Part 25 – Reflections on the "S Corporation" exemption to the Sec. 965 @USTransitionTax – Hat Tip to @SCorpAssn

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Beginnings …

A recent comment at the Isaac Brock Society includes:

It’s too bad I didn’t put my Canadian corporation in an S Corp before I knew I was a US taxpayer. I must have misplaced my crystal ball at the time. As I had when I sold my house in Canada.
What a clusterfu@k!

On November 15, 2018 I did a second interview (first interview October 16, 2018 here) with Monte Silver and his Sec. 965 advocacy. The video was featured on a post at CitizenshipTaxation.ca.

If you have not watched the November 15 interview, I suggest that you begin by watching the video (click on the above tweet). The most significant part of the interview is where Sec. 965(I) is discussed. Interestingly Sec. 965(I) provides a transition tax exemption to individuals who are the shareholders of an “S Corp”. To understand the mechanism for the exemption, click on the link in the following tweet:

This interesting exemption is available only to individuals who are shareholders of S corporations and not to other individuals. The interview also included some discussion of the fact that “S Corp” shareholders have the benefit of lobbying from a powerful lobbying association – S-Corp. The interview ended with Monte Silver describing the probability that the Sec. 965 transition tax issue is headed to the courts.

But, in the “Pay To Play Casino” that America has become:

Why are individuals who are the shareholders of an S corporation, which owns the shares of a CFC, more equal than those individual shareholders who own the shares of a CFC directly?

Let’s see …

Purpose of this post …

The purpose of this post is to explore the following issues/questions:

1. What exactly is an S Corporation?
2. How the requirements of an S Corporation reflect that that S Corps are the “small business corps” of America
3. How the S Corporation is taxed and why that taxation is consistent with the S Corporation as an entity for small business
4. An interesting history of the S Corporation
5. Why most Americans abroad are like most small business owners in America (and presumably should have similar tax treatment)
6. How the S-Corp association lobbying in DC has likely resulted in favourable “transition tax” treatment for S-Corps
7. The argument that – with respect to the “transition tax” that Americans abroad with small businesses should be treated the same way as shareholders of U.S. S-Corps
8. Should Americans abroad who don’t renounce U.S. citizenship consider using U.S. Corps to own and operate their businesses abroad?

1. What exactly is an S Corporation?

An “S corporation” is a corporation which elects a specific kind of tax treatment under the Internal Revenue Code. It is NOT a type of corporation. Rather it is the “tax treatment” used by a corporation. (A corporation can be incorporated in any state.)

The following tweet referencing an excellent article from Wolters Kluwer explain this point.

The first thing to remember is that an S corporation is simply a for-profit corporation that elected to be taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes. It is incorporated under and governed by the same state corporation laws as a corporation that was not eligible for S corporation tax status or whose shareholders chose not to elect that status. Therefore, an S corporation has the same non-tax advantages as a regular corporation. (A regular corporation is also referred to as a C corporation when discussing its tax status because it is taxed under Subchapter C of the Internal Revenue Code).

Because an S Corporation is a corporation with a specific kind of tax treatment (the profits are passed through to the shareholders), one can say that an S Corporation is really a creation of the Internal Revenue Code (On The Third Day Congress Created The S Corporation).

2. How the requirements of an S Corporation reflect that that S Corps are the “small business corps” of America

Since the S Corporation is a creation of the Internal Revenue Code, we look to the Internal Revenue Code to learn the requirements to be an S Corporation. The S Corporation is defined in Internal Revenue Code Sec 1361.

Section 1361 includes:

(a) S corporation defined

(1) In general
For purposes of this title, the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect for such year.
(2) C corporation
For purposes of this title, the term “C corporation” means, with respect to any taxable year, a corporation which is not an S corporation for such year.
(b) Small business corporation
(1) In generalFor purposes of this subchapter, the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not—
(A) have more than 100 shareholders,
(B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual,
(C) have a nonresident alien as a shareholder, and
(D) have more than 1 class of stock.

(Interestingly this sounds very much like the requirements to be a Canadian Controlled Private Corporation in Canada. Note also that most Canadian Controlled Private Corporations are “per se” corporations under the entity classification rules and cannot be treated as disregarded entities under U.S. tax law.)

It is clear that this does not and could not describe a large publicly traded corporation like Google or Apple. Notice also that S Corporation shareholders cannot include nonresident aliens.
An S Corporation is designed to provide the corporate benefits of limited liability coupled with the simplicity and tax benefits of being taxed as an individual.

3. How the S Corporation is taxed and why that taxation is consistent with the S Corporation as an entity for small business

To put it simply:

An S Corporation is a “pass through” entity. The profits (passive income excepted) of the corporation are taxed directly to the individual. This has the effects of:

– avoiding double corporate taxation (the profits are taxed only once instead of first at the corporate level and second at the individual level);
– making the S Corporation a bad vehicle for the accumulation of income for expansion, etc. (but the devil is always in the details)

From the IRS perspective:

This is very reasonable and reflects that an S Corporation is really more like an individual than an Apple or a Google. It is reflected by the following history of the S Corporation

4. An interesting history of the S Corporation

At S-Corp.org, the S Corporation Association of provides an interesting history of the origins and evolution of the S Corporation which includes:

The History and Challenges of America’s Dominant Business Structure
Before Congress created S corporations, entrepreneurs had two choices when starting a business. They could form a regular C corporation, enjoy liability protection, but face two layers of federal tax at the corporate and individual level. Or they could choose a partnership or sole proprietorship, enjoy a single layer of taxation at the individual level, but sacrifice the umbrella of liability protection.

Neither choice was optimal for small and family owned businesses. In 1946, the Department of Treasury suggested a third option – merging a single layer of federal tax with comprehensive liability protection.
A few years later, Republican President Dwight Eisenhower found himself under fire from the Democratic Congress for practicing “trickle-down economics” and favoring big corporate interests over the little guy.
At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.

In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items. In exchange for enjoying a single layer of tax, entrepreneurs electing S corporation status agreed to the following limitations:

They were required to be a domestic enterprise;

They were required to have a limited number of shareholders;

They were limited by who those shareholders could be; and

They could have just one class of stock.

You can continue and read more history here …

5. Why most Americans abroad are like most small business owners in America (and presumably should have similar tax treatment from a U.S. perspective)

It’s simple. The vast majority of Americans abroad who carry on business through Canadian Controlled Private Corporations (and similarly situated Americans living in other countries) are small business people. They are people who are simply trying to make a living. As described in a recent article from American Citizens Abroad:

“Treasury is not truly in touch with the reality of Americans abroad. Foreign corporations owned by Americans abroad exist in abundance. They are an everyday fact of life,” added Serrato.

ACA believes that it is fundamentally wrong for the Treasury Department to write regulations without knowing who is affected, and to what extent, as this goes against the fundamental requirements of the RFA.

The point is that small business people are the same inside the United States and outside the United States. The single most important characteristic is that from an economic perspective the corporation is a structure that is generally created to achieve limited liability or some other local benefit.

6. How the S-Corp association lobbying in DC has likely resulted in favourable “transition tax” treatment for S-Corps

I tip my hat to the S Corporation America. I have NO DOUBT that their lobbying and organization secured a “transition tax exemption” for S Corporations.

It is interesting to note that:

1. The individual shareholders of S Corporations were fully aware of the benefits of tax deferral by using the S Corporation as the shareholder of a CFC:

2. In its 2013 submission to the House Ways and Means Committee the S Corp association argued clearly and forcefully that the individual shareholders of S corporations should be exempt from the transition/repatriation tax:

(The same two arguments for why individual shareholders of S Corporations should have have been exempted from the transition/repatriation tax apply to ALL individuals including individuals living outside the United States.)

The complete S Corp Association submission to the Ways and Means Committee is here:

S_Corporation_Association_WG_Comment_2

7. The argument that – with respect to the “transition tax” that Americans abroad with small businesses should be treated the same way as shareholders of U.S. S-Corps

In the interview with Monte Silver we both agreed with the argument that:

(i) S Corporations are legally corporations but really business entities which are used by individuals who are operating small businesses. (the IRS requirements to qualify as an S Corporation reinforce this.) The S Corporation for practical purposes IS the individual.

(ii) Sec. 965(I) creates a transition tax exemption for S Corporations – and therefore is creating a transition tax exemption for individuals who have decided to create an S Corporation (but remain taxed as individuals).

(iii) If the principle is that individuals should be subject to the transition tax then creating an S Corporation should NOT justify a transition tax exemption for individuals.

(iv) If the principle is that individuals should be exempt from the transition tax then ALL individuals (including Americans abroad) should be exempt from the transition tax even if they are individuals who use an S Corporation.

(v) Individuals in general should be treated the same whether they form an S Corporation or not.

(vi) In conclusion: Since individuals who form S Corporations are exempt from the Sec. 965 transition tax then individuals who live outside of American and have small business corporations should be exempt from the Sec. 965 transition tax.

8. Should Americans abroad who don’t renounce U.S. citizenship consider using U.S. Corps to own and operate their businesses abroad?

Think of it! In order to protect themselves from the U.S. Government Americans abroad might consider (1) creating an S Corporation and then (2) creating a foreign corporation (local to the shareholder) to run his business. Sounds totally crazy! But, it might be worth considering for a simple reason:

Congress does not care about Americans abroad and does not care that it doesn’t care!

Congress does listen to the S Corporation Association of America!

Legislation in America (as Conrad Black once said) is: A pay to play casino.

Practically speaking, what should those Americans Abroad with neither representation nor lobbying do?

John Richardson Follow me on Twitter @Expatriationlaw

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