IRS has privately ruled that each income beneficiary's share of an electing small business trust (ESBT) constitutes a separate and independent share of the trust under Code Sec. 663(c) and also separately qualifies as a qualified subchapter S trust (QSST), provided that the trust's income is distributed currently. Accordingly, if certain requirements are met, each income beneficiary can file a QSST election and revoke the ESBT election for his separate share without terminating the ESBT election for the other income beneficiaries' shares.
Background. A QSST is a certain type of trust that is an eligible S corporation shareholder. A QSST owns stock in one or more S corps. and distributes (or is required to distribute) all of its income currently to its sole income beneficiary. At all times during the life of the current income beneficiary, there must be only one beneficiary (who is a U.S. citizen or resident), any corpus distributed during the life of the current income beneficiary must be distributed only to that beneficiary, the income interest of the current income beneficiary must terminate on the earlier of the death of the income beneficiary or the termination of the trust, and on termination of the trust during the life of the current income beneficiary, the corpus must be distributed to the beneficiary. (Code Sec. 1361(d)(3))
A trust that has multiple beneficiaries can still meet the QSST single beneficiary requirement if each beneficiary has a separate and independent share of the trust, each of which is treated as a separate trust for federal income tax purposes. (Reg. §1.1361-1(j)(3)) Under Code Sec. 1361(d)(3), a substantially separate and independent share of a trust under Code Sec. 663(c) (i.e., for computing the amount of distributable net income allowable to each beneficiary) is treated as a separate trust for purposes of Code Sec. 1361(c) and Code Sec. 1361(d). In general, under Reg. §1.663(c)-3(a), the applicability of the separate share rule provided by Code Sec. 663(c) will depend upon whether distributions of the trust are to be made in substantially the same manner as if separate trusts had been created.
An ESBT is another type of trust that is an eligible S corporation shareholder. A trust must satisfy the following requirements to qualify as an ESBT: it can only have as beneficiaries individuals, estates, or certain charitable organizations; no interests in the trust can be acquired by purchase; an ESBT election must be made; the trust cannot make a QSST election with respect to any stock held by the trust; and it is not a tax-exempt trust or a charitable remainder annuity trust or unitrust. (Code Sec. 1361(e)(1))
Under Reg. §1.1361-1(m)(6), an ESBT election can only be revoked with IRS consent. However, if a trust seeks to convert from an ESBT to a QSST, consent to revoke the ESBT election is granted as of the effective date of the QSST election, if the requirements of Reg. §1.1361-1(m)(7) are met.
Facts. Trust was established under the will of a decedent and holds stock in an S corporation. Trust elected to be an ESBT under Code Sec. 1361(e)(3).
Trust's terms provide for the trustee to distribute specific dollar amounts of net income to certain named beneficiaries. B, the only named beneficiary still alive, receives an undisclosed amount of net income per month. After paying B, Trust's income is divided into as many equal parts as there are grandchildren of the decedent who are living or who have died leaving issue. C is the last surviving grandchild, and there are a number of grandchildren who died leaving issue.
Upon the death of C, the income of Trust is to be divided into as many equal parts as there are great-grandchildren of the decedent who are living or who have died leaving issue. On an earlier date, Trust received a Court order modifying Trust to add a provision that any child of C born after a certain date shall not be a great-grandchild, a descendent, or an issue within the meaning of Trust, and any such child shall not be entitled to receive any distributions of income or corpus from Trust. Thus, upon the death of C, each of the beneficiaries will be entitled to a certain amount of the corpus of Trust. Some beneficiaries' shares of Trust income will increase, but no beneficiaries' shares will decrease.
No corpus of Trust can be distributed before termination of Trust. Trust will terminate a certain number of years after the death of C. On termination of Trust, corpus will be distributed in equal shares to the income beneficiaries in the same percentages as the income was distributed.
IRS rules favorably. In a taxpayer-friendly private letter ruling (PLR), IRS concluded that:
(1) each income beneficiary's share in Trust is a separate and independent share under Code Sec. 663(c);
(2) provided that the income is distributed currently, each separate share qualifies as a QSST; and
(3) provided that Reg. §1.1361-1(m)(7) 's requirements are met, each income beneficiary can make an election under Code Sec. 1361(d)(2) to revoke the ESBT election for their separate share and treat it as a QSST. The revocation of the ESBT election for one or more separate shares won't affect the current ESBT election for the shares of the remaining income beneficiaries. IRS stated that this ruling is contingent upon B disclaiming his interest in Trust, effective as of an undisclosed date, within 30 days from the date of the PLR.
References: For separate shares in a QSST, see FTC 2d/FIN ¶D-1464; United States Tax Reporter ¶13,614.03; TaxDesk ¶611,020; TG ¶4724.