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Dual resident taxpayers as S corporation shareholders.

The IRS recently issued Prop. Regs. Sec. 301.7701(b)-7 concerning resident alien S shareholders who elect to be taxed as nonresidents under an income tax treaty. The proposed rules could adversely affect all shareholders of an S corporation with one or more dual resident shareholders.' The regulations are proposed to be effective for tax years of S corporations beginning after July 27, 1992. Further, they would have retroactive effect on electing shareholders for earlier tax years.

Under the proposed rules, if a resident alien shareholder of an S corporation elects to be taxed as a nonresident alien under a treaty "tiebreaker" provision, the corporation's status as an S corporation will terminate, unless --the nonresident alien shareholder agees to be taxed on the income earned through the S corporation, and--the S corporation agrees to withhold on amounts attributable to the nonresident alien shareholder.

Specifically, such shareholders would be required to either waive treaty benefits and file amended returns as U.S. residents or to take into account their share of the S corporation's income for such prior years as effectively connected income.

Most U.S. income tax treaties contain a "tiebreaker" provision that determines the country of residence of an individual who is a resident of both countries under their respective domestic laws. Under U.S. laws, a resident alien who claims to be a nonresident of the United States under a treaty tiebreaker provision is treated as a nonresident for computing his U.S. Federal income tax liability (Prop. Regs. Sec. 301.7701(b)-7(a)(4)(iii)). For all other purposes, however, the individual is treated as a U.S. resident (Prop. Regs. Sec. 301.7701(b)-7(a)(4)(ii)). For instance, the individual would be a U.S. shareholder for determining whether a foreign company is a controlled foreign corporation, which could subject U.S. shareholders to tax. The individual may also have to comply with certain U.S. shareholder reporting requirements, The existing regulations are silent on the treatment of dual resident S shareholders.

Using this rationale, a dual resident claiming nonresident status under a treaty should be considered to be a U.S. person for determining whether a company can qualify as an S corporation vis-avis other U.S. shareholders, although the individual is taxed as a nonresident. It is further arguable that a dual resident taxed as a nonresident under a treaty should be subject to tax on the S corporation's earnings under look-through principles (see Sec. 1366(b)). On the other hand, Sec. 1361(b) prohibits an S corporation from having nonresident alien shareholders. In addition, there is no applicable withholding provision that would specifically apply to require S corporations to withhold on amounts attributable to nonresident aliens.

Under Prop. Regs. Sec. 301.7701(b)-7(a)(4)(iiv), S shareholders who elect to be taxed as nonresidents must agree to be taxed as if they were engaged in the S corporation's trade or business through a permanent establishment. The character and source of the income included in the nonresident's income will be determined as if earned by the nonresident engaged in such activities directly. Further, the S corporation must agree to withhold quarterly on the nonresident's pro rata share of effectively connected income as if the S corporation were a foreign partnership subject to rules similar to those contained in Sec. 1446. The failure of either party to enter into this agreement will cause termination of the corporation's S election. As a result, the S corporation's income will be taxed at the corporate level and all the shareholders will be subject to tax on distributions.

The electing shareholder will also be taxed on the disposition of the S stock as if he had disposed of an interest in a partnership. Thus, if all the S corporation's income is attributable to a U.S. business, all the shareholder's gain will be effectively connected income under Rev. Rul. 91-32.

A resident alien who could use a treaty tiebreaker to claim nonresident status, but who does not claim this treaty benefit, is considered a U.S. person for purposes of Sec. 1361(b) and does not have to take any action.

These rules are proposed to be effective for S tax years beginning after July 27, 1992. They are also proposed to have retroactive effect on electing shareholders (but not S corporations) for S tax years beginning before this date. They would require a resident alien who claims or claimed to be a nonresident under a treaty for a prior year to either waive his treaty benefits and file an amended return as a U.S. resident or determine the pro rata share of S corporation items in a manner consistent with Sec. 1366 and take those amounts into income. Following the proposed rules will be considered to be taking such income into account in a manner consistent with Sec. 1366.

From Richard A. Gordon, Esq., and Diane L. Renfroe, Esq., Washington, D.C.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Gordon, Richard A.
Publication:The Tax Adviser
Date:Nov 1, 1992
Words:831
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