Dual resident taxpayers as S corporation shareholders.

• Author: Gordon, Richard A.

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...