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William & Mary Annual Tax Conference Conferences, Events, and Lectures

1991

S Corporation Stock in Trusts and Estates -Preserving the S Election and Other PracticalProblemsW. Birch Douglass III

Copyright c 1991 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository.https://scholarship.law.wm.edu/tax

Repository CitationDouglass, W. Birch III, "S Corporation Stock in Trusts and Estates - Preserving the S Election and Other Practical Problems" (1991).William & Mary Annual Tax Conference. 195.https://scholarship.law.wm.edu/tax/195

S CORPORATION STOCK IN TRUSTSAND ESTATES -- PRESERVING THE S ELECTION

AND OTHER PRACTICAL PROBLEMS

By

W. Birch Douglass, III

McGuire, Woods, Battle & BootheRichmond, Virginia

I. INTRODUCTION

A. The Importance of S Corporations.

1. Since the repeal of the General Utilities rule bythe Tax Reform Act of 1986, the S corporation isfrequently the entity of choice for avoidingdouble taxation on the sale of a business orselected assets or for getting the corporateearnings into the hands of the shareholders.

2. Current income tax savings can be realizedbecause of the spread between the top corporaterate of 34 percent and the top individual rate of31 percent.

3. Undistributed earnings increase the basis in theS stock.

4. S corporations are not subject to the alternativeminimum tax, the accumulated earnings tax, or thepersonal holding company tax.

5. These advantages may be of greater importance toa trust or estate where the beneficiaries are notemployees of the business.

B. Basic Choice of Entity Considerations.

1. Limited liability can make the S corporation moreattractive than a partnership or soleproprietorship where an entity other than a Ccorporation is to be used.

2. An S corporation as a general partner in alimited partnership is attractive in manysituations as a way to obtain both limitedliability and pass-through treatment withoutsubjecting the entire enterprise to the

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disadvantages of S status (for example, the riskof an impermissible shareholder or gain on thein-kind distribution of an asset).

3. S corporation stock may be easier to administerin a trust or estate than a proprietorship orpartnership interest.

4. The liquidation, split up, or reorganization ofan S corporation can involve more tax cost than apartnership.

5. S corporations cannot have multiple classes of

interests whereas partnerships can.

C. S Corporation Qualification Requirements.

1. The corporation must be a domestic corporation.

2. The corporation must have no more than 35shareholders.

3. The corporation must not be part of an affiliatedgroup (for example, it must not own 80 percent ormore of the stock of any corporation).

4. Each shareholder must be an individual, anestate, a grantor trust, a qualified subchapter Strust (QSST), or a voting trust. Corporations,partnerships, nonresident aliens, and other typesof trusts are not permitted shareholders.

5. The corporation can have only one class ofoutstanding shares. Voting and nonvoting commonshares are allowed if the right to vote is theonly distinction. Preferred shares are notpermitted.

6. An election form signed by the corporation andall shareholders must be filed with the InternalRevenue Service no later than 2-1/2 months afterthe beginning of the first year of S status.

7. The corporation generally cannot have terminatedor revoked an S election within the last fiveyears.

D. OSST Requirements.

1. Qualification requirements. S1361(d)(3).

a. There must be only one income beneficiary ata time.

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b. The income beneficiary must be a U.S. citizenor resident.

c. All fiduciary accounting income must bedistributed or required to be distributedcurrently to the income beneficiary. In PLR9103015 the Internal Revenue Service heldthat the distribution of income "at leastannually" was required for QSST purposes.Payments to or for a spouse or child of thebeneficiary are permitted if in satisfactionof the beneficiary's legal obligation. PLR8907010. The instrument may permit income tobe accumulated at any time that the trust isnot an S corporation shareholder. PLR9014008. Income may not, however, be paid tothe beneficiary's revocable or grantor trust.PLR 9014008 and PLR 9014008. Undistributed Scorporation income is not "income" for QSSTpurposes and is not subject to the currentdistribution requirements. PLR 9025011.

d. Corpus must be distributable only to theincome beneficiary during the incomebeneficiary's life. A trust is not a QSST ifits terms provide that in the event the trustdoes not hold shares of an S corporation, thetrust may terminate during the life of thecurrent income beneficiary and distribute itscorpus to persons other than the currentincome beneficiary. Rev. Rul. 89-55, 1989-1C.B. 268. The trust cannot be a QSST whereremaindermen as well as current incomebeneficiaries have Crummey powers ofwithdrawal. PLR 901687.

e. If the trust terminates during the incomebeneficiary's life, all the trust assets mustbe distributable to the income beneficiary.

f. The income beneficiary's income interest mustcontinue until the income beneficiary's deathor earlier termination of the trust.

2. The QSST election is made by the beneficiary, notthe trustee. §1361(d)(2)(A).

3. A separate election is required for each Scorporation. §1361(d)(2) (B)(ii).

4. The election continues as to each successiveincome beneficiary unless there is an affirmativerefusal to consent to the election.§1361(d) (2) (B) (ii).

E. Taxation of S Shareholders.

1. Generally shareholders of an S corporation aretaxed in a manner similar to partners in apartnership.

2. S shareholders separately take into account theirpro rata shares of items of income, loss,deduction, or credit and their pro rata shares ofnonseparately computed income or loss.

3. The character of an item is determined as ifreceived directly from the source from which itwas realized by the S corporation.

4. Items are taken into account by the S shareholderin his taxable year in which falls the last dayof the S corporation's taxable year.

5. When there is a change in share ownership, itemsare allocated ratably on a per share, per daybasis unless an election is made to close thebooks. Note that in a partnership thepartnership's taxable year closes with respect toa partner who sells his entire interest.

6. A deceased S shareholder must include on hisfinal return his share of items through his dateof death. All items for the balance of the yearare reported by his estate. Note that in apartnership all income (or loss) in year of deathis reported on the fiduciary income tax returnand none on the deceased partner's final return.

7. Distributions of the accumulated adjustmentsaccount (AAA) are tax free (generally up to oneyear after termination of S election), althoughsuch distributions produce taxable gain to theextent they exceed the shareholder's basis in hisstock. Distributions in excess of AAA aretaxable if the S corporation is a converted Ccorporation and has accumulated earnings andprofits (AE&P). Beyond AAA and AE&P,distributions are treated as a return of basis,with any excess treated as capital gain. Notethat in a partnership distributions of property(other than cash) in excess of basis are nottaxed to the partner.

8. Basis of S stock is computed in a manner similarto that used for a partnership. Note that basisis not increased for corporate debt.

9. Losses of an S corporation may only be deductedto the extent of the basis of the S shareholderin his stock and debt.

10. The at-risk rules of section 465 apply to Scorporations as well as partnerships.

11. The passive activity loss limitation rules ofsection 469 allow losses from passive activitiesto be used only to the extent of net income frompassive activities. These rules apply to Sshareholders and trusts and estates holding Sstock. Material participation is determined byreference to the activity of the fiduciary,except for grantor trusts and QSSTs in whichcases the material participation of thebeneficiaries is relevant. General Explanationof the Tax Reform Act of 1986, at 242, n. 33.

12. If the S election is terminated on other than thefirst day of the taxable year and the Scorporation is a partner in a partnership, it isconsidered to have sold its entire interest inthe partnership on the last day of the S shortyear if the normalization election under section1362(e) (3) is made or the 50 percent ownershipchange rule of section 1362(e)(6)(D) applies.Prop. Reg. §1.1362-4(c)(5).

II. PLANNING THE ESTATE OF THE S SHAREHOLDER

A. Asking the Right Questions.

1. Does the client own any S stock?

2. Will the S election be continued?

3. Does the S corporation have assets that mayproduce capital gains?

4. Is the S corporation a converted C corporationwith AE&P?

5. Do the S corporation shareholders have buy-sellor other agreements?

6. Do the articles of incorporation or bylaws of theS corporation contain transfer restrictions orother provisions relating to the S status?

7. Has the board of directors of the S corporationadopted resolutions relating to the payment ofdividends?

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8. Are any of the client's intended beneficiariesnonresident aliens or likely to become bankruptor wish to pledge their shares?

9. What repercussions will flow if the clientdisposes of his S stock in a manner thatterminates the S election?

10. Will the beneficiaries be content with the Selection? Should voting control be separatedfrom beneficial ownership?

11. Does the client own shares in any C corporationthat is likely to make an S election?

B. Deciding Whether to Leave the S Stock Outright or in

Trust.

1. Outright -- the easy way out.

a. Lets the beneficiaries step into thedecedent's shoes upon distribution by theexecutor.

b. Keeps the trustee from being put in anuncomfortable position.

c. The S corporation may operate with moreflexibility by not having a fiduciary as ashareholder.

d. Permits the use of more stringent shareholderagreements.

2. Advantages of trusts.

a. Protection and conservation of both the Sstock and the S election.

b. Tax planning opportunities can result from aQSST election through the operation ofSubpart E.

Example: If a bypass trust holdsan interest in a partnership thathas a capital gain, the gain istaxed to trust and reduces thevalue of the trust for theremaindermen. If the trust holds Sstock and the beneficiary makes theQSST election, capital gains of theS corporation are taxed to thebeneficiary (reducing the size ofhis estate) without reducing the

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trust's value. On the other hand,obviously not every beneficiarywould be happy with this result.

3. Limitations of trusts.

a. The use of sprinkling trusts and contingentincome beneficiary provisions is prohibited.

b. A successor income beneficiary can disaffirmthe QSST election. §1361(d)(2)(B)(ii). Anin terrorem clause terminating the trust infavor of another beneficiary will preclude aQSST election. See Rev. Rul. 89-55, 1989-1C.B. 268.

C. Drafting for Testamentary Flexibility.

1. Assuming nontax considerations do not dictate whoshould get the stock, consider giving theexecutor broad discretion to take income taxeffects into account in allocating anddistributing assets.

a. If S stock is specifically bequeathed ordistributions will not be pro rata, theexecutor should be authorized or directed tomake equitable adjustments.

b. Conflicts of interest can arise where theexecutor is also a beneficiary, in whichevent directions as opposed to discretion maybe more appropriate.

c. Authorize the fiduciary to sell to familymembers for notes that can be held in asprinkling trust.

d. Authorize the trustee to divide a trust ifneeded or desirable in making a QSST election(but do not authorize the trusts to berecombined when S stock is no longer held).

2. A separate "pocket" trust designed to hold Sstock may be the best alternative.

a. Allows other assets to be placed in asprinkling trust.

b. Permits use of different trustees. Forexample, a corporate fiduciary may bereluctant to serve as trustee over a trustwith S stock or may be reluctant to sign ashareholders agreement. It may also be

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unacceptable to the family to give acorporate trustee effective control over Sstock.

c. If there is a surviving spouse, the trustshould be structured as a qualifiedterminable interest property (QTIP) trust. AQTIP trust by its very nature meets all ofthe QSST requirements (although the reverseis not true). This gives the flexibility toqualify the S stock for a marital deductionand use the unified credit to shelter otherassets (for example, where the S corporationis not likely to appreciate because it isdistributing all of its earnings to itsshareholders).

d. Consider authorization for the trustee of acredit shelter or other nonmarital deductionQSST to purchase all or a portion of the Scorporation stock that is allocated to amarital trust. This may be desirable forcontrol purposes where because of values onlya portion of the S stock could be allocatedto the credit shelter trust. If the purchaseis from a marital trust for a promissorynote, estate-freezing opportunities exist inthe surviving spouse's estate.

3. Trusts for the benefit of children (orgrandchildren).

a. The typical "pot" trust for the collectivebenefit of the children until the youngestreaches a specified age will not meet theQSST requirements.

b. The safest approach is a separate simpletrust for each beneficiary. Although acomplex trust is permissible, the simpletrust approach eliminates the potential forlosing S status if the trustee fails todistribute all income (or misclassifies areceipt as principal instead of income).Note that the trust may permit income to beaccumulated at any time that it is not an Sshareholder. PLR 9014008.

c. A trust satisfying the separate share rule ofsection 663(c) can be used where it isdesired to avoid the extra fiduciary feesthat would result from the use of separatetrusts. §1361(d) (3).

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d. The will can provide that a non-QSST willconvert into a QSST upon receiving S stock.For example, a sprinkling trust for aspecific child and his or her issue canautomatically convert into a simple trust forthe child. However, the will cannot providethat the trust changes back to a sprinklingtrust after it no longer holds S stock. SeeRev. Rul. 89-55, 1989-1 C.B. 268.

4. Preparing for disclaimers.

a. Consider a special trust for S stock withdispositive provisions in the event of adisclaimer. For instance, a disclaimer of Sstock from a marital trust to a creditshelter bypass trust will cause a loss of Sstatus if the credit shelter trust is not inQSST form.

b. Maximum S election tax-planning benefits (forexample, basis adjustments) will not beavailable for a single trust that has made apartial QTIP election.

c. A disclaimer from a marital trust to a creditshelter bypass trust should be effective evenif it relates just to S stock.

D. Irrevocable Life Insurance Trust.

1. Although an insurance trust will initially haveonly cash upon the insured's death, it should bedrafted with the expectation that the trusteewill purchase illiquid assets, including S stock,from the probate estate.

a. The insurance provides liquidity for thepayment of estate taxes and otheradministration expenses.

b. If the S stock is likely to increasesubstantially in value, it may be desirableto hold it in a trust designed to be exemptfrom further estate and generation-skippingtransfer taxes.

c. Be sure to provide for the same flexibilityas in a testamentary trust, that is, includeprovisions for separate trusts which qualifyas QSSTs or provide appropriate fiduciarydiscretion.

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2. Consider a split-dollar arrangement between thetrust and the S Corporation.

a. Permits the equivalent of an interest-freeloan from the corporation to the trustwithout being characterized as such. SeeRev.. Rul. 64-328, 1964-2 C.B. 11.

b. Reduces the trust's share of the premiumpayments to a relatively nominal amount,thereby facilitating the effective use ofCrummey annual withdrawal powers to shelterthe annual premium-related gifts.

c. Particularly effective in the case of second-to-die life insurance because of the lowpremiums and even lower P.S. 38 costs (thejoint and survivor equivalent of P.S. 58).

d. There is a concern that the dividends or cashvalue buildup in the policy (to the extent inexcess of the amounts to be repaid to thecorporation) will be taxable to the insuredor the trust. See Rev. Rul. 66-110, 1966-1C.B. 12.

e. Where the insured's interest in a policy wasforfeitable until a certain date, at whichtime the employer's interest in the policywas "rolled out" to the employee, theInternal Revenue Service has ruled that thenet value of the policy at the time of therollout was taxable to the employee undersection 83(a). PLR 7916029 and PLR 8310027.

f. Even if the employee or the trust is subjectto income tax on the constructive transfer ofthe cash value buildup, the net effect may bea wash because of the deductibility to thecorporation.

g. Care must be taken that the rollout of thecorporation's interest in the policy does notconstitute a transfer for value to the trustunder section 101(a)(2). Use of a collateralassignment split-dollar arrangement (ratherthan the endorsement method) will avoid theneed for a transfer of the policy and thuslessen this potential exposure (and may alsolessen the likelihood of taxation of thepolicy buildup as discussed above).

h. The Internal Revenue Service has approved asplit-dollar arrangement between a

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corporation and a shareholder (asshareholder), in which case the constructivebenefits to the insured are treated asdividends rather than compensation (therebyavoiding the application of section 83).Rev. Rul. 79-50, 1979-1 C.B. 138. See alsoJohnson v. Commissioner, 74 T.C. 1316 (1980).Assuming the S corporation has sufficientAAA, this arrangement may have preferableincome tax consequences, but beware ofinadvertently creating a second class ofstock where there is more than oneshareholder.

E. Inter Vivos Transfers.

1. Many clients prefer the simplicity of simplymaking direct gifts of S stock to children orgrandchildren.

a. Gifts can be outright or in Uniform Transfersto Minors Act custodianships.

b. A section 2503(c) trust will qualify as aQSST as long as all income is distributed. Atrust for a single beneficiary, all thecontributions to which are sheltered by aCrummey withdrawal power, will be treated asa section 678 trust by the Internal RevenueService and thus as an eligible Sshareholder.

c. Standard principles of valuation apply,including potential minority and lack ofmarketability discounts.

d. If the client is concerned about maintainingcontrol, he can create and give awaynonvoting shares without violating the one-class-of-stock rule of section 1361(b) (1)(D).

2. If a client's children (or grandchildren) areemployed by an S corporation of which the clientis the principal shareholder, the lowergeneration employees should receive maximumreasonable compensation, and the client shouldreceive minimum reasonable compensation.

a. Be aware of the general income tax rules onreasonable compensation, and of section1366(e), permitting the Internal RevenueService to adjust the S corporation incometax consequences within the family group.

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b. This is an easy opportunity to derive modesttransfer tax benefits, but should not beabused.

III. POSTMORTEM PLANNING WITH S CORPORATIONS

A. AdvantaQes of Holding S Stock in the Estate RatherThan Distributing to a Trust.

1. An estate may hold S stock indefinitely, subjectonly to the prolonged administration rules ofsection 1.641(b)-3(a) of the regulations.

a. An estate that is kept open to hold S stockduring the period of estate tax deferralunder section 6166 is a permissibleshareholder. Rev. Rul. 76-23, 1976-1 C.B.264.

b. The IRS will not issue an advance ruling onwhether the administration of an estate isunduly prolonged. Rev. Proc. 91-3, 1991-1I.R.B. 52.

c. If administration is unduly prolonged, statusas an estate ceases. Brown v. United States,890 F.2d 1329 (5th Cir. 1989); Old VirginiaBrick Co. v. Commissioner, 367 F.2d 276 (4thCir. 1966). If the entity is then treated asa trust, eligibility as an S shareholder maybe lost.

2. An estate may "sprinkle" income to itsbeneficiaries.

a. There is no requirement that thebeneficiaries themselves be permittedshareholders.

b. Trusts that would otherwise not be permittedshareholders can receive S income from anestate.

3. An estate can elect a fiscal year, thuspermitting limited deferral of income. §441.

a. This can be particularly advantageous if asizeable distribution of AE&P is to be madein order to provide liquidity to the estate.

b. Staggered fiscal years may create flexibilityin matching passive activity income withpassive activity losses.

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4. An estate (or living trust that receives theresidue of the estate) does not pay estimatedtaxes for any taxable year ending before the datethat is two years after the decedent's death.S6654 (1) (2).

B. Initial S Election by Estate as Sole Shareholder.

1. The executor should be alert to this opportunity.

a. If the decedent dies within 2-1/2 months ofthe beginning of the C corporation's taxableyear, a retroactive election apparently canbe made..

b. A retroactive election has the effect ofcausing the newly elected S corporation'sincome attributable to the predeath portionof the year to become taxable on thedecedent's final return.

2. Significant deferral is available under certaincircumstances.

Example: Decedent dies March 1, 1991owning a calendar year corporation.Decedent's will leaves Estate outright toBeneficiaries. By March-15, 1991,Executor files Form 2553 making an Selection. Executor selects a fiscal yearof March 31 for Estate. Income of Scorporation for period from March 1, 1991through December 31, 1991 goes onEstate's Form 1041 for year ended March31, 1992. S corporation income receivedby Estate after April 1, 1991 anddistributed to Beneficiaries will bereflected on their K-is for Estate'sMarch 31, 1992 fiscal year end andreported on their calendar 1992 returns.Result is that Beneficiaries receiveincome as early as April, 1991 but do notpay income taxes on it until April, 1993.

3. Ideal candidate is an estate that qualifies forsection 6166 deferral and owns a C corporationwith appreciated long-term assets.

a. Making the S election begins the 10-yearbuilt-in gain period.

b. Current earnings of the corporation can bewithdrawn by the estate in order to pay

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interest and principal under the section 6166election.

c. Upon expiration of the deferral period(assuming at least 10 years had beenelected), the corporation's assets can besold and the corporation liquidated withoutdouble tax.

4. Under section 1361(c)(2)(A)(ii) a grantor trustholding stock has two years from the date of thegrantor's death to participate in an S election,assuming the trust is fully includible in thegrantor's gross estate.

a. Because the trust is the actual shareholder,it will exercise all voting rights in makingthe election from the standpoint of thecorporation. However, the shareholderconsent to the election must be made by thegrantor's executor because the estate of thegrantor is treated as the shareholder foreligibility purposes. §1361(c) (2) (B) (ii).

b. Although it is not clear who bears the incometax burden (the estate or the trust), thebenefits (dividends).go to the trust'sbeneficiaries. Most commentators take theposition that the trust receives the K-I andbears the income tax burden and that thedeemed owner rules only apply for eligibilitypurposes.

c. Apparently a QSST election cannot be made bythe grantor trust during the two-year periodthe estate is treated as the shareholder evenif the trust would otherwise qualify. Prop.Reg. §i.1361-IA(i) (e).

C. Use of Disclaimers.

1. If all trusts under the plan are impermissibleshareholders, a disclaimer may enable the stockto pass to an eligible shareholder.

Example: Stock goes to sprinkling trustlasting for life of Child, terminating atChild's death in favor of Grandchildren.If Child disclaims stock, it will passdirectly to Grandchildren and S electioncontinues.

2. If the S stock is left in trust with other assetsand it is desired to disclaim only the S stock,

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the stock must be "removed from the trust" inorder to be a qualified disclaimer. Reg.§25.2518-3(a)(2). For this purpose it should bepermissible for the S stock to pass by reason ofthe disclaimer to a separate trust, qualifying asa QSST for the disclaimant's child.

3. Disclaimers relate back to the date of death, andas a result a disclaimer may be used after the -fact to shift the income tax burden of the Sincome.

4. See PLR 9025086 and PLR 9045060 as examples ofthe use of disclaimers to meet the QSSTrequirements. Reformations can also be used tosatisfy the criteria. PLR 8907004, PLR 9032007,and PLR 9103015.

D. Subchapter J Issues Where Stock is an Asset of theResiduary Estate.

1. While S stock is held in the estate, the Scorporation income allocable to the estate isincludible by the estate on its Form 1041.

2. If distributions are made by the estate to itsbeneficiaries, distributable net income (DNI) iscarried out to the beneficiaries even thoughthere may be no fiduciary accounting income.

3. If no distributions are made by the estate, theestate must pay the income taxes attributable tothe S income allocated to the estate even thoughthe S corporation may not have paid anydividends. These income taxes are probablychargeable to the principal account under the lawof most states.

4. Unless the S stock is to be distributed pro ratato the beneficiaries, inequities can arise.

Example: Will gives Executor authorityto allocate assets to the beneficiaries.Executor allocates S stock to A andmarketable securities to B. Taxes on Scorporation income allocable to portionof year preceding distribution to A areborne equally by A and B.

5. The fiduciary should consider the income taxeffects in determining distribution date valuesand in timing the distribution of the S stock.

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6. An equitable adjustment may be appropriate if theincome tax effects were not taken into account ina nonfractional distribution of the S stock.

7. For S stock going into trust, equitableadjustments between the income beneficiary andthe remainderman may be necessary depending uponthe circumstances.

E. SubchaDter J Issues Where Stock is SpecificallyBeaueathed.

1. Until the S stock is distributed to the legatee,the S corporation income allocable to the estateis includible on its Form 1041. Is the resultdifferent if under state law title to personalproperty is deemed to pass automatically to thelegatee at the decedent's death?

2. Absent the ability of the executor to make anequitable adjustment of some type, the residuarybeneficiaries will bear the full expense of theincome taxes attributable to the S income that isretained by the S corporation, whereas the amountof such income will increase the basis of the Sstock.

3. Even where the S corporation pays out itsearnings, the residuary beneficiaries can suffer.

Example: Will leaves S stock to A,residue to B. S corporation has incomeof $100 which it distributes to Estate.Estate also has $100 of taxable dividendsand $100 of tax-exempt interest. Estatedistributes the $100 S dividend to A andthe other $200 to B. A will have taxableincome of only $66.66 [(300 - 100) x 1/3= 66.66]. B will have taxable income of$133.33 [(300 - 100) x 2/3 = 133.33]instead of $100.

See, however, Ferguson, Freeland & Stephens,Federal Income Taxation of Estates andBeneficiaries, at pp. 572 - 573, which concludesin these circumstances that the S corporationdividend would be treated as specificallyallocated to A within the meaning of Regulationsection 1.661(b)-l and section 1.662(b)-l, withthe result that the S corporation distributionwould be traced to A and fully taxable to A ifthe dividend is distributed in the year in whichit is received by the estate.

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4. Conversely, if the S corporation suffers a loss,the loss belongs to the estate as long as the Sstock is still held by the executor.

a. Whether the loss can be used may depend uponthe finding of material participation by theexecutor.

b. The loss may shelter current income thatbelongs to the residual beneficiary.

5. These mismatching problems can be avoided orminimized by having the executor distribute the Sstock as quickly as possible.

a. The distribution of the S stock itself doesnot carry out DNI. §663(a).

b. Refunding bonds and other security devicescan be used to protect the fiduciary (forexample, a grantor trust created by thelegatee may be used if there is a concernthat a pledge agreement or escrow for thebenefit of the estate would constitute animpermissible shareholder).

F. S Stock as an Asset of the Marital Trust.

1. If the estate plan divides into a "sprinkling"credit shelter trust and a marital trust, themarital trust is the only permissible shareholderof the two. If death taxes are payable from thecredit shelter or other nonmarital trust and itis desired to use S stock in a section 303redemption to fund such taxes, theoretically thetrust would have to be the holder of the stock atleast momentarily prior to the redemption, (see§303(b)(3)), but it is not a permissibleshareholder.

2. A QTIP trust by its very nature has all therequirements of a QSST, but the surviving spousemust be amenable to the QSST election.

3. A testamentary general power of appointment trustlikewise can qualify as a QSST.

4. A marital trust over which the spouse is given anunlimited power of withdrawal is a section 678grantor-type trust but also meets the QSSTrequirements.

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a. Because the trust is a permitted shareholderas a result of section 678, a QSST electioncannot be made. Prop. Reg. S1.1361-iA(i)(3).

b. An advantage of making the QSST election isthat the S election will automaticallycontinue if there is a successive incomebeneficiary. Otherwise, the two-year rule ofsection 1361(c)(2)(A)(ii) applies. If thesurviving spouse has a messy estate with taxproblems, the trustee of the marital trustmay not be willing to distribute within twoyears of the surviving spouse's death. Arelease of the power of withdrawal may bedesirable to permit a QSST election.

5. Will the QSST election continue if the assets ofthe marital trust are added to another trust thathas not itself made a QSST election but iseligible to do so? What if the marital trustsimply divides into separate trusts for thechildren at the spouse's death? What if themarital trust continues in trust for a particularchild? What if the marital trust isdistributable outright, but there will be delaysbeyond the 60-day or two-year period (forexample, while awaiting the estate tax closingletter)? The successive income beneficiary rulesare not very clear. See Prop. Reg. §1.1361-IA(i)(5).

6. A general power of appointment trust over whichthe spouse is given a special lifetime power ofappointment in favor of children, charity, orothers would not appear to qualify for QSSTtreatment.

a. Section 1361(d)(3)(A)(ii) requires that anycorpus distributed during the life of theincome beneficiary may be distributed only tosuch beneficiary.

b. A disclaimer of the special power would notbe a qualified disclaimer under section 2518because of the retained general power (seeReg. §25.2518-3(d), Ex. (9)), but as long asit is effective under state law it should notmatter because the retention of thetestamentary general power prevents acompleted gift for gift tax purposes, and byhypothesis the trust will be fully includiblein the spouse's estate in any event.

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7. An estate trust also qualifies for QSSTtreatment, but the trustee must be attentive tothe requirement that all trust income be actuallydistributed to the spouse currently.

8. A surviving spouse may be reluctant to make theQSST election without assurance that the Scorporation will make sufficient distributions ofits earnings, particularly if capital gains arelikely at the S corporation level.

a. The potential problems are aggravated if theS corporation is a partner in partnershipsthat are generating taxable income but notdistributing earnings.

b. If extraordinary dividends are principal andthe spouse is only entitled to income, thespouse may want a say in what capital assetsthe S corporation sells.

9. Because the S stock may generate little or noincome, the spouse should be given the right toforce conversion.

a. This may present practical problems inmaintaining the S election unless adequatelydealt with in the shareholders agreement.

b. If the spouse is not given this conversionright, the marital deduction may bejeopardized (for example, if the maritaltrust is a QTIP or a general power ofappointment trust).

G. S Stock as an Asset of the Credit Shelter Trust.

1. If the estate plan divides into .a QTIP maritaland a credit shelter trust for the sole benefitof the spouse for life, which otherwise qualifiesas a QSST, the executor has more flexibility toplan.

2. The spouse need not be given the right to forceconversion of S stock in the credit sheltertrust, but note the position of the InternalRevenue Service that failure of an incomebeneficiary to enforce a reasonable rate ofreturn mandated by state law results in taxablegifts to the remaindermen. See PLR 8923007 andPLR 9015024. The instrument should specificallyauthorize the retention of the S stock even if itis nonincome producing.

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3. A single trust over which a partial QTIP electioncan be made is not an appropriate planningtechnique where S stock is involved, as thecredit shelter portion may be encumbered withmarital deduction savings provisions thatrestrict the benefits of QSST planning. see,however, PLR 9023015, which sanctions the use ofa provision requiring the conversion ofnonincome-producing property which is applicableby its terms only to that portion of the trustfor which a QTIP election is made.

4. A QSST election over a credit shelter trustholding stock in an S corporation that payslittle or no dividends results in indirecttransfers to the remaindermen without the paymentof gift taxes by virtue of the income taxes paidby the surviving spouse on the S earnings thatwere retained by the S corporation. To whatextent do Dickman-like theories apply if thespouse is in effective control of the Scorporation's dividend policies?

5. Because of the interplay of the 65-day rule ofsection 663(b) and section 1361(d) (4) (B), thetrustee of a QSST has the unilateral ability for65 days to terminate retroactively the S electionto the beginning of the current taxable year.

H. Principal and Income Issues.

1. Where the governing instrument is silent, statelaw (for example, Uniform Principal and IncomeAct) determines whether an S corporationdistribution is income or principal for fiduciaryaccounting purposes and which account bears theexpense of the income taxes attributable to the Scorporation income (whether or not distributed).

2. All ordinary and extraordinary cash dividends anddividends in kind (other than the corporation'sown shares) are generally deemed income.

3. When assets of a corporation are liquidated,amounts paid as cash dividends declared beforesuch liquidation are generally deemed income, andall other amounts paid on disbursement of thecorporate assets to the stockholders aregenerally deemed principal.

4. All disbursements of corporate assets to thestockholders, whenever made, which are designatedby the corporation as a return of capital or

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division of corporate property are generallydeemed principal.

5. Expenses incurred as carrying charges on anunproductive estate are generally paid out ofprincipal. An unproductive estate under theUniform Principal and Income Act is one that formore than a year has not produced an average netincome of at least one percent per annum of itsvalue and the trustee is under a duty to changethe form of investment.

6. Earnings accumulated by the S corporation overthe years and then distributed in one large cashdividend would not be principal, althoughpresumably the principal account would beentitled to reimbursement for any income taxes ithad borne on such income as it was earned.

7. Does the fiduciary who may be in control of the Scorporation have a duty to cause the corporationto make a designation concerning a return ofcapital?

8. Is the sale of a division and a subsequentdistribution of part but not all of the proceedswithin the liquidation rules of the UniformPrincipal and Income Act? If not, what if allthe proceeds were distributed? What if none ofthe proceeds were distributed but regulardividends were paid -- who bears the income taxeson the sale, the income beneficiary or theremainderman?

9. What is the effect of including provisions in thegoverning instrument granting the fiduciary theright to determine what is income and principal?

10. Rule of thumb suggested by John B. Huffaker:

One fairly logical rule to follow... would be to allocate the tax burdento the income distribution if an amountis distributed and to principal if it isnot. Then when there is an incomedistribution in excess of current income,principal could be reimbursed. Thisassumes the executor has discretion.

Huffaker, Estate PlanninQ for S CorporationStock, 42 NYU Inst. on Fed. Tax'n 15-1, 15-19(1984).

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11. The difficulty in determining what is income andwhat is principal can place the fiduciary in adifficult spot, particularly in the QSST setting.

a. To maintain QSST status all of the income(within the meaning of section 643(b)) mustbe distributed or required to be distributedcurrently. §1361(d)(3)(B).

b. Income means income determined under theterms of the governing instrument andapplicable local law. Reg. §1.643(b)-1.

c. Presumably a simple trust satisfies the testbecause of its governing instrumentrequirement and eliminates the possibilitythat QSST status could be accidentally lost.

d. With a complex trust as a QSST the trusteeshould probably lean toward classifying areceipt as income and not principal. The Scorporation should consider having thetrustee sign an agreement at the time of theS election agreeing to certify each year thatthe required distributions have been made.

e. If not all income is distributed by the QSST,an inadvertent termination ruling may berequested under section 1362(f).

IV. INADVERTENT TERMINATIONS

A. Typical Terminating Events Involving Trusts.

1. Transfers to ineligible trusts. Rev. Rul. 86-110, 1986-2 C.B. 150, has typical facts anddiscusses inadvertent termination relief.

2. Failure to make the QSST election upon transferof shares to an otherwise eligible trust. PLR9139010.

3. Failure of QSST to distribute all income. PLR9042010.

4. Retention of S stock beyond the 60-day or two-year period. PLR 9111044 and PLR 9119034.

5. Failure of secondary beneficiaries to make QSSTelections after the death of the primary QSSTbeneficiary.

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B. Procedure to Continue Election.

1. Section 1362(f) provides that if the InternalRevenue Service determines the termination wasinadvertent, if steps were taken within areasonable period of time after discovery of theevent so that the corporation is once more an Scorporation, and if the corporation and allshareholders agree to make any necessaryadjustments, the S election of the corporationshall be treated as continuing notwithstandingthe terminating event.

2. The legislative history indicates that Congressintends the Internal Revenue Service to beliberal. S. Rep. No. 97-640, 97th Cong. 2d Sess.12-13 (1982), 1982-2 C.B. 718, 723-24.

3. However, formal private letter ruling proceduresmust be followed to obtain this relief. Rev.Proc. 91-1, 1991-1 C.B. 9.

4. User fee of $2,500 applies. §8.01(11), Rev.Proc. 91-1, 1991-1 C.B. 9.

C. Alternatives to IRS Ruling.

1. Playing the audit lottery is dangerous.Overlooking a possible inadvertent terminationand continuing to file as an S corporation can bedetrimental for all parties. Particular problemscan arise later upon a sale of all or a portionof the stock or assets of the corporation.

2. Foregoing the continuation of the S election canhave adverse tax consequences, such as the lossof future increases in the basis of the stock.

3. Re-electing S status in five years may beinadvisable because of the loss of theintervening benefits and the beginning of a newbuilt-in gain period under section 1374.

V. UNANSWERED QUESTIONS

A. Manner of Reporting.

1. What K-is does the QSST beneficiary receive?Does the S corporation issue a K-1 to the trusteeor the QSST beneficiary?

2. Is gain (or loss) on the sale of S stock by aQSST taxed to the trust or the beneficiary? Is

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the result different if only a portion of the Sstock is sold by the trust?

3. Is there anything to report when S stock held ina GRIT-type trust grantor trust is repurchased bythe grantor?

B. Other Issues.

1. Does a QTIP marital trust always qualify for QSSTtreatment?

2. How do the successive income beneficiary rulesapply at the death of the QSST beneficiary whenthe trust is subdivided into a number of separatetrusts or is distributable to a number ofbeneficiaries?

3. How is income ascertained when the QSST isincluded in the estate of the income beneficiaryand the trust must contribute its share of deathtaxes?

4. Who makes the QSST election when S stock is heldin an inter vivos QTIP trust? To whom is theincome taxable?

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