S corporations: planning for FTCs.

The increasingly global marketplace has caused many U.S. corporations-including electing S corporations--to establish sales, marketing and manufacturing operations in various foreign jurisdictions. As these activities generally subject the U.S. taxpayer to foreign taxation, the U.S. foreign tax credit (FTC) mechanism plays an important role in avoiding double taxation. Limitations placed on S corporations' use of FTCs make it especially important to carefully plan an S corporation's expansion into the global marketplace.

There are a number of constraints applying to S corporations that may help determine the appropriate foreign structure. An S corporation cannot own 80% or more of another corporation (Sec. 1361(b)). Additionally, an S corporation, unlike a regular corporation, is not entitled to deduct or claim foreign taxes as a credit. Any foreign income taxes directly paid by an S corporation (such as withholding or branch taxes) are passed through to the shareholders who can either elect to deduct the taxes or claim the amounts as an FTC on their individual returns (Secs. 1363(c)(2)(B), 1366(a)i)) and 1373, and Regs. Sec. 1.702-1(a)(6)). The shareholder combines the foreign taxes passed through from the S corporation with other available FTCs. The shareholder may elect to claim the credit on an accrual basis even though the taxpayer is on the cash basis of accounting (Regs. Sec. 1.905-1).

An even more important limitation is that an S corporation cannot pass through so-called "deemed paid" FTCs under Sec. 902. When a dividend is received from a foreign corporation, a domestic C corporation may claim an FTC to the extent of the underlying foreign taxes paid by the foreign corporation on the earnings that gave rise to the dividend (Sec. 902). Deemed paid credits are not available to noncorporate taxpayers.

Sec. 1373 specifically provides that an S corporation is treated as a partnership for purposes of the FTC, subpart F and international boycott provisions, and that S shareholders will be treated as partners of such partnerships. Partnerships are not entitled to claim FTC and only foreign taxes directly paid by the partnership flow through to the partners (Sec. 702(a)(6)).

The fact that an S corporation or its shareholders cannot take advantage of the deemed paid FTC will greatly influence the manner in which an S corporation structures its foreign operations. The establishment of a foreign corporation owned directly by the shareholders of the S corporation or, alternatively, owned 79% by the S corporation and 21% by the shareholders will not be tax effective due to the lack of deemed paid FTCs.

The simple alternative would be for the S corporation to establish a branch in a foreign country. Any foreign taxes paid by the branch would flow through the S corporation to the shareholders. However, in many cases, a greater foreign presence than a branch is necessary in order for the corporation to effectively compete in the foreign marketplace or alternatively to seek limited liability protection in the foreign country.

Another possible alternative is the use of a hybrid entity owned by the S corporation that would be treated as a corporation for foreign purposes yet be treated as a partnership for U.S. tax purposes. The use of the hybrid entity could achieve the limited liability protection and corporate status needed in order to effectively compete in the foreign marketplace, yet provide the S shareholders with an FTC for the taxes paid by the foreign entity. In addition, the ownership of such a foreign entity could exceed 79% without causing the loss of S status.

A number of rulings have been issued dealing with the classification for U.S. tax purposes of certain hybrid entities, including entities established in Germany, the United Kingdom and France. These entities are considered hybrids because incorporation documents and the laws under which they are established are flexible enough to limit corporate characteristics.

In determining whether an entity is a partnership or corporation for U.S. tax purposes, the IRS applies the definition found in the Sec. 7701 regulations. Regs. Sec. 301.7701-2(a)(1) defines a corporation as having six characteristics, including having associates, an objective to carry on a business for joint profit, continuity of life, centralization of management, limited liability and free transferability of interests. An entity will be treated as a corporation if it possesses more than half of these characteristics (Regs. Sec. 301.7701-2(a)(3)). However, because having associates and the objective to carry on a business for joint profit are common to both partnership and corporate entities, these characteristics are ignored and the organization must possess three of the four remaining characteristics to be treated as a corporation. Therefore, if at least two of the remaining characteristics are not present, the entity will be treated as a partnership for U.S. tax purposes, regardless of whether the entity is treated as a corporation under foreign law.

It is also important that the foreign entity possess at least two "partners." For example, 95% of the entity could be held directly by the S corporation and 5% directly by its shareholders. When there is only one S shareholder, the classification of the foreign entity as a partnership may be more difficult, the Service could conceivably treat the S corporation and the shareholder as one person for this purpose. In this situation, it may be important to have a percentage of the entity owned by another party.

The IRS has ruled that a German GmbH (German unincorporated entity) qualified as a partnership for U.S. tax purposes when its incorporation documents included restrictions on transferability of interests and continuity of life (Letter Ruling 901009.81. The Service has also held that limited and unlimited liability U.K. corporations may also be treated as partnerships for U.S. tax purposes (Letter Rulings 9002056 and 91320541.

It is also important to note that the IRS has attempted to limit the importance (at least with respect to limited liability entities) of restrictions placed on transferability of interests and limited life when the entity is ultimately owned by a common U.S. shareholder. In Rev. Rul. 77-214, the Service applied this so-called single economic interest theory to determine that an entity that was 100% owned by a common U.S. shareholder was not treated as a partnership even though the entity's incorporation documents provided for restrictions on transferability of interests and limited life. However, other rulings and cases (e.g., MCA, Inc. 685 F2d 1099 (9th Cir. 1982)) have provided that it should be possible to avoid this argument if at least 5% of the foreign entity is owned by a person with a separate and distinct economic interest from that of the principal shareholder. (Indications are that the IRS may be reconsidering Rev. Rul. 77-214 and its application of the single economic interest theory.)

In summary, the establishment of a full-fledged foreign entity with limited liability and corporate status for local marketing and business purposes may be possible without adversely affecting either a corporation's S status or the ultimate tax burden on the S shareholders.

From Simon L. Beaumont, CPA, Boston, Mass.