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

2 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).

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

5 Treas. Reg. §1.1361-1(m)(2). 6 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).

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

11 Treas. Reg. §1.641(c)-1(d)(1) and (2). 12 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).

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

17 Treas. Reg. §1.641(c)-1(f). 18 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).

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

27 Id. 28 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).

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. §1.1361-

1(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

32 Treas. Reg. §1.641(c)-1(d)(2)(ii). 33 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).

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 W-

2 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 S-

portion 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 non-

fiduciary 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

37 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).

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 199-

200 (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. 99-

313 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

38 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.

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.