[Federal Register Volume 60, Number 140 (Friday, July 21, 1995)]
[Rules and Regulations]
[Pages 37578-37589]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-17914]
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DEPARTMENT OF THE TREASURY
26 CFR Parts 1, 18 and 602
[TD 8600]
RIN 1545-AE86
Definition of an S Corporation
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
definition of an S corporation under section 1361 of the Internal
Revenue Code of 1986. Changes to the applicable tax law were made by
the Subchapter S Revision Act of 1982, the Tax Reform Act of 1984, the
Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of
1988, and the Omnibus Budget Reconciliation Act of 1989. The final
regulations provide guidance on the requirements to be an S
corporation.
EFFECTIVE DATE: These regulations are effective July 21, 1995.
FOR FURTHER INFORMATION CONTACT: Laura Howell, telephone 202-622-3060
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the requirements of the Paperwork Reduction Act (44
U.S.C. 3504(h)) under control number 1545-0731. The estimated annual
burden per respondent varies from 30 minutes to 60 minutes, depending
on individual circumstances, with an estimated average of 45 minutes.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
Desk Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.
[[Page 37579]]
Background
On October 7, 1986, the IRS published in the Federal Register a
notice of proposed rulemaking containing proposed amendments to the
Income Tax Regulations (26 CFR Part 1) under section 1361 of the
Internal Revenue Code (Code). These amendments were proposed to conform
the regulations to sections 2 and 6 of the Subchapter S Revision Act of
1982 and to section 721(c) and (f) of the Tax Reform Act of 1984. After
consideration of all comments received by Treasury and the IRS
regarding the proposed amendments, those amendments are adopted as
revised by this Treasury decision. The final regulations also reflect
the amendments made to section 1361 by sections 901(d)(4)(G) and
1879(m) of the Tax Reform Act of 1986, section 1018(q)(2) of the
Technical and Miscellaneous Revenue Act of 1988, and section 7811(c)(6)
of the Omnibus Budget Reconciliation Act of 1989.
On January 26, 1983, the IRS published temporary regulation
Sec. 18.1361-1 under section 1361(d)(2) of the Internal Revenue Code of
1954 (TD 7872) in the Federal Register to provide guidance as to the
election to treat a qualified subchapter S trust as a wholly-owned
grantor trust. The temporary regulations are adopted as revised by this
Treasury decision, and Sec. 18.1361-1 of the temporary regulations is
removed.
Explanation of Provisions
The proposed regulations define a domestic corporation as a
corporation as defined in section 7701(a)(2) created or organized in
the United States or under the law of the United States or any state or
territory. Commentators recommended that this definition be clarified
to provide that an association, unincorporated but taxable as a
corporation, may elect to be treated as an S corporation. The final
regulations revise the definition of a domestic corporation for
purposes of the S corporation provisions by providing that an entity
that is classified as an association taxable as a corporation under
Sec. 301.7701-2 of the Procedure and Administration Regulations may
elect to be treated as an S corporation provided it meets the other
requirements of a small business corporation.
Section 1361(b)(2)(C) provides that an insurance company subject to
tax under subchapter L may not elect to be treated as an S corporation.
However, the Subchapter S Revision Act of 1982 (the Act) provided a
grandfather rule for a qualified casualty insurance electing small
business corporation. The proposed regulations provide the grandfather
rules for a qualified casualty insurance electing small business
corporation. Additionally, the Act provided a grandfather rule with
regard to the affiliation rule under section 1361(b)(2)(A) for a
corporation that is affiliated with a foreign corporation or DISC. The
final regulations remove the grandfather rules for a qualified casualty
insurance electing small business corporation since they are no longer
generally applicable. However, corporations that fit within those
grandfather rules and certain corporations having oil and gas
production should refer to section 6(c) of Public Law 97-354 for
appropriate guidance.
The proposed regulations provide a special rule for a corporation
having a shareholder who has a legal life estate or usufruct interest
in the stock. The proposed regulations provide requirements for such
shareholder to qualify as an eligible shareholder. Upon further
consideration by the IRS and Treasury, the final regulations remove
this special rule from the proposed regulations. The issue will be
addressed in other published guidance.
The proposed regulations provide that persons for whom stock of a
corporation is held by a nominee, guardian, custodian, or agent are
generally considered to be shareholders of the corporation, but if
stock is owned by a partnership, the partnership (and not its partners)
is considered to be the shareholder and the corporation does not
qualify as a small business corporation. Commentators questioned why
stock which is held by a partnership as nominee for an individual
should not be considered to be owned by the individual rather than the
partnership for purposes of determining whether a corporation qualifies
as an S corporation. Commentators suggested that this point be
clarified. The final regulations adopt this suggestion by providing
that a partnership may hold S corporation stock as a nominee for a
person who will be treated as the shareholder.
The proposed regulations contain a rule that prohibits a
nonresident alien from being an eligible S corporation shareholder.
Commentators recommended an additional rule that would warn that a U.S.
citizen married to a nonresident alien who, under applicable local law,
has an interest in the U.S. citizen's stock could not be a shareholder
of an S corporation. The final regulations provide that, if a U.S.
shareholder's nonresident alien spouse has a current ownership interest
in the shareholder's stock under applicable local law, the S
corporation has an ineligible shareholder and therefore does not
qualify as a small business corporation. For example, the laws of a
nonresident alien spouse's country may give the nonresident alien
spouse a community property interest in the U.S. spouse's property. In
that case, the corporation would not constitute a small business
corporation as of the date the nonresident spouse acquired an interest
in the stock of the corporation, and the corporation's S election would
terminate. See Ward v. United States, 661 F.2d 226 (Ct. Cl. 1981). If
the termination is inadvertent, relief may be available under section
1362(f) of the Code.
The final regulations add and reserve Sec. 1.1361-1(g)(2)
addressing the status of dual residents. When the proposed regulations
under Sec. 301.7701(b)-7(a)(4) (published in the Federal Register (26
CFR 518) on April 27, 1992) are finalized, this section will contain a
cross reference to those final regulations.
For purposes of section 1361(c)(2)(A)(i), the proposed regulations
define a subpart E trust as a trust all of which (income and corpus) is
treated (under subpart E, part I, subchapter J, chapter 1 of the Code)
as owned by one individual (whether or not the grantor) who is a
citizen or resident of the United States. Commentators expressed
concern regarding the definition of a subpart E trust and suggested
that for purposes of determining whether a trust meets the subpart E
requirements under section 1361(c)(2)(A)(i), the relevant period for
making that determination is the period during which the trust holds S
corporation stock. The final regulations adopt the commentators'
suggestion. Therefore, whether the trust is a wholly-owned trust during
any period in which the trust does not hold S corporation stock is not
relevant. In addition, the final regulations define a subpart E trust
as a trust all of which is treated as owned by an individual. This
definition tracks the language of section 1361(c)(2)(A)(i). Therefore,
the trust is a permitted shareholder if the grantor or another person
includes in computing taxable income and credits all of the trust's
items of income, deductions, and credits against tax under the rules in
Sec. 1.671-3.
The final regulations clarify that a voting trust is a permitted
shareholder only if it is a subpart E trust. Further, the final
regulations add rules concerning who is treated as the shareholder for
purposes of sections 1366, 1367, and 1368 when certain permitted trusts
hold stock of an S
[[Page 37580]]
corporation. For example, when stock of an S corporation is held by a
trust that ceases to be a subpart E trust upon the death of the deemed
owner, and the trust is a permitted shareholder for a 60-day period (or
a 2-year period if applicable) under section 1361(c)(2)(A)(ii), the
trust (and not the estate of the deemed owner) is treated as the
shareholder for purposes of sections 1366, 1367, and 1368, even though
the estate is treated as the shareholder for purposes of section
1361(b)(1).
The final regulations provide that if a husband and wife file a
joint return, are both U.S. citizens or residents, and are both
designated beneficiaries of a trust, they are treated as one
beneficiary for purposes of meeting the requirements of a qualified
subchapter S trust (QSST). In addition, the final regulations add a
rule that if any distribution from the trust satisfies the grantor's
legal obligation to support the income beneficiary, the trust ceases to
be a QSST as of the date of the distribution because under section
677(b) the grantor would be treated either as the owner of the ordinary
income portion of the trust or as a beneficiary of the trust under
section 662 and Sec. 1.662(a)-4.
The proposed regulations provide the general rule that would deny a
trust qualification as a QSST if the terms of the trust do not preclude
the possibility that in the future the trust may not meet the
requirements of section 1361(d)(3)(A). Commentators suggested that the
general rule be deleted because it should be sufficient if a trust
currently complies with those requirements. For example, it was
suggested that if the income beneficiary has a lifetime special power
to appoint the income and corpus of the trust to another person, the
trust would qualify as a QSST until the power is exercised. The final
regulations do not adopt this suggestion because the statute clearly
requires that the terms of the trust instrument provide that, during
the life of the current income beneficiary, there be only one income
beneficiary, and that any corpus distributed may be distributed only to
such beneficiary. The statute generally precludes the possibility of
future non-compliance. However, because of the concern expressed that a
trust instrument could not feasibly preclude the addition to a trust of
a beneficiary that is mandated by a court of law, the final regulations
provide for this exception to the general rule.
Commentators requested guidance as to whether a qualified
terminable interest property (QTIP) trust qualifies as a permitted
shareholder of an S corporation. The final regulations provide that a
trust treated as a QTIP trust under section 2056(b)(7) will qualify as
a QSST, and a trust treated as a QTIP trust under section 2523(f) may
qualify as a subpart E trust if wholly-owned by the grantor. In the
latter case, the trust does not satisfy all of the QSST requirements
because the grantor is treated as the owner of the income portion of
the trust under sections 672(e) and 677.
Commentators also requested guidance as to whether an income
beneficiary of a trust that meets the QSST requirements, and who is
treated as the owner of all of the trust, or the portion of the trust
that consists of S corporation stock under subpart E (and thus is a
permitted shareholder under section 1361(c)(2)(A)(i)), may nevertheless
make a protective QSST election. The final regulations add provisions
for a protective QSST election for income beneficiaries of certain
grantor trusts.
The final regulations also change the result in Rev. Rul. 92-84,
1992-2 C.B. 216. Rev. Rul. 92-84 holds that if a QSST sells its S
corporation stock, the current income beneficiary and not the trust
must recognize any gain or loss. After the publication of Rev. Rul. 92-
84, practitioners expressed concern with respect to the sale of the
stock by a QSST in an installment sale. Practitioners questioned
whether the trust could effectively use the installment method under
section 453 to report gain realized on the sale of the stock and
expressed concern about how the IRS would treat an installment sale of
S stock by a QSST. Practitioners suggested that since the income
beneficiary was treated as the owner of the stock sold, the income
beneficiary would be treated as the owner of the installment obligation
received in exchange for the sale of the stock. However, concern was
expressed that because the QSST ceases to be a QSST as to the S
corporation stock that was sold, the income beneficiary would no longer
be treated as the owner of the installment obligation held by the trust
and there may have occurred a disposition of the installment obligation
under section 453B(a).
On further consideration, the IRS and Treasury have determined that
the income beneficiary of a QSST who is a section 678 deemed owner of
the S corporation stock solely by reason of section 1361(d)(1) should
not be treated as the owner of the consideration received by a QSST
upon its disposition of S corporation stock. Under the final
regulations, the consideration is treated as received by the trust in
its status as a separate taxpayer under section 641. Thus, for example,
any gain recognized on a sale of the S corporation stock is the gross
income of the trust. Similarly, the trust may report any gain realized
upon the sale under section 453 if the sale otherwise qualifies as an
installment sale. This provision of the final regulations reflects an
interpretation of section 1361(d)(1) and has no bearing upon the
operation or effect of the principles of sections 671 through 679
beyond the context of a QSST.
If a QSST has sold or otherwise disposed of all or a portion of its
S corporation stock in a tax year that is open under the statutes for
both the QSST and the income beneficiary but before the effective date
of these final regulations, the QSST and the income beneficiary may
treat the transaction under Rev. Rul. 92- 84 or under these final
regulations. However, the QSST and the income beneficiary must take
consistent reporting positions. The final regulations require that the
QSST and the income beneficiary must state on their respective returns
that they are taking consistent reporting positions.
Effect on Other Documents
Rev. Rul. 92-84, 1992-2 C.B. 216 is obsolete as of July 21, 1995.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations and, therefore, a Regulatory Flexibility Analysis is
not required.
Drafting Information: The principal author of these final
regulations is Laura Howell, Office of Chief Counsel (Passthroughs
and Special Industries). However, other personnel from the IRS and
Treasury Department participated in their development.
List of Subjects
26 CFR Parts 1 and 18
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1, 18 and 602 are amended as follows:
[[Page 37581]]
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805. * * *
Sections 1.1361-1(j) (6), (10) and (11) also issued under 26 U.S.C.
1361(d)(2)(B)(iii). * * *
Par. 2. Section 1.1361-0 is revised to read as follows:
Sec. 1.1361-0 Table of contents.
This section lists captions contained in Sec. 1.1361-1.
Sec. 1.1361-1 S Corporation defined.
(a) In general.
(b) Small business corporation defined.
(1) In general.
(2) Estate in bankruptcy.
(3) Treatment of restricted stock.
(4) Treatment of deferred compensation plans.
(5) Treatment of straight debt.
(6) Effective date provisions.
(c) Domestic corporation.
(d) Ineligible corporation.
(1) General rule.
(2) Exceptions.
(3) Inactive corporation exception.
(e) Number of shareholders.
(1) General rule.
(2) Special rules relating to stock owned by husband and wife.
(f) Shareholder must be an individual or estate.
(g) No nonresident alien shareholder.
(1) General rule.
(2) Special rule for dual residents.
(h) Special rules relating to trusts.
(1) General rule.
(2) Foreign trust.
(3) Determination of shareholders.
(i) [Reserved]
(j) Qualified subchapter S trust.
(1) Definition.
(2) Special rules.
(3) Separate and independent shares of a trust.
(4) Qualified terminable interest property trust.
(5) Ceasing to meet the QSST requirements.
(6) Qualified subchapter S trust election.
(7) Treatment as shareholder.
(8) Coordination with grantor trust rules.
(9) Successive income beneficiary.
(10) Affirmative refusal to consent.
(11) Revocation of QSST election.
(k)(1) Examples.
(2) Effective date.
(l) Classes of stock.
(1) General rule.
(2) Determination of whether stock confers identical rights to
distribution and liquidation proceeds.
(3) Stock taken into account.
(4) Other instruments, obligations, or arrangements treated as a
second class of stock.
(5) Straight debt safe harbor.
(6) Inadvertent terminations.
(7) Effective date
Par. 3. Section 1.1361-1 is amended by adding paragraphs (a), and
(c) through (k) to read as follows:
Sec. 1.1356-1 S corporation defined.
(a) In general. For purposes of this title, with respect to any
taxable year--(1) The term S corporation means a small business
corporation (as defined in paragraph (b) of this section) for which an
election under section 1362(a) is in effect for that taxable year.
(2) The term C corporation means a corporation that is not an S
corporation for that taxable year.
* * * * *
(c) Domestic corporation. For purposes of paragraph (b) of this
section, the term domestic corporation means a domestic corporation as
defined in Sec. 301.7701-5 of this chapter, and the term corporation
includes an entity that is classified as an association taxable as a
corporation under Sec. 301.7701-2 of this chapter.
(d) Ineligible corporation--(1) General rule. Except as otherwise
provided in this paragraph (d), the term ineligible corporation means a
corporation that is--
(i) A member of an affiliated group (determined under section 1504
without regard to any exception contained in section 1504(b)), whether
or not that affiliated group has ever filed a consolidated return;
(ii) A financial institution to which section 585 applies (or would
apply but for section 585(c)) or to which section 593 applies;
(iii) An insurance company subject to tax under subchapter L;
(iv) A corporation to which an election under section 936 applies;
or
(v) A DISC or former DISC.
(2) Exceptions. See the special rules and exceptions provided in
sections 6(c) (2), (3) and (4) of Public Law 97-354 that are applicable
for certain casualty insurance companies and qualified oil
corporations.
(3) Inactive corporation exception. (i) For purposes of paragraph
(d)(1)(i) of this section, a corporation (parent corporation) will not
be treated as a member of an affiliated group during any period within
a taxable year by reason of the ownership of stock in another
corporation (subsidiary corporation) if the subsidiary corporation--
(A) Has not begun business at any time on or before the close of
that period; and
(B) Does not have gross income for that period.
(ii) The determination under paragraph (d)(3)(i) of this section of
the date on which a subsidiary corporation begins business is made by
taking into account all the facts and circumstances of the particular
case. A corporation has not begun business, however, merely because it
is in existence. Ordinarily, a corporation begins business when it
starts the business operations for which it was organized. Mere
organizational activities, such as the obtaining of the corporate
charter, are not alone sufficient to constitute the beginning of
business. An example of a corporation that has not begun business is a
corporation incorporated for the sole purpose of reserving a corporate
name in a state or states in which the parent corporation is not doing
business. If the activities of a corporation have advanced to the
extent necessary to establish the nature of its business operations,
however, the corporation is deemed to have begun business. For example,
a corporation that acquires operating assets necessary for the type of
business contemplated may be deemed to have begun business.
(iii) If a subsidiary corporation ceases to be an inactive
corporation as defined in paragraph (d)(3)(i) of this section, then the
parent corporation's election under section 1362(a) will terminate on
the earlier of the first day that the subsidiary corporation begins
business, or the first day, determined under the subsidiary
corporation's method of accounting, that the subsidiary corporation
realizes gross income.
(iv) The application of paragraph (d)(3) of this section is
illustrated by the following examples:
Example 1. In 1996, Corporation P, a C corporation, owns all of
the stock of Corporation Q. P and Q both use the calendar year as
their taxable year. For purposes of paragraph (d)(1)(i) of this
section, P would not be considered at any time during 1996 to be a
member of an affiliated group solely by reason of its ownership of
Q's stock if Q has not begun business at any time on or before
January 1, 1997, and has no gross income for calendar year 1996 or
any prior calendar year. Thus, P could qualify as a small business
corporation during 1996 if it meets the other requirements provided
in section 1361(b). Assuming that P's ownership of Q stock remains
unchanged, P would cease to be a small business corporation on the
day that Q either begins business or realizes gross income
(determined under Q's method of accounting), whichever day occurs
earlier.
Example 2. Assume the same facts as in Example 1, except that
Corporation Q had begun business prior to 1995, but became inactive
in 1995. For purposes of paragraph (d)(1)(i) of this section, P is
considered to be a member of an affiliated group because Q had begun
business prior to becoming inactive in 1995. Therefore, even though
Q was inactive in 1996, P is not eligible to make the S election
until P liquidates Q.
(e) Number of shareholders--(1) General rule. A corporation does
not
[[Page 37582]]
qualify as a small business corporation if it has more than 35
shareholders. Ordinarily, the person who would have to include in gross
income dividends distributed with respect to the stock of the
corporation (if the corporation were a C corporation) is considered to
be the shareholder of the corporation. For example, if stock (owned
other than by a husband and wife) is owned by tenants in common or
joint tenants, each tenant in common or joint tenant is generally
considered to be a shareholder of the corporation. (For special rules
relating to stock owned by husband and wife, see paragraph (e)(2) of
this section; for special rules relating to restricted stock, see
paragraphs (b) (3) and (6) of this section.) The person for whom stock
of a corporation is held by a nominee, guardian, custodian, or an agent
is considered to be the shareholder of the corporation for purposes of
this paragraph (e) and paragraphs (f) and (g) of this section. For
example, a partnership may be a nominee of S corporation stock for a
person who qualifies as a shareholder of an S corporation. However, if
the partnership is the beneficial owner of the stock, then the
partnership is the shareholder, and the corporation does not qualify as
a small business corporation. In addition, in the case of stock held
for a minor under a uniform gifts to minors or similar statute, the
minor and not the custodian is the shareholder. For purposes of this
paragraph (e) and paragraphs (f) and (g) of this section, if stock is
held by a decedent's estate, the estate (and not the beneficiaries of
the estate) is considered to be the shareholder; however, if stock is
held by a subpart E trust (which includes voting trusts), the deemed
owner is considered to be the shareholder.
(2) Special rules relating to stock owned by husband and wife. For
purposes of paragraph (e)(1) of this section, stock owned by a husband
and wife (or by either or both of their estates) is treated as if owned
by one shareholder, regardless of the form in which they own the stock.
For example, if husband and wife are owners of a subpart E trust, they
will be treated as one individual. Both husband and wife must be U.S.
citizens or residents, and a decedent spouse's estate must not be a
foreign estate as defined in section 7701(a)(31). The treatment
described in this paragraph (e)(2) will cease upon dissolution of the
marriage for any reason other than death.
(f) Shareholder must be an individual or estate. Except as
otherwise provided in paragraph (e)(1) (relating to nominees and
paragraph (h) (relating to certain trusts) of this section, a
corporation in which any shareholder is a corporation, partnership, or
trust does not qualify as a small business corporation.
(g) Nonresident alien shareholder--(1) General rule. (i) A
corporation having a shareholder who is a nonresident alien as defined
in section 7701(b)(1)(B) does not qualify as a small business
corporation. If a U.S. shareholder's spouse is a nonresident alien who
has a current ownership interest (as opposed, for example, to a
survivorship interest) in the stock of the corporation by reason of any
applicable law, such as a state community property law or a foreign
country's law, the corporation does not qualify as a small business
corporation from the time the nonresident alien spouse acquires the
interest in the stock. If a corporation's S election is inadvertently
terminated as a result of a nonresident alien spouse being considered a
shareholder, the corporation may request relief under section 1362(f).
(ii) The following examples illustrate this paragraph (g)(1)(i):
Example 1. In 1990, W, a U.S. citizen, married H, a citizen of a
foreign country. At all times H is a nonresident alien under section
7701(b)(1)(B). Under the foreign country's law, all property
acquired by a husband and wife during the existence of the marriage
is community property and owned jointly by the husband and wife. In
1996 while residing in the foreign country, W formed X, a U.S.
corporation, and X simultaneously filed an election to be an S
corporation. X issued all of its outstanding stock in W's name.
Under the foreign country's law, X's stock became the community
property of and jointly owned by H and W. Thus, X does not meet the
definition of a small business corporation and therefore could not
file a valid S election because H, a nonresident alien, has a
current interest in the stock.
Example 2. Assume the same facts as Example 1, except that in
1991, W and H filed a section 6013(g) election allowing them to file
a joint U.S. tax return and causing H to be treated as a U.S.
resident for purposes of chapters 1, 5, and 24 of the Internal
Revenue Code. The section 6013(g) election applies to the taxable
year for which made and to all subsequent taxable years until
terminated. Because H is treated as a U.S. resident under section
6013(g), X does meet the definition of a small business corporation.
Thus, the election filed by X to be an S corporation is valid.
(2) Special rule for dual residents. [Reserved]
(h) Special rules relating to trusts--(1) General rule. In general,
a trust is not a permitted small business corporation shareholder.
However, except as provided in paragraph (h)(2) of this section, the
following trusts are permitted shareholders:
(i) Qualified Subpart E trust. A trust all of which is treated
(under subpart E, part I, subchapter J, chapter 1) as owned by an
individual (whether or not the grantor) who is a citizen or resident of
the United States (a qualified subpart E trust). This requirement
applies only during the period that the trust holds S corporation
stock.
(ii) Subpart E trust ceasing to be a qualified subpart E trust
after the death of deemed owner. A trust which was a qualified subpart
E trust immediately before the death of the deemed owner and which
continues in existence after the death of the deemed owner, but only
for the 60-day period beginning on the day of the deemed owner's death.
However, if a trust is described in the preceding sentence and the
entire corpus of the trust is includible in the gross estate of the
deemed owner, the trust is a permitted shareholder for the 2-year
period beginning on the day of the deemed owner's death. A trust is
considered to continue in existence if the trust continues to hold the
stock of the S corporation during the period of administration of the
decedent's estate or if, after the period of administration, the trust
continues to hold the stock pursuant to the terms of the will or the
trust agreement. See Sec. 1.641(b)-3 for rules concerning the
termination of estates and trusts for federal income tax purposes. If
the trust consists of community property, and the decedent's community
property interest in the trust is includible in the decedent's gross
estate under chapter 11 (section 2001 and following, relating to estate
tax), then the entire corpus of the trust will be deemed includible in
the decedent's gross estate. Further, for the purpose of determining
whether the entire corpus of the trust is includible in the gross
estate of the deemed owner, if the decedent's spouse was treated as an
owner of a portion of the trust under subpart E immediately before the
decedent's death, the surviving spouse's portion is disregarded.
(iii) Electing Qualified subchapter S trusts. A qualified
subchapter S trust (QSST) that has a section 1361(d)(2) election in
effect (an electing QSST). See paragraph (j) of this section for rules
concerning QSSTs including the manner for making the section 1361(d)(2)
election.
(iv) Testamentary trusts. A trust (other than a qualified subpart E
trust or an electing QSST) to which S corporation stock is transferred
pursuant to the terms of a will, but only for the 60-day period
beginning on the day the stock is transferred to the trust.
(v) Qualified Voting trusts. A trust created primarily to exercise
the voting
[[Page 37583]]
power of S corporation stock transferred to it. To qualify as a voting
trust for purposes of this section (a qualified voting trust), the
beneficial owners must be treated as the owners of their respective
portions of the trust under subpart E and the trust must have been
created pursuant to a written trust agreement entered into by the
shareholders, that--
(A) Delegates to one or more trustees the right to vote;
(B) Requires all distributions with respect to the stock of the
corporation held by the trust to be paid to, or on behalf of, the
beneficial owners of that stock;
(C) Requires title and possession of that stock to be delivered to
those beneficial owners upon termination of the trust; and
(D) Terminates, under its terms or by state law, on or before a
specific date or event.
(2) Foreign trust. For purposes of paragraph (h)(1) of this
section, in any case where stock is held by a foreign trust as defined
in section 7701(a)(31), the trust is considered to be the shareholder
and is an ineligible shareholder. Thus, even if a foreign trust
qualifies as a subpart E trust (e.g., a qualified voting trust), any
corporation in which the trust holds stock does not qualify as a small
business corporation.
(3) Determination of shareholders--(i) General rule. For purposes
of paragraph (b) of this section (qualification as a small business
corporation), and, except as provided in paragraph (h)(3)(ii) of this
section, for purposes of sections 1366 (relating to the pass-through of
items of income, loss, deduction, or credit), 1367 (relating to
adjustments to basis of shareholder's stock), and 1368 (relating to
distributions), the shareholder of S corporation stock held by a trust
that is a permitted shareholder under paragraph (h)(1) of this section
is determined as follows:
(A) If stock is held by a qualified subpart E trust, the deemed
owner of the trust is treated as the shareholder.
(B) If stock is held by a trust defined in paragraph (h)(1)(ii) of
this section, the estate of the deemed owner is generally treated as
the shareholder as of the day of the deemed owner's death. However, if
stock is held by such a trust in a community property state, the
decedent's estate is the shareholder only of the portion of the trust
included in the decedent's gross estate (and the surviving spouse
continues to be the shareholder of the portion of the trust owned by
that spouse under the applicable state's community property law).
The estate ordinarily will cease to be treated as the shareholder
upon the earlier of the transfer of the stock by the trust or the
expiration of the 60-day period (or, if applicable, the 2-year period)
beginning on the day of the deemed owner's death. If the trust
qualifies and becomes an electing QSST, the beneficiary and not the
estate is treated as the shareholder as of the effective date of the
QSST election, and the rules provided in paragraph (j)(7) of this
section apply.
(C) If stock is held by an electing QSST, see paragraph (j)(7) of
this section for the rules on who is treated as the shareholder.
(D) If stock is transferred to a testamentary trust (other than a
qualified subpart E trust or an electing QSST), the estate of the
testator is treated as the shareholder until the earlier of the
transfer of that stock by the trust or the expiration of the 60-day
period beginning on the day that the stock is transferred to the trust.
(E) If stock is held by a qualified voting trust, each beneficial
owner of the stock, as determined under subpart E, is treated as a
shareholder with respect to the owner's proportionate share of the
stock held by the trust.
(ii) Exceptions. Solely for purposes of section 1366, 1367, and
1368 the shareholder of S corporation stock held by a trust is
determined as follows--
(A) If stock is held by a trust (as defined in paragraph (h)(1)(ii)
of this section) that does not qualify as a QSST, the trust is treated
as the shareholder. If the trust continues to own the stock after the
expiration of the 60-day period (or, if applicable, the 2-year period),
the corporation's S election will terminate unless the trust is
otherwise a permitted shareholder. If the trust is a QSST described in
section 1361(d) and the income beneficiary of the trust makes a timely
QSST election, the beneficiary and not the trust is treated as the
shareholder from the effective date of the QSST election; and
(B) If stock is transferred to a testamentary trust described in
paragraph (h)(1)(iii) of this section (other than a qualified subpart E
trust or a trust that has a QSST election in effect), the trust is
treated as the shareholder. If the trust continues to own the stock
after the expiration of the 60-day period, the corporation's S election
will terminate unless the trust otherwise qualifies as a permitted
shareholder.
(i) [Reserved]
(j) Qualified subchapter S trust--(1) Definition. A qualified
subchapter S trust (QSST) is a trust (whether intervivos or
testamentary), other than a foreign trust described in section
7701(a)(31), that satisfies the following requirements:
(i) All of the income (within the meaning of Sec. 1.643(b)-1) of
the trust is distributed (or is required to be distributed) currently
to one individual who is a citizen or resident of the United States.
For purposes of the preceding sentence, unless otherwise provided under
local law (including pertinent provisions of the governing instrument
that are effective under local law), income of the trust includes
distributions to the trust from the S corporation for the taxable year
in question, but does not include the trust's pro rata share of the S
corporation's items of income, loss, deduction, or credit determined
under section 1366. See Secs. 1.651(a)-2(a) and 1.663(b)-1(a) for rules
relating to the determination of whether all of the income of a trust
is distributed (or is required to be distributed) currently. If under
the terms of the trust income is not required to be distributed
currently, the trustee may elect under section 663(b) to consider a
distribution made in the first 65 days of a taxable year as made on the
last day of the preceding taxable year. See section 663(b) and
Sec. 1.663(b)-2 for rules on the time and manner for making the
election. The income distribution requirement must be satisfied for the
taxable year of the trust or for that part of the trust's taxable year
during which it holds S corporation stock.
(ii) The terms of the trust must require that--
(A) During the life of the current income beneficiary, there will
be only one income beneficiary of the trust;
(B) Any corpus distributed during the life of the current income
beneficiary may be distributed only to that income beneficiary;
(C) The current income beneficiary's income interest in the trust
will terminate on the earlier of that income beneficiary's death or the
termination of the trust; and
(D) Upon termination of the trust during the life of the current
income beneficiary, the trust will distribute all of its assets to that
income beneficiary.
(iii) The terms of the trust must satisfy the requirements of
paragraph (j)(1)(ii) of this section from the date the QSST election is
made or from the effective date of the QSST election, whichever is
earlier, throughout the entire period that the current income
beneficiary and any successor income beneficiary is the income
beneficiary of the trust. If the terms of the trust do not preclude the
possibility that any of the requirements stated in paragraph (j)(1)(ii)
of this
[[Page 37584]]
section will not be met, the trust will not qualify as a QSST. For
example, if the terms of the trust are silent with respect to corpus
distributions, and distributions of corpus to a person other than the
current income beneficiary are permitted under local law during the
life of the current income beneficiary, then the terms of the trust do
not preclude the possibility that corpus may be distributed to a person
other than the current income beneficiary and, therefore, the trust is
not a QSST.
(2) Special rules--(i) If a husband and wife are income
beneficiaries of the same trust, the husband and wife file a joint
return, and each is a U.S. citizen or resident, the husband and wife
are treated as one beneficiary for purposes of paragraph (j) of this
section. If a husband and wife are treated by the preceding sentence as
one beneficiary, any action required by this section to be taken by an
income beneficiary requires joinder of both of them. For example, each
spouse must sign the QSST election, continue to be a U.S. citizen or
resident, and continue to file joint returns for the entire period that
the QSST election is in effect.
(ii)(A) Terms of the trust and applicable local law. The
determination of whether the terms of a trust meet all of the
equirements under paragraph (j)(1)(ii) of this section depends upon the
terms of the trust instrument and the applicable local law. For
example, a trust whose governing instrument provides that A is the sole
income beneficiary of the trust is, nevertheless, considered to have
two income beneficiaries if, under the applicable local law, A and B
are considered to be the income beneficiaries of the trust.
(B) Legal obligation to support. If under local law a distribution
to the income beneficiary is in satisfaction of the grantor's legal
obligation of support to that income beneficiary, the trust will not
qualify as a QSST as of the date of distribution because, under section
677(b), if income is distributed, the grantor will be treated as the
owner of the ordinary income portion of the trust or, if trust corpus
is distributed, the grantor will be treated as a beneficiary under
section 662. See Sec. 1.677(b)-1 for rules on the treatment of trusts
for support and Sec. 1.662(a)-4 for rules concerning amounts used in
discharge of a legal obligation.
(C) Example. The following example illustrates the rules of
paragraph (j)(2)(ii)(B) of this section:
Example. F creates a trust for the benefit of F's minor child,
G. Under the terms of the trust, all income is payable to G until
the trust terminates on the earlier of G's attaining age 35 or G's
death. Upon the termination of the trust, all corpus must be
distributed to G or G's estate. The trust includes all of the
provisions prescribed by section 1361(d)(3)(A) and paragraph
(j)(1)(ii) of this section, but does not preclude the trustee from
making income distributions to G that will be in satisfaction of F's
legal obligation to support G. Under the applicable local law,
distributions of trust income to G will satisfy F's legal obligation
to support G. If the trustee distributes income to G in satisfaction
of F's legal obligation to support G, the trust will not qualify as
a QSST because F will be treated as the owner of the ordinary income
portion of the trust. Further, the trust will not be a qualified
subpart E trust because the trust will be subject to tax on the
income allocable to corpus.
(iii) If, under the terms of the trust, a person (including the
income beneficiary) has a special power to appoint, during the life of
the income beneficiary, trust income or corpus to any person other than
the current income beneficiary, the trust will not qualify as a QSST.
However, if the power of appointment results in the grantor being
treated as the owner of the entire trust under the rules of subpart E,
the trust may be a permitted shareholder under section 1361
(c)(2)(A)(i) and paragraph (h)(1)(i) of this section.
(iv) If the terms of a trust or local law do not preclude the
current income beneficiary from transferring the beneficiary's interest
in the trust or do not preclude a person other than the current income
beneficiary named in the trust instrument from being treated as a
beneficiary of the trust under Sec. 1.643(c)-1, the trust will still
qualify as a QSST. However, if the income beneficiary transfers or
assigns the income interest or a portion of the income interest to
another, the trust may no longer qualify as a QSST, depending on the
facts and circumstances, because any transferee of the current income
beneficiary's income interest and any person treated as a beneficiary
under Sec. 1.643(c)-1 will be treated as a current income beneficiary
for purposes of paragraph (j)(1)(ii) of this section and the trust may
no longer meet the QSST requirements.
(v) If the terms of the trust do not preclude a person other than
the current income beneficiary named in the trust instrument from being
awarded an interest in the trust by the order of a court, the trust
will qualify as a QSST assuming the trust meets the requirements of
paragraphs (j)(1) (i) and (ii) of this section. However, if as a result
of such court order, the trust no longer meets the QSST requirements,
the trust no longer qualifies as a QSST and the corporation's S
election will terminate.
(vi) A trust may qualify as a QSST even though a person other than
the current income beneficiary is treated under subpart E as the owner
of a part or all of that portion of a trust which does not consist of
the S corporation stock, provided the entire trust meets the QSST
requirements stated in paragraphs (j)(1) (i) and (ii) of this section.
(3) Separate and independent shares of a trust. For purposes of
sections 1361 (c) and (d), a substantially separate and independent
share of a trust, within the meaning of section 663(c) and the
regulations thereunder, is treated as a separate trust. For a separate
share which holds S corporation stock to qualify as a QSST, the terms
of the trust applicable to that separate share must meet the QSST
requirements stated in paragraphs (j)(1) (i) and (ii) of this section.
(4) Qualified terminable interest property trust. If property,
including S corporation stock, or stock of a corporation that intends
to make an S election, is transferred to a trust and an election is
made to treat all or a portion of the transferred property as qualified
terminable interest property (QTIP) under section 2056(b)(7), the
income beneficiary may make the QSST election if the trust meets the
requirements set out in paragraphs (j)(1) (i) and (ii) of this section.
However, if property is transferred to a QTIP trust under section
2523(f), the income beneficiary may not make a QSST election even if
the trust meets the requirements set forth in paragraph (j)(1)(ii) of
this section because the grantor would be treated as the owner of the
income portion of the trust under section 677. In addition, if property
is transferred to a QTIP trust under section 2523(f), the trust does
not qualify as a permitted shareholder under section 1361 (c)(2)(A)(i)
and paragraph (h)(1)(i) of this section (a qualified subpart E trust),
unless under the terms of the QTIP trust, the grantor is treated as the
owner of the entire trust under sections 671 to 677. If the grantor
ceases to be the income beneficiary's spouse, the trust may qualify as
a QSST if it otherwise satisfies the requirements under paragraphs
(j)(1) (i) and (ii) of this section.
(5) Ceasing to meet the QSST requirements. If a QSST for which an
election under section 1361(d)(2) has been made (as described in
paragraph (j)(6) of this section) ceases to meet any of the
requirements specified in paragraph (j)(1)(ii) of this section, the
provisions of this paragraph (j) will cease to apply as of the first
day on which that requirement ceases to be met. If such a trust ceases
to meet the
[[Page 37585]]
income distribution requirement specified in paragraph (j)(1)(i) of
this section, but continues to meet all of the requirements in
paragraph (j)(1)(ii) of this section, the provisions of this paragraph
(j) will cease to apply as of the first day of the first taxable year
beginning after the first taxable year for which the trust ceased to
meet the income distribution requirement of paragraph (j)(1)(i) of this
section. If a corporation's S election is inadvertently terminated as a
result of a trust ceasing to meet the QSST requirements, the
corporation may request relief under section 1362(f).
(6) Qualified subchapter S trust election--(i) In general. This
paragraph (j)(6) applies to the election provided in section 1361(d)(2)
(the QSST election) to treat a QSST (as defined in paragraph (j)(1) of
this section) as a trust described in section 1361(c)(2)(A)(i), and
thus a permitted shareholder. This election must be made separately
with respect to each corporation whose stock is held by the trust. The
QSST election does not itself constitute an election as to the status
of the corporation; the corporation must make the election provided by
section 1362(a) to be an S corporation. Until the effective date of a
corporation's S election, the beneficiary is not treated as the owner
of the stock of the corporation for purposes of section 678. Any action
required by this paragraph (j) to be taken by a person who is under a
legal disability by reason of age may be taken by that person's
guardian or other legal representative, or if there be none, by that
person's natural or adoptive parent.
(ii) Filing the QSST election. The current income beneficiary of
the trust must make the election by signing and filing with the service
center with which the corporation files its income tax return the
applicable form or a statement that--
(A) Contains the name, address, and taxpayer identification number
of the current income beneficiary, the trust, and the corporation;
(B) Identifies the election as an election made under section
1361(d)(2);
(C) Specifies the date on which the election is to become effective
(not earlier than 15 days and two months before the date on which the
election is filed);
(D) Specifies the date (or dates) on which the stock of the
corporation was transferred to the trust; and
(E) Provides all information and representations necessary to show
that:
(1) Under the terms of the trust and applicable local law--
(i) During the life of the current income beneficiary, there will
be only one income beneficiary of the trust (if husband and wife are
beneficiaries, that they will file joint returns and that both are U.S.
residents or citizens);
(ii) Any corpus distributed during the life of the current income
beneficiary may be distributed only to that beneficiary;
(iii) The current beneficiary's income interest in the trust will
terminate on the earlier of the beneficiary's death or upon termination
of the trust; and
(iv) Upon the termination of the trust during the life of such
income beneficiary, the trust will distribute all its assets to such
beneficiary.
(2) The trust is required to distribute all of its income
currently, or that the trustee will distribute all of its income
currently if not so required by the terms of the trust.
(3) No distribution of income or corpus by the trust will be in
satisfaction of the grantor's legal obligation to support or maintain
the income beneficiary.
(iii) When to file the QSST election. (A) If S corporation stock is
transferred to a trust, the QSST election must be made within the 16-
day-and-2-month period beginning on the day that the stock is
transferred to the trust. If a C corporation has made an election under
section 1362(a) to be an S corporation (S election) and, before that
corporation's S election is in effect, stock of that corporation is
transferred to a trust, the QSST election must be made within the 16-
day-and-2-month period beginning on the day that the stock is
transferred to the trust.
(B) If a trust holds C corporation stock and that C corporation
makes an S election effective for the first day of the taxable year in
which the S election is made, the QSST election must be made within the
16-day-and-2-month period beginning on the day that the S election is
effective. If a trust holds C corporation stock and that C corporation
makes an S election effective for the first day of the taxable year
following the taxable year in which the S election is made, the QSST
election must be made within the 16-day-and-2-month period beginning on
the day that the S election is made. If a trust holds C corporation
stock and that corporation makes an S election intending the S election
to be effective for the first day of the taxable year in which the S
election is made but, under Sec. 1.1362-6(a)(2), such S election is
subsequently treated as effective for the first day of the taxable year
following the taxable year in which the S election is made, the fact
that the QSST election states that the effective date of the QSST
election is the first day of the taxable year in which the S election
is made will not cause the QSST election to be ineffective for the
first year in which the corporation's S election is effective.
(C) If a trust ceases to be a qualified subpart E trust but also
satisfies the requirements of a QSST, the QSST election must be filed
within the 16-day-and-2-month period beginning on the date on which the
trust ceases to be a qualified subpart E trust. If the estate of the
deemed owner of the trust is treated as the shareholder under paragraph
(h)(3)(ii) of this section, the QSST election may be filed at any time
but no later than the end of the 16-day-and-2-month period beginning on
the date on which the estate of the deemed owner ceases to be treated
as a shareholder.
(D) If a corporation's S election terminates because of a late QSST
election, the corporation may request inadvertent termination relief
under section 1362(f). See Sec. 1.1362-4 for rules concerning
inadvertent terminations.
(iv) Protective QSST election when a person is an owner under
subpart E. If the grantor of a trust is treated as the owner under
subpart E of all of the trust, or of a portion of the trust which
consists of S corporation stock, and the current income beneficiary is
not the grantor, the current income beneficiary may not make the QSST
election, even if the trust meets the QSST requirements stated in
paragraph (j)(1)(ii) of this section. See paragraph (j)(6)(iii)(C) of
this section as to when the QSST election may be made. See also
paragraph (j)(2)(vi) of this section. However, if the current income
beneficiary (or beneficiaries who are husband and wife, if both spouses
are U.S. citizens or residents and file a joint return) of a trust is
treated under subpart E as owning all or a portion of the trust
consisting of S corporation stock, the current income beneficiary (or
beneficiaries who are husband and wife, if both spouses are U.S.
citizens or residents and file a joint return) may make the QSST
election. See Example 8 of paragraph (k)(1) of this section.
(7) Treatment as shareholder. (i) The income beneficiary who makes
the QSST election and is treated (for purposes of section 678(a)) as
the owner of that portion of the trust that consists of S corporation
stock is treated as the shareholder for purposes of sections
1361(b)(1), 1366, 1367, and 1368.
(ii) If, upon the death of an income beneficiary, the trust
continues in existence, continues to hold S corporation stock but no
longer satisfies the QSST requirements, and is not a qualified subpart
E trust, then, solely for purposes of section 1361(b)(1), as of the
[[Page 37586]]
date of the income beneficiary's death, the estate of that income
beneficiary is treated as the shareholder of the S corporation with
respect to which the income beneficiary made the QSST election. The
estate ordinarily will cease to be treated as the shareholder for
purposes of section 1361(b)(1) upon the earlier of the transfer of that
stock by the trust or the expiration of the 60-day period beginning on
the day of the income beneficiary's death. However, if the entire
corpus of the trust is includible in the gross estate of that income
beneficiary, the estate will cease to be treated as the shareholder for
purposes of section 1361(b)(1) upon the earlier of the transfer of that
stock by the trust or the expiration of the 2-year period beginning on
the day of the income beneficiary's death. For the purpose of
determining whether the entire trust corpus is includible in the gross
estate of the income beneficiary, any community property interest in
the trust held by the income beneficiary's spouse which arises by
reason of applicable U.S. state law is disregarded. During the period
that the estate is treated as the shareholder for purposes of section
1361(b)(1), the trust is treated as the shareholder for purposes of
sections 1366, 1367, and 1368. If, after the 60-day period, or the 2-
year period, if applicable, the trust continues to hold S corporation
stock, the corporation's S election terminates. If the termination is
inadvertent, the corporation may request relief under section 1362(f).
(8) Coordination with grantor trust rules. If a valid QSST election
is made, the income beneficiary is treated as the owner, for purposes
of section 678(a), of that portion of the trust that consists of the
stock of the S corporation for which the QSST election was made.
However, solely for purposes of applying the preceding sentence to a
QSST, an income beneficiary who is a deemed section 678 owner only by
reason of section 1361(d)(1) will not be treated as the owner of the S
corporation stock in determining and attributing the federal income tax
consequences of a disposition of the stock by the QSST. For example, if
the disposition is a sale, the QSST election terminates as to the stock
sold and any gain or loss recognized on the sale will be that of the
trust, not the income beneficiary. Similarly, if a QSST distributes its
S corporation stock to the income beneficiary, the QSST election
terminates as to the distributed stock and the consequences of the
distribution are determined by reference to the status of the trust
apart from the income beneficiary's terminating ownership status under
sections 678 and 1361(d)(1). The portions of the trust other than the
portion consisting of S corporation stock are subject to subparts A
through D of subchapter J of chapter 1, except as otherwise required by
subpart E of the Internal Revenue Code.
(9) Successive income beneficiary. (i) If the income beneficiary of
a QSST who made a QSST election dies, each successive income
beneficiary of that trust is treated as consenting to the election
unless a successive income beneficiary affirmatively refuses to consent
to the election. For this purpose, the term successive income
beneficiary includes a beneficiary of a trust whose interest is a
separate share within the meaning of section 663(c), but does not
include any beneficiary of a trust that is created upon the death of
the income beneficiary of the QSST and which is a new trust under local
law.
(ii) The application of this paragraph (j)(9) is illustrated by the
following examples:
Example 1. Shares of stock in Corporation X, an S corporation,
are held by Trust A, a QSST for which a QSST election was made. B is
the sole income beneficiary of Trust A. On B's death, under the
terms of Trust A, J and K become the current income beneficiaries of
Trust A. J and K each hold a separate and independent share of Trust
A within the meaning of section 663(c). J and K are successive
income beneficiaries of Trust A, and they are treated as consenting
to B's QSST election.
Example 2. Assume the same facts as in Example 1, except that on
B's death, under the terms of Trust A and local law, Trust A
terminates and the principal is to be divided equally and held in
newly created Trust B and Trust C. The sole income beneficiaries of
Trust B and Trust C are J and K, respectively. Because Trust A
terminated, J and K are not successive income beneficiaries of Trust
A. J and K must make QSST elections for their respective trusts to
qualify as QSSTs, if they qualify. The result is the same whether or
not the trustee of Trusts B and C is the same as the trustee of
trust A.
(10) Affirmative refusal to consent--(i) Required statement. A
successive income beneficiary of a QSST must make an affirmative
refusal to consent by signing and filing with the service center where
the corporation files its income tax return a statement that--
(A) Contains the name, address, and taxpayer identification number
of the successive income beneficiary, the trust, and the corporation
for which the election was made;
(B) Identifies the refusal as an affirmative refusal to consent
under section 1361(d)(2); and
(C) Sets forth the date on which the successive income beneficiary
became the income beneficiary.
(ii) Filing date and effectiveness. The affirmative refusal to
consent must be filed within 15 days and 2 months after the date on
which the successive income beneficiary becomes the income beneficiary.
The affirmative refusal to consent will be effective as of the date on
which the successive income beneficiary becomes the current income
beneficiary.
(11) Revocation of QSST election. A QSST election may be revoked
only with the consent of the Commissioner. The Commissioner will not
grant a revocation when one of its purposes is the avoidance of federal
income taxes or when the taxable year is closed. The application for
consent to revoke the election must be submitted to the Internal
Revenue Service in the form of a letter ruling request under the
appropriate revenue procedure. The application must be signed by the
current income beneficiary and must--
(i) Contain the name, address, and taxpayer identification number
of the current income beneficiary, the trust, and the corporation with
respect to which the QSST election was made;
(ii) Identify the election being revoked as an election made under
section 1361(d)(2); and
(iii) Explain why the current income beneficiary seeks to revoke
the QSST election and indicate that the beneficiary understands the
consequences of the revocation.
(k)(1) Examples. The provisions of paragraphs (h) and (j) of this
section are illustrated by the following examples in which it is
assumed that all noncorporate persons are citizens or residents of the
United States:
Example 1. (i) Terms of the trust. In 1996, A and A's spouse, B,
created an intervivos trust and each funded the trust with
separately owned stock of an S corporation. Under the terms of the
trust, A and B designated themselves as the income beneficiaries and
each, individually, retained the power to amend or revoke the trust
with respect to the trust assets attributable to their respective
trust contributions. Upon A's death, the trust is to be divided into
two separate parts; one part attributable to the assets A
contributed to the trust and one part attributable to B's
contributions. Before the trust is divided, and during the
administration of A's estate, all trust income is payable to B. The
part of the trust attributable to B's contributions is to continue
in trust under the terms of which B is designated as the sole income
beneficiary and retains the power to amend or revoke the trust. The
part attributable to A's contributions is to be divided into two
separate trusts both of which have B as the sole income beneficiary
for life. One trust, the Credit Shelter Trust, is to be funded with
an amount that can pass free of estate tax by reason of A's
available estate tax unified
[[Page 37587]]
credit. The terms of the Credit Shelter Trust meet the requirements
of section 1361(d)(3) as a QSST. The balance of the property passes
to a Marital Trust, the terms of which satisfy the requirements of
section 1361(d)(3) as a QSST and section 2056(b)(7) as QTIP. The
appropriate fiduciary under Sec. 20.2056(b)-7(b)(3) is directed to
make an election under section 2056(b)(7).
(ii) Results after deemed owner's death. On February 3, 1997, A
dies and the portion of the trust assets attributable to A's
contributions including the S stock contributed by A, is includible
in A's gross estate under sections 2036 and 2038. During the
administration of A's estate, the trust holds the S corporation
stock. Under section 1361(c)(2)(B)(ii), A's estate is treated as the
shareholder of the S corporation stock that was included in A's
gross estate for purposes of section 1361(b)(1); however, for
purposes of sections 1366, 1367, and 1368, the trust is treated as
the shareholder. B's part of the trust continues to be a qualified
subpart E trust of which B is the owner under sections 676 and 677.
B, therefore, continues to be treated as the shareholder of the S
corporation stock in that portion of the trust. On May 13, 1997,
during the continuing administration of A's estate, the trust is
divided into separate trusts in accordance with the terms of the
trust instrument. The S corporation stock that was included in A's
gross estate is distributed to the Marital Trust and to the Credit
Shelter Trust. A's estate will cease to be treated as the
shareholder of the S corporation under section 1361(c)(2)(B)(ii) on
May 13, 1997 (the date on which the S corporation stock was
transferred to the trusts). B, as the income beneficiary of the
Marital Trust and the Credit Shelter Trust, must make the QSST
election for each trust by July 27, 1997 (the end of the 16-day-and-
2-month period beginning on the date the estate ceases to be treated
as a shareholder) to have the trusts become permitted shareholders
of the S corporation.
Example 2. (i) Qualified subpart E trust as shareholder. In
1997, A, an individual established a trust and transferred to the
trust A's shares of stock of Corporation M, an S corporation. A has
the power to revoke the entire trust. The terms of the trust require
that all income be paid to B and otherwise meet the requirements of
a QSST under section 1361(d)(3). The trust will continue in
existence after A's death. The trust is a qualified subpart E trust
described in section 1361(c)(2)(A)(i) during A's life, and A (not
the trust) is treated as the shareholder for purposes of sections
1361(b)(1), 1366, 1367, and 1368.
(ii) Trust ceasing to be a qualified subpart E trust on deemed
owner's death. Assume the same facts as paragraph (i) of this
Example 2, except that A dies without having exercised A's power to
revoke. Upon A's death, the trust ceases to be a qualified subpart E
trust described in section 1361(c)(2)(A)(i). A's estate (and not the
trust) is treated as the shareholder for purposes of section
1361(b)(1). Because the entire corpus of the trust is includible in
A's gross estate under section 2038, A's estate will cease to be
treated as the shareholder for purposes of section 1361(b)(1) upon
the earlier of the transfer of the Corporation M stock by the trust
(other than to A's estate), the expiration of the 2-year period
beginning on the day of A's death, or the effective date of a QSST
election if the trust qualifies as a QSST. However, until that time,
because the trust continues in existence after A's death and will
receive any distributions with respect to the stock it holds, the
trust is treated as the shareholder for purposes of sections 1366,
1367, and 1368. After the 2-year period, if no QSST election is
made, the corporation ceases to be an S corporation, but the trust
continues as the shareholder of a C corporation.
(iii) Trust continuing to be a qualified subpart E trust on
deemed owner's death. Assume the same facts as paragraph (ii) of
this Example 2, except that the terms of the trust also provide that
if A does not exercise the power to revoke before A's death, B will
have the sole power to withdraw all trust property at any time after
A's death. The trust continues to qualify as a qualified subpart E
trust after A's death because, upon A's death, B is deemed to be the
owner of the entire trust under section 678. Because the trust does
not cease to be a qualified subpart E trust upon A's death, B (and
not A's estate) is treated as the shareholder for purposes of
sections 1361(b)(1), 1366, 1367, and 1368. Since the trust qualifies
as a QSST, B may make a protective QSST election under paragraph
(j)(6)(iv) of this section.
Example 3. 60-day rule under section 1361(c)(2)(A)(ii) and
(iii). F owns stock of Corporation P, an S corporation. In addition,
F is the deemed owner of a qualified subpart E trust that holds
stock in Corporation O, an S corporation. F dies on July 1, 1996.
The trust continues in existence after F's death but is no longer a
qualified subpart E trust. The entire corpus of the trust is not
includible in F's gross estate. On August 1, 1996, F's shares of
stock in Corporation P are transferred to the trust pursuant to the
terms of F's will. Because the stock of Corporation P was not held
by the trust when F died, section 1361(c)(2)(A)(ii) does not apply
with respect to that stock. Under section 1361(c)(2)(A)(iii), the
last day on which F's estate could be treated as a permitted
shareholder of Corporation P is September 29, 1996 (that is, the
last day of the 60-day period that begins on the date of the
transfer from the estate to the trust). With respect to the shares
of stock in Corporation O held by the trust at the time of F's
death, section 1361(c)(2)(A)(ii) applies and the last day on which
F's estate could be treated as a permitted shareholder of
Corporation O is August 29, 1996 (that is, the last day of the 60-
day period that begins on the date of F's death).
Example 4. (i) QSST when terms do not require current
distribution of income. Corporation Q, a calendar year corporation,
makes an election to be an S corporation effective for calendar year
1996. On July 1, 1996, G, a shareholder of Corporation Q, transfers
G's shares of Corporation Q stock to a trust with H as its current
income beneficiary. The terms of the trust otherwise satisfy the
QSST requirements, but authorize the trustee in its discretion to
accumulate or distribute the trust income. However, the trust, which
uses the calendar year as its taxable year, initially satisfies the
income distribution requirement because the trustee is currently
distributing all of the income. On August 1, 1996, H makes a QSST
election with respect to Corporation Q that is effective as of July
1, 1996. Accordingly, as of July 1, 1996, the trust is a QSST and H
is treated as the shareholder for purposes of sections 1361(b)(1),
1366, 1367, and 1368.
(ii) QSST when trust income is not distributed currently. Assume
the same facts as in paragraph (i) of this Example 4, except that,
for the taxable year ending on December 31, 1997, the trustee
accumulates some trust income. The trust ceases to be a QSST on
January 1, 1998, because the trust failed to distribute all of its
income for the taxable year ending December 31, 1997. Thus,
Corporation Q ceases to be an S corporation as of January 1, 1998,
because the trust is not a permitted shareholder.
(iii) QSST when a person other than the current income
beneficiary may receive trust corpus. Assume the same facts as in
paragraph (i) of this Example 4, except that H dies on November 1,
1996. Under the terms of the trust, after H's death, L is the income
beneficiary of the trust and the trustee is authorized to distribute
trust corpus to L as well as to J. The trust ceases to be a QSST as
of November 1, 1996, because corpus distributions may be made to
someone other than L, the current (successive) income beneficiary.
Under section 1361(c)(2)(A)(ii), H's estate (and not the trust) is
considered to be the shareholder for purposes of section 1361(b)(1)
for the 60-day period beginning on November 1, 1996. However,
because the trust continues in existence after H's death and will
receive any distributions from the corporation, the trust (and not
H's estate) is treated as the shareholder for purposes of sections
1366, 1367, and 1368, during that 60-day period. After the 60-day
period, the S election terminates and the trust continues as a
shareholder of a C corporation. If the termination is inadvertent,
Corporation Q may request relief under section 1362(f). However, the
S election would not terminate if the trustee distributed all
Corporation Q shares to L, J, or both before December 30, 1996, (the
last day of the 60-day period) assuming that neither L nor J becomes
the 36th shareholder of Corporation Q as a result of the
distribution.
Example 5. QSST when current income beneficiary assigns the
income interest to a person not named in the trust. On January 1,
1996, stock of Corporation R, a calendar year S corporation, is
transferred to a trust that satisfies all of the requirements to be
a QSST. Neither the terms of the trust nor local law preclude the
current income beneficiary, K, from assigning K's income interest in
the trust. K files a timely QSST election that is effective January
1, 1996. On July 1, 1996, K assigns the income interest in the trust
to N. Under applicable state law, the trustee is bound as a result
of the assignment to distribute the trust income to N. Thus, the
QSST will cease to qualify as a QSST under section
1361(d)(3)(A)(iii) because N's interest will terminate on K's death
(rather than on N's death). Accordingly, as of the date of the
[[Page 37588]]
assignment, the trust ceases to be a QSST and Corporation R ceases
to be an S corporation.
Example 6. QSST when terms fail to provide for distribution of
trust assets upon termination during life of current income
beneficiary. A contributes S corporation stock to a trust the terms
of which provide for one income beneficiary, annual distributions of
income, discretionary invasion of corpus only for the benefit of the
income beneficiary, and termination of the trust only upon the death
of the current income beneficiary. Since the trust can terminate
only upon the death of the income beneficiary, the governing
instrument fails to provide for any distribution of trust assets
during the income beneficiary's life. The governing instrument's
silence on this point does not disqualify the trust under section
1361(d)(3)(A)(ii) or (iv).
Example 7. QSST when settlor of trust retains a reversion in the
trust. On January 10, 1996, M transfers to a trust shares of stock
in corporation X, an S corporation. D, who is 13 years old and not a
lineal descendant of M, is the sole income beneficiary of the trust.
On termination of the trust, the principal (including the X shares)
is to revert to M. The trust instrument provides that the trust will
terminate upon the earlier of D's death or D's 21st birthday. The
terms of the trust satisfy all of the requirements to be a QSST
except those of section 1361(d)(3)(A)(ii) (that corpus may be
distributed during the current income beneficiary's life only to
that beneficiary) and (iv) (that, upon termination of the trust
during the life of the current income beneficiary, the corpus, must
be distributed to that beneficiary). On February 10, 1996, M makes a
gift of M's reversionary interest to D. Until M assigns M's
reversion in the trust to D, M is deemed to own the entire trust
under section 673(a) and the trust is a qualified subpart E trust.
For purposes of section 1361(b)(1), 1366, 1367, and 1368, M is the
shareholder of X. The trust ceases to be a qualified subpart E trust
on February 10, 1996. Assuming that, by virtue of the assignment to
D of M's reversionary interest, D (upon his 21st birthday) or D's
estate (in the case of D's death before reaching age 21) is entitled
under local law to receive the trust principal, the trust will be
deemed as of February 10, 1996, to have satisfied the conditions of
section 1361(d)(3)(A)(ii) and (iv) even though the terms of the
trust do not explicitly so provide. D must make a QSST election by
no later than April 25, 1996 (the end of the 16-day-and-2-month
period that begins on February 10, 1996, the date on which the X
stock is deemed transferred to the trust by M). See example (5) of
Sec. 1.1001-2(c) of the regulations.
Example 8. QSST when the income beneficiary has the power to
withdraw corpus. On January 1, 1996, F transfers stock of an S
corporation to an irrevocable trust whose income beneficiary is F's
son, C. Under the terms of the trust, C is given the noncumulative
power to withdraw from the corpus of the trust the greater of $5,000
or 5 percent of the value of the corpus on a yearly basis. The terms
of the trust meet the QSST requirements. Assuming the trust
distributions are not in satisfaction of F's legal obligation to
support C, the trust qualifies as a QSST. C (or if C is a minor, C's
legal representative) must make the QSST election no later than
March 16, 1996 (the end of the 16-day-and-2-month period that begins
on the date the stock is transferred to the trust).
Example 9. (i) Filing the QSST election. On January 1, 1996,
stock of Corporation T, a calendar year C corporation, is
transferred to a trust that satisfies all of the requirements to be
a QSST. On January 31, 1996, Corporation T files an election to be
an S corporation that is to be effective for its taxable year
beginning on January 1, 1996. In order for the S election to be
effective for the 1996 taxable year, the QSST election must be
effective January 1, 1996, and must be filed within the period
beginning on January 1, 1996, and ending March 16, 1996 (the 16-day-
and-2-month period beginning on the first day of the first taxable
year for which the election to be an S corporation is intended to be
effective).
(ii) QSST election when the S election is filed late. Assume the
same facts as in paragraph (i) of this Example 9, except that
Corporation T's election to be an S corporation is filed on April 1,
1996 (after the 15th day of the 3rd month of the first taxable year
for which it is to be effective but before the end of that taxable
year). Because the election to be an S corporation is not timely
filed for the 1996 taxable year, under section 1362(b)(3), the S
election is treated as made for the taxable year beginning on
January 1, 1997. The QSST election must be filed within the 16-day-
and-2-month period beginning on April 1, 1996, the date the S
election was made, and ending on June 16, 1996.
Example 10. (i) Transfers to QTIP trust. On June 1, 1996, A
transferred S corporation stock to a trust for the benefit of A's
spouse B, the terms of which satisfy the requirements of section
2523(f)(2) as qualified terminable interest property. Under the
terms of the trust, B is the sole income beneficiary for life. In
addition, corpus may be distributed to B, at the trustee's
discretion, during B's lifetime. However, under section 677(a), A is
treated as the owner of the trust. Accordingly, the trust is a
permitted shareholder of the S corporation under section
1361(c)(2)(A)(i), and A is treated as the shareholder for purposes
of sections 1361(b)(1), 1366, 1367, and 1368.
(ii) Transfers to QTIP trust where husband and wife divorce.
Assume the same facts as in paragraph (i) of this Example 10, except
that A and B divorce on May 2, 1997. Under section 682, A ceases to
be treated as the owner of the trust under section 677(a) because A
and B are no longer husband and wife. Under section 682, after the
divorce, B is the income beneficiary of the trust and corpus of the
trust may only be distributed to B. Accordingly, assuming the trust
otherwise meets the requirements of section 1361(d)(3), B must make
the QSST election within 2 months and 15 days after the date of the
divorce.
(iii) Transfers to QTIP trust where no corpus distribution is
permitted. Assume the same facts as in paragraph (i) of this Example
10, except that the terms of the trust do not permit corpus to be
distributed to B and require its retention by the trust for
distribution to A and B's surviving children after the death of B.
Under section 677, A is treated as the owner of the ordinary income
portion of the trust, but the trust will be subject to tax on gross
income allocable to corpus. Accordingly, the trust does not qualify
as an eligible shareholder of the S corporation because it is
neither a qualified subpart E trust nor a QSST.
(2) Effective date--(i) In general. Paragraph (a), and paragraphs
(c) through (k) of this section apply to taxable years of a corporation
beginning after July 21, 1995. For taxable years beginning on or before
July 21, 1995, to which paragraph (a), and paragraphs (c) through (k)
do not apply, see Sec. 18.1361-1 of this chapter (as contained in the
26 CFR edition revised April 1, 1995).
(ii) Exception. If a QSST has sold or otherwise disposed of all or
a portion of its S corporation stock in a tax year that is open for the
QSST and the income beneficiary but on or before July 21, 1995, the
QSST and the income beneficiary may both treat the transaction as if
the beneficiary was the owner of the stock sold or disposed of, and
thus recognize any gain or loss, or as if the QSST was the owner of the
stock sold or disposed of as described in paragraph (j)(8) of this
section. This exception applies only if the QSST and the income
beneficiary take consistent reporting positions. The QSST and the
income beneficiary must disclose by a statement on their respective
returns (or amended returns), that they are taking consistent reporting
positions.
PART 18--TEMPORARY INCOME TAX REGULATIONS UNDER THE SUBCHAPTER S
REVISION ACT OF 1982
Par. 4. The authority citation for part 18 is revised to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 5. Section 18.0 is revised to read as follows:
Sec. 18.0 Effective date of temporary regulations under the Subchapter
S Revision Act of 1982.
The temporary regulations provided under Sec. 18.1377-1, 18.1379-1,
and 18.1379-2 are effective with respect to taxable years beginning
after 1982, and the temporary regulations provided under Sec. 18.1378-1
are effective with respect to elections made after October 19, 1982.
Secs. 18.1361-1 and 18.1366-5 [Removed]
Par. 6. Sections 18.1361-1 and 18.1366-5 are removed.
[[Page 37589]]
Sec. 18.1378-1 [Amended]
Par. 7. Section 18.1378-1 is amended as follows:
1. The fourth sentence of paragraph (b)(2)(i) is amended by
removing the language ``Sec. 18.1362-1(b)'' and adding the language
``Sec. 1.1362-6(b)(2)(ii) of this chapter'' in its place.
2. The fifth sentence of paragraph (b)(2)(i) is removed.
3. The second sentence of paragraph (b)(2)(ii) is amended by
removing the language ``Sec. 18.1362-1(a)'' and adding the language
``Sec. 1.1362-6(b)(2)(i) of this chapter'' in its place.
4. Paragraph (b)(3) is removed.
5. Paragraph (c) is removed and reserved.
6. Paragraph (e) is removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 8. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Sec. 602.101 [Amended]
Par. 9. Section 602.101, paragraph (c) is amended by removing the
entry for 18.1361-1 from the table and adding the entry ``1.1361-1 . .
. 1545-0731'' in numerical order to the table.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: May 9, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-17914 Filed 7-20-95; 8:45 am]
BILLING CODE 4830-01-U
