REVENUE RULE 93-31

1993-1 C.B. 186, 1993-17 I.R.B. 5.

Internal Revenue Service
Revenue Ruling

SEPARATE SHARE OF A TRUST AS A QUALIFIED SUBCHAPTER § TRUST

Published: April 26, 1993

§ 1361. S Corporation Defined, 26 CFR 18.1361-1: Election to treat qualified subchapter § trust as a trust described in § 1361(c)(2)(A)(i).

(Also § 663; 1.663(c) 3.)

Separate share of a trust as a qualified subchapter § trust. A separate and independent share of a trust, within the meaning of § 663(c) of the Code, cannot qualify as a qualified subchapter § trust if there is a remote possibility that the corpus of the trust will be distributed during the lifetime of the current income beneficiary to someone other than the beneficiary.

ISSUE

Is a substantially separate and independent share of a trust, within the meaning of § 663(c) of the Internal Revenue Code, a qualified subchapter § trust (QSST), if there is a remote possibility that the corpus of the trust will be distributed during the lifetime of the current income beneficiary to someone other than that beneficiary?

FACTS

X is a small business corporation that made a valid election in 1987 to be an § corporation. During 1993, A, an individual, transferred shares of stock in X to T, a trust. The terms of the trust instrument provide that income is payable in equal shares to B and C. Upon the death of either B or C, one-half of the remaining trust corpus is to be distributed to whomever that beneficiary has appointed or, in the absence of an appointee, to that beneficiary's estate. The trust instrument further provides that, in general, distributions from T are to be made in substantially the same manner as if separate trusts had been created. However, the trust instrument also authorizes the trustee to distribute all or a portion of the trust corpus to B if necessary (after taking account of B's other income) for B's health, education, support or maintenance. B has other income that is so substantial that the possibility of exercise of the power to distribute corpus by the trustee is remote.

LAW AND ANALYSIS

§ 1361(a)(1) of the Code defines the term "S corporation" as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

§ 1361(b)(1)(B) of the Code provides that a small business corporation cannot have as a shareholder a trust other than a trust described in § 1361(c)(2).

§ 1361(c)(2)(A) of the Code provides that, for purposes of § 1361(b)(1)(B), trusts described in § 1361(c)(2)(A)(i)-(iv) may be shareholders of a small business corporation. In the situation presented, T is not a trust described in § 1361(c)(2)(A)(i)-(iv). However, an election may be made under § 1361(d)(2) to treat a trust not otherwise described in § 1361(c)(2)(A)(i) as though it were described in that § if the trust is a QSST.

For a trust to qualify as a QSST under § 1361(d)(3) of the Code, all of the income (within the meaning of § 643(b)) of the trust must be distributed (or required to be distributed) currently to one individual who is a citizen or resident of the United States. In addition, under § 1361(d)(3)(A), the terms of the trust must require that (i) during the life of the current income beneficiary there may be only one income beneficiary of the trust; (ii) any corpus distributed during the life of the current income beneficiary may be distributed only to that beneficiary; (iii) the income interest of the current income beneficiary in the trust must terminate on the earlier of that beneficiary's death or the termination of the trust; and (iv) upon the termination of the trust during the life of the current income beneficiary, the trust must distribute all of its assets to that beneficiary. § 1361(d)(3) further provides that a substantially separate and independent share of a trust, within the meaning of § 663(c), is treated as a separate trust for purposes of § 1361(c) and (d).

§ 663(c) of the Code requires that if a single trust has more than one beneficiary, substantially separate and independent shares of different beneficiaries are treated as separate trusts for the sole purpose of determining the amount of distributable net income in the application of sections 661 and 662. The existence of substantially separate and independent shares and the manner of treatment as separate trusts are determined in accordance with regulations.

Under § 1.663(c)-1(c) of the Income Tax Regulations, the separate share rule may apply even though separate and independent accounts are not maintained for each share on the books of account of the trust, and even though no physical segregation of assets is made or required.

§ 1.663(c)-3(a) of the regulations provides, in part, that the applicability of the separate share rule will generally depend upon whether distributions of the trust are to be made in substantially the same manner as if separate trusts had been created.

§ 1.663(c)-3(b) of the regulations provides, in part, that separate share treatment will not be applied to a trust or portion of a trust subject to a power to distribute corpus to or for one or more beneficiaries within a group or class of beneficiaries, unless payment of corpus to one beneficiary cannot affect the proportionate share of corpus of any shares of the other beneficiaries, or unless substantially proper adjustment must be made (under the governing instrument) so that substantially separate and independent shares exist. However, under § 1.663(c)-3(d), separate share treatment may apply to a trust even if the trust is subject to a power to pay out to a beneficiary of a share of the trust an amount of corpus in excess of the beneficiary's proportionate share of the trust corpus if the possibility of exercise of the power is remote.

In the situation presented, the possibility that B will receive more than B's proportionate share of the trust corpus is ignored for purposes of § 663(c) of the Code because it is remote. As a result, the shares of B and C in T are treated as separate trusts under § 663(c), and therefore also as separate trusts under § 1361(d)(3). Accordingly, each share of T must meet the QSST requirements of § 1361(d)(3) for X to retain its status as a small business corporation after the transfer of shares in X to T.

The cross-reference in § 1361(d)(3) to the separate share rule under § 663(c) does not modify the express statutory requirements of § 1361(d)(3) that must be met for a trust to qualify as a QSST. Therefore, the applicability of the separate share rule under § 662(c) does not override the requirement in § 1361(d)(3)(ii) that, for a trust to be a QSST and thus an eligible shareholder of a small business corporation under § 1361(d), its terms must provide that there is only one income beneficiary and that any corpus distributed during the life of the current income beneficiary may be distributed only to that beneficiary. Moreover, it is clear that § 1361(d) envisions a trust with a single current income beneficiary. § 1361(d)(2) provides that the beneficiary must elect to be treated as a QSST and § 1361(d)(1) provides that the beneficiary is taxed on his or her allocable share of the § corporation income. Allowing any trust having beneficiaries with contingent interests to hold stock in an § corporation would create uncertainty, for example, in determining whether and when the contingent beneficiaries should be taxable on § corporation income and who should make the QSST election.

Because the trust instrument in this situation provides for the possibility (however remote) that corpus allocable to C's separate share will be distributed to B, C's share of T does not meet the § 1361(d)(3)(A)(ii) requirement that the terms of a QSST require that any corpus distributed during the life of the current income beneficiary may be distributed only to that beneficiary. Therefore, A's transfer of stock in X to T caused a termination of X's status as an § corporation.

HOLDING

A substantially separate and independent share of a trust, within the meaning of § 663(c) of the Code, is not a QSST if there is a remote possibility that the corpus of the trust will be distributed during the lifetime of the current income beneficiary to someone other than that beneficiary.

If a shareholder inadvertently causes a termination of an § corporation by transferring stock to a trust that does not meet the definition of a QSST, relief may be requested under § 1362(f) of the Code and the regulations thereunder.

DRAFTING INFORMATION

The principal author of this revenue ruling is J. Scott Hargis of the Office of Assistant Chief Counsel (Pass-throughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Hargis on (202) 622- 3050 (not a toll-free call).

Rev. Rul. 93-31, 1993-1 C.B. 186, 1993-17 I.R.B. 5.