Treasury recently detailed the rules it intends to issue in regulations that address the application of sections 951 and 951A of the Internal Revenue Code to some S corporations with accumulated earnings and profits (E&P). Notice 2020-69 allows these S corporations to elect entity treatment for global intangible low-taxed income (GILTI) purposes for tax years ending on or after June 22, 2019.
Section 951A(a) provides that each person that is a U.S. shareholder of a controlled foreign corporation (CFC) for any tax year of that U.S. shareholder shall include in gross income its GILTI for that tax year. A U.S. shareholder is a U.S. person that owns at least 10 percent of the total combined voting power or value of the stock of the foreign corporation. Under section 951A, a U.S. shareholder can be taxed on the GILTI inclusion even if no distribution is made by the CFC.
For CFC and GILTI purposes, S corporations are treated as partnerships and their shareholders are treated as partners. In final regulations implementing the GILTI inclusion, Treasury adopted an aggregate approach to partnerships which, as applied to S corporations, would treat each shareholder as proportionately owning the stock of any CFC owned by the S corporation. Under this aggregate approach, an S corporation would not have a GILTI inclusion. Instead, any shareholder treated as a U.S. shareholder of the CFC would have a GILTI inclusion amount.
This aggregate approach, however, created problems for S Corporations with accumulated E&P. If a shareholder is treated as a U.S. shareholder of the CFC and recognizes income from the GILTI inclusion, the income would be treated as shareholder-level income, rather than as an income item of the S Corporation. As a result, the GILTI inclusion would not be added to the S Corporation’s accumulated adjustment account (AAA), which ensures that distributions of income previously taxed to the S Corporation’s shareholders are not subject to tax. If a subsequent distribution exceeds the AAA, it may be taxed as a dividend to the shareholders.
To remedy this problem, Notice 2020-69 announced Treasury’s intent to issue regulations allowing some S Corporations to recognize the GILTI inclusion amount at the entity level. The GILTI inclusion would be treated as an item of the S corporation’s income and, in turn, it would increase the S Corporation’s AAA. The goal is to provide assistance to those S corporations adversely affected by the adoption of the final GILTI regulations. Section 3.02(1) of the notice sets out the requirements for an S corporation to make the entity treatment election. The S corporation must (1) have elected S corporation status before June 22, 2019; (2) be treated as owning stock of a CFC on June 22, 2019, within the meaning of section 958(a) if entity treatment applied; (3) have transition accumulated E&P on September 1, 2020, or on the first day of any subsequent tax year; and (4) maintain records to support the determination of the transition accumulated E&P.
Once the entity treatment election is made, it is irrevocable, so care must be taken in deciding whether to make it. If the election is not made, the GILTI inclusion will be at the shareholder level, and any shareholder that is not also a U.S. shareholder of the CFC will not have a GILTI inclusion for that year. Only those shareholders that are also U.S. shareholders of the CFC would have a GILTI inclusion. Electing entity treatment, by contrast, would cause all shareholders of the S corporation, including those that are not U.S. shareholders, to have a GILTI inclusion. All shareholders would be required to pay tax on their GILTI inclusions, but they would also obtain a tax benefit because of the increase to the S corporation’s AAA.
Thus, before making an entity treatment election, an S corporation needs to understand what percentage of its equity is owned by U.S. shareholders to determine whether the future benefit associated from the increase to the AAA is more valuable than the additional GILTI inclusion to shareholders that aren’t U.S. shareholders of the CFC owned by the S corporation. In many cases, the tax benefit produced by the increase to the AAA may be less valuable than the tax costs imposed on the shareholders, particularly those shareholders that are not treated as U.S. shareholders of the CFC. Before making this irrevocable election, an S corporation therefore must determine what percentage of its shareholders are U.S. shareholders of the CFC.
The full article in its original form can be found here.
Robert M. Kane, Jr. is an associate in the tax and benefits department at Ropes & Gray (Boston office). His practice focuses on tax aspects of domestic and cross-border mergers and acquisitions.