Regulations on Dual Resident Shareholders of S Corporations

Article excerpt

Until recently, it was unclear whether the IRS would permit certain "dual resident" individuals to use sub-chapter S to avoid federal taxation of income from U.S. business operations. In April, the IRS proposed regulations that address this issue.

Generally speaking, a dual resident individual is a U.S. resident alien for federal income tax purposes under the IRC, who qualifies as a U.S. non-resident under a "tie-breaker" provision in a tax treaty. Tie-breaker provisions, which are included in most U.S. income tax treaties, provide rules that treat an individual who is a resident of both treaty countries under their respective internal laws as a resident of only one of the countries for purposes of determining eligibility for treaty benefits. If a dual resident individual could qualify as a U.S. non-resident under such a provision while being treated as a U.S. resident for purposes of IRC Sec. 1361(b)(1)(C) (which disallows subchapter S status for any corporation that has a non-resident alien as a shareholder), his or her share of the income of an S corporation that conducted business in the U.S. night escape federal taxation.

The new proposed regulations provide that a dual resident individual who claims any treaty benefit as a U.S. nonresident shall generally be treated as a U.S. nonresident for purposes of Sec. 1361(b)(1)(C). Thus, under Prop. Reg. sec. 301.7701(b)-7(a)(4)(iii), if such an individual is a shareholder in an S corporation for any portion of a taxable year for which a treaty benefit is claimed, the corporation's subchapter S election will be terminated. According to this proposed regulation, such a termination will be effective as of the first day of the taxable year of the dual resident in which he or she is a shareholder of the corporation and claims treaty benefits as a U.S. nonresident

A WAY OUT

Prop. Reg. Sec. 301.7701 (b)-7(a)(4) (iv) provides a special exception. To qualify for this exception, the following conditions, stated broadly, must be satisfied:

1. The S corporation in question must not have been a C corporation or a direct or indirect successor to a corporation that at any time was a C corporation.

2. For purposes of determining federal income tax liability, the character and source of subchapter S items included in the dual resident's income must be determined as though the items had been realized by the dual resident (i.e., in accordance with the usual treatment applicable to S corporation shareholders).

3. The dual resident shall be considered as carrying on business through a U.S. permanent establishment if the business of the S corporation is so carried on. …