Treasury Issues S Corporation Guidance for Subpart F and GILTI along with QBAI Guidance in Notice 2020-69

Summary

In September of 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued Notice 2020-69 (the Notice). The Notice announces that Treasury intends to issue regulations addressing the application of Sections 951 and 951A to certain S corporations with accumulated earnings and profits (AE&P) as described in Section 316(a)(1). In addition, Treasury intends to issue regulations addressing the treatment of qualified improvement property (QIP) under the alternative depreciation system (ADS) of Section 168(g) for purposes of calculating qualified business asset investment (QBAI) under the foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) provisions.

 

Background

On October 10, 2018, Treasury published a notice of proposed rulemaking (REG-104390-18) in the Federal Register (83 FR 51072) under Section 951A (2018 proposed regulations). Section 1.951A-5 of the 2018 proposed regulations (proposed Treas. Reg. § 1.951A-5) provided a “hybrid approach” for domestic partnerships that are U.S. shareholders (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.^[1] 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 Section 958(a) as if the domestic partnership were a foreign partnership.^[2] For a summary discussion of the 2018 proposed regulations, see our September 2018 tax alert.
 
On June 21, 2019, Treasury published final regulations (T.D. 9866) in the Federal Register (84 FR 29288) under Section 951A (final regulations). 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.^[3] 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 Section 958(a) in the same manner as if the domestic partnership were a foreign partnership.
 
On the same day, Treasury also published a notice of proposed rulemaking (REG-101828-19) in the Federal Register (84 FR 29114) under Section 958 (2019 proposed regulations). Section 1.958-1 of the 2019 proposed regulations (proposed Treas. Reg. § 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.^[4] 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.
 
For a summary discussion of the final regulations and 2019 proposed regulations, see our June 2019 tax alert.
 
Under Section 1373(a), an S corporation is treated as a partnership and its shareholders as partners for purposes of Sections 951 and 951A, among other provisions. Therefore, for purposes of determining a GILTI inclusion amount under Treas. Reg. § 1.951A-1(e), as well as determining a Subpart F inclusion or GILTI inclusion amount under proposed Treas. Reg. § 1.958-1(d), an S corporation is not treated as owning stock of a foreign corporation within the meaning of Section 958(a) but instead is treated in the same manner as a foreign partnership (each S corporation shareholder is treated as proportionately owning the stock of the S corporation-owned CFC). Under this aggregate treatment, Section 961(a) applies to increase a U.S. shareholder’s basis in the shares of the S corporation when the U.S. shareholder has a Subpart F inclusion or GILTI inclusion amount attributable to the S corporation-owned CFC.
 
Section 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 accumulated adjustments accounts (AAA), as defined by Section 1368(e)(1), to support the distribution. AE&P does not include amounts that would increase an S corporation’s AAA.^[5] An S corporation’s AAA functions similarly to the basis-adjustment rules set forth in Section 1367 and is adjusted positively to account for income taxed to its shareholders.^[6] AAA is limited to income generated by the corporation during its status as an S corporation and preserves the single-level-of-tax treatment to S corporation shareholders that is fundamental to subchapter S of the Internal Revenue Code.
 
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.^[7] If an S corporation with AE&P distributes property to its shareholders, 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.^[8] In particular, Section 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, Section 1368(c)(2) requires the distribution to be taxed as a dividend (as defined in Section 316) to the S corporation’s shareholders to the extent of the S corporation’s AE&P.
 
Following the June 21, 2019, publication of the final regulations, Treasury announced in Notice 2019-46 that it plans to issue regulations that would permit certain domestic partnerships or S corporations to apply the 2018 proposed regulations, including the hybrid approach in proposed Treas. Reg. § 1.951A-5, in their entirety, for taxable years that ended before June 22, 2019, to reduce compliance and processing burdens resulting from domestic partnerships and S corporations that had furnished Schedules K-1 to their partners and shareholders for the 2018 taxable year on or before the publication date of the final regulations and had relied on proposed Treas. Reg. § 1.951A-5. For a summary discussion of Notice 2019-46, see our June 2019 tax alert.

 

Guidance Under Notice 2020-69

Treasury states in the Notice that it intends to issue the forthcoming S corporation regulations under Section 958 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 Treas. Reg. § 1.951A-5 (and illustrated in Treas. Reg. § 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 to the extent of available stock basis, and AE&P generated by a former C corporation will be taxed as dividends when distributed.
 
Treasury goes on to further state that it intends for 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 an S corporation’s 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, Treasury expects to provide rules and examples consistent with those set forth in sections 3.02 and 3.03, respectively, of the Notice. These transition rules are expected to apply solely to S corporations with “transition AE&P,” (as defined in section 3.02(3) of the Notice). The Notice provides rules on the requirements for the elective entity treatment,^[9] the time and manner of making the election,^[10] determining transition AE&P^[11] and examples illustrating the rules set forth in the Notice.^[12]
 
Treasury also states in the Notice that it expects to amend the regulations under Sections 959 and 961 concerning previously taxed earnings and profits to provide rules to address the transition of S corporations from entity treatment to aggregate treatment.
 
In addition, Treasury states in the Notice that it expects the forthcoming QIP-QBAI regulations under Sections 250 and 951A of the Code to clarify that the technical amendment to Section 168 enacted in Section 2307(a) of the CARES Act ^[13] applies to determine the adjusted basis of property under Section 951A(d)(3) as if it had been enacted as part of Section 13204 of the TCJA. Treasury further states that it has determined that this clarification is consistent with congressional intent that the provisions of the technical amendment be given effect as if included in Section 13204 of the TCJA.
 
The forthcoming S corporation regulations will provide that the transition rules and examples set forth in sections 3.02 and 3.03 of the Notice may be applied to taxable years of S corporations ending on or after June 22, 2019. For rules applicable to taxable years ending before June 22, 2019, see Notice 2019-46. Until the date of issuance of the forthcoming S corporation regulations, an S corporation and its shareholders may rely on the rules set forth in sections 3.02 and 3.03 of the Notice provided that the S corporation and its shareholders that are U.S. shareholders of the CFC consistently apply the rules set forth in sections 3.02 and 3.03 of the Notice with respect to all CFCs whose stock the S corporation owns within the meaning of Section 958(a) of the Code.
 
Consistent with Section 2307(b) of the CARES Act, the forthcoming QIP-QBAI regulations will provide that the rules described in section 4 of Notice will apply retroactively. In the case of the regulations under Section 951A, the forthcoming QIP-QBAI regulations will 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. In the case of the regulations under Section 250, the forthcoming QIP-QBAI regulations will apply to taxable years of U.S. persons beginning after December 31, 2017.^[14] Before the issuance of the forthcoming QIP-QBAI regulations, U.S. shareholders and domestic corporations (including any individuals that elect to apply Section 962) may rely on the rules described in section 4 of the Notice for a taxable year beginning after December 31, 2017, provided they consistently apply those rules for purposes of FDII and GILTI under Sections 250 and 951A to such taxable year and all subsequent taxable years.
 
Pursuant to Section IV. of the Policy Statement on the Tax Regulatory Process issued by Treasury on March 5, 2019, if no proposed regulations or other guidance is released within 18 months after September 21, 2020, taxpayers may continue to rely on the rules described in the Notice but, until additional guidance is issued, Treasury will not assert a position adverse to the taxpayer based in whole or in part on the Notice.
 
For additional details, see the Notice.
 

BDO Insights

Despite the statutory language in Section 1373(a), the Notice provides different treatment for S corporations for purposes of the Subpart F and GILTI provisions in certain limited situations. Please contact an International Tax Specialist if you would like more information regarding the content of this tax alert.

 

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^[1] See proposed Treas. Reg. § 1.951A-5(b).
^[2] See proposed Treas. Reg.  § 1.951A-5(c).
^[3] See Treas. Reg. § 1.951A-1(e)(1).
^[4] See proposed Treas. Reg. § 1.958-1(d)(1).
^[5] See Section 1371(c).
^[6] See Section 1368(e)(1).
^[7] See Treas. Reg. Section 1.951A-1(e).
^[8] See generally Section 1368(c).
^[9] See section 3.02(1) of the Notice.
^[10] See section 3.02(2) of the Notice.
^[11] See sections 3.02(3) and (5) of the Notice.
^[12] See section 3.03 of the Notice.
^[13] Under the technical amendment, Section 2307(a)(1)(A) of the CARES Act amended Section 168(e) by adding clause (vii) to paragraph (3)(E), providing that QIP is classified as 15-year property, Section 2307(a)(1)(B) of the CARES Act amended the definition of QIP in  Section 168(e)(6) by providing that the improvement must be “made by the taxpayer,” and Section 2307(a)(2) of the CARES Act amended the table in  Section 168(g)(3)(B) to provide a class life of 20 years for QIP for purposes of the ADS. Under Section 2307(b) of the CARES Act, the technical amendment is effective as if its provisions had been included in Section 13204 of the TCJA and, therefore, applies to property placed in service after December 31, 2017.
^[14] See Section 7805(b)(2).