Selected Estate Planning Thoughts for Sub-chapter S Corporation Shareholders

Transcription

1 Selected Estate Planning Thoughts for Sub-chapter S Corporation Shareholders By Lester B. Law Senior Vice President National Wealth Strategies Group U.S. Trust Bank of America Private Wealth Management Naples, Florida For Joint Fall CLE Meeting ABA Section of Real Property, Trust and Estate Law ABA Section of Taxation Chicago, IL September 24 26, 2009

2 Disclosures IMPORTANT: This brief summary of planning ideas is for discussion purposes only. It does not contain legal, tax, investment, or insurance advice and cannot be relied upon for implementation and/or protection from penalties. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. IRS Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used by any person or entity for the purpose of (i) avoiding tax related penalties imposed by any governmental tax authority or agency, or (ii) promoting, marketing or recommending to another party any transaction or matter discussed herein. We advise you to consult with an independent tax advisor on your particular tax circumstances. U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC Bank of America Corporation. All rights reserved.

3 Table of Contents I. Introduction 1 II. The C Corporation v. S Corporation 1 A. Corporate Level Requirements 1 1. Classes of Stock 2 2. Number of Shareholders 2 3. Making an Effective Election 4 B. Eligible Shareholders 4 1. During Lifetime 5 a. Individuals 5 b. Grantor Trust 5 c. Qualified Subchapter S Trust ( QSST ) 6 d. Electing Small Business Trust ( ESBT ) 9 e. Voting Trusts 12 2 After Death 12 a. Most Common Types of Shareholders 12 b. Other Shareholders During and After Administration 12 i. During Estate and Trust Administration 12 ii. Continuing Grantor Trusts 13 iii. Testamentary S Trusts 13 iv. Estates 13 c. Examples 14 d. Summary 15 III. Tax Implications to Shareholders 15 A. Individuals as Owners of S Corp Stock 15 B. Grantor Trusts 16 C. QSSTs General Rules If S Corp Stock is Disposed When Beneficiary of QSST Dies Planning Pointers 18 D. ESBT Income Tax Issues Examples 20 E. Continuing Grantor Trusts In General Examples Planning Opportunity Code 645 An Initial Look 23 F. Testamentary Trusts 24 G. Estates 24

4 IV. Elections Available for Apportionment of Income 25 A. General Rule 25 B. Separate Year Election (a)(2) 25 C. Estate Income DNI / FAI 26 D. Planning Pointers During Life After Death 27 V. A Few Words on C Corps On Concepts that Apply to S Corps 28 A. Basis Step Up / Down General Rule Code Exceptions Liquidating a Corporation 29 a. In General 29 b. Complete Liquidation 29 c. Partial Liquidation 30 i. Code 303 Redemptions 30 ii. Planning With Promissory Notes 34 iii. Must Property Be Distributed to Pay Taxes 35 iv. Reduction of E&P 35 v. Transferring Hard To Value Assets 36 vi. Section 311(b) 36 B. S Corps / Trusts and Estates 37 VI. Discussion on Planning with Chenoweth in Mind 37 A. Chenoweth 37 B. Reverse Chenoweth 39 C. Planning With Chenoweth / Reverse Chenoweth in Mind 42 VII. Federal Income Tax on S Corps 42 A. Built-In-Gains Tax 42 B. Excess Net Passive Income Tax 44 VIII. Flavor of Income - Section A. Code B. Understanding Code 1239 in the S Corp Context 48 IX. Conclusion 48

5 I. Introduction Selected Estate Planning Thoughts for Sub-chapter S Corporation Shareholders Lester B. Law 1 Our Constitution is in actual operation. Everything appears to promise that it will last; but in this world nothing is certain but death and taxes. Benjamin Franklin I doubt that Ben ever thought that this phrase in the letter to his friend, Jean Baptiste Leroy, 2 would be so often quoted. I also doubt that Ben thought that the tax system would be so onerous, complicated and that it would continue to haunt the living after death! The purpose of this outline is to provide the reader with some helpful thoughts in planning with Subchapter S corporations ( S Corps ) 3, taking into considering some of the administrative burdens when the corporate interests pass outright (or more particularly in trusts) during life and after the shareholder s death. II. The C Corporation v. S Corporation S Corps are unique in that they have their own special rules under Subchapter S of the Internal Revenue Code, and they also operate under the rules of Subchapter C of the Internal Revenue Code, to the extent that the rule is not covered under Subchapter S. 4 Thus, by example, when dealing with distributions, redemptions, and attribution rules, quite often the planner must be familiar with both the Subchapter S rules as well as the Subchapter C rules. A. Corporate Level Requirements There are several requirements for a corporation to be treated as an S Corp (versus a C Corp). The purpose of this outline is not to provide a detailed analysis of the requirements; rather it is to provide the estate planner with general information both from the corporation s perspective and the shareholder s perspective. 5 1 Lester B. Law is a Senior Vice President with U.S. Trust, Bank of America Private Wealth Management s National Wealth Strategies Group. 2 The People s Almanac, David Wallechinsky & Irving Wallace, For purposes of this outline, corporations taxed under Subchapter S of the Code will be called S Corps and corporations taxed under Subchapter C will be called C Corps. All references to the Internal Revenue Code of 1986, shall be referred to as the Code or IRC. 4 IRC 1371(a). 5 For a detailed analysis of all of the requirements, see Christian and Grant, Subchapter S Taxation 4 th Ed., Warren, Gorman and Lamont, and Eustice and Kunst, Federal Income Taxation of S Corporations, 4 th Ed., Warren Gorman and Lamont. Page 1

6 1. Classes of Stock Generally an S corporation can only have one class of stock. 6 The regulations speak in terms of the stock confer[ing] identical rights to distribution and liquidation proceeds, 7 and then illustrates whether stock confers such identical rights to distribution and liquidation proceeds. 8 Specifically, the regulations provide that a difference of voting rights is allowed. 9 It should be noted that it is important to review not only the stock certificate and articles of incorporation to determine if there is one class of stock, but is it also important to review bylaws, shareholder agreements, compensation and/or employment agreements to see if the other agreements create substantial rights to cause the corporation to have a second class of stock. In determining if there is more than one class of stock, generally only those shares that are both issued and outstanding are considered. 10 Case law, private letter rulings and Treasury Regulations provide guidance on whether the specific corporation has one class of stock. It is beyond the scope of this outline to discuss the topic; however, the author impresses upon the reader to review the pertinent corporate documents to ensure that the one class of stock rule is not violated. Importantly, if the reader is involved in the drafting of documents or planning to change the agreements between the parties or to provide special rights to one or more shareholders vis-à-vis the other shareholders, the reader should review whether those new agreements will create a second class of stock. 2. Number of Shareholders S Corps are currently limited to 100 shareholders. 11 a. Types of Shareholders Generally, only individuals, estates and certain trusts can be shareholders Code 1361(b)(1)(D) and Treas. Reg (l)(1). 7 Treas. Reg (l)(1). 8 Treas. Reg (l)(2). 9 Treas. Reg (l)(2). 10 Treas. Reg (l)(1). Accordingly, even if an agreement, under the corporate documents, call for a second class of stock (e.g., preferred stock) if such second class of stock has not been issued and is not outstanding, then it will be ignored. Suffice to say, if the agreement allows for a second class, one should look to eliminate that provision so long as the corporation desires to be an S corp. 11 Code 1361(b)(1)(A) provides this limitation. Originally, the number was limited to 10 shareholders, that number increased over time, and in 2005, the limit was raised from 75 to 100 shareholders. Code 1361(c)(1)(A) provides that husbands and wives are treated as one shareholder and 1361(c)(1)(D) treats members of one family as one shareholder. See further discussion on this issue at Footnote Code 1361(b)(1)(B) and Treas. Reg (e). A custody accounts holding S Corp stock is also allowed. And, estates in bankruptcy and guardianship estates are considered estates for the rule. Page 2

7 i. Determining the Number of Shareholders I. Individuals and Estates One would think that it is relatively easy to determine the number of shareholders if the only owners of the stock are individuals and estates. 13 That would be true if the individuals were unrelated to each other; however, it gets a little complicated when family members own stock in the same S Corp. Generally, each individuals is counted as one person, however, a husband and wife who file their tax returns jointly are treated as only one person (and not two). 14 And, under a set of complex rules that are in the final regulations, certain family members are treated as one person. 15 An estate is treated as one person. 16 II. Trusts A. In General When it comes to trusts that qualify as shareholders (e.g., an Electing Small Business Trust ( ESBT ), Qualified Subchapter S Trust ( QSST ) or grantor trust 17 )) determining the number of shareholders is not so simple. The reason for this is that with trusts there are generally many persons who have different beneficial interests (e.g., some are current and vested, some are future and vested, some are contingent and unvested, some are vested subject to divestment, some are entitled to income, while others are only entitled to principal, etc.). Understanding this issue and the multitude of interests that a trust beneficiary could have, the Regulations provide that only those trust beneficiary that are considered potential current beneficiaries will be counted for purposes of the 100 shareholder limitation. B. Potential Current Beneficiaries A potential current beneficiary is any person who at any time is entitled to a distribution of income or principal (whether mandatory or discretionary). 18 As of 2004, the determination of whether one is entitled to a distribution is made without regard to 13 Code 1361(b)(1)(B) and (c)(1)(b). 14 Code 1361(c)(1) and Treas. Reg (e)(2). Note: although husbands and wives are treated as one person for the 100 person rule, they are generally treated as separate persons for all of the other rules for subchapter S corporations. Further, divorced spouses are treated separately. 15 Code 1361(c)(1) and Treas. Reg (e)(2). There is a complex set of look-thru rules through trusts to determine if persons are members of a family. Additionally, there are rules related to how many generations one must review to see if one is a member of the family. If two or more individuals (after applying the rules) are deemed to be members of a family, then those individuals will only be counted as one shareholder. If you believe that you will run up against the 100 shareholder limitation, you should carefully review the member of the family rules to see if you can take advantage of the rule 16 Code 1361(c)(1) and Treas. Reg (e)(1). Decedent s estates count as one shareholder. An estate of a bankrupt also counts as one shareholder. 17 A grantor trust is generally defined as a trust all of which is treated under subpart E of part I of subchapter J of the Code (i.e., Code (inclusive)) that is owned by an individual who is a resident and citizen of the U.S. This is the definition under Code 1361(c)(2). 18 Code 1361(e)(2). Page 3

8 a power of appointment. Stated otherwise, in examining whether one is a potential current beneficiary, any power of appointment is disregarded, thus, donees of the power are not considered potential current beneficiaries, unless the power is exercised in favor of that particular donee (or donees). 19 The potential current beneficiaries are treated as shareholders of the S Corp. If there are no potential current beneficiaries for a particular year, then the trust is treated as the shareholder. 20 C. Daily Analysis The regulations make it clear that the determination of whether one is a potential current beneficiary is made at any point in time (i.e., day by day, depending upon the various circumstances and the drafting of the trust, the potential current beneficiaries may change). If a trust holds S Corp stock, it is important to review the trust instrument to determine the potential current beneficiaries, so that one could determine if the 100 shareholder rule is in jeopardy. D. Only for the 100 Rule It is important to understand that the potential current beneficiary test is only for the purpose of determining if the 100 shareholder limitation is met (or not). Separate and apart from this are rules regarding whether a trust qualifies as a QSST or ESBT, for those rules on beneficiaries (called eligible beneficiaries ), see the sections below that discuss the separate types of trust. 3. Making an effective Election All of the shareholders must elect to have the corporation be treated as an S Corp. So long as the requirements of the S Corp are not violated, then the corporation is taxed as such, and generally this means that the shareholders will be taxed on the pass-thru income on a per diem, pro rata basis. 21 B. Eligible Shareholders Unlike C Corps, S Corps can only have certain types of shareholders. In general, we can divide the types of shareholders as those that are eligible during lifetime and those that are eligible after the death of the shareholder Code 1361(e)(2); Treas. Reg (m)(4)(iv). 20 Code 1361(c)(2)(B)(v); Treas. Reg (m)(4)(vii). 21 Code 1366(a)(1); Treas. Reg (a)(1). Additionally, the character of items of income, loss, deduction, credit, etc., at the corporate level passes-thru to the shareholder under Code 1366(b). The shareholders take into account his or her pro rata share on a per diem basis under Code 1377(a)(1) and Treas. Reg (a)(1). 22 For purposes of this outline, since the focus is on estate planning with S Corps, our coverage of the 100 person limit is cursory, the reader is encouraged to review the rules on his or her own.. See generally, IRC 1361 and Treasury Regulations There are a number of complex requirements of determining the number of shareholders. For a more detailed discussion of this, please see, Subchapter S. Taxation, Christian & Grant, 7.01([1] et seq., and Federal Income Taxation of S Corporations, Eustice & Kunst, Page 4

9 1. Lifetime Eligible Shareholders a. Individuals Generally, all individuals, 23 other than non-resident aliens, 24 are permitted shareholders. An individual may own stock as a joint tenant, tenant by the entireties and as a tenant in common. 25 b. Grantor Trust There are two types of grantor trusts that are allowed as permitted shareholders: (i) grantor trusts where the grantor is treated as an owner under IRS Sections 671 through and including 677, and (ii) grantor trusts where someone other than the grantor is treated as an under IRC section i. Grantor is Treated as Owner Trusts that are treated as wholly grantor trusts 27 are permitted as shareholders. 28 The statute provides that the deemed owner will be treated as the shareholder. 29 If the trust is not a wholly owned grantor trust, it will not be a shareholder. The trust may qualify as an ESBT, however.ii.b.1.d 30 ii. Non-Grantor is Treated as Owner Crummey power holders can be considered the owner of a grantor trust as a result of Code Section 687, if the trust is otherwise a wholly a grantor trust as to the Crummey power holder, such person will be the shareholder of the S Corp stock. The IRS has issued a plethora of rulings on this topic IRC 1361(b)(1)(B). 24 IRC 1361(b)(1)(C). 25 Treasury Regulations (e). 26 Note: prior to 1981, a non-grantor could not be considered a deemed owner. 27 For a relatively recent outline on grantor trusts, see, Open Issues and Close Calls Using Grantor Trusts in Modern Estate Planning, Howard M. Zaritsky, 43 rd Heckerling Institute on Estate Planning (Jan 2009). 28 IRC 1361(c)(2)(A)(i). The statute literally states, A trust all of which is treated (under subpart E of part I of subchapter J of this chapter) as owned by an individual who is a citizen or resident of the United States. Thus, the individual must be a US citizen or resident. If the trust is not deemed wholly owned by the grantor, then the trust could be partially a grantor trust and partially an ESBT. See discussion below in section II.B.1.d on page 9 of this outline on ESBTs. 29 Code 1361(c)(2)(A)(i) 30 See, Section II.B.1.d of this outline discussing ESBTs. 31 The IRS has issued a number of private rulings on this particular issue. For a current discussion on this topic, see Section III of Zaritsky s Open Issues and Close Calls titled Grantor Trusts and Crummey Powers. See also, PLRs , , , and , where IRS privately ruled that the trust with a Crummey power qualified as a shareholder under IRC 1361(c)(2)(A)(i) because the Crummey beneficiary was considered the grantor and the trust was considered a wholly owned grantor trust (by reason of IRC 678(a), and the Crummey beneficiary of the trust was the shareholder for income tax purposes under IRC 1361(c)(2)(B)(i). See also, PLR and But see, an old PLR ( ) which had an interesting twist to the Crummey provision, which caused the trust not to be treated as a grantor trust (Note: Today, this could be saved by an ESBT election). In a series of rulings, PLRs , , and , the IRS ruled that a trust that gives beneficiaries Page 5

10 Upon the death of the Grantor of a grantor trust, in general the trust may be an eligible trust for a period of two years. See discussion below in Section III.E of this outline on page 21 below. It should be noted that the estate of the deemed owner (generally the grantor of the grantor trust will be considered the shareholder for income tax reporting purposes. 32 c. Qualified Subchapter S Trust ( QSST ) Probably the best known and most common trust that holds S Corp stock after death is the qualified subchapter S trust ( QSST ). In order for a trust to be treated as a QSST it must meet the following requirements under the Code: (a) during the life of the current income beneficiary, there shall be only one income beneficiary of the trust; 33 (b) any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary; 34 (c) the income interest of the current income beneficiary in the trust shall terminate on the earlier of such beneficiary's death or the termination of the trust, 35 (d) upon the termination of the trust during the life of the current income beneficiary, the trust shall distribute all of its assets to such beneficiary, 36 and (e) all of the income (within the meaning of Code 643(b)) is distributed (or required to be distributed) currently to 1 individual who is a citizen or resident of the United States. 37 The Treasury s Regulations provide that if the terms of the trust do not preclude the possibility that any of the first four requirements (i.e., under 1361(d)(3)(A) through (D) inclusive) will not be met, the trust will not qualify as a QSST. Example 1: The terms of the trust are silent with respect to corpus distributions. Further 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. Since, the terms of the trust do not preclude the possibility that corpus may be distributed to a person other than the current income beneficiary, the trust can not qualify as a QSST. 38 withdrawal rights (i.e., Crummey powers) that lapse will treat the trust as a grantor trust under 678 even after the lapse, therefore, the so-called Crummey beneficiaries become grantors of the trust. In light of rising income tax rates, the reader may want to review this PLR to see if it is beneficial to shift the S Corp income to the junior generations (i.e., the Crummey beneficiaries). See PLRs , and where Crummey powers existed, and the trust has a 675(4) power to exchange assets. In those rulings, the IRS ruled that if the facts and circumstances illustrated that the powers were properly used, that the grantor / creator of the trust (by reason of 675(4) is the owner for the period of time until the power of substitution was relinquished. Thereafter, the IRS ruled that the beneficiaries would be considered the grantors under 678. This is an interesting taxpayer-friendly ruling. 32 IRC 1361(c)(2)(B)(ii). See also, Treasury Reg (h)(1)(ii) and (h)(3)(i)(B). 33 Code 1361(d)(3)(A)(i); Treas. Reg (j)(1)(ii)(A). 34 Code 1361(d)(3)(A)(ii); Treas. Reg (j)(1)(ii)(B). 35 Code 1361(d)(3)(A)(iii); Treas. Reg (j)(1)(ii)(C). 36 Code 1361(d)(3)(A)(iv); Treas. Reg (j)(1)(ii)(D). 37 Code 1361(d)(3)(B); Treas. Reg (j)(1)(i). 38 Treas. Reg (j)(1)(iii). Page 6

11 Importantly, the determination of whether the terms of a trust meet all of such requirements depends upon both (a) the terms of the trust instrument and (b) applicable local law. 39 i. Election Requirements I. In General The QSST election can not take effect until the S Corp has filed its S election (on Form 2553). If the QSST election is made at the same time that the S Corp files its election on Form 2553, each trust could execute the document on the second page of the Form II. Requisite Information on the Election If, during life, the S stock has been transferred to a non-grantor trust 40 that qualifies as a QSST, the current income beneficiary of the trust must make the election by signing a statement with the following information: name, address, and taxpayer identification number of the current income beneficiary, the trust, and the corporation; 41 statement that the election is being made under section 1361(d)(2); 42 the date on which the election is to become effective; 43 the date on which the stock of the corporation was transferred to the trust; 44 and all information and representations necessary to show that under the terms of the trust and state law: during the life of the current income beneficiary, there will be only one income beneficiary; 45 any corpus distributed during the life of the current income beneficiary may be distributed only to that beneficiary; 46 the current beneficiary's income interest will terminate on the earlier of the beneficiary's death or upon termination of the trust; 47 and 39 Treas. Reg (j)(2)(ii)(A). 40 Under the regulations grantor trust status trumps QSST status, thus, by definition if the S Corp stock is transferred to a grantor trust, as QSST election can not be made. 41 Treas. Reg (j)(6)(ii)(A). 42 Treas. Reg (j)(6)(ii)(B). 43 Treas. Reg (j)(6)(ii)(C). 44 Treas. Reg (j)(6)(ii)(D). 45 Treas. Reg (j)(6)(ii)(E)(1)(i). 46 Treas. Reg (j)(6)(ii)(E)(1)(ii). Page 7

12 upon the termination of the trust during the life of such income beneficiary, the trust will distribute all its assets to such beneficiary; 48 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; 49 and 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. 50 There is no pre-printed form for this election; thus, the drafting attorney should prepare a statement with the above requirements on the statement. 51 III. Simple and Complex Trusts Qualifying as QSSTs It should be noted that a complex trust may qualify as a QSST if the trustee actually distributes all of the income annually. A simple trust will qualify (regardless of whether the income is actually distributed). A careful reading of the requirements is essential to determine whether the trust will qualify as a QSST. IV. When to file the QSST Election A. In General Generally, the filing of the election is to be made within the 16-day and 2-month period beginning on the date that the S Corp stock is transferred to a trust that would not otherwise be considered an eligible shareholder (e.g., a Grantor Trust). The QSST election can not take effect until the S Corp has filed its S election (on Form 2553). If the QSST election is made at the same time that the S Corp files its election on Form 2553, each trust could execute the document on the second page of the Form B. Some Special Rules If a corporation's S election terminates because of a late QSST election, the corporation may request inadvertent termination relief either under IRS Notice or by private letter ruling. The IRS issued Rev. Proc with provides a simplified procedure for beneficiaries of QSSTs to obtain relief if they file late elections. If the 47 Treas. Reg (j)(6)(ii)(E)(1)(iii). 48 Treas. Reg (j)(6)(ii)(E)(1)(iv). 49 Treas. Reg (j)(6)(ii)(E)(2). 50 Treas. Reg (j)(6)(ii)(E)(3). 51 In looking for a pre-printed form, the author found that most of the research software available to him had some suggested forms which had all of the requisite information. Thus, there is no need to recreate the QSST election wheel I.R.B Page 8

13 beneficiary does not meet the requirements 53 under Rev. Proc , then the beneficiary must file for a letter ruling. 54 d. Electing Small Business Trust ( ESBT ) i. In General Electing Small Business Trusts ( ESBTs ) introduced in 1997 to the Code are the newest type of trust that is eligible to hold S Corp stock. 55 According to the House and Senate Committee reports, the rationale of introducing the ESBT was to facilitate family estate planning with regard to trusts owning S Corp stock. 56 By comparison to QSSTs, consistent with Congress desire to make ESBTs better estate planning vehicles, ESBTs may have multiple income beneficiaries, accumulate income, sprinkle both income and principal among the various beneficiaries, and serve as generation-skipping vehicles. In general to qualify as an ESBT the trust must provide that: (1) individuals, estates and certain charitable organizations 57 are permissible beneficiaries; 58 (2) no interest in the trust may be acquired by purchase; 59 and (3) the trustee made an election under Code 1361(e)(3). 60 The ESBT can not be (a) a QSST, 61 (b) a tax-exempt trust, 62 or (c) a charitable remainder trust. 63 Interestingly, a grantor trust may elect to be an ESBT. 64 ii. The Beneficiaries of an ESBT Determining the beneficiaries of an ESBT is important for determining who is subject to income tax ramifications with regard to the trust. Under the Code, as set forth above, a 53 Rev. Proc provides that the following minimum requirements must be met in order to take advantage of the benefits of that revenue procedure: 54 Code 1362(f) and Treas. Reg., See also, PLR ESBTs were introduced to the Code as part of P.L , Small Business Job Protection Act of 1996 (August 20, 1996). 56 S. Rep. No , Senate Finance Committee Report on HR 3448, the Small Business Job Protection Act of 1996 (P.L. No ), (June 19, 1996) and H. R., Rep. No , House Ways and Means Committee Report on the Small Business Job Protection Bill of 1996 (P.L ) (May 23, 1996). Both Committee reports stated that the reason for change was as follows: The Committee believes that a trust that provides for income to be distributed to (or accumulated for) a class of individuals should be allowed to hold S Corp stock. This would allow an individual to establish a trust to hold S Corp stock and "spray" income among family members (or others) who are beneficiaries of the trust. The Committee believes allowing such an arrangement will facilitate family financial planning. 57 Code 1361(e) provides that organizations described in Code 173(c)(2), (3), (4) or (5) or an organization described in Code 170(c)(1) which holds a contingent interest in the trust and which is not a current beneficiary, qualify as a beneficiary. The Code defines a current income beneficiary at subsection (e)(2). 58 Code 1361(e)(1)(A)(i); Treas. Reg (m)(1)(i). 59 Code 1361(e)(1)(A)(ii); Treas. Reg (m)(1)(iii). 60 Code 1361(e)(1)(A)(iii); Treas. Reg (m)(2). 61 Code 1361(e)(1)(B)(i); Treas. Reg (m)(1)(iv). 62 Code 1361(e)(1)(B)(ii); Treas. Reg (m)(1)(iv). 63 Code 1361(e)(1)(B)(iii); Treas. Reg (m)(1)(iv). 64 Treas. Reg (m)(4)(ii) and (v). Page 9

14 trust can only qualify as an ESBT if all of the beneficiaries are individuals, estates, or certain charitable organizations. The Treasury Regulations refine the Code by providing that the beneficiaries of an ESBT include any person who has a present, remainder, or reversionary interest in the trust. 65 Generally, either a trust or an individual could be considered a beneficiary of the ESBT. For trusts to be considered a beneficiary, the trust must qualify as a distributee trust. A distributee trust is defined as 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. 66 If the distributee trust is a charitable organization defined in 170(c)(2) or (3), then the trust would be considered the beneficiary. If the distributee trust is a trust that is not such a charitable organization, then the regulations require that one looks through the trust to determine the beneficiaries. 67 Example 2: Let s assume that a trust is created for surviving spouse ( SS ) for life and remainder in trust for children for life. The beneficiaries of the ESBT are SS and the remainder trust. Since the remainder trust is not a charitable organization defined under Code 170(c)(2) and (3), one must look through the remainder trust to determine the beneficiaries. In this case, SS and the decedent s children are the beneficiaries of the ESBT. Recall, the purpose of determining the beneficiaries of the trust is solely to determine whether the beneficiary is an eligible shareholder. Thus, it is critical to review the rules to determine who are the permissible current beneficiaries and the eligible beneficiaries of the potential ESBT. iii. Some Detail I. The Election Requirements A. Who Makes the Election. The trustee of the trust must make the ESBT election by signing and filing, with the service center where the S Corp files its income tax return, a statement (the election statement ) that meets the requirements set forth below. 68 B. Election Statement The election statement must include the following: (a) the name, address, and taxpayer identification number of the trust, the potential current beneficiaries, and the S Corps in which the trust currently owns stock; (b) an identification of the election as an ESBT election made under Code 1361(e)(3); (c) the first date on which the trust owned stock in each S Corp; (d) the date on which the election is to become effective (not earlier 65 Treas. Reg (m)(1)(ii)(A). 66 Treas. Reg (m)(1)(ii)(B). 67 Treas. Reg (m)(1)(ii)(A). 68 Treas. Reg (m)(2)(i). Note: That particular subsection of the regulations also provides logistical guidance when there is more than one trustee acting, how to make an election if there are multiple S Corps, and what happens if the service center where one files the S Corp return changes. Page 10

15 than 15 days and two months before the date on which the election is filed); and (e) certain representations signed by the trustee. 69 C. Timing of Election 1. In general The election must be filed within the same time requirements for filing a qualified subchapter S trust (QSST) election Late Elections Like QSSTs, the IRS has permitted late elections for ESBTs No Protective Election Unlike a QSST an ESBT can not make a protective ESBT election. Any attempt to make an election would cause the trust to be an ineligible shareholder and effectively terminate the S election for the S Corp. Relief may be available under Code 1361(f) if an inadvertent, ineffective election is attempted Grantor Trusts A trust that qualifies as an ESBT may make an ESBT election notwithstanding that the trust is a wholly-owned grantor trust. 73 See below for the income tax reporting by the trust, its beneficiaries and the deemed owner. D. Effect of the election. 1. Treatment for Income Taxes If a trust makes a valid ESBT election, the trust will be treated as an ESBT for income tax purposes as of the effective date of the ESBT election Employer Identification Number An ESBT has only one employer identification number (EIN). If an existing trust makes an ESBT election, the trust continues to use the EIN it currently uses Taxable Years i. First Year If an ESBT election is effective on a day other than the first day of the trust's taxable year, the ESBT election does not cause the trust's taxable year to close. 76 ii. Terminating Year The termination of the ESBT election (including a termination caused by a conversion of the ESBT to a QSST) other than on the last day of the trust's taxable year also does not cause the trust's taxable year to close Treas. Reg (m)(2)(ii)(A) through (E) inclusive. The representations of the trustee include that (1) the trust meets the definitional requirements of Code 1361(e)(1); and (2) All potential current beneficiaries of the trust meet the shareholder requirements of Code 1361(b)(1). 70 Treas. Reg (m)(2)(iii). 71 Rev. Proc provides relief for an S Corp terminating its election only if the S Corp's was caused by the fact the election was not timely filed. If this is the case, the trustee can seek relief under the revenue procedure to validate a late filed election. 72 Treas. Reg (m)(2)(v) Treas. Reg (m)(2)(v). Treas. Reg (m)(3(i). Treas. Reg (m)(3(ii). Treas. Reg (m)(3(iii). Treas. Reg (m)(3(iii). Page 11

16 4. Allocation of Income for Tax Purposes If, during the taxable year of an S Corp, a trust is an ESBT for part of the year and an otherwise eligible shareholder for the rest of the year, the taxable income is allocated between the two owners of trusts under Code 1377(a), as discussed above in Section II.B.1.d.iii.I.D.4, beginning on page12 of this outline. 78 e. Voting Trust Voting trusts are allowed as shareholders. 79 Generally, in estate planning, one does not come across these trusts too often. None the less, it is important to understand the issues related to voting trusts that may apply to the estate planner. The Code does not provide detailed analysis of the necessary requirements to qualify as a voting trust, the Treasury Regulations however provides that there is a written agreement providing that the trustee has the right to vote the stock, that distributions be made to the beneficial owners of the stock, that the stock pass to the beneficial owners at the end of the trust term, and the trust terminate at a specific date or event (under state law or under the terms of the agreement. 80 Further, to qualify as a voting trust, the beneficial owners must be treated as the owner of their respective portions of the trust under Subpart E and the trust After Death Eligible Shareholders a. Most Common Types of Shareholders We all know that only certain trusts can hold S Corp stock. Qualified subchapter S Trusts ( QSSTs ) 82 and electing small business trusts ( ESBTs ) 83 are eligible shareholders during life and at death. These trusts are probably the best known shareholder-trusts that are available to hold S Stock during life and at death, if for no other reason the tax attorneys have used the initials of the latter two (i.e., QSSTs and ESBTs) for mnemonics. b. Other Shareholders During and After Administration i. During Estate / Trust Administration In the estate settlement process, there are two other possible trusts that would qualify as shareholders, these are (1) trusts that were grantor trusts during the life of the grantor (hereinafter, Continuing Grantor Trusts ) and (2) a trust which receives S Corp stock from the decedent s estate (hereinafter, Testamentary S Trusts ); however, the 78 Treas. Reg (m)(3(iv). 79 IRC 1631(c)(2)(A)(iv), as clarified by Treasury Regulations (h)(1)(v). 80 Treas. Reg (h)(1). 81 Treas. Reg (h)(1). It is not clear what this means. Does this mean that there are actually separate trusts? Recall, that for grantor trust treatment the trust must be wholly a grantor trust as to the deemed owner? Does this mean that the trust is bifurcated based on ownership? It is not clear. Hopefully, there will be a ruling or pronouncement to clarify the issue in the future. 82 Code 1361(d). 83 Code 1361(c)(2)(A)(v) and 1361(e). Page 12

17 trust only qualifies for a 2-year period of time after the trust receive the property from the estate. 84 Additionally, an estate qualifies as a shareholder. 85 ii. Continuing Grantor Trusts If S Corp stock was held by a grantor trust before death, the trust can continue to hold the S Corp stock for a period of 2-years after the death of the deemed owner of the trust (i.e., Continuing Grantor Trusts). 86 Provided that the trust was wholly a grantor trust, no special election is necessary. iii. Testamentary S Trusts As set forth above, an estate may transfer (or a Quailed Revocable Trust (as such term is defined below at III.E.4 beginning on Page 23) may make a deemed transfer) of S Corp stock to a trust (hereinafter a Testamentary S Trust ) and such recipient trust would qualify as an eligible S Corp shareholder for a period of up to two years after the date of the transfer (or deemed transfer). 87 The 2-year period is shortened upon disposition from the trust to another eligible shareholder (e.g., a QSST or an individual). 88 iv. Estates In addition to the trusts that can be shareholders during the settlement process, estates of decedent s can be shareholders, too. 89 Interestingly, unlike the 2-year time limitation for the Continuing Grantor Trust and the Testamentary S Trusts, the statute does not place a time limit on the period of time that an estate could hold S Corp stock. In fact, in an older case decided before the re-write of subchapter S in 1982, the Court held that the estate could be held in the estate for a reasonable time, beyond that reasonable time the beneficiaries would be considered the owners of the S Corp stock. 90 In a revenue ruling issued almost 30 years ago under the old subchapter S laws and prior to the re-write of Code 6166 the IRS held that the administration of the estate will not be considered unreasonably prolonged for purposes of section 641(a)(3) 91, and thus the estate will continue to be an eligible shareholder within the meaning of section 84 Code 1361(c)(2)(A)(iii). 85 Code 1361(b)(i)(B). 86 Code 1362(c)(2)(A)(ii). 87 Code 1361(c)(2)(A)(iii); and Treas. Reg (h)(iv)(A) and (B). 88 Code 1361(c)(2)(A)(iii); and Treas. Reg (h)(iv)(A) and (B). 89 Code 1361(b)(i)(B). 90 Old Virginia Brick Company, Inc. v. Comm., 367 F2d 276 (4 th Cir. 1966). The Appeals court sided with the opinion of the Tax Court, quoting the Tax Court s reasoning that once the period necessary for the performance of ordinary administrative duties is ended, thus, the estate should only be held open for a reasonable period and the assets should be held in the estate for such period. The Appeals Court then stated that it would look to see if the beneficiaries of the estate qualified as shareholders of the small business corporation. In reviewing the legislative history of subchapter S, the author notes that the eligible shareholders before the re-write of the law in 1982 were similar to the eligible shareholders under the then-new law. See, Legislative History of Subchapter S Revision Act of 1982 (P.L ) S Rep. No. 640, 97th Cong., 2d Sess. (1982). Thus, it appears that the precedent of Old Virginia would likely be followed today. See also, Treas. Reg (h)(1)(ii). 91 Today, the reference would be to Code 641(a). Page 13

18 1371(a) for the period during which the estate complies with the provisions of section Thus, if an estate qualifies for the benefits of Code 6166 and the qualifying entity or entities are S Corp stock, then, during the 6166 payment period (assuming that the estate continues to meet all of the requirements under 6166) the estate could hold the S Corp stock. As set forth in section III.E.4 of this outline on page 23, there may be some benefit to holding S Corp stock in an estate or if the S Corp stock is owned by a wholly owned grantor trust at death, making a Code 645 election. c. Examples The following examples illustrate the various entities that can be shareholders during the settlement process: Example 3: During her lifetime, D, held some S Corp stock in her revocable trust. The revocable trust is a standard revocable trust that provides that D can revoke the trust at any time and the trust is solely for her benefit during life. Upon death the trust provides for the creation of a credit shelter trust and marital QTIP trust for her husband, H, for life and remainder to D s children. During D s lifetime, the stock is held in a grantor trust, which is an eligible shareholder. Upon D s death, that stock could continue to be held in D s now irrevocable trust (i.e., the Continuing Grantor Trust) for a period of two years. After that 2-year period, the trustee could, depending upon the terms of the trust, distribute shares to an ESBT or QSST. Thus, in this example, at D s death, there could be there are three possible trusts holding the stock. Example 4: Let s assume the same facts as in Example 3, except in this case let s assume that in stead of titling her stock in her revocable D holds her stock in S Corp in her individual name. Let s further assume that X s Will is a pour-over will that pours-over to her Revocable Trust. During life, D is an eligible shareholder because she is an individual. At death, D s estate becomes a shareholder. The stock can be held in the estate for a reasonable time. 93 When the personal representative distributes the stock to the revocable trust, the S Corp stock could be held in a transitional / administrative trust (i.e., a Testamentary S Trust) for a period of two years after the personal representative distributed the stock from the estate. Thereafter, again, depending upon the terms of the trust, the trustee could distribute shares to an ESBT or QSST. In this case, there were five different possible Rev. Rul , C.B See Footnote 90. Page 14

19 shareholders (i.e., the individual, the estate, the Testamentary S Trust, the QSST and ESBT) from the date of death through the administration process. Example 5: Let s assume the facts of Example 3, and further assume that D held stock both in her individual name and her revocable trust. D could have held the stock both in her individual name and her revocable trust. At death, her estate and the revocable trust becomes a shareholder. In this example, the S Corp stock could possibly be held in her estate, a Testamentary S Trust, a Continuing Grantor Trust, an ESBT and/or a QSST. d. Summary As can be seen by the examples, during the relatively short period of administration the various entities hold the S Corp stock. What is important is from an income tax standpoint, each of the different entities is taxed differently (as discussed below in Section III beginning on page 15 of this outline), so that the tax ramifications to the various entities (i.e., estates and trusts) and the beneficiaries of the same could be dramatically different. Suffice to say, during the estate / trust settlement process, there is a possibility that the S Corp stock could be held by up to five (5) different entities all of which are taxed in slightly different manner. III. Tax implications of Shareholders - Who is the Shareholder? In general S Corps do not pay federal income taxes; 94 items of income, deduction, gain, loss and credits (hereinafter tax attributes ) are passed through to the shareholder. 95 Where trusts are the record holders of the stock for state law purposes depending upon the type of trust, (a) the grantor of the trust (or actually the deemed owner of the trust), (b) the trust, and/or (c) the beneficiary of the trust are subject to the pass through tax attributes. In the case of an ESBT, it is possible for all three (i.e., the deemed owner, the trust and the beneficiary) to be subject to tax attributes. What further complicates the issue is the allocation of fiduciary income and principal when the trust is taxed on the pass-through income. Thus, a clear understanding of the type of trust that is the owner of the stock and the tax implications is critical during the period of administration. A. Individuals as owners of S Corp Stock Individuals are the easiest shareholders to deal with income, deductions, losses, credits, etc., are allocated to that individual based upon his or her pro rata, per diem ownership This is true for S Corps that have been S Corps from their inception and continued to be S Corps for all times. If the S Corp was once a C Corp and had accumulated E&P, then it is possible for the S Corp to pay an income tax. It is beyond the scope of this outline to discuss these issues here. 95 Code 1366(a)(1); Treas. Reg (a)(1). Additionally, the character of items of income, loss, deduction, credit, etc., at the corporate level passes-thru to the shareholder under Code 1366(b). The shareholders take into account his or her pro rata share on a per diem basis under Code 1377(a)(1) and Treas. Reg (a)(1). 96 See Footnote 95. Page 15

20 B. Grantor Trusts Grantor trusts are relatively easy to deal with. As set forth above, the entire trust must be treated as a grantor trust. Once the deemed owner is determined, income, deductions, losses, credits, etc., are allocated to that deemed owner based upon the deemed owner s ownership on a pro rata, per diem ownership. 97 C. QSSTs 1. General Rules QSSTs treats the beneficiary of the QSST akin to the grantor or deemed owner of grantor trust; therefore, during the beneficiary s lifetime, income deductions, losses, credits, etc., are allocated to that deemed owner based upon the deemed owner s ownership on a pro rata, per diem ownership. 98 However, special rules apply if the QSST disposes of the stock, and when the beneficiary dies. 2. If S Corp Stock is Disposed The regulations provide that if the S Corp stock is disposed, solely for determining the tax consequences of such disposition, the income beneficiary is not treated as deemed section 678 owner. 99 The theory here is that the if the stock is disposed (e.g., sold) the trust (with respect to that disposed stock) is no longer is deemed to be a QSST; therefore, under regular income tax trust rules, the trust is deemed to be owner of the stock and the tax attributes from the sale are attributed to the trust (and not the current beneficiary). It should be noted that Congress however recognized two exceptions that should apply in the event of a disposition --- (i) section 469 passive activity loss carryover issues; and (ii) 465 at-risk limitation issues. 100 The rationale behind these exceptions was to ensure that if the rules of 469 and 465 limited losses or deductions during the time that the S Corp stock was held by the QSST, thus, limiting the losses directly at the income beneficiaries level, that upon disposition, the same income beneficiary should be able to take advantage of the provisions of 469 and 465 that attempt to release the loss carryovers upon disposition of a passive or at-risk activity. a. Examples Example 6: Let s assume that Hugh is the beneficiary of a QSST created for him by his father, Richard. Let s assume that the QSST own S Corp. Let s assume that the QSST sells the S Corp stock to an unrelated 3 rd party. 97 See Footnote See Footnote Treas. Reg (j)(8). It should be noted that the provisions of this regulation are contrary to the original position that the IRS once held in Rev. Rul , C.B The Service ruled that the income beneficiary of a QSST rather than the trust itself, recognizes gain or loss when the trust sells all or part of its stock in an S Corp, even if under local trust law the gain or loss is allocable to corpus rather than to income. In 1995, the IRS issued TD 8600 which added Treas. Reg (j)(8), which became effective for taxable years beginning after July 28, Code 1361(d)(1)(C). Page 16

21 As of the date of the sale, the QSST election terminates as to the stock sold and any gain or loss recognized on the sale will be recognized by the trust (i.e., Hugh, will not recognize the income from the sale). Thus, the portions of the trust other than the portion consisting of S Corp 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. 101 Example 7: Let s assume the same facts as Example 6, except let s assume that the QSST distributes the S Corp stock Hugh, the income beneficiary. In this case, 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). Thus, the portions of the trust other than the portion consisting of S Corp 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. 102 b. S Corp K-1s - Who gets them? The income beneficiary of the QSST should receive the K-1 each year from the time that the trust becomes a QSST. The rules for the allocation of income (i.e., per diem, pro rata) would apply for the first and last year that the income beneficiary is the deemed owner of the S Corp stock in the QSST. 3. When Beneficiary of QSST Dies a. While S Corp Stock is held by Trust i. The Law Upon the death of the income beneficiary of a QSST, the seminal issue is to determine whether the trust continues or whether the trust terminates under local law. The regulations provide that if the income beneficiary dies and (a) the trust continues in existence, (b) the trust continues to hold the S Corp stock but the trust no longer satisfies the QSST requirements, (c) the trust is not a grantor trust, and (d) the trust does not qualify as an ESBT, then solely for determining the shareholder, as of the date of the income beneficiary s death, the estate of the income beneficiary is treated as the shareholder of the S Corp stock held by the QSST (or former QSST as the case may be). 103 The regulations go on to provide that the estate ordinarily will cease to be treated as the shareholder for purposes of section 1361(b)(1) upon the earlier of (a) the transfer of that stock by the trust or (b) the expiration of the 2-year period beginning on Treas. Reg (j)(8). Treas. Reg (j)(8). Treas. Reg (j)(7)(ii). Page 17

22 the day of the income beneficiary's death. If the trust continues to hold the stock beyond the 2-year period the S Corp will no longer be an eligible S Corp. With regard to whether a new QSST election is necessary after the death of the income beneficiary of a QSST, the Treasury s regulations literally read as follows: 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. The rule appears to be if the trust continues then no new QSST election needs to be filed, but if the trust terminates an election has to be filed by the income beneficiary of that new trust. The determination of whether a trust continues or terminates is dependent upon state law. The regulations provide wonderful examples to illustrate the point. ii. Examples Example 8: Shares of stock in Corporation X, an S Corp, 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 and under local law, the trust is deemed to continue for the benefit of J and K, where 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 9: Assume the same facts as in Example 8, 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 separate, new 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. 4. Planning Pointers In the author s prior life as a practicing attorney, the second example was much more common than the first example. Thus, the consulting attorney should remember to consider making new elections upon the death of an income beneficiary of a QSST. Page 18

23 D. ESBTs By comparison to QSSTs, as stated above, ESBTs may have multiple income beneficiaries. Additionally, there is no requirement regarding the distribution of income and/or principal. Simply put ESBTs may provide the trustee with mandatory or discretionary income and principal distribution powers. It is for this reason that the ESBT is viewed as a good estate planning vehicle. However, the cost of the flexibility is a potential for higher income taxes, maybe. 1. Income Tax Issues a. In General Assuming that the trust qualifies as an ESBT and the proper elections were properly made, the issue becomes who is subject to the income tax consequences. The rules for ESBTs are similar to the rules for complex trusts. Like complex trusts, generally all of the income is either taxed to the distribute beneficiary or the trust (depending upon DNI). b. More Specifically i. Regulations under Code 641(c) govern As mentioned above, ESBTs are taxed similarly to complex trusts; in fact, the rules regarding income taxation are set forth under Treasury Regulations 1.643(c)-1) (i.e., the regulations under subchapter J and not subchapter S). ii. S Portions and Non-S Portions To simplify the rules, one should think of an ESBT as having either one, two or three possible portions ( portions is the name given in the Treasury s regulations, thus, the author will follow that convention). An ESBT will have an S portion and a Non-S portion. As one could guess, if the ESBT held only S Corp Stock, then the ESBT would have only an S portion if the trust holds assets other than S Corp Stock, then the ESBT would have an S portion and a Non-S portion. iii. Grantor Trust Portion Once the S portion and the Non-S portion is determined, as to each portion, one is to determine if any part of the portions are grantor trusts, if so then the portions are separated into grantor trust portions and non-grantor trust portions. Effectively, the grantor trust portions of both the S portion and the Non-S portion would be combined and reported to the deemed owner of the grantor trust. iv. Taxation I. S Portion The S portion is that portion of the trust that consists of S Corp stock. The S portion is then divided into that portion what is (a) not treated as a grantor trust and (b) that portion that is treated as a grantor trust Code 641(c)(1)(A); Treas. Reg (c)-1(b)(2). Page 19

24 The ESBTs tax attributable to the S portion of the S Corp stock is determined under special rules. 105 The tax on the S portion is determined by reference to normal income tax rules with a few modifications. The two most notable of these are there is no exemption amount and that income tax rate for the income attributable to the S Corp stock will be taxed at the highest marginal income tax rate. 106 Most importantly, the S Portion is taxed to the ESBT. This means that the trust pays the income at the highest marginal rates, and any distributions to the beneficiaries pass tax free. See example below. II. Non-S Portion The Non-S Portion, unlike the S Portion, is generally taxed under the regular rules for taxing trusts with no S Corp stock. Thus, to the extent that a part of that trust is a grantor trust, then the regular grantor trust rules apply. To the extent that part of that trust is not a grantor trust and to the extent that items of S Corp income, deduction, etc., were not caught under the S Portion rules, then they will be combined with the Non-S portion and the normal subchapter J rules would apply. 107 III. Grantor Trust Portion The tax attributes related to the grantor trust portion of the ESBT are taken into account on the deemed owner s income tax return in accordance with normal grantor trust rules. 108 Recall that the deemed owner could be either the grantor of the trust or someone other than the grantor under Examples a. In General The regulations have a wonderful example that details how the Grantor Portion, S Portion and Non-S Portion work in tandem. The author suggests that the reader take the time to work the example to get a better understanding of the rules. The following example is based on that comprehensive example See generally, Code 641(c). It should be noted that the instructions for Form 1041 provides guidance on how the income should be reported for income tax purposes. 106 Code 641(c)(2)(A) and Reg (c)-1(e)(1) (for the highest rate); and Code 641(c)(2)(B) and Treas. Reg (c)-1(e)(2) (for the denial of the exemption). In addition to the above, the Code and regulations provide that the only items of income, loss, deduction, or credit taken into account are: (1) the items required to be taken into account under Code 1366 (see, Code 641(c)(2)(C)(i); Treas. Reg (c)-1(d)(2)); (2) gain or loss from the disposition of S Corp stock (including gain when distributions are in excess of basis), except that capital losses are allowed only to the extent of capital gains (see, Code 641(c)(2)(C)(ii); Treas. Reg (c)-1(d)(3)(i); (3) to the extent provided in the regulations, state or local income taxes and administrative expenses to the extent allocable to items (1) and (2) (see, Code 641(d)(2)(C)(iii); Treas. Reg (c)-1(d)(4)(i); and (4) for S Corp taxable years beginning after 2006, any interest expense paid or accrued on indebtedness incurred to acquire stock in an S Corp. Code 641(d)(2)(C)(iv). 107 Treas. Reg (c)-1(g)(1). 108 Treas. Reg (c)-1(b)(1) and 1.641(c)-1(c). 109 Treas. Reg (c)-1(l). Page 20

25 Example 10: Assume (a) trust has a valid ESBT election ( T ); (b) B, an individual, has a 10% grantor trust portion in T; (c) No other person is treated as the owner of any other portion of Trust under subpart E; (d) T owns stock in X, an S Corp and in Y, a C corporation. Further assume that during 2009, T receives a distribution from X of $5,000, all of which is applied against Trust's adjusted basis in the X stock in accordance with section 1368(c)(1). T receives $1,000 as a qualified dividend from Y. Assume no deductions. Trust makes a distribution of $1,000 to its beneficiary, A. B is taxed on 10% of X s and Y s taxable income (i.e., 10% of $5,000 and 10% of $1,000). T is taxed on 90% of the $5,000 (or %4,500) at the highest marginal rate as the S Portion; and 90% of the income from Y (i.e., 90% of $1,000 or $900) is reduced by the personal exemption of $100 (i.e., net is $800), and thus passes out to A as a qualified dividend. Example 11: Same as Example 12, except that T sells all of its stock in X to an unrelated person T and its beneficiaries and realizes a capital gain of $5,000. This 10% of the gain (or $500) passes to the B (i.e., the grantor trust portion) and 90% gain (or $4,500) is taken into account by the S portion and is taxed using the appropriate capital gain rate found in section 1(h) to T. Example 12: Same as Example 10, except Y is not a corporation, rather it is a partnership and has taxable income of $1,000, further X, the S Corp, makes a distribution of $2,000 to A. In this case, B is taxed on 10% of X s and Y s taxable income (i.e., 10% of $5,000 and 10% of $1,000). T is taxed on 90% of the $5,000 (or $4,500) at the highest marginal rate as the S Portion; and 90% of the income from Y (the partnership) (i.e., 90% of $1,000 or $900) is reduced by the personal exemption of $100 (i.e., net is $800), and thus passes out to A as passthrough taxable income. Note of the amount that passes out to A, only $800 is taxable to A and $1,200 is a non-taxable distribution. E. Continuing Grantor Trusts 1. In General For the maximum 2-year time period that a Continuing Grantor Trust is the shareholder, even though the trust is a shareholder for state law purposes, for federal income tax purposes, the estate of the deemed owner (i.e., the decedent) and not the Continuing Grantor Trust is to report the income, gains, losses, etc Code 1361(c)(2)(b). Treas. Reg (h)(3)(i)(B) provides that [i]f 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 Page 21

26 2. Examples It should be noted that it is not necessary that the estate pour-over to the Continuing Grantor Trust, the results of this could be quite peculiar. The following examples will show some unusual results. Example 13: Let s assume that D, has a revocable trust ( RT ) that is treated as wholly a grantor trust for purposes of Code 1361(C)(2)(A)(i). Let s further assume that during his life, D places 100% of his S Corp stock (called S, Inc. ) into his revocable trust. Let s then assume that D dies on January 31, Let s assume that D s will pours-over into D s RT. Let s assume that D s RT creates standard A-B trusts for his wife, W, for life and remainder outright to D s and W s children. Further that both of the A-B trusts qualify as QSSTs. When D dies RT will be considered an eligible shareholder under Code 1361(C)(2)(A)(ii) for a period of 2-years (i.e., RT will be a Continuing Grantor Trust). Upon the expiration of the 2-year period, or if the stock is funded in the A-B trusts and a QSST election is made to take effect sooner, RT ceases to be a Continuing Grantor Trust, rather the stock will be held by the QSSTs. During the period of administration, effectively, D s estate would report the taxable income of S, Inc., on the estate s Form Since the A-B trust will be the only beneficiaries, and since W is the income beneficiary of the trusts, to the extent of DNI distributions, ultimately W would report the income on her tax return. Since RT is the owner of the stock for state law purposes, any distributions from S, Inc. to RT would pass through to W as income distributions. Example 14: Let s assume the same facts as Example 13, except that RT is not a revocable trust, rather it is an intentionally defective grantor trust ( IDGT ) that was irrevocable for state law purposes and that D s will does not pour-over into that trust. In this case, the tax ramifications pass to W (to the extent that there are DNI distributions); however, the economic benefit passes to the beneficiaries of the IDGT. 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 2-year period beginning on the day of the deemed owner's death. For stock that is treated as community property, that portion of the stock deemed to be the decedent s share shall be the shareholder for Federal income tax purposes. Code 1361(c)(2)(b). Page 22

27 3. Planning Opportunity This may be a planning opportunity for the family, if they want to sell the assets or the stock in the family S Corp. One may want to consider the following steps: (1) do not elect QSST treatment; and (2) consider a partial redemption of the stock before the 2- year time period. If it is their desire at some later point in time, consider selling the balance of the stock. The benefit of this is that the tax attributes are borne by the estate, but the assets flow to the trust. This would be especially beneficial from a generation-skipping transfer ( GST ) tax planning perspective (i.e., where the IDGT is GST exempt). 4. Code 645 An initial look A trustee of a so-called qualified revocable trust ( QRT ) 111 together with the personal representative of an estate is allowed to make an election (i.e., the 645 election ) to combine the incomes of the two entities (i.e., the QRT and the estate) and to report the income as part of the estate for the 645 election period. 112 The 645 election period (discussed in detail below) is generally either two years from date of death (if no estate tax return was necessary) or six months after the estate receives a closing letter from the IRS. 113 a. Effect on Holding S Corp Stock i. Treat the Trust like an Estate Effectively, by making a 645 election, if the Continuing Grantor Trust qualifies as a QRT, the income of the Continuing Grantor Trust is combined with the estate s income and reported on the estate s income tax return. The rules applicable to the Continuing Grantor Trust (e.g., the 2-year holding period) would not apply, because such trust would be treated as part of the estate. Stated differently, during the 645 election period, the S Corp stock can be held by the Continuing Grantor Trust for state law purposes, yet be taxed for federal income tax purposes as if it were held by an estate. ii. What happens after termination of the 645 election or transfer of S Corp stock from the QRT? Under the regulations, after the 645 election period terminates 114 or if the QRT transfers the S Corp stock, the succeeding trust will be considered a Testamentary S Trust (i.e., with a 2 year period beginning from the end of the 645 election period) without regard to whether the successor trust would qualify as a permitted shareholder For purposes of this discussion, we will assume that a standard revocable trust (i.e., where the grantor has the right to revoke, amend, alter and/or modify the trust) typically used in basic estate planning qualifies as a QRT. 112 Code Treas. Reg (f)(2)(ii)(a). 114 Treas. Reg (h)(i). 115 See, Treas. Reg (h)(1)(iv)(B). Page 23

28 iii. PLR Private Letter Ruling provides some guidance on S Corp stock utilizing a 645 election. 116 This PLR provides us with a few planning suggestions: First, Rev. Rul is still being cited by the Service, which stands for the proposition that S Corp stock may be held by an estate during the Code 6166 payment period and holding the stock in an estate for that period (which could be as long as 15 years) will not be deemed to be a prolonged period of time. Second, if a 645 election is made, even though the S Corp stock is held by a trust for state law purposes, it will be deemed to be held by the estate for income tax purposes and the theory behind Rev. Rul will apply. Therefore, if the 645 election is made the decedent s estate is deemed as if it owned the stock for federal income tax purposes, even though the S Corp stock would have been held by a trust at the time of death (and not the decedent s estate. And, if the estate qualifies for 6166 treatment, the holding of the S Corp stock is still subject to the 645 election period (i.e., which begins at the date of death and generally ends 12 months 118 after the estate tax closing letter is sent by the IRS), and it is not extended by Thus, after the 12 month period, the trust is deemed to transfer the property to a testamentary trust, thereby creating another two-year holding period in that trust. As one could see, the 645 election could significantly extend the period of time that S Corp stock is held in a trust / estate other than a QSST and/or ESBT. F. Testamentary S Trusts Like the Continuing Grantor Trust, during its 2-year holding period, the Testamentary S Trust becomes the shareholder for state law purposes, and for federal income tax purposes the estate will report the income, gains, losses, etc. 119 G. Estates If an estate is a shareholder the tax attributes from the S Corp flows thru to the estate Private Letter Ruling (April 11, 2005). Actually, when obtaining the PLR, the reader will find that the questions presented to the IRS appear to address 6166, however, the Service gratuitously discusses Code 645. The author found other rulings where Code 645 was mentioned, but there was no analysis of the particular code section. 117 See discussion of Rev. Rul above. 118 Treas. Reg (f)(2)(ii) provides that the period ends six months after the final determination for the estate tax liability. The regulations further provide the final determination of the liability for tax ends six months after the issuance by the Internal Revenue Service of an estate tax closing letter. Thus, the two six-month periods are combined, which totals 12 months. 119 Code 1361(c)(2)(b)(iii); and Treas. Reg (h)(3)(1)(D). For stock that is treated as community property, that portion of the stock deemed to be the decedent s share shall be the shareholder for Federal income tax purposes. Code 1361(c)(2)(b)(iii); and Treas. Reg (h)(3)(1)(D). 120 Code Page 24

29 In the year of death, there will be at least two shareholders sharing the tax attributes of the S Corp: (a) the decedent and (b) his or her estate. In general, (a) the decedent s final return (sometimes referred to as the Final 1040 ) will generally report the decedent s pro rata share of the tax attributes through the date of death, and (b) the estate will report its pro rata share of tax attributes from the date of death to the end of the taxable year of the estate. Combined, the tax attributes reported by the decedent and her estate would total the same amount as if the decedent lived through the end of the year. During the settlement process, through various elections, some of the tax attributes could be manipulated to be reported more by one party (e.g., the decedent on his Final 1040) or by her estate on its first income tax return (the First Form 1041 ). See discussion below at Section IV beginning on page 25 of this outline for a full discussion of this topic. IV. Elections available for apportionment of income A. General Rule In general, the S Corp s tax attributes for the entire tax year are allocated on a per diem basis to the shareholder based upon the shareholder s pro rata ownership. 121 B. Separate Year Election (a)(2) Upon the death of a shareholder, 122 if an S Corp elects with the consent of all affected shareholders, the S Corp may terminate the corporation s tax year with respect to that decedent shareholder, thereby creating two tax years (i.e., one before death, and one after death) for that shareholder and his or her estate. 123 The tax attributes before death would be allocated pro rata to the Final 1040 and the tax attributes for the S Corp s tax year after death would be allocated pro rata on the estate s First Form An affected shareholder is the decedent and the decedent s estate. 125 Thus, the personal representative of the estate would be the person consenting to the request. The S Corp must attach a statement to the corporation s timely filed income tax return (i.e., the Form 1120S) for the tax year in which the decedent-shareholder died. The election must include the following: (a) a declaration by the S Corp that it is electing under section 1377(a)(2) and Treas. Reg (b) to treat the taxable year as if it consisted of two separate taxable years; (b) information setting forth when and how the shareholder's entire interest was terminated (e.g., death); (c) the signature on behalf of the S Corp of an authorized officer of the corporation under penalties of perjury; and (d) a statement by the corporation that the corporation and each affected shareholder 121 Code 1366 and 1377(a)(1). 122 Treas. Reg (b)(4) explains that under 1377(a)(2) death of a shareholder qualifies as a termination of a shareholder s interest. 123 Code 1377(a)(2). 124 Treas. Reg (b)(1). 125 Treas. Reg (b)(5)(ii). Page 25

30 consent to the S Corp making the terminating election. 126 There is no formal IRS form for this election, thus, the tax preparer simply prepares a document that would include the requisite information and have the appropriate persons sign the document. C. Estate Income DNI / FAI Income allocated to the estate is reportable on the estate s income tax return (i.e., Form 1041). Pass-through ordinary income becomes part of distributable net income ( DNI ), and in general, pass through capital gain is not included in DNI. 127 The character of the receipt of the assets from the corporation for fiduciary accounting income ( FAI ) purposes and the dispositive terms of the will would dictate whether, the pass-through income stays in the estate or passes outright to the beneficiaries of the estate. 128 D. Planning Pointers 1. During Life In terms of lifetime planning, there are times that various trusts may own stock of an S Corp. When a trust converts from one type of trust to another, or if the deemed owner changes (e.g., where the trust is treated as a grantor trust as to the grantor (under Code 675(4)) and the grantor releases the power so that it is treated as a grantor trust as to the beneficiaries (under Code 678)), there is authority under Section 1377(a)(1) and the Treasury Regulations that one could elect under Code 1377(b) if it is beneficial. 129 Let s use the following example to understand the benefits of the 1377 election. Example 15: Let s assume (a) Carol owned 50% of the stock in CAC Corp, an S Corp and that the other 50% is owned a trust (the Trust ) that Carol created which is a grantor trust by reason of 674(4) 130 where her child, Richard, the beneficiary, but for Carol s 675(4) power, would be treated as the owner, (b) Carol and CAC Corp. have the same tax year (a calendar year), (c) CAC Corp will recognize $1.2 million for the year, where most of that capital gain will be recognized from the sale of its only asset on January 31, and (d) there will be a total of $120,000 of municipal interest income (i.e., tax-free income) earned evenly over the entire year. Let s assume that on February 1, after the major transaction, Carol turned off her section 675(4) power, so that she is no longer the deemed owner under the grantor trust rules, rather her only child, who is the beneficiary of the trust is the grantor (under section 678). 126 Treas. Reg (b)(5)(i)(A) (D). 127 Code 643(a)(3); Treas. Reg., 1.643(a) See, section III.E.4 of this outline beginning on page 23, discussing the issue of where a revocable trust is treated as part of an estate (i.e., the 645 election). 129 See, Treas. Reg (a)(2)(iii). Also see an example of converting from a QSST to an ESBT under Treas. Reg (c) Example The power that causes the trust to be a grantor trust is the power of substitution. Page 26

31 If we use the default rule, the pro rata per diem income on the Carol s income tax return ( Carol s Form 1040 ) would be $650,000 (approximately 100% of 1/12 th and 50% of 11/12 th ) of long term capital gain; $65,000 (approximately 100% of 1/12 th and 50% of 11/12 th ) of municipal income. Her Child, Richard, through the Trust, would reflect (approximately $550,000 of capital gain (i.e., 50 % of 11/12 th of long term capital gain; $55,000 (approximately 50% of 11/12 th ) of municipal income. If CAC Corp elects and Carol consents, then they could elect to allocate income as earned. Carol would pick up the entire capital gain (i.e., 100% of $1.2 million) and $65,000 of municipal interest income and Richard will pick up only $55,000 of municipal income. In this case, approximately $550,000 of capital gain is borne by Carol. If Carol s capital gains rate is 15%, Carol would pay $82,500. What this translates to is a tax-free gift of $82,500. Thus, by simply toggling between the grantor status, and taking advantage of the 1377 election, Carol (in the above example) transferred tax-free value to her child, Richard. 2. After death Likewise, if there will be a substantial change of income before and after a change in ownership (e.g., the decedent s date of death), it may make some sense to make the election. Recall, the election does not affect the other shareholders of the S Corp; the election only affects the person who has changed ownership (e.g., the decedent in the case of death). Thus, one could manipulate the amount of income that flows to either the decedent s Final 1040 or the estate s First Form Example 16: Let s assume the same facts as Example 15, except that on February 2 nd, after the grantor trust toggle had been shifted to Richard, Carol died unexpectedly. If we use the default rule, the pro rata per diem income on the Carol s final income tax return ( Carol s Form 1040 ) would be $650,000 (approximately 100% of 1/12 th and 50% of 11/12 th ) of long term capital gain; $65,000 (approximately 100% of 1/12 th and 50% of 11/12 th ) of municipal income. Richard, through the Trust, would reflect (approximately $550,000 of capital gain (i.e., 50 % of 11/12 th of long term capital gain; $55,000 (approximately 50% of 11/12 th ) of municipal income. If CAC Corp elects and Carol consents, then they could elect to allocate income as earned. Carol would pick up the entire capital gain (i.e., 100% of $1.2 million) and $65,000 of municipal income, and Richard will pick up only $55,000 of municipal income. Page 27

32 The benefit of the election can be seen in the case where Carol. The benefit (vis-à-vis Example 15) may be is slightly increased if Carol is subject to estate tax, since the extra income tax liability (of $82,500) would be allowed as a deduction against the gross estate, and therefore, decrease the estate tax payable at Carol s death. If Carol is subject to a 45% estate tax, this would translate to an extra benefit of approximately $37,000. Thus, as a result of properly using the 1377 election, Carol and her family could continue to shift value from Carol s generation to Richard s generation. V. A Few Words on C Corps On Concepts That Apply to S Corps Too As a result of death, sometimes the family desires to terminate the business or is forced to terminate or reduce its size. Thus, liquidation at death is a significant issue facing the survivors. If the heirs consider liquidating or utilizing assets of the business, a good understanding of income taxes with regard to corporations is critical. The following should be considered in the settlement process as it applies to closely-held 131 C Corps and S Corps. A. Basis Step Up / Down of the Stock In general, at death the basis of the stock in the hands of the decedent s estate will be its fair market value. 132 Unlike partnerships where there is the Section 754 election, there is no inside basis adjustment provision for C Corps and S Corps, 1. General Rule Code 1014 The basis of stock (whether C or S Corp) at death will be the value at date of death. 133 Remember, this is generally a step-up in basis, but it may be a step-down depending upon date of death fair market value and the tax basis immediately before death. 2. Exceptions Code 1014(c) and (e) i. Code 1014(c) Items that are considered Income in Respect of a Decedent ( IRD ) are not to be allocated to basis. 134 This will be more relevant for S Corps, and generally not relevant for C Corps. 131 The author uses the term closely held to denote those entities that are generally held by one family or perhaps a few families. 132 It is beyond the scope of this outline to detail the issues of valuing a C Corp, suffice to say, in general, discount for lack of marketability, minority interest and income tax payable for liquidation are generally considered in valuing a corporation (whether S or C). One should also consider in closely held businesses where the decedent may have been a significant person in the business a loss of Key Person discount. Finally, the basis of the stock may be different if alternate value is used under Code 2032 (i.e., the alternate valuation provisions). Please refer to the Empire Valuation s Outline written by Hugh Woodside. 133 IRC Page 28

33 ii. Code 1014(e) If a decedent acquired appreciated property as a gift from any person (called the donor ) within one year of the decedent s death, and if such donor will receive the appreciated property back from the decedent, the basis will not be stepped up, it will be the same basis that the decent had immediately before death. 135 It should be noted that this rule does not apply to depreciated property. 3. Liquidating a C Corporation a. In General - Tax On Liquidation Before 1986, liquidations of closely held C Corps were generally non-taxable. As a result of the passage of the Tax Reform Act of 1986, which repealed the General Utilities Doctrine, liquidations of C Corps are taxable at the corporation and shareholders levels. Thus, the dreaded double layer of tax is most evident today in C Corp liquidations! b. Complete Liquidation i. Gain at the corporate level - Section 336 In general, Code 336 provides that C Corps recognize gain or loss when they distribute property to the stockholders in complete liquidation of the entity. The C Corp is treated as if it had sold the property to the shareholder. Gain or loss 136 would be the difference between the C Corp s adjusted basis and the fair market value of the property on the date of distribution. Note: Since there is no preferential capital gain treatment for C Corps, the gain inside the entity will be taxed at its usual corporate income tax rates; however, for S Corps, the character of the gain at the corporate level flows through to its shareholders. ii. Corporate Tax Reporting If the corporation completely liquidates, within 30 days after the board of directors adopts the plan of liquidation the C Corp must file a Form 966. Additionally, generally the C Corp would have to file Forms 1099 for distributions to the shareholders. iii. Gain / Loss at the Shareholder Level Code 331 Amounts received by distributee-shareholder from a liquidating distribution are treated as full payment in exchange for the shareholder's stock. If the C Corp was indebted to the distributee-shareholder and such debt was forgiven, that amount of the debt is added to the proceeds that the shareholder received Code 1014(c). 135 Code 1014(e). 136 Code 336(d)(1)(A) and (d)(2) limit losses in certain circumstances. If losses are disallowed, they are generally lost in complete liquidations. 137 Code 331(a). Page 29

34 Gain or loss is computed based upon the general rules under Code 1001 (as to amount of gain) and 1221 (as to its nature). 138 Generally, if there is a gain at death, it will be long-term capital gain. It should be noted, when the stock is discounted, there may be some gain recognized to the estate and/or heir of the decedent. c. Partial Liquidation / Redemptions Partial liquidations are not covered under Code 336, rather they are covered under the rules of 302 and 303 (discussed below). The general rule is that a partial liquidation is treated as a distribution taxable as a dividend, unless there is a special exception (enumerated in 302(b) and 303)). If a special exception applies, then the distributeeshareholder treats the distribution as a sale or exchange transaction (i.e., affording such shareholder capital gain treatment). It is beyond the scope of this outline to detail the four exceptions under 302. However, for the estate planning lawyer, Code 303 is very important to understand. i. Code 303 Redemptions I. In General In general, Code 303, which applies to all corporations (i.e., C Corps and S Corps alike), 139 provides that if the estate may need cash to fund estate taxes and certain expenses and obligations, and if the entity redeems the decedent shareholder s stock, that such redemption would be treated as a sale transaction (i.e., capital gain treatment) rather than a dividend. Code 303 appears relatively straight-forward, but there are some intricacies. In illiquid estates, sometimes estate tax and other obligations are financed by the IRS families sometime avail themselves of Code 6166 provisions. The advisor must understand the basic differences between the requirements under Code 303 and 6166, which is explained below. II. Code 303 Basic Requirements A. Code 303(a) For a redemption to qualify for special treatment under Code 303, a number of requirements must first be met. First, property must be distributed to a shareholder. 140 Second, the distribution must be in redemption of the corporation s stock. 141 Third, the corporation s stock must have been included in the gross estate of a decedent. 142 Fourth, there are dollar limitations on the amount that would be treated as a 303 redemption. 143 To the extent that the fair value of what was 138 Note: in the event that a loss is recognized, code 1244 may offer a benefit of converting the loss from a capital loss to an ordinary loss. 139 See, Code 1368(e)(1)(B) and 1371(a). 140 Code 303(a). 141 Code 303(a). 142 Code 303(a). 143 Code 303(a). To the extent that the fair value exceeds the certain amount, then it will be treated (all else being equal and no other special provision applying) as a distribution subject to the dividend rules under Code 301. Page 30

35 distributed does not exceed estate taxes and certain expenses, then the amount so distributed would be treated as being in full payment and in exchange of the stock. B. Gross Estate of a Decedent Interestingly, the corporation need not redeem the stock from the estate. What is required is that the stock was included in the gross estate of a decedent at some point in time. C. Property The corporation must distribute property in redemption of its shares. There are a number of cases and ruling determining what is property for purposes of 303. Generally, the cases under Code 301 through 318, inclusive, define property as being money, securities and any other property. According to Code 317, property does not include stock or some other form of equity in the company. See discussion below at section V.A.3.c.ii of this outline beginning on page 34 where the concept of distributing a promissory note is discussed. D. Class of Stock Code 303 applies to any and all classes of stock. This should be distinguished from Code 6166 which deals only with voting stock. Thus, assuming all other requirements are met under Code 303, if the decedent s estate has only non-voting stock, then Code 303 would apply to the redemption, whereas, Code 6166 would not apply. This may be relevant for families where the senior generation may have passed the voting stock to the junior generation and maintained non-voting stock. E. Gross Estate of a Decedent - Stockholder A prerequisite for Code 303 application is that the stock was included in the gross estate of a decedent. Code 303 does not require that the estate own the stock at the time of the redemption. The Treasury Regulations under Code provide 144 See generally, Treas. Reg (f), which provides as follows: (f) While section 303 will most frequently have application in the case where stock is redeemed from the executor or administrator of an estate, the section is also applicable to distributions in redemption of stock included in the decedent's gross estate and held at the time of the redemption by any person who acquired the stock by any of the means comprehended by Part III, Subchapter A, Chapter 11 of the Code, including the heir, legatee, or donee of the decedent, a surviving joint tenant, surviving spouse, appointee, or taker in default of appointment, or a trustee of a trust created by the decedent. Thus, section 303 may apply with respect to a distribution in redemption of stock from a donee to which the decedent has transferred stock in contemplation of death where the value of such stock is included in the decedent's gross estate under section Similarly, section 303 may apply to the redemption of stock from a beneficiary of the estate to whom an executor has distributed the stock pursuant to the terms of the will of the decedent. However, section 303 is not applicable to the case where stock is redeemed from a stockholder who has acquired the stock by gift or purchase from any person to whom such stock has passed from the decedent. Nor is Page 31

36 examples of whether the provisions of Code 303 are met depending upon who the owner is at the time of the redemption. To summarize the regulations, it appears that Code 303 applies to: (a) estates and revocable trusts still holding the stock during the period of administration; (b) beneficiaries of the estate (other than those to satisfy a pecuniary bequest); and (c) owners of stock that were given the stock during the decedent s life but the stock was pulled back into the gross estate (for some reason (e.g., 2035)) 145. Code 303 would not apply in the case where: (a) the stockholder purchased the stock from the estate / trust; (b) the stockholder acquired the stock as a gift from a person who would have been entitled to Code 303; or (c) a beneficiary of an estate received the stock in satisfaction of a pecuniary bequest. In general, the tenor of the type of stockholder who could avail him or herself of Code 303 could be summed up by the Fifth Circuit Court of Appeal which held that Code 303 is available to one who has a substantial relationship to the estate of the decedent and as a beneficiary of the will. 146 III. Extent to which Code 303 applies Code 303 applies only to the extent that the value of the distributed property does not exceed the sum of the following two amounts: (a) estate / death / inheritance taxes (including interest); (b) funeral and administration expenses allowable as deductions to the estate under Code IV. Threshold Percentages 35% and 20% Tests A. 35% Test Stock in only One Corporation In order for Code 303 to apply, the total value of the stock included in the decedent s gross estate must exceed 35% of the difference between (a) the gross estate of the decedent and (b) the sum of the amounts allowable as a deduction under 2053 and It should be noted that in calculating the 35% amount the expenses under Code 2054 are deductible, but determining the maximum amount that is to be allowed favorable Code 303 treatment is not reduced by The author suggests that one review Code 303(a)(2) and 303(b)(2)(A)(ii) carefully section 303 applicable to the case where stock is redeemed from a stockholder who has acquired the stock from the executor in satisfaction of a specific monetary bequest. E.g., see 2035(c)(1)(A). U.S. v. Lake, 406 F.2d 941 (5 th Cir. 1969). Code 303(a)(1) and (2). Code 303(b)(2)(A). Page 32

37 B. 20% Test - Stocks in Two or More Corporations Code 303(b)(2)(B) has a special rule in the event that there is more than one corporation. In this case, the amount of each corporation s stock must be evaluated to determine whether the amount included in the decedent s gross estate is greater than 20% of the total value of all of the outstanding shares of that particular corporation (i.e., the 20% corporations). If that is the case, all the so called 20% corporations may be aggregated and treated as one corporation for purposes of the 35% amount under Code 303(b)(2)(A). Additionally, there is a spousal attribution rule for property held as community property, joint tenants, tenants by the entireties and as tenants in common. 149 However, see Section V.A.3.c.i.V on page 33 of this outline dealing with the shareholder s relationship to the estate tax. V. Redeemed Shareholder s Relationship to the Estate Tax Code 303(b)(3) provides that 303 is unavailable to any shareholder who does not bear the burden of the payment of estate taxes and obligations under 303(a)(1) or (2). This would mean that if a surviving spouse receives the stock outright or in a trust to which the marital deduction is applicable, then favorable treatment is unavailable to the surviving spouse (or marital trust) if his or her (or its) stock is redeemed. Simply put, the person whose stock is being redeemed must be obligated in some manner to pay the estate taxes, expenses and/or obligations under 303(a)(1) or (2). Thus, generally a surviving spouse could not avail him or herself of the favorable 303 treatment. VI. Time Limit A. Pre-death distributions By definition, code 303 can not apply to any distributions made before the decedent dies. B. Post-death distributions In general, there are four (4) time limitation periods to be concerned about: (a) the three year period; (b) Tax Court period; (c) code 6166 period; and (d) the four year period Year Period In general, if the estate tax return for the decedent is timely filed then distributions made after the decedent s date of death and within 3 years and 90 days of the date of filing the tax return are to be given 303 special treatment Code 303(b)(2)(B)(last sentence). 150 There are a number of rulings under Code 303(b)1)(A) that provide guidance in the event that an estate tax return is not timely filed. See, e.g., Rev. Rul C.B. 94 and Rev. Rul , C.B Page 33

38 2. Tax Court Period If the estate files a petition in Tax Court for a re-determination of a deficiency, then the time period will expire at the later of the 3 year and 90 day period (above) or 60 days after the decision becomes final. 151 It is important that the petition for redetermination be filed in Tax Court (i.e., that the taxpayer not pay the re-determined tax and file the petition in tax court). 152 The regulations provide that if one attempts to file a frivolous case in Tax Court, solely for the purpose of extending the time, 303(b)(1)(B) time limit will be ignored (i.e., one would fall under the 303(b)(1)(A) 3- year rule Coordination with 6166 If a Code 6166 election has been made, in general, the payments may be made during that permissible time (generally 10 years) Year Period Notwithstanding the rules above, if payments are made more than 4 years after the decedent s date of death, special 303 treatment is available only to the extent of the lesser of: (a) the unpaid amount of estate taxes, expenses and obligations under 303(a)(1) and (2) as of that date; 155 or (b) the amount of estate taxes, expenses and obligations under 303(a)(1) and (2) paid during the 1-year period beginning on the date of distribution. 156 ii. Planning With Promissory Notes Sometimes corporations consider distributing promissory notes to its shareholders in redemption of stock (discussed below in section); this suggestion raises the issue of whether the note is debt or equity, 157 and whether the promissory note is debt or equity. There are a plethora of cases and rulings under Code 351 and the reorganization code sections that detail the debt v. equity issue; a discussion of that issue is beyond the scope of this outline. In the case law and rulings, the following property distributed from an entity was deemed to be property: (a) a corporation s own promissory note; (b) an unsubordinated debenture issued by the company; and (c) the cancellation of debt owed by the decedent. By example, in Revenue Ruling , the corporation redeemed the estate s stock in exchange for cash and an unsecured promissory note payable over a 5-year period of time. Implicit in the ruling, the IRS decided that a 5-year unsecured promissory note was not deemed to be the corporation s equity. The IRS also determined it was 151 Code 303(b)(1)(B). 152 See, Davis v. U.S., 277 F. Supp 602 (1967). 153 Treas. Reg (e). 154 Code 303(b)(1)(C). 155 Code 303(b)(4)(A). 156 Code 303(b)(4)(B). 157 If the note is deemed to be debt, it is considered property ; if it is equity it is not considered property ; thus, Code 303 would not apply. Page 34

39 irrelevant that the note will be paid beyond the 3 year and 90 period of time. What is relevant is that the note is distributed within the applicable period of time. Based upon this ruling, if (a) it is possible to avail the shareholder of preferential 303 treatment and (b) there is insufficient cash in the corporation at the time of the distribution, the corporation could distribute a promissory note. One must review the case law regarding what is debt versus equity to ensure that the note that is distributed would not be treated as equity. 158 iii. Must the Property Distributed Be used to pay taxes and obligations? The simple answer to this is no! Thus, this is where Code 303 could provide certain shareholders benefits. iv. Reduction of Earnings & Profits ( E&P ) No one likes E&P! This is true because it creates the concept of double taxation. Even with the recent reduction of the income tax on qualified dividends 159, the shareholder of a corporation receiving dividends is effectively taxed twice on the funds coming to the individual (albeit at lower tax rates). If the beneficial treatment of qualified dividends is not indefinitely extended, E&P is something that will rear its head again in a very negative way. Distributions treated (a) as dividends and (b) as redemptions that are not dividends reduce E&P. 160 However, if the distribution is a dividend (as opposed to a redemption that is not treated as a dividend), one must report the dividend as ordinary income, without reducing one s tax basis in the stock. Distributions in redemption of stock that are not treated as dividends reduce the tax basis of the stock. Both types of distributions reduce E&P. The reduction of E&P for redemptions is covered under Code 312(n)(7). 158 There are a number of cases in the corporate formation area (i.e., Code 351 cases) and in the sale of assets to related parties from a corporation where this issues has been decided. For instance, see, Bradshaw v. U.S., 683 F.2d 365 (Cl. Ct. 1982); Bramlett v. Comm., 960 F.2d 526 (5 th Cir. 1992); Curry v. Comm., 43 TC 667 (1965); Gyro Engineering Corp., v. Comm., 417 F.2d 437 (9 th Cir 1969), Burr Oaks, Corp. v. Comm., 43 TC 635 (1965); Plantation Patterns, Inc., v. Comm., 462 F.2d 712 (5 th Cir. 1972); Aqualane Shores, Inc., v. Comm., 269 F.2d 116 (5 th Cir., 1959); Slappey Drive Industrial Park v. US. 561 F.2d 572 (5 th Cir. 1977); Fin Hay Realty, Co., v. U.S., 398 F.2d rd Cir 1968); and Estate of Mixon v. U.S., 464 F.2d 394 (5 th Cir. 1972) note this case is the basis for what some commentators have called the Mixon Factors, which sets forth the types of issues that the court would review in determining if an instrument is debt or equity. Note: See, also, an interesting S Corp case, Segel v. Comm., 89 T.C. 816 (1987), where the IRS argued to treat the advances to a S Corp as loans, instead of stock, so that there would not be tax free distributions under old Suffice it to say, the issue is very important to the planner and the planner should not automatically believe that the creation of a promissory note would be considered debt; thus, a study of the issue is warranted before advising the client to use a debt instrument. 159 Under Code 1(h)(11) as recently modified by the Tax Increase Prevention and Reconciliation Act of 2005, placed into effect on May 17, 2006, for this year (i.e., 2007) through 2010, non-corporate shareholder's "qualified dividend income" is taxable as net capital gain rather than ordinary income. 160 Code 312(a). Page 35

40 Section 312(n)(7) literally states: If a corporation distributes amounts in a redemption to which section 302(a) or 303 applies, the part of such distribution which is properly chargeable to earnings and profits shall be an amount which is not in excess of the ratable share of the earnings and profits of such corporation accumulated after February 28, 1913, attributable to the stock so redeemed. Thus, to state it otherwise, accumulated E&P would be reduced on a ratable basis based upon the percentage of shares that were redeemed. There are a couple of issues of note here. First, the statute speaks in terms of accumulated E&P and not current and accumulated E&P. 161 Second, it may be possible to reduce E&P greater than the amount of the distribution. By example, let s assume that the value of the stock (with discounts) is $1 million. Let s also assume that the stock was 50% of the outstanding corporation s stock and that the accumulated E&P was $3 million. In reading the statute, one would reduce accumulated E&P by $1.5 million. Note, however, that the Senate committee reports mention that the E&P reduction would have been limited to the amount of the distribution. v. Transferring Hard to Value Assets from the Corporation Properly structured, one could distribute hard to value assets from a corporation as part of a Code 303 redemption. This strategy eliminates the hard to value asset from the corporation, which may reduce income tax on the distribution. If one utilizes the statutory approach (discussed above in section V.A.3.c.iv of this outline) to reduce E&P, one could reduce E&P above the value of the distributed assets. This could be quite beneficial from an income tax perspective for the shareholders and the corporation. vi. Section 311(b) As stated above, Code 336(a) applies to complete liquidations. By comparison, Code 311(b) applies to partial liquidations. However, under Code 311(b) only gain is recognized (i.e. losses are lost!). If a corporation distributes property (other than cash to a shareholder) gain is recognized to the extent that the fair market value of the property distributed exceeds such property s tax basis. If the property s fair market value is less than its tax basis, no loss is recognized. Thus, the distribution of any appreciated property is deemed to cause income to be recognized to the corporation Interestingly, the statute only addresses accumulated E&P and not current E&P. QUERY: would current E&P be reduced? It appears that the intent when the statute was enacted that current and accumulated E&P were to be included in the reduction, however, this is not explicitly stated in the statute. 162 Code 311(b). Page 36

41 d. Basis in hands of Shareholder The basis of property distributed shall be the fair market value of the property. 163 e. Holding Period The holding period for the property received will begin on the date of the distribution of the property. B. S Corps / Trusts and Estates By comparison to C Corps, S Corps add a layer of income tax complexity at death. The complexity arises from rules limiting the number and types of eligible shareholders, different pass through nature of the income during various stages of settlement, and the interrelationship of Subchapters S and J when stock is placed in trusts. S Corps that were once C Corps, and that continued to have accumulated and undistributed E&P after the conversion, add one yet more layer of complexity. VI. Discussion on Planning with Chenoweth in Mind When planning with closely held entities, whether C Corps, S Corps, partnerships, or limited liability companies, one must be mindful of where the ownership of the entity lies before and after transfers for estate planning purposes. The issue that sometimes arises is the mismatching between an item that is included for estate tax purposes may be different for a deduction against such inclusion (whether the deduction is the marital or charitable deduction. It is beneficial when the mismatch favorable to the taxpayer; however, this mismatch, may work against the taxpayer too. Let s examine the case of Estate of Chenoweth v. Comm., 164 as well as the following rulings by the Service, TAM and TA , to see what can be gleaned from the case and rulings in planning with S Corps (and other closely held entities). A. Chenoweth Chenoweth is generally regarded as a taxpayer victory case. In this case, at his death in 1982, Dean Chenoweth ( Dean ) died leaving 255 shares (being 51%) of the total issued and outstanding 500 shares of common stock of Chenoweth Distributing Co., Inc, ( Company ) to his wife, Julia Jenilee Chenoweth ( Jenny ), and the balance (i.e., 245 shares which represented 49% of the stock) to his daughter, Kelli. The estate valued the stock at roughly $2.8 million. The IRS and Jenny agreed as to the value of the Company. The IRS and Jenny disagreed as to the amount of the marital deduction that Jenny took on Dean s estate tax return. 167 Jenny stated that the 51% of the Company s stock transferred to her carried with it a control premium. The IRS said it did not. 163 Code 301(d) TC 1577 (1987). 165 TAM (August 31, 1990). 166 TAM (October 14, 1993). 167 In the case, as actually filed, Jenny originally reported the marital deduction at a pro rata 51% of the dollar value of the amount included in the gross estate (i.e., roughly 51% of the approximate $2.8 million), which totaled $1.45 million. On petition to the Tax Court, Jenny argued a control premium of Page 37

42 The Tax Court held that the 51% carried a control premium, thus, the marital deduction exceeded a pro rata share of the $2.8 million included in the estate. The Tax Court reasoned as follows: First, the value of the stock included in the gross estate under 2031 are valued at the moment of death. The Court also reasoned that the amount to be included in the gross estate, if it was a controlling value would be included at a premium. The Court then acknowledged that the parties did not disagree on the 100% inclusion of the stock in the gross estate. Second, the Court then focused on the marital deduction, particularly on The Court wrote: At this point, the focus of our inquiry has changed. For purposes of section 2031, we were concerned only with the value of the assets to be included in the decedent's gross estate as a whole, and without reference to the destination of those assets under decedent's will or through the laws of descent and distribution. Under section 2056, however, a somewhat different question is presented: What is the asset that passes to the decedent's surviving spouse, and what is the value of it? Here, for the first time, we are concerned with the destination of the asset and the nature and value of that interest which passes. The Court then looked to Provident National Bank v. U.S., 168, and Ahmanson Foundation v. Comm. 169 The Court used those cases to analyze the issue and stated that Provident and Ahmanson cases pose the following theories: A. Both cases agree on the proposition that changes can be wrought in the nature and value of an asset in a decedent's gross estate by the provisions of decedent's will, which may change the nature of that asset by changing some of its characteristics, and hence its value, by splitting it off from other similar assets and sending it to a different destination. Thus, in the Provident case, the value of the stock which decedent bequeathed to the marital trust had engrafted upon it the new stock into which it was to be converted pursuant to decedent's will, and thus arguably acquired a new and greater value. In Ahmanson, taking away from the stock passing to the charity the voting power, and lodging that in a different person, arguably changed the quality and value of the stock passing to the charity, and therefore had a depressing effect on its value for purposes of the charitable deduction. The parallel to the instant case is clear: that decedent, in breaking his 100-percent ownership of the company into 2 unequal shares, and in giving the majority interest to his 38% should be attributed to the 51%, thus, the marital deduction should be approximately $2.0 million. Thus, there was a disparity of the value of the 51% included in the gross estate at roughly $1.45 million and the marital deduction of $2.0 million. This was, at that time, a novel issue to the Tax Court F.2d 1081 (3d Cir. 1978), and holding on remand at 502 F. Supp. 908 (E.D. Pa 1980) F.2d 761 (9th Cir. 1981). Page 38

43 surviving spouse, created a new and different asset, which carried with it the control premium for valuation purposes, and (probably) reduced the value of the minority block of stock remaining in the gross estate by some amount also, although not necessarily by the same amount. See, Estate of Salsbury v. Commissioner, supra. B. As to the second closely interrelated point, the two cases diverge. In Provident, the court held that the values of decedent's assets must be computed in the same manner and at the same values both for purposes of section 2031 and section In Ahmanson, on the contrary, the Court held that perfect symmetry was not required. The result of this is that they were persuaded as to Point A, that that the block of control stock passing to Jenni, the surviving spouse, was entitled to a premium. As to Point B the Tax Court recognized that the symmetry issue was not presented to the court, but in dicta still stated that they felt that the Ahmanson s Courts non-symmetry holding was the more persuasive. The take-away from this case is that it is possible for the marital deduction to exceed the pro rata section 2031 value of the stock that is included in the gross estate, when the entire value of the stock is in the estate and a control share of stock is transferred to the surviving spouse (or trust for the surviving spouse). What appears to be a logical extension of the rule is that it may be possible for the marital deduction may be less than the pro rata section 2031 value of the stock that is included in the gross estate when the entire value is included in the gross estate and a non-controlling share is transferred to the surviving spouse. Apparently, this is the holding in TAM and , as discussed in the next section. B. Reverse Chenoweth TAM and TAM The Technical Advice Memoranda and are sometimes cited as reverse-chenoweth results, in that in these cases, the marital deduction was reduced as a result of the marital devise being valued at a discount. Thus, unlike Chenoweth, where the marital deduction exceeded the pro rata value of the stock included in the gross estate, in these TAMs the marital deduction was less than pro rata value of the stock included in the gross estate. Let s examine the TAMS 1. TAM There were two issues raised in TAM : Issue No. 1--To what extent is the property used to fund the marital trust treated as passing from the decedent to the surviving spouse? Issue No. 2--To what extent is a minority discount appropriate in valuing the fragmented portion of the decedent's stockholding that passes to the marital trust? Page 39

44 In this TAM, Decedent died holding 100% of the stock of Corporation. Effectively, under the Will, Decedent gave 51% of the stock to his son and 49% to his surviving spouse. 170 The IRS ruled as follows: Based on the above we conclude that, because Spouse's qualifying income interest for life exists with respect to only 49% of the stock of Corporation, a minority discount is appropriate in determining the value of the interest deductible under section 2056 of the Code. In coming to this conclusion, the IRS reasoned as follows: Where the transfer to the surviving spouse is unrestricted, but consists of less than the decedent's entire interest in property, it is appropriate to value the interest passing to the surviving spouse as a separate interest in property rather than as an undivided portion of the decedent's entire interest. See Chenoweth v. Comm., 88 T.C (1987). The estate contends that in this case it is improper to value Spouse's shares in Corporation as a separate interest because both trusts have identical Co-Trustees. Because of the dual nature of their fiduciary responsibilities, they would be estopped from taking action with respect to Son's trust that would be inimical to the best interest of the marital trust. "Any action by [the trustees] to direct or allow the trust holding 51% of the share ownership to exercise its theoretical control position independent of the interest of the interest of the other trust, would be... a violation of the fiduciary responsibilities of the trustees with regard to the marital trust." We do not agree. As a general rule, a fiduciary, finding him or herself in a position of conflicting interests, would be under a legal duty to avoid the conflict rather than attempt to balance the two interests. See, generally, Bogert, Trusts (Rev. 2d Ed.) Sec 543. However, assuming arguendo that the testator's appointment of identical Co-Trustees abrogates the general rule (by implying that the Testator had approved the conflict of interest position and, thus, had restricted the duty of the Co-Trustees to a balancing act), the resulting restriction would have the effect of transferring value from the controlling interest to the minority interest. Here, because the controlling interest is held by the Son's trust, Spouse can be said to hold a valuable interest in that trust. However, in light of the fact that Spouse does not have a qualifying income interest for life in the Son's trust, no deduction is allowable for the value of any interest she may hold therein. 170 child. Note these facts are opposite to the facts of Chenoweth 51% went to the spouse and 49% to the Page 40

45 2. TAM TAM had two issues. The second issue of TAM was similar to the second issue of TAM (discussed above). Specifically TAM s issues were: 1) For purposes of gross estate valuation, is the decedent's stock in Company treated as a single controlling interest block of stock or (in view of the fact that the stock passes to two different beneficiaries) as two separate minority interest blocks of stock? (2) For purposes of estate tax marital deduction valuation, is the portion of the decedent's stockholding in Company that passes to the surviving spouse treated as a separate minority interest block of stock? In this ruling, the decedent died testate in 1990 survived by his spouse and two children. The facts reveal that at the time of decedent s death, he owned two blocks of stock: (i) 400 preferred shares in Company; and (ii) 37,728 common shares in Company. Apparently the IRS and the estate agreed that as one combined block (x) each of the 400 shares of preferred stock (as a block of stock) is worth $1,300 (per share), and (y) each of the 37,728 shares of common stock is worth $13.00 (per share). Additionally, the IRS and the estate agreed that considered as separate blocks (a) each of the 400 shares preferred stock is worth $ (per share) and (b) each of the 37,728 share of the common stock is worth $6.98 per share. The IRS and the estate seemed to agree that the fact that the two blocks are worth less as separate blocks reflects the difference in the voting power of the stock when considered as a combined block versus the value of the voting power of the stock when the two blocks are treated as separate blocks. The decedent left the 37,728 share of common stock to a credit shelter trust, and the 400 shares of preferred stock to a marital trust. The IRS concluded as follows: As to the first issue regarding the value of the stock included in the decedent's gross estate, the value of the stock in the Company is treated as a single controlling interest block of stock even though the stock passes to two different beneficiaries. Therefore, using the higher value of $1,300 per share of preferred stock and $13.00 per share for common stock. As to the second issue of determining the value for the marital deduction, the IRS ruled that the portion of the decedent's stockholding in Company that passes to the surviving spouse is treated as a separate minority interest block. Therefore, the value of the marital deduction for the preferred stock passing to the marital trust, the value would be $ per share. Page 41

46 The result of this is that for estate inclusion purposes, the value of the 400 share of the preferred stock was $1,300 per share or $520,000, and for marital deduction purposes the 400 shares was $ per share or $367,920. Thus, the taxpayer effectively would pay tax on the difference. C. Planning With Chenoweth / Reverse Chenoweth in Mind Chenoweth is a taxpayer friendly case. The above-mentioned TAMs are not. Planning to have the result of Chenoweth, or avoiding the result of the TAMs is important. To accomplish the Chenoweth result, it seems fairly settled that one could simply follow the case s fact patter and leave the control interest to the spouse. This only solves part of the problem, because at the spouse s death, in theory, the value of the estate would include the control premium. To minimize this at the spouse s death, the spouse could transfer enough of an interest to a trust for children so that her controlling interest would disappear. If what we have is a situation where the assets passing to the surviving spouse will be a non-control interest, the best way to plan around this is to have the decedent either give away sufficient control during life so that the 2031 value does not have the control premium built in to the value. VII. Federal Income Taxes on S Corps In general an S Corp is not subject to a federal income tax. 171 However, there are two federal income taxes that can be imposed on an S Corp: (a) the Built In Gains ( BIG ) tax 172 and (b) the excess net passive income ( ENPI ) tax. 173 These taxes can only be imposed on S Corps that were once C Corps. In other words, those S Corps that were S Corps from day one of operation (sometimes referred to as virgin S Corps ), are not subject to the respective taxes. A. Built In Gains Tax 1. In General Code 1374(a) imposes a tax on the net built in gains tax for any S Corp that was once a C Corp. Stated in the negative, Code 1374 will not apply if the S Corp was a virgin S Corp. The tax will also only be imposed during the 10 year period starting from the date that the corporation was treated as an S Corp. In a special rule as part of the American Recovery and Reinvestment Act of 2009, the 10- year time period is reduced. Specifically, Code 1374(d)(7)(B) was changed so that for S Corps with tax years beginning in 2009 and 2010, the 10 year period is reduced, if the seventh tax (of the original 10 year recognition period) ended before that year. The practical result of this is that if a corporation makes an S election in 2002, by 2009, the BIG tax will not apply, and likewise, if the corporation makes an S election in 2003, by 2010, the BIG tax will not apply Code 1363(a) and Treas. Reg., (a)(1). Code 1374; Treas. Reg ; and (a)(2). Code 1375; Treas. Reg ; and (a)(2). Page 42

47 It should be noted that this is only a special 2 year provision. The 10-year period has not been permanently reduced to 7 years Purpose of the BIG Tax The BIG tax was imposed to capture the any net appreciation of assets in the corporation at the time of the conversion from a C Corp to an S Corp. Thus, the tax is not imposed on assets purchased after the conversion that have appreciated. 3. The BIG picture of How the BIG Tax Is Imposed It is beyond the scope of this outline to determine how the BIG tax is calculated and the nuances in the calculation. 175 In general terms, if an asset is sold, the first step is to determine if the asset was in existence at the time of conversion, if it was not in existence, no BIG tax will apply (since the tax only applies to items in existence at the conversion date). If the item was in existence, then there is a determination of the recognized BIG. 176 The recognized BIG is generally equal to the difference between the adjusted basis of the property and its fair market value on the date of conversion. In general terms, on the date of conversion, the corporation would value each of its assets. The difference between an assets value and its basis at the time would equal the asset s unrealized built in gain or unrealized built in loss. If the net of these two amounts is a net unrealized built in gain, then the BIG tax would apply. If the net of these two amounts is a net unrealized built in loss, the BIG does not apply. The reason for this is that even if an asset is sold and a recognized BIG is incurred, the recognized BIG is limited to the unrealized BIG that has not been recognized. If there is no unrealized BIG, there can be no recognized BIG. If there is no recognized BIG, there can be no tax (since the tax is assessed on the recognized BIG). After the recognized built in gains and losses are netted, if the amount is a net gain (net BIG) 177, then the net BIG can be reduced by certain net operating losses and loss carryovers. 178 The amount becomes the base amount upon which the tax is initially assessed. The tax rate is the highest rate of tax under Code 11(b) (currently 35%). 179 After the tax is computed, if there are any credits, they can be used to offset the initial tax Code 1374(d)(7). It should be noted at the time of writing this outline, that there is pending legislation to reduce the 10 year period to 5 years. 175 For a detailed explanation of the BIG tax, See Christian & Grant, Subchapter S Taxation, 15.06[1] and Eustice & Kunst, Federal Income Taxation of S Corporations, 7.06[4]. 176 Code 1374(d)(3)(A). 177 Code 1374(d)(2). 178 Code 1374(b)(2). 179 Code 1374(b)(1). 180 Code 1374(b)(3). Page 43

48 4. Importance of Valuation of Corporate Assets The BIG tax is based upon the difference in the value of the asset in existence on the date of conversion and the disposition value. It is critical that each asset in the corporation be valued, so that the BIG tax can be quantified at the time of conversion. It is best to have a contemporaneous valuation of the assets, instead of a valuation done after the conversion. 5. Planning to Avoid 1374 There are only a couple of ways to avoid the 1374 BIG tax. First, one could simply wait the 10 year / 7 year period of time and not sell the assets. Second, one could simply attempt to offset any built in gains with built in losses. 6. Using the 1374 Tax for Discounts Although the BIG tax is a temporary albatross around the neck of the S Corp shareholder, it is also a friend in terms of valuating a share of the stock in the S Corp. In a recent case, Estate of Litchfield, 181 the Tax Court allowed a 17.4% discount for the BIG tax. It should be noted that the Tax Court specifically indicated that the unique facts of this situation would allow the estate the BIG tax discount. Care should be used in assuming that one will always get a discount for the potential BIG tax. 182 B. Excess Net Passive Income Tax 1. In General The excess net passive income (ENPI) tax can only be applied under the following circumstances: (1) the S Corp was once a C Corp; (2) the S Corp has accumulated E&P from the C Corp at the close of its taxable year; (3) more than 25% of the S Corps gross receipts for the tax year is made up of passive investment income. Unless these three requirements are met, there can be no imposition of the ENPI tax. 183 The ENPI tax is assessed at the highest corporate rate (currently 35%) 184. The ENPI tax is assessed on the excess net passive income T.C. Memo , 97 CCH TCM 1079 (2009). 182 See also, Estate of Jelke, 507 F3d 1317 (11 th DCA ), and Estate of Dunn, 301 F3d 339 (5 th DCA 2002). 183 Code 1375(a). 184 Code 1375(a) flush language. The statute provides that [s]uch tax shall be computed by multiplying the excess net passive income by the highest rate of tax specified in section 11(b). Currently the highest income tax rate is 34%. 185 Code 1375(a) flush language. Page 44

49 2. ENPI - Definitions ENPI is equal to the following formula 186 : Net Passive Income X Passive Investment Income 25% of gross receipts Passive Investment Income ENPI can not however, exceed the corporation s income (as adjusted for a few items) The statutory definition of net passive income is not the best; it defines net passive income as passive investment income less deductions directly connected with the generation of such income. 188 It looks to Code 1362(d)(3) for the definition of passive investment income. Gross receipts is also defined at 1362(d)(3). Passive investment income generally means income from investments that generate royalties, rents, dividend, interest and annuities. 189 There are a number of items excluded from such income, for instance, passive investment income excludes interest income from the sale of goods in the ordinary course of business. 190 The gist of the exclusions is to exclude income generated in the ordinary course of business Relationship with the BIG Tax To the extent that gain is taxed under Code 1374, it will not be taxed under the taxing scheme of Code What If the Corporation Thought there was No E&P And There Was! In the event the S Corp makes and error and does not realize that it has E&P, the statute gives the Commissioner the ability to waive the tax, if it is determined that the S Corp, in good faith, thought that there was no E&P and the S Corp takes action to mitigate the issue. 193 The IRS has privately ruled on this issue, however, it appears by the ruling that the Code 1375 ENPI tax was not avoided, but the termination of the S Corp status was avoided Code 1375(b)(1)(A). Code 1375(b)(1)(B). Code 1375(b)(2). Code 1362(d)(2)(C)(i). Code 1362(d)(2)(C)(ii). See, Code 1362(d)(2)(C)(iii),(iv) and (v). Code 1375(b)(4). See, Treas. Reg A(d). PLR , July 25, Page 45

50 5. Termination of S Corp Status 3 Year Rule If the S Corp has (a) three consecutive years where passive investment income exceeds 25% of the gross receipts, and (b) the S Corp has accumulated earnings and profits at the end of each of those three consecutive years, the S Corp status will be terminated. 6. Planning to Avoid the Sting of 1375 As the authors of a treatise stresses, Code 1375 should be avoided. 195 To avoid this, the S Corp could distribute E&P, increase gross receipts and/or reduce passive investment income. In light of the lower income tax rates for dividends and capital gains, and with the anticipation that rates will increase in the next few years, it may make some sense to distribute E&P if it is feasible. VIII. Flavor Of Income The Possible Bite of 1239 It has been said that estate planning with S Corps is somewhat similar to planning with to partnerships. Maybe Maybe not. Clearly, with regard to planning for distributions from an S Corp and partnerships, nothing could be more different. The rules for partnerships and S Corps are very, very different. For partnership s, for instance, there is the Code 754 election, as well as the general treatment that distributions from partnerships (provided that they are pro rata) are generally tax-free, whether in complete liquidation or in partial redemption. This is clearly not the case with S Corps. With S Corps, there is no analogous section to Code 754 (i.e., the adjustment to inside basis rule). Additionally, as discussed above, Code 311(b) (for partial distributions of appreciated property) and 336 (for complete liquidations) generally provide for recognition of gain on the distribution of appreciated property to a shareholder. In the case of an estate, one may believe that with S Corps (unlike C Corps), if you simply liquidate the corporation after death, if the liquidation of the assets and distribution of the proceeds happens in the same tax year for the corporation and its owners, that there should be no gain or loss recognized, as a result of the pass through rules. Here is an over-simplified example: Example 1: Let s assume that Corp X is owned 100% by H. H dies and leaves Corp X to W. Let s ignore and estate tax issues. The GAAP balance sheet of Corp X (with attendant market values) is as follows: Description Book Value Market Value Assets $1,000,000 $5,000,000 Liabilities 0 0 Shareholder s Equity $1,000,000 $5,000, Christian & Grant, Subchapter S Taxation, Page 46

51 Upon H s death, the outside basis of his stock in Corp X will be increased to $5.0 (i.e., the value at date of death); however the inside basis of the assets will be $1.0 million. The inside basis does not get adjusted upon death. Assuming that Code section 1239 did not exist, Corp X could liquidate the company on Day 1 in Year 1 and distribute the assets to W. The result of this is that the gain on the liquidation would be $4.0 million. This same $4.0 million gain will be added to W s new basis of $5.0 million, therefore, increasing it to $9.0 million, and then when W receives the assets in liquidation, W would recognize a loss of $4.0 million. The gain and the loss would offset each other. In this simple example, we assume that the gain of $4.0 million is capital gain and the loss is capital loss, thus, under the rules of offsetting gains and losses, it would be a wash, and the assets in the hands of W would receive a step-up basis of $5.0 million. In a simple world, when one would inherit S Corp stock (especially if the entire company was inherited) and if the inside basis of the assets is less than the outside basis (i.e.,. the assets had appreciated over time)one would simply liquidate the company, distribute the assets and receive a step up in basis in the assets. This is not a simple world, because of Code A. Code (a) The Conversion from Capital to Ordinary Income Code 1239(a) states as follows: In the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation provided in Code 167. According to legislative history, the original purpose of 1239 (under the 1939 Code) was to prevent the practice of selling a low basis-high value depreciable asset to a controlled corporation in order to "step up" the basis of the asset for depreciation purposes in the hands of the corporation at the cost of a capital gain tax to the selling shareholder. The corporation's basis would be its cost for the property, which in turn would reflect appreciation in value in the hands of the shareholder (b) Related Persons Code 1239(b) defines related persons to include a person and all entities which are controlled entities with respect to such person See, General Explanation of the Tax Reform Act of H.R , 94 th Cong, P.L See also, Joint Committee on Taxation General Explanation of the Tax Reform Act of 1976, CB Code 1239(b)(1). Page 47

52 (c) Controlled Entities Section 1239(c) defines controlled entities as a corporation 50% or more of such corporation is owned by or for such the person. 198 The constructive ownership rules under 267(c) (other than 267(c)(3)) apply in determining ownership. B. Understanding Code 1239 In the S Corp Context In general, if the S Corp has depreciable property and it desires to liquidate the corporation in an attempt to achieve a step-up in basis (i.e., because the assets in the corporation has a higher market value than its basis), if the S Corp is owned more than 50% (directly or indirectly through attribution) by the owner, the gain will be ordinary income, which will pass through to the owner. The loss recognized (because the value of the assets will be less than the stepped-up basis plus the pass through gain) would be a capital loss. Unfortunately, the capital loss will not offset the ordinary income. Thus, unless the owner has other capital gains that can offset the loss, the liquidation should not be attempted (i.e., because of the capital loss limitation rules). One may want to consider the following alternatives. Consider change of ownership in a manner in which the entity will not be considered a controlled entity, through the use of giving assets away in trusts, or otherwise, or perhaps selling the property to unrelated persons, thereby recognizing gain (which may be capital or 1231 gain, which may be converted to capital gain under the hotch-pot rules. Suffice to say, one must be careful when considering the liquidation of an S Corp in an attempt to effectively achieve a step-up of the inside basis of the assets. IX. Conclusion Understanding the basic rules of who can be shareholders, how are shareholders taxed, the various issues of allocating income when there is a change of ownership (as a result of death or otherwise), is very important to understand. Of equal importance in the planning process for S Corps (and other closely held entities) is the issue of avoiding the Chenoweth issue. Proper planning can avoid or minimize the issue. Further, the planner should always be mindful of Code 1239, it presents an income tax trap for the unwary. Careful consideration must be given in those circumstances. Planning and administering S Corps requires one to understand the rules and how they apply. The rules are like any other set of tax rules, they are often complex, sometimes difficult to interpret and very specific. If one navigates carefully, one can plan so as to minimize any negative tax impacts to the family. 198 Code 1239(c)(1). Page 48