (the TCJA), which was enacted at the end of 2017, dramatically changed the U.S. cross-border tax regime. Many of the TCJA's international tax reforms that have received considerable attention deal with multinational corporations. However, there are somewhat lesser known provisions in the TCJA that relate to foreign individuals.
This Holland & Knight alert deals with one such provision: a change to the U.S. "S" corporation rules that presents interesting opportunities for foreign individuals who wish to restructure their investments in U.S. real estate or operating businesses.
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 U.S. citizen or a U.S. resident for U.S. federal income tax purposes (known as a "nonresident alien").
Certain specific types of trusts that are classified as "domestic" trusts for U.S. federal income tax purposes may own stock in an S corporation. One of these types of trusts is the "electing small business trust" (ESBT).
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 IRS to be classified as an ESBT.
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 U.S. real estate or operating businesses that are currently owned by C corporations. This will be illustrated below through a "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 the U.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 the U.S. federal estate tax if he were to die while owning his interest in the U.S. business described below.
- Foreign Corp owns 100 percent of the stock of a U.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 separate U.S. limited liability companies (the "LLCs). Each LLC owns a building in Florida 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 for U.S. federal tax purposes. All of the activities, income, losses, etc. of the LLCs "consolidate" onto the U.S. federal corporate income tax return of U.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, U.S. Corp will be subject to U.S. federal income tax at a flat rate of 21 percent on its taxable income from the activities of the LLCs. (Prior to the TCJA, the U.S. federal corporate income tax was imposed at graduated rates of up to 35 percent. The TCJA reduced the U.S. federal corporate income tax rate to 21 percent).
The Florida corporate income tax is currently imposed at a rate of 4.458 percent. The Florida corporate income tax was previously imposed at a flat rate of 5.5 percent, but the rate was recently temporarily reduced through 2021. The Florida corporate income tax is deductible for U.S. federal corporate income tax purposes. For the sake of convenience, assume that U.S. Corp is subject to a combined U.S. federal and Florida corporate income tax rate of 25 percent on its taxable income.
In addition, U.S. federal income tax law imposes a 30 percent dividend withholding tax on dividends paid by U.S. Corp to Foreign Corp. (Although the 30 percent dividend withholding tax may be reduced by treaty, we have assumed that Foreign Corp would not be entitled to any treaty benefits).
Therefore, for example, if U.S. Corp earns $10 million of income and distributes that income to Foreign Corp, the following consequences will apply:
- U.S. Corp will be subject to U.S. federal and Florida corporate income tax of $2.5 million ($10 million x 25 percent).
- U.S. Corp will have $7.5 million left to distribute to Foreign Corp as a dividend ($10 million – $2.5 million).
- The $7.5 million distributed by U.S. Corp to Foreign Corp as a dividend will be subject to a U.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 on U.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.
Under the TCJA, Mr. X can potentially reduce the overall U.S. income tax rate on the earnings of the LLCs through a restructuring into an ESBT and S corporation.
For example, Mr. X could form an irrevocable Delaware trust (the Delaware Trust) that is properly drafted so that it is classified as a domestic trust and as an ESBT. The trust should be drafted so that it protects Mr. X and his family from the U.S. estate tax with respect to the U.S. assets that it owns. Putting aside tax matters, the trust can provide for the orderly passage of assets on Mr. X's death and can also provide creditor protection benefits.
Mr. X could then arrange for Foreign Corp to merge "downstream" into U.S. Corp, and then Mr. X could contribute the stock of U.S. Corp to the Delaware Trust. U.S. Corp could then make an S corporation election, and the Delaware Trust could make an ESBT election.
After the restructuring, the following U.S. income tax consequences should apply to the income earned by the LLCs (subject to a host of technical conditions and requirements):
- The LLCs' annual rental income should be subject to a single level of U.S. federal income tax. The U.S. federal income tax will be imposed on the Delaware Trust (rather than U.S. Corp), at graduated rates of up to 37 percent. There will be no additional U.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 to U.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 U.S. income tax savings.
The discussion above demonstrates, in general terms, some of the key U.S. income tax savings that can be obtained by converting from a C corporation structure to a ESBT/S corporation structure. However, multiple technical U.S. tax rules must be taken into account in establishing, maintaining and reorganizing into this structure. Failure to pay attention to these rules can result in significant adverse consequences.
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 U.S. tax advisors:
- 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 by U.S. law (such as a Delaware 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 into U.S. Corp may, in certain specific cases, be subject to tax under the Foreign Investment in Real Property Tax Act (FIRPTA). Furthermore, even if the reorganization is potentially tax-free under FIRPTA, certain IRS 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 to U.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.
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 U.S. tax rules must be taken into consideration in order for this planning to work.
Originally published as a Holland & Knight Alert on February 20, 2020.