In Notice 2020-69[1] the IRS outlined items that will be contained in to be issued proposed regulations related to S corporations with accumulated earnings and profits impacted by IRC §§951 and 951A. The revisions are meant to address the proposed and then modified final regulations on GILTI and FDII issued by the IRS previously. The IRS’s change of direction from handling the S corporation as an entity for GILTI to treating it under an aggregate approach can lead to problems in getting shareholders the cash to pay the tax if the S corporation has accumulated earnings and profits. The Notice and eventual regulations seeks to address that issue.

GILTI in General

The Notice begins by discussing the provisions in general that will be impacted by the Notice:

Section 951(a) of the Code generally requires a United States shareholder (as defined in § 951(b)) (U.S. shareholder), to include in its gross income its pro rata share of subpart F income (as defined in § 952) of a controlled foreign corporation (as defined in § 957) (CFC) and the amount determined under § 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under § 959(a)(2)) (subpart F inclusion).

Section 951A(a) requires a U.S. shareholder of any CFC for any taxable year to include in gross income the shareholder’s GILTI for such taxable year (GILTI inclusion amount). The U.S. shareholder’s GILTI inclusion amount is calculated based on certain items — such as tested income, tested loss, and QBAI — of each CFC owned by the U.S. shareholder (tested items). See § 1.951A-1(c) of the Income Tax Regulations. In general, a U.S. shareholder’s GILTI inclusion amount is determined by reference to the U.S. shareholder’s pro rata share of the tested items based on the stock of all the CFCs that the U.S. shareholder owns within the meaning of § 958(a). See § 951A(e)(1) (cross referencing § 951(a)(2)). The GILTI provisions in § 951A, enacted in § 14201(a) of the TCJA, apply to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. See § 14201(d) of the TCJA.

Section 951(b) defines a U.S. shareholder, with respect to any foreign corporation, as a United States person (U.S. person) that owns (within the meaning of § 958(a)), or is considered as owning by applying the ownership rules of § 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such corporation or 10 percent or more of the value of all shares of all classes of stock of the foreign corporation. See also § 1.951-1(g). Section 957(c) generally defines a U.S. person for purposes of subpart F by reference to § 7701(a)(30), which defines a U.S. person as a citizen or resident of the United States, a domestic partnership, a domestic corporation, and certain estates and trusts.[2]

Partnerships and S corporations pose a problem for this regime, since they aren’t themselves taxable entities generally. The tax law sometimes views the partnership or S corporation as an entity (say for selecting the overall method of accounting) while other times looking through the structure to apply rules at the individual level (such as if a §1231 gain will be ultimately taxed at capital gain rates) applying an aggregate test. That is, the passthrough was viewed as simply an aggregation of the various owners.

As the Notice indicates, IRC §1373(a) provides that an S corporation will be treated like a partnership for purposes of Subpart A and F of Part III and Part V of Subchapter N of the IRC. The Notice points out that, prior to TCJA, domestic partnerships and S corporations were treated as entities for the then applicable Subpart F inclusion for CFC. Thus, the test for the existence of a U.S. shareholder took place at the partnership/S corporation level, with the equity holder having to take into account his/her share of the Subpart F inclusion amount even if the equity holder was not him/herself a holder of enough of an interest in the CFC (even counting their proportionate share held by the partnership or S corporation) to be a U.S. shareholder of the CFC.

Foreign partnerships were treated differently, however. For those, the partners were each deemed to own proportionately the stock of the CFC held by the foreign partnership.

The original 2018 proposed regulations implementing the new GILTI provisions took a hybrid approach, borrowing from both the entity and aggregate view. As the Notice provides:

On October 10, 2018, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-104390-18) in the Federal Register (83 FR 51072) under § 951A (2018 proposed regulations). Section 1.951A-5 of the 2018 proposed regulations (proposed § 1.951A-5) provided a “hybrid approach” to a domestic partnership that is a U.S. shareholder (U.S. shareholder partnership) of a CFC (partnership-owned CFC). Under the hybrid approach, a U.S. shareholder partnership would determine its GILTI inclusion amount, and the partners of the partnership that were not also U.S. shareholders of the partnership-owned CFC would take into account their distributive share of the partnership’s GILTI inclusion amount. See proposed § 1.951A-5(b). Partners that also were U.S. shareholders of a partnership-owned CFC would not take into account their distributive share of the partnership’s GILTI inclusion amount. Instead, such partners would be treated as proportionately owning the stock of the partnership-owned CFC within the meaning of § 958(a) as if the domestic partnership were a foreign partnership. See proposed § 1.951A-5(c).

Because § 1373(a) treats S corporations as partnerships for purposes of subpart F, the hybrid approach in the 2018 proposed regulations also applied to S corporations that held stock of a CFC. For example, proposed § 1.951A-5(g)(5) (Example 5) applied entity treatment (outlined in section 2.02(1) of this notice) to an S corporation shareholder that was not a U.S. shareholder of a CFC owned by the S corporation (S corporation-owned CFC), and aggregate treatment (outlined in section 2.02(2) of this notice) to an S corporation shareholder that was a U.S. shareholder of the S corporation-owned CFC.[3]

However, this approach was not taken in the 2019 final regulations. Those regulations shifted entirely to the aggregate view that previously applied to foreign partnerships for Subpart F income. The partnership itself is not tested to see if it is a U.S. shareholder—rather, each partner looks at his/her overall ownership interest in the CFC, including the equity holder’s proportionate share of the entity’s holdings, to determine if he/she will be treated as a U.S shareholder:

On June 21, 2019, the Treasury Department and the IRS published final regulations (T.D. 9866) in the Federal Register (84 FR 29288) under § 951A (final regulations). The final regulations did not adopt the hybrid approach included in the 2018 proposed regulations and instead adopted aggregate treatment for domestic partnerships. Accordingly, under the final regulations, a domestic partnership does not have a GILTI inclusion amount, and therefore no partner of the partnership has a distributive share of a GILTI inclusion amount. See § 1.951A-1(e)(1). Rather, for purposes of determining the GILTI inclusion amount of any partner of a domestic partnership, each partner is treated as proportionately owning the stock of a CFC owned by the partnership within the meaning of § 958(a) in the same manner as if the domestic partnership were a foreign partnership. Because only a U.S. person that is a U.S. shareholder can have a GILTI inclusion amount, a partner that is not a U.S. shareholder of a partnership-owned CFC does not have a GILTI inclusion amount determined by reference to the partnership-owned CFC. Section 1.951A-1(e)(1) applies to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. See § 1.951A-7.[4]

The Notice describes the resulting Subpart F and GILTI tax treatment for a partner under proposed regulations issued with the final regulations:

On June 21, 2019, concurrent with the final regulations, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-101828-19) in the Federal Register (84 FR 29114) under § 958 (2019 proposed regulations). Section 1.958-1 of the 2019 proposed regulations (proposed § 1.958-1) mirrored the aggregate treatment of domestic partnerships for purposes of GILTI inclusions as set forth in the final regulations, and also extended it to apply for purposes of subpart F inclusions. See proposed § 1.958-1(d)(1). Accordingly, subject to certain exceptions in proposed §1.958-1(d)(2), for purposes of §§ 951 and 951A and any other provision that applies by reference to § 951 or 951A, the 2019 proposed regulations provided that a domestic partnership is not treated as owning stock of a foreign corporation within the meaning of §958(a); instead, a domestic partnership is treated in the same manner as a foreign partnership for purposes of determining the persons that own stock of the foreign corporation within the meaning of § 958(a). See proposed § 1.958-1(d)(1). Under proposed § 1.958-1(d)(2), a domestic partnership is treated as an entity for purposes of determining whether any U.S. person (including the domestic partnership) is a U.S. shareholder, whether any U.S. shareholder is a controlling domestic shareholder (as defined in § 1.964-1(c)(5)), or whether any foreign corporation is a CFC.

Consistent with the final regulations with respect to GILTI, under the 2019 proposed regulations a partner that is not a U.S. shareholder with respect to a partnership-owned CFC does not take into account a subpart F inclusion or GILTI inclusion amount by reference to the partnership-owned CFC.

The 2019 proposed regulations are proposed to apply to taxable years of foreign corporations beginning on or after the date of publication of the Treasury decision adopting the rules as final regulations in the Federal Register. See proposed § 1.958-1(d)(4). Subject to a consistency requirement, however, the 2019 proposed regulations provide that a domestic partnership may apply the regulations, once finalized, to taxable years of a foreign corporation beginning after December 31, 2017, and to taxable years of the domestic partnership in which or with which such taxable years of the foreign corporation end. See id.[5]

Impact of the Rules on S Corporation Distributions

The new aggregate approach creates issues with distributions from an S corporation. Under current regulations, an S corporation shareholder who now has an income inclusion under the aggregate approach on his/her personal return would not see a corresponding increase in AAA at the S corporation level, as that is a corporate account.

The Notice explains:

The aggregate treatment provided in the final regulations, as applied to S corporations with AE&P, does not result in a positive adjustment of AAA because the GILTI inclusion amount arises at the shareholder level, rather than at the S corporation level. See § 1.951A-1(e). If an S corporation with AE&P distributes property to its shareholders, for example, to provide its shareholders with funds to pay the resulting federal income tax arising from their GILTI inclusion amount with respect to stock of CFCs owned by the S corporation, the S corporation would need an amount of AAA equal to the amount of that distribution to prevent the distribution from being included in such shareholders’ gross income to the extent of AE&P. See generally § 1368(c). Although the S corporation could generate additional AAA as needed through a distribution from a CFC, comments have asserted that such an approach could result in foreign withholding taxes or undesired reductions in working capital that otherwise would be devoted to the CFC’s businesses.

As stated in section 2.02(7) of this notice, § 1368(c)(1) provides that tax-free distribution treatment to shareholders of an S corporation with AE&P results only to the extent the S corporation has sufficient AAA to support the distribution. In the absence of enough AAA, § 1368(c)(2) requires the distribution to be taxed as a dividend (as defined in § 316) to the S corporation’s shareholders to the extent of the S corporation’s AE&P. In other words, if an S corporation has no AAA, the amount of the adjusted basis in a shareholder’s S corporation stock — including any positive basis adjustment under § 961(a) resulting from a shareholder’s GILTI inclusion — does not affect dividend treatment. Once the S corporation exhausts its AE&P, distributions are once again applied to shareholder stock basis. Comments regarding the application of the final regulations to S corporations and their shareholders focused on these interactions between the aggregate treatment and the distribution rules for AE&P under subchapter S.[6]

Thus, S corporations with shareholders who are seeing a GILTI inclusion amount may find they are paying tax on a distribution made to allow them to pay the tax if there is not a corresponding distribution from the CFC—a distribution that may not make sense for various reasons. The issue will only arise if the S corporation has accumulated earnings and profits (AE&P) since in that case the distributions will become tax dividends to shareholders once the corporate level AAA is exhausted.

Election for S Corporation with AE&P to be Treated Under the Entity Method

The Notice announces that the IRS plans to address this problem in new regulations to be released under IRC §958. The Notice states:

The Treasury Department and the IRS intend to issue the forthcoming S corporation regulations under § 958 of the Code to ease the transition of S corporations with AE&P on September 1, 2020 from the historic entity treatment and the hybrid treatment under proposed §1.951A-5 (and illustrated in § 1.951A-5(g)(5) (Example 5)) to the aggregate treatment required under the final regulations (transition rules). The forthcoming S corporation regulations will ensure that distributions of income already taxed to S corporation shareholders will be tax-free, and AE&P generated by a former C corporation will be taxed as dividends when distributed.

The Treasury Department and the IRS intend the transition rules to assist S corporations with AE&P and their shareholders by allowing them to recognize the GILTI inclusion amount at the entity level so it is treated as an item of income, thereby increasing its AAA before allocation to the shareholders. This increase in AAA will allow S corporations to distribute property to shareholders and avoid dividend treatment. To achieve this result, the Treasury Department and the IRS expect to provide rules and examples consistent with those set forth in sections 3.02 and 3.03, respectively, of this notice. These transition rules are expected to apply solely to S corporations with “transition AE&P,” as defined in section 3.02(3) of this notice.[7]

To address this issue, the Notice provides the S corporation and its shareholders with an option to use the entity treatment for the GILTI inclusion amount:

With respect to a taxable year, an S corporation is subject to entity treatment if (a) it (and its shareholders, if applicable) makes an election described in section 3.02(2) of this notice, (b) it has elected S corporation status before June 22, 2019, (c) it would be treated as owning stock of a CFC on June 22, 2019, within the meaning of § 958(a) if entity treatment applied, (d) it has transition AE&P (as defined in section 3.02(3) of this notice) on September 1, 2020, or on the first day of any subsequent taxable year, and (e) it maintains records to support the determination of the transition AE&P amount. Entity treatment means that an S corporation that owns stock of a CFC is treated as owning within the meaning of § 958(a) the CFC stock for purposes of applying § 951A. Thus, the S corporation determines its GILTI inclusion amount, and its shareholders take into account their distributive share of that GILTI inclusion amount. See section 2.02(1) of this notice.[8]

The Notice outlines the following rules for making this election:

With respect to the first taxable year ending on or after September 1, 2020, an S corporation may irrevocably elect to apply entity treatment on a timely filed (including extensions) original Form 1120-S, U.S. Income Tax Return for an S Corporation. For taxable years of an S corporation ending before September 1, 2020 and after June 21, 2019, the S corporation and all of its shareholders may irrevocably elect the entity treatment provided in section 3.02(1) of this notice on timely filed (including extensions) original returns or on amended returns filed by March 15, 2021, by attaching a statement thereto.

The election is made by attaching a statement to the Federal tax return. The election statement must identify the election being made, include the amount of transition AE&P as described in section 3.02(3) of this notice, and, where applicable, be signed by a person authorized to sign the return required to filed under § 6037. Form 1120-S, Schedules K-1 (Form 1120-S), and Form 8892, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), must be prepared consistent with the S corporation's election for shareholders to comply with § 6037(c).[9]

Transition AE&P – A Requirement for the Election and Treatment

As was explained earlier, an S corporation that has no accumulated earnings and profits does not face a problem with making distributions to help pay the tax generated by GILTI inclusion by shareholders in the aggregate method found in the regulations. So the Notice limits the election only to those S corporations with AE&P existing at the transition date (“Transition AE&P”) and only for the period the corporation continues to have such AE&P.

Transition AE&P is defined in the Notice as:

For purposes of this notice, the term “transition AE&P” means, with respect to an S corporation and its shareholders, the amount of AE&P of the S corporation calculated as of September 1, 2020, reduced as described in section 3.02(5) of this notice. Transition AE&P is not increased as a result of transactions occurring (or entity classification elections described in § 301.7701-3 filed) after September 1, 2020.[10]

The Notice provides that Transition AE&P is not transferrable—what would be transferred is “standard” AE&P.

For purposes of this notice, transition AE&P of an S corporation is not transferrable to another person under any provision of the Code (for example, under §§ 312(h) or 381 by reason of § 1371(a)). In other words, the transferee of the transition AE&P would receive AE&P not transition AE&P.[11]

The Notice also points out that AE&P is only to be reduced by distributions (presumably either actual distributions or elective deemed distributions of S corporation earnings and profits):

An S corporation with transition AE&P is treated as having no transition AE&P if, beginning after September 1, 2020, the S corporation distributes in one or more distributions a cumulative amount of AE&P equal to or greater than the amount of the S corporation's transition AE&P as of September 1, 2020.[12]

The Notice provides that the entity status continues until transition AE&P is exhausted:

Except as provided in Notice 2019-46, aggregate treatment applies to an S corporation if the S corporation has not made an election described in section 3.02(1) of this notice to apply the transition rules. In the case of an S corporation that has made an election to apply entity treatment as described in section 3.02(1) of this notice, aggregate treatment applies beginning with the S corporation’s first taxable year for which the S corporation has no transition AE&P on the first day of that year, and to each subsequent taxable year of the S corporation. For purposes of this section 3.02(6), aggregate treatment means the treatment of an S corporation provided under § 1.951A-1(e).[13]

Examples

The Notice has two examples of applying this election.

Example 1, Notice 2020-69

S corporation with transition AE&P

(a) Facts. Individual A and Individual B, each U.S. citizens, respectively own 5% and 95% of the single class of stock of SCX, an S corporation. SCX's sole asset is 100% of the single class of stock of FC, a CFC, which SCX has held since June 1, 2019. Neither Individual A or Individual B own shares, directly or indirectly, in any other CFC. Individual A, Individual B, SCX, and FC all use the calendar year as their taxable year. On January 1, 2021, SCX has transition AE&P of $100x and AAA of $0. SCX elects to apply the transition rules under section 3.02(1) of this notice. During the 2021 taxable year, FC has $200x of tested income (within the meaning of § 1.951A-2(b)(1)) and $0 of QBAI (within the meaning of §1.951A-3(b)).

(b) Analysis — (i) S corporation-level. As an S corporation with transition AE&P on the first day of the taxable year (here, January 1, 2021), SCX is treated as owning (within the meaning of § 958(a)) all the stock of FC for purposes applying § 951A. Accordingly, SCX, a U.S. shareholder of FC, determines its GILTI inclusion amount under § 1.951A-1(c)(1) for its 2021 taxable year. SCX's pro rata share of FC's tested income is $200x, and its pro rata share of FC's QBAI is $0. SCX's net CFC tested income (within the meaning of § 1.951A-1(c)(2)) is $200x, and its net deemed tangible income return (within the meaning of § 1.951A-1(c)(3)) is $0. As a result, SCX's GILTI inclusion amount for 2021 is $200x. At the end of 2021, SCX increases its AAA by $200x to reflect the GILTI inclusion amount. Because SCX computes its income as an individual under § 1363(b), it cannot take a § 250 deduction for any GILTI inclusion amount. See § 1.250(a)-1(c)(1).

(ii) S corporation shareholder-level. Neither Individual A nor Individual B is treated as owning the stock in FC within the meaning of § 958(a). Accordingly, Individual A and Individual B include in gross income their pro rata shares of SCX's GILTI inclusion amount as described in § 1366(a), which is $10x ($200x x 5%) for Individual A and $190x ($200x x 95%) for Individual B.

Example 2, Notice 2020-69

Effect of distribution on transition AE&P

(a) Facts. The facts are the same as in Example 1 of this section 3.03, except that, on December 31, 2021, SCX distributes $300x to its shareholders. In addition, FC has an additional $200x of tested income (within the meaning of § 1.951A-2(b)(1)) and $0 of QBAI (within the meaning of §1.951A-3(b)) during the 2022 taxable year.

(b) Analysis — (i) Determination of transition AE&P. Before taking into account the distribution on December 31, 2021, the results for taxable year 2021 are the same as set forth in paragraphs (b)(i) and (b)(ii) of Example 1 of this section 3.03. $200x, the portion of SCX's $300x distribution that does not exceed AAA, is subject to §1368(c)(1). The remaining distribution of $100x is treated as a dividend under § 316 to the extent of SCX's AE&P. As of January 1, 2022, SCX has $0 of transition AE&P under section 3.02(5) of this notice because the cumulative amount of SCX's distributions out of AE&P after September 1, 2020 equals or exceeds the amount of SCX's transition AE&P as of September 1, 2020.

(ii) S corporation-level. Because SCX has no transition AE&P as of January 1, 2022, aggregate treatment applies to SCX for its taxable year 2022 and for each subsequent taxable year. As a result, for purposes of determining a GILTI inclusion amount in its taxable year 2022, SCX is not treated as owning (within the meaning of §958(a)) the FC stock; instead, SCX is treated in the same manner as a foreign partnership for purposes of determining the FC stock owned by Individual A and Individual B under § 958(a)(2). See § 1.951A-1(e)(1). Accordingly, SCX does not have a GILTI inclusion amount for its 2022 taxable year (or for any subsequent taxable year ) and therefore will not increase its AAA as a result of its ownership of FC stock for its taxable year 2022 (or for any subsequent taxable year).

(iii) S corporation shareholder-level — (A) Individual A. For purposes of determining the GILTI inclusion amount of Individual A for taxable year 2022, Individual A is treated as owning 5% of the FC stock under § 958(a). Individual A is not, however, a U.S. shareholder of FC because Individual A owns (within the meaning of § 958(a) and (b)) less than 10% (that is, only 5%) of the FC stock. Accordingly, Individual A does not have a GILTI inclusion amount for taxable year 2022.

(B) Individual B. For purposes of determining the GILTI inclusion amount of Individual B for taxable year 2022, Individual B is treated as owning 95% of the FC stock under § 958(a). In addition, Individual B is a U.S. shareholder of FC because Individual B owns (within the meaning of § 958(a) and (b)) at least 10% (that is, 95%) of the FC stock. Accordingly, Individual B's pro rata share of FC's tested income is $190x ($200x x 0.95), and Individual B's pro rata share of FC's QBAI is $0. Individual B's net CFC tested income is $190x, and Individual B's net deemed tangible income return is $0. As a result, Individual B's GILTI inclusion amount for taxable year 2022 is $190x.

[1] Notice 2020-69, September 1, 2020, https://www.irs.gov/pub/irs-drop/n-20-69.pdf (retrieved September 30, 2020)

[2] Notice 2020-69, Section 2.01

[3] Notice 2020-69, Section 2.02(3)

[4] Notice 2020-69, Section 2.02(4)

[5] Notice 2020-69, Section 2.02(5)

[6] Notice 2020-69, Section 2.02(8)

[7] Notice 2020-69, Section 3.01

[8] Notice 2020-69, Section 3.02(1)

[9] Notice 2020-69, Section 3.02(2)

[10] Notice 2020-69, Section 3.02(3)

[11] Notice 2020-69, Section 3.02(4)

[12] Notice 2020-69, Section 3.02(5)

[13] Notice 2020-69, Section 3.02(6)