Association Requests Clarification of GILTI Recognition by S Corps

June 5, 2020

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
Department of Treasury
1500 Pennsylvania Avenue, NW
Washington DC 20220

Re: Guidance Related to Section 951A (Global Intangible Low-Taxed Income)

Dear Mr. Kautter:

The members of the S Corporation Association are requesting quick action by the Treasury Department to provide clarity on how GILTI income should be recognized by S corporations that maintain accumulated adjustments accounts (AAA). These comments are in response to the preamble to the final GILTI regulations, which requests comments regarding their impact on S corporations and their owners. We appreciate this opportunity to comment and Treasury's recognition that the final rules may not work for S corporations the same way they work for partnerships.

GILTI/AAA Mismatch

As we discussed last year, Notice 2019-46 provided welcome relief to S corporations. It allowed them to elect the hybrid approach for determining the GILTI income of their CFCs — as outlined in the proposed GILTI rules published on October 10, 2018 — addressed the bulk of the compliance, penalty risk, termination of S elections, and cash distribution challenges created by the aggregate approach included in the final GILTI regulations published on June 21, 2019. But the Notice applied to tax year 2018 only. For tax years 2019 and beyond, there remains an open question of whether these same S corporations will be required to revert to the aggregate approach outlined in the final GILTI regulations issued on June 21, 2019.

Treas. Reg. § 1.951A-1(e) creates a mismatch between the GILTI income recognized by shareholders and the AAA maintained by S corporations. This mismatch will make some S corporation distributions fully taxable to shareholders despite the S corporation shareholders paying current tax on tested income recognized by the S corporation's controlled foreign corporations (CFCs). This becomes particularly evident where the S corporation is obligated to make tax distributions to shareholders that have GILTI inclusions from the S corporation's CFCs.

Example 1: An S corporation with AE&P that owns a tested income CFC does not recognize an item of income with respect to that tested income, though US shareholder S corporation shareholders would recognize GILTI income. The S corporation is required to pay a tax distribution for any income taxes owed by its shareholders as a result of S corporation earnings. If there is less AAA than tax due by the shareholders, the S corporation's tax distribution that would facilitate the shareholder paying tax on their GILTI inclusion would constitute a taxable dividend to the shareholder even though they paid income tax with respect to earnings flowing from the S corporation. Only upon a distribution from the CFC to the S corporation would the S corporation recognize an item of taxable income and increase AAA accordingly.

Unlike Subchapter K, which consistently straddles the line between the entity and aggregate theories, an S corporation cannot so easily shed its character as an entity. The AE&P rules of Section 1368(b) and the application of cornerstone Subchapter C provisions (e.g., Sections 311(b), 332, and 361) to S corporations tether S corporations to the “entity theory” in a manner that is dissimilar to the aggregate theories inherent to Subchapter K of the Code and the economic relationship between partners. Unlike a domestic partnership, an S corporation with historic accumulated E&P (AE&P) is firmly rooted to the entity theory. As a result, it is only once the corporation has distributed it's AE&P that shareholders more clearly escape the threat of double taxation.

Treas. Reg. § 1.951A-1(e), which imposes aggregate treatment on all domestic pass-through entities, is inconsistent with the statutory scheme of Subchapter S. This seems particularly true where the S corporation retains C corporation US tax attributes, such as AE&P, which may yet subject the shareholders to the double taxation inherent to the entity theory. Worse, the regulations lead to situations where an S corporation is forced to source tax distributions from offshore operations rather than a source determined by business needs.

Proposal

In keeping with the temporary solution embraced by Notice 2019-46, we propose the following alternatives for Treasury to apply the GILTI rules without creating unintended challenges for S Corporations. We ask Treasury to provide guidance that Treas. Reg. § 1.951A-1(e) and Proposed Reg. § 1.958-1(d) apply so as to treat an S corporation with AE&P as the 958(a) US shareholders with respect to CFCs held by the S corporation. We propose that under this scheme, such an S corporation would calculate a GILTI inclusion, which would be treated as an item of income of the corporation for purposes of the adjustments under Sections 1367 and 1368(d). An S corporation without AE&P would apply the existing regulations, as its shareholders look to their outside basis, rather than AAA, to determine the taxation of corporate distributions under section 1368(b). As a matter of sound tax policy, it is important that any proposal to resolve the timing issues created under Treas. Reg. § 1.951A-1(e) and Proposed Reg. § 1.958-1(d) consider the basis adjustments made under sections 961(a), 961(b), and 1367(a) to ensure consistency between the treatment of each shareholder's US tax basis, S corporation AAA, and PTEP associated with underlying CFCs.

Example 2: Under the proposal, an S corporation with AE&P that owns a tested income CFC would recognize an item of GILTI income as the section 958(a) US shareholder of such CFC. The S corporation would recognize an increase in AAA equal to the S corporation's GILTI inclusion. This GILTI income would be allocated to the S corporation shareholders on a pro rata basis. A distribution by the S corporation, whether for shareholder taxes or otherwise, would then not constitute a taxable dividend to the shareholders to the extent of the AAA resulting from a GILTI inclusion. Upon exhaustion of the S corporation's AE&P, the S corporation would not be required to maintain AAA and existing Treas. Reg. 1.951A-1(e) would result in outside basis in the shareholder's S corporation stock, facilitating similar tax-free distributions of corporate earnings. A distribution of CFC earnings would not be required in order to close the mismatch created under the current regulation.

The proposal would apply to tax years 2019 and beyond. In addition, we ask that you allow S corporations to use these rules to file an amended return for 2018. Many S corporations were unable to file using the Notice 2019-46 option simply because there was not enough time between its publication date and the filing deadline.

The proposal could affect less-than-10-percent shareholders of an S corporation's CFCs, as compared with final Treas. Reg. § 1.951A-1(e) and Prop. Reg. § 1.958-1(d). While under the proposal, these minority shareholders may be subject to current tax on CFC tested income and subpart F, this treatment is consistent with the historic statutory scheme of both Subchapter S and Subpart F of the Code, as well as the transition tax provisions of section 965 enacted by the Tax Cuts and Jobs Act.

Ease of Administration

The proposal would reduce the administrative burden associated with treating an S corporation as an aggregate for purposes of GILTI and subpart F. Treas. Reg. § 1.951A-1(e) and Prop. Reg. § 1.958-1(d) require unprecedented coordination between tax attributes that accrue at the corporation and those attributable to the S corporation's shareholders. Form 5471 Schedules J and P, as well as other policies such as the multiple filers exception have been frustrated and made more complex as a result of adopting the aggregate theory.

S-Corp thanks Treasury for the work that went into these rules to date — particularly the release of Notice 2019-46 — as well as the further opportunity to comment on the final GILTI regulations and how they affect S corporations. We appreciate your consideration of our proposal and look forward to future communications.

Sincerely,

Brian Reardon
President
S Corporation Association