Linked trusts are eligible for S status

Linked trusts were eligible to be S shareholders PLR 200912005

Mike Habib, EA Tax Relief & Tax Resolution Services

IRS has privately ruled that a trust having a second trust as a remainder beneficiary could choose to be treated as an electing small business trust (ESBT) and thus was eligible to be a shareholder of an S corporation. IRS also concluded that the second trust was not a charitable remainder trust. As a result, the second trust will be eligible to be treated as an ESBT when it becomes a potential current beneficiary of the first trust.

Facts. Trust 1, which was created under Will 1, is the sole shareholder of Company, a C corporation. Company intends to elect to be treated as an S corporation. Trust 1 has individual beneficiaries and remainder beneficiaries. The remainder beneficiaries of Trust 1 are all individuals except for Trusts 2 and 3, which were created under Will 2. Trust 3 is a tax-exempt Code Sec. 501(c)(3) organization. Trust 2 has individual beneficiaries. Upon the death of the last of them, Trust 2 will terminate and the trust estate will be added to Trust 3.

Trust 2 is required to pay, not less often than annually, either a sum certain (not less than 5% nor more than 50% of the initial net fair market value (FMV) of all property placed in trust), or a fixed percentage (which is not less than 5% nor more than 50%) of the net fair market value of its assets, valued annually, to one or more persons.

Trust 1 has not made an election to be a qualified subchapter S trust (QSST) and is not exempt from income tax. All current beneficiaries of Trust 1 received their trust interests by inheritance and not by purchase.

Rulings sought. Trust 1 asked IRS to rule that it is eligible to be an ESBT under Code Sec. 1361(e), and is thus eligible to be an S corporation shareholder under Code Sec. 1361(b)(1)(B) and Code Sec. 1361(c)(2) . It also asked IRS to rule that Trust 2 is not a charitable remainder trust under Code Sec. 664(d).

Background. An S corporation is a small business corporation for which an election under Code Sec. 1362(a) is in effect for a tax year. (Code Sec. 1361(a)(1)) A small business corporation cannot have as a shareholder a person (other than an estate, a trust described in Code Sec. 1361(c)(2), or an organization described in Code Sec. 1361(c)(6)) who is not an individual.

An ESBT may be an S shareholder. (Code Sec. 1362(c)(2)(A)(v)) An ESBT must meet the following requirements:

(1) The trust must not have any beneficiaries other than individuals, estates, or charitable organizations described in Code Sec. 170(c)(2) through Code Sec. 170(c)(5) (relating to various charitable organizations, war veterans organizations, fraternal lodges, and cemetery organizations). Nonresident aliens may be beneficiaries (but not potential current beneficiaries). Organizations described in Code Sec. 170(c)(1) (i.e, state governments, U.S. possessions, political subdivisions of states or U.S. possessions, and the U.S. and the District of Columbia) may also be ESBT beneficiaries. However, they may only hold contingent interests and may not be potential current beneficiaries. (Code Sec. 1361(e)(1)(A)(i))

(2) No interest in the trust may have been acquired by purchase. (Code Sec. 1361(e)(1)(A)(ii)) (3) An election to be an ESBT must apply to the trust. (Code Sec. 1361(e)(1)(A)(iii)) (4) A QSST election must not have been made with respect to any stock held by the trust. (Code Sec. 1361(e)(1)(B)(i)) (5) The trust must not be a tax-exempt trust, a charitable remainder annuity trust (CRAT), or a charitable remainder unitrust (CRUT). (Code Sec. 1361(e)(1)(B)(ii), Code Sec. 1361(e)(1)(B)(iii))

Reg. § 1.1361-1(m)(1)(ii)(A) provides that for purposes of Reg. § 1.1361-1, a beneficiary includes a person who has a present, remainder, or reversionary interest in the trust. Under Reg. § 1.1361-1(m)(1)(ii)(B), a distributee trust is the beneficiary of the ESBT only if the distributee trust is an organization described in Code Sec. 170(c)(2) or Code Sec. 170(c)(3). In all other situations, any person who has a beneficial interest in a distributee trust is a beneficiary of the ESBT. (Reg. § 1.1361-1(m)(1)(ii)(B))

A distributee trust is a trust that receives or may receive a distribution from an ESBT, whether the rights to receive the distribution are fixed or contingent, or immediate or deferred. (Reg. § 1.1361-1(m)(1)(ii)(B))

A potential current beneficiary is, 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 (determined without regard to any power of appointment to the extent such power remains unexercised at the end of such period). (Code Sec. 1361(e)(2)) For purposes of determining whether a corporation is a small business corporation, each potential current beneficiary of an ESBT generally is treated as a shareholder of the corporation. (Reg. § 1.1361-1(m)(4)(i)) No person is treated as a potential current beneficiary solely because that person holds any future interest in the trust.

Reg. § 1.1361-1(m)(4)(iv) contains the rules for determining who are the potential current beneficiaries of an ESBT if a distributee trust becomes entitled to, or at the discretion of any person, may receive a distribution from principal or income of an ESBT. If the distributee trust is not a trust described in Code Sec. 1362(c)(2)(A), then the distributee trust is the potential current beneficiary of the ESBT and the corporation’s S corporation election terminates. (Reg. § 1.1361-1(m)(4)(iv)(B))

If the distributee trust is a trust described in Code Sec. 1362(c)(2)(A), the persons who would be its potential current beneficiaries if the distributee trust were an ESBT are treated as the potential current beneficiaries of the ESBT. (Reg. § 1.1361-1(m)(4)(iv)(C)) For this purpose, a trust will be deemed to be so described if it would qualify for a QSST election or an ESBT election if it owned S corporation stock. (Reg. § 1.1361-1(m)(4)(iv)(D))

A charitable remainder trust () is a trust formed to make current distributions to one or more noncharitable income beneficiaries and to pay the entire remainder to charity or use it for a charitable purpose. A CRT must be either a charitable remainder annuity trust (CRAT) or a charitable remainder unitrust (CRUT). A CRAT is a trust which is to pay its income beneficiary or beneficiaries a specified sum each year that can’t be less than 5% nor more than 50% of the initial net FMV of all property placed in trust. A CRUT is a trust which is to pay the income beneficiary or beneficiaries a fixed percentage each year, not less than 5% nor more than 50% of the net FMV of its assets, as valued annually. Some variations are permitted.

Ruling 1. IRS concluded that Trust 2 is a distributee trust. Therefore, its beneficiaries will be treated as the beneficiaries of Trust 1 for ESBT qualification purposes. Consequently, Trust 1 is eligible to elect to be treated as an ESBT and is thus eligible to be an S shareholder.

Ruling 2. IRS concluded that Trust 2 is not a charitable remainder trust. Therefore, Trust 2 will not be ineligible to be treated as an ESBT when it becomes a potential current beneficiary of Trust 1. Consequently, Trust 2 will qualify for deemed Code Sec. 1361(c)(2)(A) treatment under Reg. § 1.1361-1(m)(4)(iv)(D).

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