PLANNING WITH ELECTING SMALL BUSINESS TRUSTS
Authors – Laura Howell-Smith, Director, Deloitte Tax LLP
Richard D. Blau, Snell & Wilmer, LLP
Portions of this article first appeared in the June 2007 issue of
Estate Planning and September 8, 2005 Tax Management
Estates, Gifts and Trusts Journal by Laura Howell-Smith.
Other portions of this article appear in S Corporations:
Federal Taxation §19:35 by Richard D. Blau, Bruce Lemons
and Thomas P. Rohman.
A. GENERAL RULES FOR AN ELECTING SMALL BUSINESS
TRUST
The requirements for an electing small business trust (“ESBT”) are
not as restrictive as those for a qualified subchapter S trust (“QSST”). For
example, an ESBT can have multiple beneficiaries and the trust income can
be accumulated and sprinkled among the multiple beneficiaries. As
provided by IRC section 1361(e), a trust is eligible to be an ESBT if it is a
domestic trust, and all beneficiaries are individuals, estates, or certain types
of charitable organizations. No beneficiary can acquire a trust interest by
purchase and the trustee must make a timely election under IRC section
1361(e). In addition, the trust cannot be a QSST that holds stock in a
corporation that is subject to the QSST election, an exempt trust, nor a
charitable remainder trust.
1. Potential Current Beneficiary
A concept that applies only to an ESBT and no other trust is the
concept of a “potential current beneficiary” (“PCB”). PCB means, with
respect to any period, any person who at any time during such period is
entitled to, or at the discretion of any person may receive, a distribution from
the principal or income of the trust. Therefore, a person who solely owns a
future or contingent trust interest will not be treated as PCB until the future
event occurs.1 For example, a person who holds a trust interest that does not
vest until after the death of another person is not a PCB. For taxable years
beginning after December 31, 2004, a person who could receive a trust
1
Treas. Reg. §1.1361-1(m)(4)(i) and (v).
distribution pursuant to a power of appointment will not be considered a
PCB until the power is exercised.
The significance of a PCB is that the PCB is treated as a shareholder
for purposes of determining the number of “eligible” shareholders and
whether the shareholder eligibility rules are met under IRC section 1361(b).
Therefore, a nonresident alien who may be a potential recipient, in any
period, of trust income or principal will disqualify the trust as an S
shareholder and will terminate the S election. If the number of PCBs causes
the number of shareholders to exceed the applicable allowable number of
shareholders,2 the trust will not qualify as an ESBT causing the termination
of the corporation‟s S election. If all or a portion of an ESBT is treated as
owned by a person under subpart E, such owner is a PCB in addition to other
trust beneficiaries meeting the PCB definition.3
If an ESBT disposes of all of the S corporation stock, then any person
treated as a PCB will not be treated as a PCB one year before the
disposition.4 (For tax years beginning before 2005, it is 60 days.)
Therefore, if an ESBT disposes of all the S corporation stock, the ESBT‟s
PCBs generally will not include anyone who became a PCB for the one-year
period preceding the disposition. For instance, if a nonresident alien became
a PCB mid-year, if the trustee disposed of all of the S corporation stock
before year-end, the nonresident alien would not be considered a PCB for
that year, the trust would not be ineligible, and the corporation‟s election to
be an S corporation would not terminate. If a person who is not qualified to
be an S corporation owner becomes a beneficiary of a trust which has a valid
ESBT election in effect, the trust has a one year period in which to dispose
of all its S corporation stock. If the trust does not dispose of the stock within
this one year window, the corporation‟s status as an S corporation will
terminate.
1.
ESBT Election
Unlike a QSST, in which the beneficiary must make the QSST
election, the ESBT election is made by the trustee of the ESBT. However,
the trustee must make the ESBT election within the same time constraints
For taxable years beginning after December 31, 2004, an S corporation can have up to 100 shareholders. In
addition, if a PCB or an income beneficiary of a QSST is a member of six generations of a family, the family is
treated as one shareholder for purposes of the number of shareholder rule as provided by Notice 2005-91,
2005-51 IRB 1164.
3 Treas. Reg. §1.1361-1(m)(4)((ii). In addition, note that a grantor trust may make an ESBT election.
4 IRC section 1361(e)((2).
2
imposed upon a QSST election in order for the election to be timely.5 If the
trust holds stock in more than one S corporation, the Trustee need make just
one election. The election applies to the taxable year for which the election
is made and all subsequent years unless it is revoked with the consent of the
IRS.6 If the election is being revoked because the trust wishes to convert to
a QSST, the IRS will automatically consent if certain requirements are met. 7
Upon the termination of an ESBT, the S corporation stock must be
immediately transferred to another qualified S corporation shareholder. If
the stock is transferred to a trust that is qualified to be a QSST, the trust‟s
beneficiary must make a timely QSST election (within 2 months and 15 days
after the trust becomes a shareholder) or the corporation‟s S status will
terminate.
If a corporation‟s election terminates or is invalid because of a late
ESBT election, the corporation and the trust may request inadvertent
termination or invalid election relief under a simplified method described in
Rev. Proc. 2003-43, 2004-1 C.B. 998 if applicable or under IRC section
1362(f) through a private letter ruling request.8
2.
Tax Treatment
An ESBT is treated as two separate share trusts for tax purposes, an S
portion that consists of all of the S corporation stock and a non-S portion
that consists of all other trust assets.9 If an ESBT is a partial grantor trust,
one can have three portions, the grantor portion, a non-grantor S-portion,
and a non-grantor non S portion. However, only the S-portion of the trust is
treated as the shareholder for taxable income, basis, and distributions
purposes under IRC sections 1366, 1367 and 1368. Any grantor portion of
an ESBT continues to be subject to the grantor tax rules under subpart E of
the Code.10
(a). Taxation of S Portion
The S portion of an ESBT is taxed as a separate trust the tax attributes
of which cannot be merged or commingled with the tax items of the non-S
Treas. Reg. §1.1361-1(m)(2).
Treas. Reg. §1.1361-1(m)(6).
7 Treas. Reg. §1.1361-1(m)(7).
8 Treas. Reg. §1.1361-1(j)(6)(iii)(E).
9 Treas. Reg. §1.641(c)-1(a).
10 Treas. Reg. §1.641(c)-1(c).
5
6
portion. The S portion takes into account the items of income, deductions,
gains, losses and credits reported to it on its S corporation schedule K-1.11
The S portion‟s pro rata share of S corporation‟s tax items will generally be
calculated on a per-share, per-day basis as provided under section 1377(a)(1)
for any shareholder unless an election to close the tax year has been made.
If state and local income taxes and administrative expenses relate to
both the S portion and the non-S portion, the expenses must be allocated on
a reasonable basis.12 Distributions to a trust beneficiary from either the S
portion or the non-S portion are includible in the beneficiary‟s gross estate
only to the extent of the distributable net income of the non-S portion.13
Accordingly, only the non-S portion will report any income distribution
deduction. The items of income, deduction, loss, and credit of the S portion
are excluded for purposes of determining distributable net income.
Once the ESBT election terminates or is revoked, the special taxation
rules no longer apply. If upon termination or revocation the S portion has a
net operating loss, a capital loss, or deduction in excess of income, then any
such loss, carryover, or excess deduction will be allowed as a deduction to
the now non-ESBT trust, if the trust continues, or to the beneficiaries
succeeding to the property of the trust if the ESBT terminates.
The regular subchapter J rules apply in determining the extent to
which any loss, deduction, or credit may be taken into account in
determining the taxable income of the S portion.
The S Portion will be taxed at the highest individual rate on all
ordinary income.14 Further, the S Portion will also be taxed on any gain or
loss on the S corporation stock if the trust disposes of the stock.15 Capital
gains will be taxed at individual rates. However, no deduction is allowed for
capital losses that exceed capital gain. Similar to the loss limitations for
individual shareholders, any operating losses may be limited by the S
portion‟s basis in S corporation stock, the at-risk rules and the passive loss
rules. If operating losses are not limited, the NOL may be carried to other
years and deducted against other income of the S Portion.16
The S portion‟s stock basis will be adjusted in the same manner as an
individual shareholder‟s stock basis so that it will be increased by income
Treas. Reg. §1.641(c)-1(d)(1) and (2).
Treas. Reg. §1.641(c)-1(d)(4)(i).
13 Treas. Reg. §1.641(c)-1(j).
14 Treas. Reg. §1.641(c)-1(e)(1).
15 Treas. Reg. §1.641(c)-1(d)(3)(i).
16 Treas. Reg. §1.1366-2(a)(4).
11
12
and decreased by deductions and distributions.17 If the trustee distributes
any S corporation stock to a beneficiary, the beneficiary will take the stock
at a carryover basis (its adjusted basis). Distributions to the trust from the S
corporation in excess of the S portion‟s stock basis will be taxed to the S
Portion as capital gain.18
If the S portion holds more than one S corporation stock, the S Portion
must aggregate income items and gain or loss on for all its S stock
investments for purposes of determining the S portion‟s taxable income.19
The S Portion is allowed to deduct state and local income tax and
administrative expenses that are either (1) directly related to the S Portion, or
(2) allocated to the S Portion on a reasonable basis.20 For example, state
income taxes imposed on the ESBT as a whole must be allocated between
the S portion and the non-S portion.
If the trustee sells or disposes of any S corporation stock on the
installment method, the income recognized under this method is taken into
account by the S portion.21 However, any interest recognized on the
installment obligation is taken into account by the non-S portion.22 Most
distressing is that interest paid by the trust to purchase stock in any S
corporation is allocated to the S portion but is not a deductible
administrative expense for purposes of determining the taxable income of
the S portion.23 In addition, this interest is not deductible by the non-S
portion.24 The AMT exemption amount of the S portion is zero.25
(b). Taxation of the Non-S Portion
All of the non-S income is taxed to the non-S portion. Its taxable
income is determined by taking into account all items of income, deduction,
and credit except those properly reflected in the S portion.26 The non-S
portion is taxed as a regular complex trust and may consist of several
separate shares for purposes of computing distributable net income and the
Treas. Reg. §1.641(c)-1(f).
Treas. Reg. §1.641(c)-1(d)(3)(iii).
19 Treas. Reg. §1.641(c)-1(d)(2)(iii).
20 Treas. Reg. §1.641(c)-1(d)(4)(i).
21 Treas. Reg. §1.641(c)-1(d)(3)(ii).
22 Treas. Reg. §1.641(c)-1(g)(3).
23 Treas. Reg. §1.641(c)-1(d)(4)(ii).
24 Id.
25 Treas. Reg. §1.641(c)-1(d)(2)(i).
26 Treas. Reg. §1.641(c)-1(g)(1).
17
18
income distribution deduction.27 The non-S Portion is taxed on any
dividends received from the S corporation that are paid from its C
corporation earnings and profit account.28 The trust will receive a 1099-DIV
for these amounts.
The non-S portion is allowed to deduct all state and local taxes,
administrative expenses, and other expenses directly related to the income
from the other assets or allocated to the non-S portion on a reasonable
basis.29 The non-S portion deducts the trust‟s personal exemption.
If income from the sale or disposition of any S corporation stock is
reported by the trust on the installment method, the interest on the
installment obligation is includible in the gross income of the non-S
portion.30 Note that the recognized income on this installment obligation is
included in the gross income of the S portion.
The non-S portion is entitled to claim a charitable contribution
deduction only to the extent of gross income of the non-S portion and then
only if permitted by the trust instrument.31 However, unlike for the S
portion, contributions made after the close of the taxable year may possibly
be treated as being made during the year if certain conditions are met and the
necessary election is made.
B. TAX PLANNING WITH ESBTS
Charitable Contributions
While a section 501(c)(3) organization is eligible to be a shareholder
of an S Corporation as provided by IRC section 1361(c)(6)(A), many
individuals may not want to give stock outright to a charitable organization.
In addition and beyond the scope of this paper, a charitable organization may
not want stock outright because income and distributions will be subject to
the unrelated business income tax (“UBIT”) rules. Alternatively, an
individual can give to a charitable organization indirectly by transferring the
stock to a trust of which one or more charitable organizations may be
beneficiaries. If a trust is not a trust of which a qualified charitable
organization is the sole beneficiary and therefore itself treated as a qualified
Id.
Treas. Reg. §1.641(c)-1(g)(2).
29 Treas. Reg. §1.641(c)-1(h).
30 Treas. Reg. §1.641(c)-1(g)(3).
31 Treas. Reg. §1.641(c)-1(g)(4).
27
28
charitable organization, the only other type of charitable trust that may hold
S corporation stock is a charitable lead trust to which an ESBT election must
be made. The types of trusts that may hold stock for the benefit of a
charitable organization is an ESBT. With an ESBT the charitable
organization may be the sole beneficiary, one of multiple beneficiaries, or
the lead sole beneficiary for a certain number of years with qualifying
noncharitable beneficiaries as remainder persons. This type of trust is
commonly referred to as a charitable lead trust. IRC sections
1361(e)(1)(B)(ii) and (iii) specifically excludes tax exempt trust and a
charitable remainder trust from the definition of an ESBT.
There are a number of other specific ESBT charitable qualification
and taxation rules.
One of these rules concern whether a class of charitable beneficiaries
that may possibly receive a distribution from an ESBT will be considered
PCBs. Prior to the amendment made to section 1361(e)(2) concerning
powers of appointment, a typical estate planning power to add charitable
beneficiaries would not allow a trust to qualify as an ESBT because the
potential charitable beneficiaries would be treated as PCBs possibly causing
the number of shareholders to exceed the 100 shareholder limitation. In
2004, Congress amended IRC section 1361(e)(2) to provide that the term
“potential current beneficiary” does not include a potential appointee of a
power of appointment until the power is exercised. The preamble to the
proposed regulations of this statutory amendment provides that the Treasury
Department and the Service received comments concerning powers to select
an unlimited class of charitable beneficiaries that do not constitute powers of
appointment under the definition in IRC section 2041. The preamble
indicates that the Service recognizes that the power to select an unlimited
class of charitable beneficiaries is a common estate tax planning provision
for trust agreements.
In response to the comments, the Treasury Department and the
Service promulgated Treas. Reg. §1.1361-1(m)(4)(vi)(B). This regulation
provides that powers to distribute to certain organizations not pursuant to
powers of appointment. If a trustee or other fiduciary has a power (that does
not constitute a power of appointment for transfer tax purposes as described
in §§20.2041-1(b) and 25.2514-1(b) of this chapter) to make distributions
from the trust to one or more members of a class of organizations described
in section 1361(c)(6), such organizations will be counted collectively as only
one potential current beneficiary for purposes of this paragraph (m), except
that each organization receiving a distribution also will be counted as a
potential current beneficiary. This rule does not apply to a power to
currently distribute to one or more particular charitable organizations
described in section 1361(c)(6). Each of such organizations is a potential
current beneficiary of the trust.
This rule is illustrated in Examples 8 and 9 of Treas. Reg. §1.13611(m)(8) power of appointment regulations introduced the concept whereby a
trustee‟s or fiduciary‟s (non-transfer tax) appointment power to make
distributions to a class of one or more charitable organizations results in the
class being treated as one shareholder for purposes of the shareholder
number limitation, even assuming no exercise of the power.
Assume that a multi-generational trust provides such a power in
respect to each separate trust share and that there are 10 trust shares. Also
assume that a single ESBT election is made for the trust as a whole in
accordance with Example 1 of the regulations.
Is the trust power treated as one shareholder for purposes of the
shareholder number limitation or, alternatively, would the regulations count
10 distinct shareholders given the presence of the fiduciary‟s power in
respect to each of the 10 subtrusts?
If separate ESBT elections are made in respect to each separate trust
share (10 distinct ESBT elections are made), is the charitable class
appointment power then considered to result in 10 shareholders?
If more than one shareholder is deemed to exist in either or both of the
illustrative cases, could some future regulations project consider some type
of aggregation concept --- i.e., treating the power as resulting in only one
shareholder, at least if substantially all of the underlying PCBs are members
of the same “family”? We‟ve come so far recently in terms of family
attribution and in limiting the number of shareholders in the context of
family trusts generally; the regulations‟ treatment of a class of charitable
appointees as at least one shareholder (and perhaps multiple shareholders in
the context of a trust with separate trust shares) in the absence of exercise of
the relevant power seems like a step “backwards” in the absence of
aggregation.
There are a number of special ESBT taxation rules concerning
charitable contributions made by an S corporation and the trust. The S
portion will be allowed a charitable deduction only to the extent of the S
portion‟s pro rata share of charitable contributions made from the S
corporation‟s gross income.32 Only cash contributions by the S corporation
are deductible by the S portion. Contributions of property are not made
“from gross income” and therefore fail the requirements of IRS section
642(c).33 The IRC section 681 limitations regarding unrelated business
income also apply to determine whether the contribution is deductible by the
S portion. That is, no IRC section 642(c) deduction is permitted for that
portion of the contribution that is allocable to what would have been
unrelated net business income were the trust to have been a IRS section
501(c)(3) organization.34 The charitable contribution is deductible by the S
portion only in the year that it is an item required to be taken into account by
the trust under section 1366 of the Code. The trustee may not make an
election to treat a contribution made by the S corporation after the close of
the taxable year as made during the taxable year.35
Given increased support of charitable gift giving under the Code in
recent years generally, should the Committee re-dedicate its support of
proposals such as that contained in the Section 307 of the Modernization Act
of 2003 which would have amended RC Section 641(c)(2)(C) to expand
charitable deductions in the context of an ESBT? See also the proposed S
Corporation Modernization Act of 2011.
Domestic Production Activity Deduction (“DPAD”) – Section 199
Taxpayers are allowed a deduction under IRC section 199 for income
attributable to domestic production activities. For an S corporation, section
199(d)(1)(A)(i) provides that the DPAD is applied at the shareholder level.
Shareholders must take into account their share of each item of domestic
production gross receipts (“DPGR”) and allocable costs of goods sold and
other costs determined without regard to whether the DPGR exceeds the
allocable costs.36
Treas. Reg. §1.641(c)-1(d)(2)(ii).
Id. and Preamble to TD 8994
34 Id.
35 Treas. Reg. §1.641(c)-1(e)(1).
36 IRC section 199(d)(1)(A)(ii).
32
33
If an ESBT holds only S corporation stock, the S corporation
Schedule K-1 items of qualified production activities income (“QPAI”) and
W-2 wages and the section 199 deduction attributable to these amounts are
allocated and calculated at the S-portion level of the trust. If an ESBT
Trusts holds S corporation stock and other assets, the S corporation Schedule
K-1 items of QPAI and W-2 wages are allocated to the S-portion. A section
199 deduction is computed based upon these amounts for just the S-portion
of the trust. With respect to the non-S corporation stock, QPAI and W-2
wages of the non-S corporation assets of the trust are not aggregated with the
S-portion‟s QPAI and W-2 wages and are allocated to the beneficiary to the
extent that the DNI of the trust is distributed to the beneficiary.
If an ESBT is a partial grantor trust - the grantor portion of QPAI and W2 wages of the S-portion and the non-S portion are allocated to the deemed
owner of the grantor portion.
Interest Expense Allocation and Deductibility –
IRC section 641(c)(2)(C) (iv) allows a deduction on the S-portion of
an ESBT for any interest expense paid or accrued on indebtedness incurred
to acquire stock in an S corporation must be taken into account by the Sportion of an ESBT as a deduction effective for tax years beginning after
December 31, 2006.
Congress enacted IRC section 641(c)(2)(C)(iv) under the Small
Business and Work Opportunity Tax Act of 2007 (P.L.110-28) in response
to practitioners. Treas. Reg. §1.641(c)-1(d)(4)(ii) that has not been amended
to reflect the enactment of section 641(c)(2)(C)(iv) indicates that position of
the IRS and the Treasury Department before enactment. This regulation
provides that interest paid by the trust on money “borrowed” by the trust to
purchase stock in an S corporation is allocated to the S portion but is not a
deductible administrative expense for purposes of determining the taxable
income of the S portion. As provided in the preamble to the regulations, the
IRS Chief Counsel‟s Office and the Treasury Department believed that the
interest expense was allocated to the S-portion because the purchase of S
corporation stock increases the S-portion and not the non-S portion. The
preamble indicates that the IRS and the Treasury Department believe that for
purposes of section 641(c)(2)(C)(iii) that allows the IRS to promulgate
regulations for administrative expenses allocable to items required under
section 1366 and gain or loss from the disposition, “administrative
expenses” do not include expenses incurred to acquire additional assets.
Joint Committee: Joint Comm. on Taxation, Technical Explanation of
the Small Business and Work Opportunity Tax Act of 2007, contained in HR
1591 as reported by the Conference Committee (JCX-24-07) (Apr. 24, 2007)
indicates that the only interest expense deduction allowed to the S-portion is
one incurred on the acquisition of stock.
It is not clear whether the interest expense incurred or paid on
indebtedness incurred to make capital contributions is allocated to the S
portion and is deductible interest expense. Can making a capital
contribution be treated as acquiring additional stock? Upon a capital
contribution, the corporation can issue additional stock or not. When the
corporation does not issue additional stock, the shareholder stock basis is
increased by the amount of the capital contribution. Clearly, when the
corporation issues additional stock upon the contribution to capital, it is the
same as acquiring additional stock.
State Tax Refund Allocation –
IRC section 641(c)(2)(C)(iii) provides that the only items of income,
loss, deduction, or credit to be taken into account include state or local
income taxes to the extent allocable to section 1366 items and any gain or
loss from the disposition of stock of S corporation stock as provided in
regulations.
Treas. Reg. §1.641(c)-1(d)(4) allows the S portion to deduct state and
local income taxes directly related to S portion. Treas. Reg. §1.641(c)1(g)(4) provides that whenever state and local income taxes relate to more
than one portion of an ESBT, the taxes must be allocated between or among
the portions to which they relate. These items may be allocated in any
manner that is reasonable in light of all the circumstances, including the
terms of the governing instrument, applicable local law, and the practice of
the trustee with respect to the trust if it is reasonable and consistent. The
taxes and expenses apportioned to each portion of the ESBT are taken into
account by that portion.
When a state refunds state taxes relating to the S-portion to an ESBT
is that refund allocated to the S-portion? As an example, state taxes paid in
2008 related strictly to S- portion of the ESBT. In addition, the trust has
prior year overpayments of state taxes related 100% to S corporation income
which trust picked up as income in 2009 year (since the trust took the
deduction last year). Should these items, which are directly related to the S
corporation, be included in the S-portion tax calculation rather than be
reported on lines 8 (income) and 11 (tax deduction) on page 1 of the Form
1041?
It is clear under the regulations that the state taxes paid in 2008 that
are solely attributable to the S stock must be reported by just the S portion as
provided by Treas. Reg. section 1.641(c)-1(d)(4). Section 641(c) and the
regulations there under indicate the limited types of items that are included
in the S portion. The items attributable to the S-portion including state tax
refund probably should be allocated to the S-portion but there is no guidance
on this point.
Carryback and Carryforward ESBT Losses –
In computing the taxable income of the “S portion” of an ESBT in
respect to a particular taxable year in accordance with Treas. Reg. 1.641(c)1(d), can an ESBT‟s allocable portion of IRC section 1366 pass-through
losses carried back or carried forward from another ESBT taxable year be
considered in the computation so long as such carryback or carryforward
losses were incurred while the trust was an ESBT?
Section 641(c)(2)(C) provides that the only items of income, loss,
deduction or credit that may be taken into account by the S portion of the
ESBT are Subchapter S pass-through items, gain or loss from the disposition
of S corporation stock, any interest expense paid on indebtedness incurred to
acquire stock in the S corporation,i and, to the extent provided in
Regulations, state or local income taxes or administrative expenses to the
extent allocable to the Subchapter S pass-through income items or gain on
the sale of S stock. Accordingly, the deductions available to the S portion of
the ESBT are limited.
As an additional example, consider that while losses that pass through
the S corporation to the ESBT under Section 1366 are specifically required
to be taken into account in the S portion of the trust, the S portion of the trust
may have insufficient income to absorb these losses in a particular year. In
that case, the S portion of the trust would carry such losses back forward,
presumably, under Section 172 to a prior or future year. But, when the
losses are carried forward to the future year, the losses arise, not under
Section 1366, but, rather, under Section 172. The Service might argue that
since losses under Section 172 are not “items required to be taken into
account under section 1366” as provided in Section 641(c)(2)( C), these
types of carry forward losses can only be taken into account with respect to
the non-S portion of the trust, perhaps resulting in the inability to use the
losses against future income of the S corporation passed through to the S
portion of the trust.” ii One can argue that such an approach would not be
appropriate.iii
Typically, an S corporation individual shareholder is able to take the
shareholder‟s items of income and loss that pass through and use them in the
calculation of the shareholder‟s NOL, if any, for the year. In applying
section 172(d)(4), the shareholder combines the nonbusiness income and
deductions that pass through from the S corporation with similar items
earned or incurred by the shareholder. If a shareholder has an overall NOL,
it should carry back for two years and forward for twenty years.
Treas. Reg. § 1.641(d)(2) provides that rules otherwise applicable to
trusts apply in determining the extent to which any loss, deduction or credit
may be taken into account in determining the taxable income of the S
Portion. Section 641(c)(4) and Treas. Reg. §1.641(c)- 1(j) if, upon
termination, the S-portion has a net operating loss under section 172, then
any such loss must be allowed as a deduction, in accordance with the
regulations under section 642(h), to the trust, or to the beneficiaries
succeeding to the property of the trust if the entire trust terminates. The
regulations clearly contemplate the S-portion having a NOL.
If the S-portion can have a NOL upon the termination of an ESBT
election or the trust, then the S-portion must have at some point had the
ability to create the NOL that was not fully utilized. Accordingly, an NOL
created by an ESBT should be able to be carried back (or forward) to offset
the ESBT portion of the trust pursuant to the normal section 172 NOL
rules. This assumes that the S-portion NOL will not be used against, merged
or commingled with the non-S portion. No definitive formal guidance
exists.
In ILM 200734019 the IRS ruled that a NOL generated while an
estate held S corporation passed to the non-S portion of an ESBT upon
termination of the estate and transfer of the stock to an ESBT.
Non-Resident Aliens (“NRA”) as Permissible PCBs –
Treas. Reg. §1.1361-1(m)(1)(ii)(D) provides that a NRA is an eligible
beneficiary of an ESBT. However, Treas. Reg. §1.1361-1(m)(4)(i) provides
that an NRA is an impermissible PCB. Treas. Reg. §1.1361-1(m)(4)(i)
provides that a PCB is treated as a shareholder for purposes of IRC section
1361(b)(1) and, therefore, requires a PCB to be eligible to be an eligible
shareholder as provided by section 1361(b)(1). Therefore, a PCB cannot be
a NRA nor can the number of PCBs cause the number of shareholders to
exceed the 100 shareholder limitation.
However, why prohibit an NRA from being a PCB? With an ESBT,
the tax is paid at the trust level and at the highest US individual rate.
Therefore, there is no opportunity for tax avoidance. There have been a
number of legislative proposals including the 2010 and 2011 S Corporation
Modernization bill that would allow an NRA to be a PCB.
ESBT Powers of Appointment - General
Congress enacted IRC section 1361(e) to allow individual taxpayers
greater flexibility in estate planning. Many trusts include a power of
appointed provision allowing trust distributions to be made to a group of
identified and unidentified persons.
Prior to the 2004 legislative changes, a potential appointee of a power
of appointment was considered a PCB that could have resulted in the
number of shareholders to exceed the shareholder number limitation. Final
ESBT regulations were adopted in August 2009 and reflect the revised rules
adopted in IRC section 1361(e)(2) governing the treatment of powers of
appointment. Generally, under the revised rules of section 1361(e)(2), a
person to whom a distribution may be made during any period pursuant to a
power of appointment is not a PCB unless the power is exercised during that
period.
Treas. Reg. §1361-1(m)(4)(vi) suggests, however, that if the power is
exercised, the appointee must be treated as a PCB. Stated differently, the
regulations appear to establish an “all or nothing” proposition – hence, (i)
one is not a PCB unless a power of appointment is exercised, but (ii) if a
power of appointment is exercised, the appointee must then be treated as a
PCB. Query, if an appointee receives trust corpus other than S corporation
stock, whether the appointee must be considered a PCB given that the
property received is no longer part of the trust? Query, however, whether
one might be able to achieve the desired result in certain situations by reason
of IRC section 1361(e)(2)– i.e., so long as the applicable trust
contemporaneously ceases to hold any S corporation stock. Under IRC
section 1361(e)(2), if a trust disposes of all of its S corporation shares, any
person who first met the definition of a PCB during the one-year period
ending on the date of the disposition is not considered a PCB. Query
whether IRC Section 1361(e)(2) encourages each “separate share” of a
larger trust to make its own ESBT election.
Other Fiduciary Powers and Power of Appointment
The Preamble to the 2008 proposed ESBT regulations addressed
fiduciary powers of appointment beyond merely those powers entailing a
class of charitable appointees -- but appeared preoccupied with the
charitable organization class issue in the context of the fiduciary power.
Is it clear that a fiduciary‟s power to appoint (not falling within the
purview of a conventional power of appointment for transfer tax purposes)
to other beneficiaries is wholly disregarded until exercise? This appears
the intent of Paragraph A of new Treas. Reg. §1.1361-1(m)(4)(vi).
However, no Example addresses this issue. New Example 7 addresses nonfiduciary powers. New Examples 8 and 9 address fiduciary powers but only
in the context of charitable appointees.
Therefore, what result would obtain in Example 7 of Treas. Reg.
§1.1361-1(m)(8) if the trustee, not A, had a similar power? The same
result? But why then the detailed discussion in the Preamble to the
proposed regulations stating that a special rule was required to counteract
a potential transformation of the statute governing powers of appointment to
one addressing only beneficiaries, and not PCBs?
One or Multiple ESBT Elections
If a trust has separate shares as defined under IRC section 663(c) and
therefore treated as separate trusts for certain purposes, is an ESBT election
necessary for each separate share. Treas. Reg. §1.1361-1(m)(2) implies that
one ESBT election will suffice for a trust with separate shares. Further,
Example 1 of Treas. Reg. 1.1361-1(m)(8) suggests that only one ESBT
election is required when a trust is comprised of “separate trust shares”
within the meaning of IRC Section 663(c). The regulation notes that each
separate share will be treated as a separate trust for purposes of computing
DNI but that the trust will have only a single “S portion” taxable under IRC
Section 641(c). The Service informally clarified that one ESBT election is
appropriate but multiple elections may be made in PLR201122003.
In PLR201122003, a trust of which one ESBT election had been made
had separate shares as defined under section 643(c). The IRS accepted court
approved amendments and disclaimers so that each separate share could
qualify as a qualified subchapter S trust (“QSST”). The IRS further ruled
that the ESBT election could be revoked for some separate shares so that a
QSST election could be made without affecting the ESBT election of other
separate shares that desired to remain ESBTs. This PLR illustrates that a
single trust with separate shares as defined under section 643(c) may have
dual classifications. If a trust has separate shares, practitioners may want to
contemplate making separate ESBT elections for each separate share so that
each separate share will have the flexibility of subsequently converting to a
QSST.
Converting from an ESBT to a QSST
Treas. Reg. §1.1361-1(m)(7) allows an ESBT to convert to a QSST if
the certain requirements are met. The trust must meet the requirements of a
QSST under IRC section1361(d). A QSST election must be signed by the
income beneficiary. The trust cannot have been converted from a QSST to
an ESBT in the 36 month period preceding the new QSST election. The
QSST election effective date cannot be more than 15 days and two months
prior to the date on which the date is to be effective and cannot be more than
12 months after the date on which the election is filed.
IRC section 1361(d) requires that for the purpose of section 678(a),
the beneficiary of the trust shall be treated as the owner of that portion of the
trust which consists of stock in an S corporation to which a QSST election
has been made. Section 469(g)(12) requires that when a trust distributes a
passive activity, any suspended passive activity losses are added to the basis
and are not allowed as a deduction.
An issue arises when the S portion of an ESBT has suspended passive
losses, and then a QSST election is made or vice versa when a QSST
converts to an ESBT and the beneficiary has suspended losses. The
suspended losses are not covered in Treas. Reg. §1.641(c)-1(j) nor is
revocation of the ESBT considered a distribution to beneficiary. Are these
losses to be taken by the trust, added to the basis of the underlying S
corporation stock, or used by the trust?
ESBT Election and Required Enumeration of all PCBs
In PLR 200819006, the Service suggested that the failure to properly
identify all PCBs in an ESBT election statement results in the termination of
the subject corporation‟s S status37.
Why does Treas. Reg. §1.1361-1(m)(2)(B)(ii) require that an ESBT
election statement set forth both (i) the enumeration of all PCBs as well as
(ii) a representation by the trustee that all PCBs meet the shareholder
requirements? What is achieved by the former other than a propensity to
cause a termination of the underlying corporation‟s S election upon failure to
properly enumerate each and every PCB? Can the regulations be revised?
Alternatively, can the Service develop an expedited procedure to
obtain inadvertent termination relief in such a case that would be similar to
that set forth in Rev Proc. 2003-43, which governs in the case of certain
terminations resulting from failure to file a timely ESBT election? One can
argue that the failure to properly identify all PCBs is less of an oversight
than a failure to make the ESBT election entirely and is, therefore, deserving
of some form of expedited, inexpensive, IRC Section 1362(f) relief.
ESBTs and Golden Parachute Payments
Generally, IRC section prohibits any deduction for certain payments
to certain person if the payment is contingent upon a change in ownership or
effective control of a corporation. As provided in IRC section 280G(b)(5),
the disallowance rule does not apply if the corporation is an S corporation or
could have qualified as an S corporation. Treas. Reg. §1.280G
See also PLR 201128023 in which the Service ruled that the designation of an erroneous potential current
beneficiary in an ESBT election form contributed to an ineffective S corporation election; the ineffective S
election by the corporation was however ruled to be inadvertent under IR section 1362(f).
37
Treas. Reg. §1.280G-1, Q/A-6(a)(1), provides that a parachute
payment does not include any payment to a disqualified individual with
respect to a corporation which (immediately before the change in ownership
or control) would qualify as a small business corporation (as defined in IRC
section1361(b) but without regard to section 1361(b)(1)(C) thereof), without
regard to whether the corporation had an election to be treated as a
corporation under section1361 in effect on the date of the change in
ownership or control.
The preamble to the final IRC section 280G regulations indicates that
the prior proposed regulations did not clearly address whether a corporation
that does not elect to be treated as an S corporation, but could make the
election (because, aside from the election, the corporation otherwise meets
the requirements to be treated as an S corporation), may use the exemption
under Q/A-6(a)(1). The preamble further states that “a corporation that
could elect to be treated as an S Corporation under the Code, but does not do
so, may nevertheless use the exemption of Q/A-6(a)(1) for any payments to
a disqualified individual.” See, 68 Fed. Reg. 45,745.
The legislative history indicates that Congress enacted IRC section
280G to discourage the use of parachute payments because they may be used
to prevent a change in ownership or control, they could encourage
executives to favor a change in ownership or control that may not be in the
best interest of the shareholders, and shareholders may receive less for their
shares in the change in ownership or control. See, Joint Committee on
Taxation, General Explanation of the Deficit Reduction Act of 1984, at 199200 (1984). Small corporations, however, were exempted from the
application of IRC section 280G. As indicated by the legislative history of
section 280G, Congress believed that the shareholders in a small privately
held corporation could protect their own interests due to the nature of those
corporations. Specifically, these shareholders were presumed likely to be
aware of any potential payments contingent on a change in ownership or
control and the change in ownership or control itself. See S. REP. No. 99313 at 918 (1986). See also, H.R. REP. No. 99-426 at 901 (1985). The
legislative history indicates that a corporation qualifies for the small
business corporation exemption if it does not have a shareholder who is not
an individual (other than an estate or qualifying trust). See, H.R. REP. No.
99-426 at 901 (1985).
PLR 200817007 addressed whether a C corporation qualified for the
“small business corporation” exemption from the golden parachute rules
codified in IRC section 280G(b)(5)(A)(i) in the situation in which the
corporation‟s trust shareholders would qualify as eligible shareholders of a
“small business corporation” if ESBT elections were made in respect thereof
---i.e., the corporation would not technically constitute a “small business
corporation” without the making of the ESBT elections).
Because, however, the corporation was a C corporation and the ESBT
elections were obviously superfluous in respect to such C status, no such
ESBT elections were made. The Service noted that based on the facts
submitted and representations made in connection with the ruling request,
the corporation would have been eligible to make an S election and, in
conjunction therewith, the trust shareholders would have been eligible to
make ESBT elections. As such, the corporation qualified as a “small
business corporation” for purposes of the exemption in IRC Section
280G(b)(5)(A)(i). Given IRC Section 280G(b)(5)(A)(i) (which defines the
term “small business corporation” for this purpose without regard to the
restriction on nonresident alien shareholders), would a similar ruling apply if
the subject ESBTs had one or more PCBs who were nonresident aliens?
Sourcing of ESBT Distributions
Treas. Reg. §1.641(c) -1(i) holds that distributions for the S portion or
the non-S portion , including distributions of the S Corp stock, are
deductible under section 651 or 661in determining the taxable income of the
non-S portion and are included in the gross income of the beneficiaries
under section 652. However, the amount of the deduction or inclusion
cannot exceed the amount of the distributable net income (“DNI”) of the
non-S portion. Further, income, loss, deduction or credit from the grantor or
S portion of are excluded for purpose of determining the distribution net
income. DNI of the non-S portion
Practitioners continue to be surprised by Treas. Reg. §1.641(o)-1(i) Example 5 of Treas. Reg. 1.641(c)-1(l) illustrating this rule which treats
distributions from an ESBT as being paid first from the trust‟s DNI even if
clearly sourced from the “S portion.” Section 306 of the Modernization Act
of 2003, proposed to treat any distribution attributable to the “S portion”
separately from any distribution attributable to the “non-S portion”.
Division of ESBTs
In two recent PLRs (PLR 200913002 and PLR 200816012), the Service
sanctioned the division of ESBTs to address potential ineligible PCBs. In
both PLRs, the division was made for the subject trust to qualify as a
permitted S corporation trust. Both trusts were questionable trusts of which
a group of persons could receive trust distributions. Therefore, neither PLR
qualified as a QSST. Each trust had a NRA potential current beneficiary.
To qualify the subject trust as an ESBT each subject trust was severed
judicially or pursuant to authorization under the governing instrument.
How far may the ability to sever a trust to qualify it as an ESBT
extend? In the context of powers of appointment, many practitioners
typically restrict the class of appointees to family members and/or a
specified number of persons or entities that would be eligible S corporation
shareholders. However, a client may not wish to restrict this
discretion. Hence, can the ESBT divide into 2 trusts – and provide that the
powers of appointment (unrestricted in any fashion) would be restricted to
the trust NOT containing the S corporation stock. Alternatively, if there is a
way to turn off the PCB spigot, this issue may have less relevance.
In another PLR 201128023 the Service sanctioned the judicial
reformation and disclaimer of an ESBT to establish separate shares as
defined under IRC section 663 (c) with a single income beneficiary such that
each separate share qualified as a separate trust for section1361(c) and (d).
After the separate shares were established, the Service ruled that each
separate share would qualify as a QSST if the income beneficiary made a
QSST and the conversion of one or more separate shares to QSST would not
affect the ESBT election for the separate shares of the remaining income
beneficiary.
Post-Mortem Planning
On the death of the deemed owner of a trust that qualified under IRC
section 1361(c)(2)(A)(i) as a wholly owned grantor trust,38 the trust ceases to
be a grantor trust. The trust will be an eligible shareholder up to a two year
period of time after the death of the deemed owner.39 Although the stock
That is, all of which would be treated as owned by one individual who was a U.S. citizen or resident as a
grantor trust under subpart E or subchapter J.
39 Section 1361(c )(2)(A)(ii) provides that a trust that was a section 1361(c)(2)(A)(i) trust just before the death of
the deemed owner will be a valid trust to hold S stock for two years from the date of the deemed owner’s
death.
38
continues to be held by the trust, the estate of the deceased deemed owner of
the trust will be treated as the shareholder for S corporation eligibility
purposes and the trust is treated as the shareholder for tax purposes.40
Generally, the trust will continue to be treated as the shareholder until the
earlier of (1) the transfer of the stock by the trust, or (2) the expiration of the
two-year period beginning on the day of the deemed owner‟s death. Before
the expiration of the two-year period, the trustee and beneficiaries may
consider making qualified subchapter S trust or electing small business trust
(“ESBT”) elections if the trust otherwise meets the ESBT or QSST
qualification criteria. If the S corporation stock is not distributed to an
eligible shareholder or no ESBT or QSST election is timely made for the
trust, the trust will cease to qualify as a permitted S corporation shareholder.
Consequently, the corporation‟s election to be an S corporation will
terminate.
After the termination of a IRC section 645 election and the two-year
period provided under Treas. Reg. §1.1361-1 in which the trust will be
eligible to hold stock, either an ESBT or a QSST election must be timely
made. Alternatively, the trustee could distribute the stock to a person
eligible to be an S corporation shareholder. If an individual does not want to
give stock directly to a charity, Charitable Giving is available through use of
an ESBT.
i
For taxable years beginning prior to December 31, 2006, the interest on loans used to acquire S
corporation stock was not deductible by the S portion of the ESBT. Former Reg. § 1.641(c)-1(d)(4)(ii).
The ability to deduct interest expense on indebtedness incurred to acquire S corporation stock was effected
through an amendment to I.R.C. § 641(c) in the Small Business and Work Opportunity Tax Act of 2007.
For a discussion of the legislative history, see Joint Tax Committee, “Technical Explanation of the „Small
Business and Work Opportunity Tax Act of 2007,” JCX 29-07 (May 24, 2007). For a discussion of the
issue and the background leading to the amendment, see M Gerson, “New Interest Deduction for Electing
Small Business Trusts,” 2007 TNT 181-37.
ii
In Chief Counsel Advice ILM 200734019, an estate trust held stock in an S corporation. After
the trust had passed through losses that were unused but were carried forward under I.R.C. § 172, the trust
filed an ESBT election. The question at issue was whether these losses could be taken into account by the
S portion of the ESBT; apparently the fortunes of the corporation had turned and the corporation was
passing through income to the S portion of the trust. One way of dealing with this issue would have been
for the Service to simply have noted that since the losses had arisen before the trust was an ESBT, the
losses were necessarily part of the non-S portion of the trust. The Service did not decide the case under this
analysis. Rather, the Service referred to the statutory list of items taken into account in computing the
income of the S portion of and ESBT and concluded that since I.R.C. § 172 was not on the list, the losses
arising under I.R.C. § 172 had to be taken into account as part of the non-S portion of the ESBT.
40
Section 1361(c )(2)(B) and Treas. Reg. §1.1361-1(h)(3)(ii)(B).
iii
First, on policy grounds, it should not matter that the losses are carried forward or back under a
section of the Code other than I.R.C. § 1366. All the statute and the Regulations require is that the losses
originate under I.R.C. § 1366. There is nothing in the statute or the Regulations that annualize the loss pass
through; the only requirement is that the losses originate under I.R.C. § 1366. For example, the second
sentence of Reg. § 1.641(c)-1(d)(2)(i), which follows the sentence requiring that the loss originate in I.R.C.
§ 1366, statutes that “[r]ules otherwise applicable to trusts apply in determining the extent to which any
loss, deduction, or credit may be taken into account in determining the taxable income of the S portion [of
the ESBT].” Under the rules specified in that sentence, an I.R.C. § 1366 loss from one year of the trust
could clearly be carried back or forward under I.R.C. § 172.
Second, ignoring I.R.C. § 1366 pass through losses because they originate in a prior or succeeding
taxable year yields unreasonable results. Assume an ESBT owns two S corporations. If an I.R.C. § 1366
pass through loss arising from one of the S corporations, it would clearly be available to offset an I.R.C. §
1366 pass through of income from the other S corporation (subject to applicable limitations). The CCA
interpretation noted in the prior footnote would require that an I.R.C. § 1366 pass through of income from
the same S corporation owned by the same ESBT for a different year. That simply makes no sense.
Third, as noted in the prior footnote, the CCA‟s approach was not necessary to its conclusion. The
conclusion could have been reached on other grounds. Therefore, the CCA‟s discussion of Reg. §
1.641(c)-1(d)(2) should be regarded as dicta.
Fourth, losses suspended by the basis limitation in a particular tax year would be treated more
favorably than other losses. To illustrate, assume that in Year one, an ESBT with an ownership interest in a
single S corporation is allocated $5 of losses but the losses are suspended at the corporate level by reason of
I.R.C. § 1366(d). Assume that in Year two, the ESBT‟s allocable share of corporate income is $9. As a
consequence, because the suspended losses from Year one are treated as incurred in the following taxable
year, the “net” amount of income which passes through to the ESBT in Year two is $4 ($9--$5). In
contrast, if the $5 of losses were not suspended in Year one but also were unavailable for use as a loss
carryforward to Year two, the ESBT would be taxed in Year two on $9. There is no legitimate basis for the
distinction in treatment based on whether or not the ESBT had sufficient basis in its shares or indebtedness
to pass through losses in a particular year.
Further, Reg. § 1.641(c)-1(i), which addresses the impact of a termination or revocation of ESBT
status on various items (including an S portion net operating loss under I.R.C. § 172) does not appear to
compel an adverse result in this case. The reference in the cited regulation to an S portion net operating
loss does not necessarily support the proposition that an S portion net operating loss is unavailable for any
use whatsoever during the trust‟s ESBT tenure; the regulation appears merely to address the impact of
termination or revocation of ESBT status on any then remaining S portion net operating loss which has no
other utility to the ESBT as of that point in time.
If (i) the unfavorable taxpayer result suggested by CCA 200734019 (involving an attempt to use a
non-ESBT trust year loss carryfoward to offset a subsequent ESBT trust year gain) is correct but (ii) a
favorable taxpayer result would obtain if both the loss and the gain occurred in ESBT trust years, one
would presume an advantage in accelerating an ESBT election, at least in respect to a loss corporation
shareholder for two years following the death of the grantor, one might see an advantage in making an
ESBT election as soon as the grantor trust status ends. In such case, losses that might otherwise have been
incurred in non-ESBT years would then be incurred in ESBT years and assuming that any ESBT year loss
could be successfully carried forward or carried back to any other ESBT year, the trust would maximize its
use of the losses.