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IRS Provides S Corporation Exemption, QIP Rules for GILTI and FDII

IRS Provides S Corporation Exemption, QIP Rules for GILTI and FDII

The IRS issued guidelines on September 1 (Notification 2020-69) that provide an exemption for S Corporation with AE&P (accumulated earnings and profits) after a C corporation conversion and address the qualified improvement property (QIP ) for the foreign-derived intangible income (FDII), and global intangible low taxed income (GILTI).

 

According to the Notice, the IRS intends to issue future regulations by Section 951A of the GILTI Rules and Section 951 Chapter F rules to deal with certain S corporations with AE&P. The guide gives S Corporation the option of choosing the entity treatment for certain GILTI and FDII calculations. Still, there may be drawbacks, especially for minority shareholders. The notification also addresses the impact of retroactive changes to Qualified Improvement Property (QIP) in calculating qualified business asset investments (QBAI) for FDI purposes under Section 250 and GILTI under section 951A.

The notification provides useful guidance in these two previously uncertain areas, but swift action may require taxpayers to benefit in some areas.

 

S Corporation and AE&P

In general, US shareholders should include their proportionate share of Chapter F income and include GILTI in each fiscal year. S Corp is treated in the same way as national companies within the meaning of Sections 951 and 951A. As a result, an S corporation is not treated as a foreign corporation shareholder in some cases. Still, each shareholder of the S corporation is treated as the proportionately owning of the S Corporation's shares owned controlled foreign corporation (CFC). With this global treatment, the US shareholder determines the inclusion of GILTI (or the inclusion of Subpart F, if it adopts a settlement proposal) concerning the CFC held by the S Corp.

For S corporation, which converted from C corporation, C corporation transfers its AE&P to S corporation when S selection is made. The S Corporation Accumulated Adjustment Account (AAA) does not increase amounts included in AE&P and is limited to the company's income during its status as an S company. Future distributions are prioritized outside of an AAA, thus maintaining a single taxation level for the S company's shareholders.

When there is the inclusion of estimated revenues according to the rules mentioned above, this does not translate into a positive adjustment for AAA because the inclusion values appear at the level of the shareholders and not at the S Corporation level. Therefore, if an S Corporation distributes the AE&P properties to its shareholders, the S Corporation needs an AAA equal to the value of the distribution to prevent the inclusion of the distribution in the gross shareholder income AE&P measurement and registration as a dividend. This results in a disconnection between the two systems, "aggregate" for certain inclusions considered an "entity" for AE&P, creating unforeseen tax problems and consequences for certain S shareholders.

 

The Notice provides relief and attempts to temporarily align the two systems until S Corporation no longer has AE&P after a certain date. The notification states that the IRS intends to allow S corporations with AE&P and their shareholders to make an election to apply the entity treatment for GILTI purposes and Section 250 FDII deduction. Entity treatment means that an S corporation holding shares in a CFC collects the inclusions considered in Sections 951A and 951, allowing S corporation to determine its GILTI and Subpart F inclusions, with its shareholders taking into account their participation distribution of this amount. This allows S Corporation to treat inclusions considered an item of income to increase its AAA. This increase allows S corporations to distribute properties to shareholders and avoid the treatment of dividends to the AAA measure created by the inclusions.

 

However, the election involves additional complexity and continuity. S Corporation making such an election must pursue a new value, the 'AE&P Transition,' which aims to block and monitor AE&P from September 1, 2020, and provide a transition, offering limited treatment to S Corporation. Once the AE&P transition value is complete, companies move to global processing according to the final GILTI regulation requirements.

 

Grant Thornton Insight

Electing entity treatment has its drawbacks, including its impact on minority shareholders. Minority shareholders holding less than 10% of the capital of the underlying CFC may not have considered including in the overall approach. However, according to the entity's approach, all shareholders include in their gross profit, the attributable share of S Corporation considered as inclusions. In other words, elections can subject owners of less than 10% to GILTI income tax, which could have been avoided had the elections not taken place.

For the first fiscal year ending September 1, 2020, or later, an S corporation may irrevocably elect to apply entity processing on an original Form 1120-S on time (including extensions). For the fiscal years of an S Corporation ending before September 1, 2020, and after June 21, 2019, the S corporation and all its shareholders may irrevocably elect the treatment of the entity in the initial documents filed on time (including extensions) or amended before March 15, 2021.

 

QBAI Rules for FDII and GILTI 

This guide discusses some uncertainties in calculating QBAI caused by the retroactive nature of a change in QIP depreciation. The QIP includes a wide range of improvements to the non-residential property. A 15 year payback period was provided with the general depreciation system and a 20 year payback period with the alternative depreciation system (ADS). However, a typo in TCJA left QIP on the list of eligible properties for 15 years. The CARES Act corrected this error retroactively for properties brought into operation after December 31, 2017.

 

The uncertainty arises from the fact that Section 951A (d)(3) requires the taxpayer to calculate the QBAI by determining the adjusted ownership basis using ADS rules per Section 168(g). The regulations of Section 951A further state that the base adjusted to the specified physical property is determined without regard to any legal provision adopted after December 22, 2017, unless that law subsequently issues directly and specifically the definition of QBAI. The definition of QBAI also applies for determining the yield of tangible income under section 250. Since the CARES Act did not specifically and directly change the definition of QBAI under section 250 951A, there was uncertainty about its application to the determination of QBAI.

 

The notification clarifies that the technical amendment to Section 168 adopted under the CARES Act should apply as if it had been adopted under the TCJA. The notification further states that the IRS has determined that this clarification is consistent with Congress' intention to bring into force the provisions of the technical amendment as if they were included in the TCJA. The guide provides security for taxpayers who put the QIP into effect after December 31, 2017, and who are required to calculate the QBAI for sections 951A or 250.


Next Step 

The notice for the next steps in 2020-69 aims to assist S-Corporation by moving to a temporarily limited processing regime with entities. Taxpayers should assess the ability to choose to calculate subpart F and GILTI using entity treatment, weighing the cons and pros of that choice. Also, clarifying the life of the QIP can benefit multinational taxpayers. Taxpayers can retrospectively apply the rules of the QIP and the choice of treatment by the business entity and must consider whether they should do so in the correct returns.


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