INTRODUCTION

Changes to U.S. tax law brought about by the 2017 Tax Cuts and Job Act1 ("T.C.J.A.") have affected many longstanding tax planning tools. One favorable change amends the rules regarding the persons who can own shares of an S-corporation. Historically, the S-corporation election was terminated if a foreign individual became an owner. Under the T.C.J.A., a foreign individual may now utilize an Electing Small Business Trust ("E.S.B.T.") to obtain an interest in an S-corporation.

BENEFITS OF SCORPOR ATION INVESTING

Similar to limited liability companies ("L.L.C.'s"), S-corporations are pass-thru entities whose corporate income, losses, deductions, and credits flow through to their shareholders for Federal tax purposes. 2

The S-corporation is a creature of Federal tax law. Any corporation that meets certain hurdles can elect S-corporation status. In comparison, L.L.C.'s are creatures of state company law. The state law controls the rights and powers of the entity formed under the L.L.C. statute. I.R.S. regulations recognize an L.L.C. as a pass-thru entity.

Under the rules applicable to an S-corporation, a shareholder's deduction for corporate losses is limited to the sum of the shareholder's adjusted basis in the S-corporation stock and the shareholder's adjusted basis of any debt issued by the S-corporation to the shareholder. 3 Losses not allowed by reason of this limitation generally are carried forward by the corporation to the succeeding year. 4

Generally, the tax basis in the stock of the S-corporation is (i) increased by the items of S-corporation income attributable to shares owned by the shareholder and passed through to the shareholder's personal tax return and (ii) decreased by corporate distributions, losses, and deductions attributable to the shareholder's interest. 5 In this manner, an S-corporation shareholder is not subject to tax on corporate distributions unless the distributions exceed the shareholder's basis in the stock of the corporation.

As opposed to a partner in an L.L.C., a shareholder in an S-corporation can be paid a salary in addition to the flow through of income and gains. Indeed, if the shareholder works in the business, he or she will be treated as receiving a reasonable amount of compensation even if none is paid. That salary is subject to social security taxes for the corporation and the employee-shareholder.

LIMITATIONS ON INVESTORS

To make an S-corporation election, certain restrictions apply to the make-up of the shareholder group:

  • The corporation cannot have more than 100 shareholders.
  • There cannot be more than one class of stock.
  • The corporation cannot have shareholders other than U.S. citizens or individual residents, certain tax-exempt organizations, and certain trusts and estates. 6

Regarding the stock restriction, the corporation will be considered to have met this requirement if two classes of shares have all the same economic rights to income and appreciation of assets at the time of liquidation, even if one class has voting rights and the other class has limited rights or no rights at all. 7 As a result, an S-corporation with two or more shareholders cannot make special allocations to shareholders. 8

Historically, a trust could be a shareholder of an S-corporation in extremely limited circumstances. 9 These include the following:

  • A grantor trust with a U.S. citizen or resident individual as a grantor
  • A grantor trust covered in the preceding bullet once the grantor died (but only for two years)
  • A trust receiving stock under a will (but only for two years)
  • A trust to control voting power
  • A trust established pursuant to an individual retirement account to hold shares in depository institution in limited circumstances

The T.C.J.A. expands the circumstances in which a trust can hold shares in an S-corporation, enabling a nonresident to be a current potential beneficiary if the trust qualifies as an E.S.B.T. 10

Footnotes

1 Pub. L. No. 115-97.

2 Code §§1363, 1366.

3 Code §1366(d)(1).

4 Code §1366(d)(2).

5 Code §1367.

6 Code §1361 (b).

7 Code §1361(c)(4); Treas. Reg. §1.1361-1(l)(1).

8 Treas. Reg. §1.1361-1(l)(2)(i).

9 Code §1361(c)(2).

10 Code §1361(c)(2)(A)(iv).

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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.