REQUEST LETTER

02-033

 

NAME

ADDRESS

 

Re: Taxpayer: COMPANY

FEIN: ######

FYE: DATE

 

Dear TAXPAYER REP:

 

I am writing to request permission for COMPANY, an S Corporation that we represent, to withhold and remit income tax on behalf of its "non-resident" Electing Small Business Trust (ESBT) shareholders, thereby relieving the non-resident ESBT shareholders of filing separate income tax returns with respect of their Utah share of the S Corporation income.

 

Effective January 1, 2002, COMPANY elected to be treated as an S Corporation for federal income tax purposes. COMPANY has over 60 shareholders, each of whom are ESBTs. Prior to the S election, COMPANY filed corporate income tax returns in Utah. As Utah respects the federal S election, COMPANY will begin to file as an S Corporation in Utah for the 2002 tax year.

 

Permitting COMPANY to withholding and remit income tax on behalf of its "non-resident" ESBT shareholders will provide the following:

 

·Ease administration for the state;

·Ensure compliance with Utah's income tax laws, even where a

de minimis amount of tax would be due from any single shareholder;

·Simplify any potential audit; and

·Ensure that the appropriate tax is remitted to the state of Utah on

behalf of all of COMPANY shareholders.

 

I.                    BACKGROUND

 

Most often, trusts are formed to own income-producing assets. In many cases, trusts are formed to provide an income stream to beneficiaries while maintaining a protection of those assets within the trust. As a result, many trusts own stock in C Corporations that produce dividend income. Income earned by C Corporations owned by a trust is subject to two levels of income tax. One tax is at the C Corporation level and the other is a tax to the trust or beneficiary on dividend distributions.

 

Prior to 1996, for federal income tax purposes, the opportunity for a trust to be a shareholder in an S Corporation was highly restricted. The Small Business Job Protection Act of 1996 ("1996 Act") was passed to allow more flexibility in the types of trusts that are permitted to be S Corporation shareholders. In general, the 1996 Act permitted an electing trust, known as an Electing Small Business Trust ("ESBT"), to own shares in an S Corporation. As a result of the 1996 Act, a C Corporation that was owned by ESBTs could make an S election. The income of the corporation would then only be subject to one level of tax (i.e., at the shareholder level).

 

Under Internal Revenue Code (IRC") § 1361(e)(1), an ESBT is any trust if:

(1)               The trust does not have as a beneficiary any person other than

an individual, an estate or certain charitable organizations;

(2)               no interest in the trust was acquired by purchase; and

(3)               an election has been made by the trustee to be classified as an ESBT.

 

An ESBT that owns shares in an S Corporation may own assets in addition to the S Corporation stock. For purposes of computing its federal taxable income, however, an ESBT owning assets other than S Corporation stock is treated as two separate trusts albeit filing a single federal tax return. See Treasury Regulation § 1-641(c)-1. One trust, consisting of the S Corporation stock ownership (the "S" portion), is accounted for and taxed solely at the trust entity level. The trust is not allowed an income distribution deduction for the S Corporation portion irrespective of whether distributions have been made to the trust beneficiaries. The S portion income is taxed at the trust level and will be subject to the minimum tax rate. The second trust (the "non-S portion") is subject to the basic fiduciary income tax rules. Federal and state taxation of ESBTs is discussed in more detail in the attached appendix.

 

An ESBT is not structured to avoid state income tax. As distinguished from other trusts, the ESBT itself is the taxpayer on the S portion of the income. Although an ESBT is not an individual, an ESBT shareholder has many of the tax attributes of an individual that owns shares in an S Corporation. As with individual shareholders, an ESBT shareholder has a separate tax identification number, includes in income its pro rata share of the S Corporation income, and pays tax at the trust level on its distributive share. Thus, it is appropriate to treat an ESBT shareholder in the same manner as an individual shareholder for purposes of being included in a composite return.

 

II.                 FACTS

 

Effective January 1, 2002, COMPANY, a C Corporation 100% owned by over 60 trusts, elected to be treated as an S Corporation. Each of its trusts has made an election to be classified as an ESBT. These trusts have been shareholders of COMPANY since 1997.

 

The ESBTs are all residents of STATE. The ESBTs have income both from COMPANY(the S portion) as well as from other sources (the non-S portion). CORPORATION is commercially domiciled in STATE and does business within Utah and 41 other states.

 

III.               ANALYSIS

 

COMPANY hereby requests Utah's guidance regarding the issues set forth in subsection V of this request. Our examination of the Utah statues and regulations reveals the following:

 

Taxation of ESBTs

 

There are no statutory provisions, regulatory provisions or form instructions addressing Utah's taxation of ESBTs. A nonresident trust's income derived from Utah sources is subject to tax at the same rates applicable to individuals filing separately. Utah Code Ann. § 59-10-205. The highest individual marginal tax rate is 7%. Utah Code Ann §59-10-104(1),(2). Utah taxable income of a nonresident trust is its federal taxable income, as defined in I.R.C. § 641(a) and (b), derived from Utah sources, with certain modifications. Utah Code Ann §§ 59-10-204, 59-10-201.1. Income derived from Utah sources includes the nonresident trust's share of income gain, loss, and deduction derived from or connected with Utah sources as allocated among the trust and its beneficiaries in proportion to their respective shares of federal distributable net income. Utah Code Ann. §§59-10-117(2)(h), 59-10-207(1)(b). Shareholders of an S corporation determine income derived from Utah sources by including their distributive share of income gain, loss, and apportionment. Utah Code Ann §§59-10-204, 59-10-117(2)(d), 59-10-118.

 

Withholding Requirements

 

Utah statutes and regulations do not contain authority expressly permitting a composite return. However, S corporations are required to withhold and remit tax on nonresident shareholders' shares of the corporation's income apportioned to Utah at the rate of 7%. Utah Code Ann §59-7-703(1)(a), (2); Instructions to 2001 Form TC-20S, S Corporation Franchise or Income Tax Return, p. 9; Utah Admin. R 865-9I-13. A "nonresident shareholder" is defined to include a nonresident trust. Utah Code Ann. § 59-7-101(18). A nonresident individual shareholder is entitled to a credit on the Utah individual return for the amount of tax paid by the S corporation on behalf of the nonresident shareholder. Id at (1)(b),

 

Under Utah statues and regulations, S Corporations may, or may be required, to withhold tax at the S Corporation level on income distributable to individual shareholders. If tax is withheld by the S Corporation, only a nonresident shareholder that is an individual and that has no other Utah source income may forego filing a Utah individual income tax return. Utah Code Ann. §59-7-703(1)(c); Utah S Corporation Franchise or Income Tax return and Instructions (Form TC-20S), p. 9. Though there are no statutes, regulations, or form instructions indicating whether a nonresident shareholder that is a trust and that has no other Utah source income may forgo filing a Utah fiduciary return, it is important to point out that an ESBT shareholder has many of the tax attributes of an individual that owns shares in an S Corporation. As with individual shareholders, an ESBT shareholder has a separate tax identification number, includes in income its pro rata share of the S corporation income, and pays tax at the trust level on its distributive share. Thus it is appropriate to treat an ESBT shareholder in the same manner as an individual shareholder for purposes of reporting the income at the S Corporation level. If the tax is withheld at the S Corporation level on behalf of the ESBT shareholders, its appears that the trusts' income tax filing responsibilities would be extinguished under this election.

 

IV.              BENEFIT TO STATE

 

The Utah State Tax Commission's permission for COMPANY to withhold and remit tax on behalf of its' ESBT shareholders would result in several benefits for the shareholders and for the state, including the following:

 

·Reduce administrative burden of the state: result in a single filing by COMPANY as compared to over 60 trust returns that would be filed and would need to be processed by the Utah State Tax Commission.

 

·Ensure compliance and payment of the proper payment of tax.

 

°Absent a single filing by COMPANY, a taxpayer that

is subject to a de minimis amount of state tax may be inclined to not file a return due to the administrative burden associated with filing multiple returns.

°Accumulation of COMPANY income apportioned

to the state of Utah in one filling will permit the state to ensure full inclusion of all shareholders, correct calculation of tax and proper remittance thereof.

°Eliminate the necessity for K-1 tracking/matching.

 

· Ease of audit – the state will be able to audit COMPANY

filing and ensure that the proper tax was paid and remitted to the state. This will relieve the state of auditing each trust.

 

·Relieve the compliance burden of the shareholders. Each of the ESBTs may be required to file in each of the 42 states, including Utah, in which COMPANY does business. This could result in a requirement to prepare over 3,000 separate state tax returns.

 

V.                 RELIEF REQUESTED

 

COMPANY respectfully requests that Utah:

 

A.    Permit COMPANY to withhold and remit tax on behalf of its ESBT shareholders for the portion of the ESBTs' allocable share of income from COMPANY; and

 

B.     Relieve the ESBTs from filing separate income tax returns with respect to their S Corporation income if COMPANY files on their behalf.

 

Please confirm that if COMPANY is permitted to withhold and remit tax on behalf of its ESBST shareholders, that Utah Form TC-20S (S Corporation Franchise or Income Tax Return) should be used.

 

If withholding on behalf of the ESBT shareholders is permitted, but such withholding does not relieve the ESBTs from having to file separate income tax returns, we request that Utah permit another method of filing that would relieve the ESBTs from having to file separate trust returns, e.g., permitting COMPANY to file one composite return on behalf of all of its ESBT shareholders, thereby relieving the ESBT shareholders from Utah filing requirements on income from the S Corporation.

 

Please do not hesitate to contact me with any questions or further information at PHONE.

 

NAME

TITLE

 

Cc: NAME

 

APPENDIX

 

I.                    DISCUSSION OF FEDERAL TAXATION OF ESBTs

 

A.    Taxation of Trusts

 

Irrevocable trusts are characterized, for tax purposes, as simple or complex trusts. A trust is considered simple if all income is required to be distributed under the terms of the trust instrument. Complex trusts are trusts that are not "simple" trusts. Trusts are quasi conduits for income tax purposes. To the extent income is distributed to the beneficiary, it is taxed to the beneficiary; to the extent income is not distributed, it is taxed to the trust. IRC § 641(b). The taxable income of a trust must be computed in the same manner as in the case of an individual, except as otherwise provided in the IRC. Id.

 

The most significant difference between a fiduciary return and an individual return is that the trust receives a deduction for a distribution to a beneficiary. The distribution deduction equals the sum of money required to be distributed currently and other amounts properly paid or credited for the taxable year but such deduction shall not exceed the distributable net income of the trust. IRC § 661(a).

 

IRC § 643 provides that the term "distributable net income" ("DNI") means with respect to any taxable year the taxable income of the trust with the following modifications: (a) no distribution deduction pursuant to IRC § 661(a) is permitted: (b) no deduction for personal exemptions pursuant to IRC § 642(b) is permitted; (c) capital gains and losses are excluded to the extent that such gains are allocated to corpus; and (d) other modifications are set forth in subsection (a) of IRC § 643. IRC § 643(a).

 

B.     Taxation of ESBTs

 

The non-S portion of an ESBT is subject to the normal rules of trust taxation set forth in subparts A through D of Subchapter J of the Internal Revenue Code, as summarized above. However, the S portion of an ESBT is subject to the special rules of IRS § 641(c). In computing the taxable income of the S portion of an ESBT, only the following items of income, loss, deduction, or credit are taken into account:

 

·Income, losses, deductions and credit allocated to the ESBT as a

shareholder;

·any gain or loss from the disposition of stock in an S Corporation;

and

·State or local income taxes or administrative expenses to the extent

allocable to the S Corporation items or ownership.

 

IRC § 641(c)(2)(C). With the exception of the maximum tax imposed on capital gains, the tax rate imposed on the S portion is the highest rate imposed under IRC § 1(e)(38.6% in 2002). IRC § 641(c)(2)(A).

 

In contrast to the non-S portion of an ESBT, the S portion is not allowed a deduction for distributions to beneficiaries even if distributions are made out of the S portion of the trust. IRC § 641)(c)(3)(B). thus, the income tax with respect to the S portion is always paid by the trust. S Corporation income is not reflected in DNI and thus cannot be reflected in the beneficiary's taxable income even if a distribution to the beneficiary is made during the year.

 

C.    Filing Requirements

 

An ESBT is required to file Form 1041 (U.S. Income Tax Return of Estates and Trusts). As with any other complex trust, the tax due from the non-S portion of the ESBT is typically computed on page 1 of Form 1041, resulting in "taxable income" reported on Line 22. However, the tax due from the S portion of the ESBT is required to be calculated on a separate schedule, not provided by the IRS, and the tax due, at the maximum tax rate, must be included in "total taxes" reported on Line 23 of page 1 of Form 1041. See Instructions to Form 1041, p. 6.

 

Accordingly, the federal taxable income of the ESBT as reported on Line 22 does not reflect the income of the S portion. In addition, as set forth above, the S portion is not afforded an income distribution deduction (Line 18). Lastly, the income or losses resulting from an ESBT's S portion are not combined with, or offset against, the income of loss of the ESBT's non-S portion are not combined with, or offset against, the income of loss of the ESBT's non-S portion.

 

II.                 DISCUSSION OF STATE TAXATION OF ESBTs

 

Due to the relative newness of ESBTs (1996 Act), most states have not specifically addressed ESBTs separate from normal trusts. Of the small number of states that do specifically address ESBTs to date, most of these states expressly adopt the federal treatment of ESBTs in taxing the S portion and the non-S portion (e.g., Alabama, California, Idaho, Indiana, Maine, Nebraska and Wisconsin). The remaining few states that address ESBTs tax them as normal trusts by combining the S portion and the Non-s portion in the state's base income (e.g. Illinois, Missouri, Iowa, Oregon and North Dakota.

 

Due to the fact that only a handful of states address ESBTs separate from normal trusts, most states have not addressed a situation in which a trust is capable of being a shareholder of an S Corporation. As a result, most states have not specifically addressed whether an S Corporation shareholder than is an ESBT may file as part of a composite return, whether such filing would relieve the ESBTs from separately filing a return (provided they had no other state source income), whether any tax paid through a composite return is paid on "behalf" of the ESBT's, and what forms should be used to effectuate the composite filing and composite estimated tax payments.

 

With respect to composite return availability, the states generally fall into four categories: (1) states that expressly permit the filing of a composite return by S Corporations on behalf of shareholders that are trusts and/or ESBTs (e.g., Alabama, Maine, Massachusetts, North Carolina, Oregon and South Carolina); (2) states that permit the filing of a composite return by S Corporations but expressly prohibit trust and/or ESBT shareholders in participating in the return (e.g., California); (3) states that permit the filing of a composite return on behalf of shareholders and the statutes and regulations do not specifically address whether or not an eligibility shareholder must be a natural person (e.g. Arizona, Colorado, Delaware and Idaho); and (4) those states whose statutes and regulations do not permit an S Corporation to file a composite return, regardless of what type of entity the shareholder is.

 

In states that permit a composite return to be filed on behalf of S Corporation shareholders, most of the states impose a limitation prohibiting a composite filing if the shareholder receives income from any other source within the state other than the S Corporation. A composite filing generally relieves the shareholders from filing separate returns within the state provided that the shareholder has no income taxable to the state other than its income from the S Corporation. Most state statutes and regulations further indicate that a composite return payment is made "on behalf" of the shareholder and is not considered to be a tax imposed on the S Corporation itself. However, it is unclear in several states whether the foregoing rules are applicable to shareholders that are trusts or ESBTs and not just shareholders that are natural persons. In addition, many of the forms and form instructions that address how to file the composite return are limited to individual income tax forms or use language applicable to natural persons.

 

 

RESPONSE LETTER

 

April 15, 2003

 

NAME

ADDRESS

 

RE: Private Letter Ruling – S Corporation Shareholder Filing Requirements

 

Dear NAME,

 

We have received a request for permission for COMPANY (“COMPANY”), an S Corporation, to withhold and remit income tax on behalf of its “nonresident” Electing Small Business Trust (ESBT) shareholders, thereby relieving the nonresident ESBT shareholders of filing separate income tax returns with respect to their share of the S Corporation income. Although the original request came from an accounting firm you had employed, you have asked us to respond to you directly.

 

Utah law requires an S Corporation to withhold and remit tax on behalf of any nonresident shareholders, including those who are nonresident trusts. Utah Code Ann. §§59-7-703(1)(a); 59-7-101(18). When withholding and remitting such taxes, COMPANY should use Utah State Tax Commission Form TC-20S, S Corporation Franchise or Income Tax Return, on which it would report the amount of income allocable to each of its nonresident shareholders.

 

Whether or not each of COMPANY ESBT shareholders must also file a separate income tax return, however, was not specifically addressed in Utah law until recently. The 2003 Legislature has passed and the Governor has signed into law House Bill 73 (“HB 73”), which amends UCA §59-7-703 so that nonresident S Corporation shareholders that have no other Utah source income may forego filing a Utah individual income tax return. Specifically, UCA §59-7-703(3)(a)(ii), as amended by HB 73, provides “if the nonresident shareholder has no other Utah source income, the nonresident shareholder may elect: (A) not to claim the credit provided under Subsection (3)(a)(i) and (B) not to file a return for the taxable year.” “Nonresident shareholder” includes nonresident trusts. UCA §59-7-101(19). Moreover, “return” is specifically defined to include returns filed under Chapter 10, so it expressly covers the returns that trusts would otherwise have to file. Thus, for years after the effective date of HB 73, ESBTs may clearly elect to forego filing a Utah return under the circumstances set forth in your letter.^[1]

 

We note that HB 73 has specific retrospective operation to taxable years beginning on or after DATE. Nevertheless, we believe the Legislature’s actions show its intent that ESBTs may forego filing individual tax returns under the circumstances and for the year set forth in your letter. Accordingly, COMPANY filing of the Form TC-20S on behalf of its nonresident shareholders will be deemed to satisfy any individual filing requirement that a nonresident ESBT with no other Utah source income might have otherwise had. Should you have any other questions, please contact us.

 

For the Commission,

 

 

 

Marc B. Johnson

Commissioner

 

MBJ/KC

02-033