What is an S Corp?
Some people set up offshore LLCs and foreign trusts to protect their ownership in a U.S.-based business. Most small businesses, whether they be corporations or limited liability companies, are arranged to be taxed as subchapter S corporations, or “S corps.”
The advantages of S corp taxation include:
- The ability to flow through expenses as tax deductions
- The ability to limit the amount of profit and distributions subject to employment taxation.
An LLC that is taxed as an S corp is still an LLC—it is only treated as an S corp for tax purposes.
Foreign Ownership of S Corps
Sometimes asset protection planning calls for a person’s small business to be owned by an offshore trust. There are tax issues, however, when that small business is taxed as an S corp.
Two IRS rules are relevant. First is the IRS rule that offshore trusts are considered “grantor trusts” for U.S. income tax purposes. A grantor trust is disregarded for tax purposes so that all income and losses flow through to the grantor or trustmaker. If you set up a grantor trust, then you, individually, are the taxpayer. S corp stock may be owned by individuals, and normally, S corp stock may be owned by a grantor trust with certain provisions included.
However, there is also an IRS rule that S corp stock may not be held by a foreign entity.
So the question then is whether S corp stock may be owned by a foreign trust taxable as a “grantor trust,” considering the IRS rules that (1) grantor trusts may own S corp stock and (2) foreign entities may not hold S corp stock.
Foreign Ownership Rule Trumps Grantor Trust Rule
The answer is that a foreign trust may not own S corp stock regardless of how the trust is taxed for income tax purposes. The prohibition against holding S corp interests in a foreign entity takes precedence over the foreign trust’s taxation as a grantor trust.
Therefore, one way for a debtor to protect business ownership in a foreign trust is for the company to convert to a C corp or to a partnership. The conversion to a limited partnership is simple, but there could be negative tax consequences for some companies and conversion should not be done without prior consultation with a tax professional.
Offshore LLC Option
Another option is to alter the asset protection plan so that the S corp is held by a foreign LLC rather than an offshore trust. Typically this is a Nevis LLC.
S corp stock can be owned by a Nevis LLC when there is only one owner of the Nevis LLC. That’s because single-member LLCs are disregarded for tax purposes. The result is that the sole owner of the Nevis LLC would be treated as the owner of the S Corp. The S corp stock would therefore be owned by a qualifying individual for tax purposes.
The problem with this option is that a single-member LLC does not provide effective asset protection in Florida. There is a Florida case that permitted collection remedies against a judgment debtor’s LLC interest in a single-member Nevis LLC. The court decided that the LLC interests were subject to U.S. collection remedies because the LLC interests are deemed to be located in Florida where the debtor resides even though the LLC was formed and is maintained in another country. Courts in other states have reached the opposite conclusion, so the law remains unsettled.
Adding a second member to an LLC usually affords better asset protection because a creditor’s remedies against a multi-member LLC are limited by statute to a charging lien against LLC distributions if any. A multi-member Nevis LLC must be taxed as a corporation or partnership. These entities are not eligible S corp stock owners.
Also, if the S corp stock were held by a single-member Nevis LLC, with the single-member being an offshore trust, then the stock would be deemed owned by the foreign trust, which is an impermissible owner. Therefore, you cannot have S corp stock owned by a Nevis LLC where the LLC is owned by an offshore trust.
Domestic Asset Protection Trust Alternative
A business owner could use a domestic asset protection trust (DAPT) to hold S corp stock.
Some states have statutes that expressly protect assets owned by a self-settled irrevocable trust for the benefit of the trustmaker. Nevada, Utah, Alaska, and Delaware are among the most well-known DAPT states.
A trust could be drafted as a grantor trust so that the trust is disregarded for taxation purposes, and the trustmaker would be considered the owner of S corp stock owned by the trust.
The rules against S corp ownership by foreign trusts do not apply to a DAPT. However, there are some Florida court rulings that may limit the asset protection benefit of a DAPT for Florida residents, particularly if the assets of the DAPT are not clearly located in the DAPT state.
Businesses are commonly taxed as S corporations because the ownership type offers a corporate shield and income tax advantages. Yet S corp taxation presents barriers to asset protection planning with offshore entities. Solutions are best derived through joint efforts of asset protection attorneys and tax professionals.