Disposition of stock by a QSST.

Generally, when a qualified subchapter S trust (QSST) owns S stock, the trust beneficiary is treated as the stock's owner for Federal income tax purposes, and as the party to whom the trust's share of S income and deductions pass through. There is one principal exception to this general rule: Under Regs. Sec. 1.1361-1(j)(8), a QSST beneficiary will not be treated as the owner of the stock in determining the Federal income tax consequences of its disposition by a QSST. If the disposition is a sale, the QSST election terminates as to the stock sold, and any gain or loss recognized on the sale belongs to the trust, not the income beneficiary. As illustrated in the following example, this exception is a trap for the unwary that may generate adverse tax consequences on a disposition of QSST stock.

Example 1: On Dec. 31,1996, S corporation S sells its assets to an unrelated party for $1,000 and distributes the proceeds in a liquidating distribution. S's basis in its assets is $100. S's sole shareholder is a QSST and J is the beneficiary His basis in the stock is $800 The tax consequences of the transaction to the trust and to J are:

                                    J           Trust

Corporate gain
 on asset sale
 passed through
 to shareholder                   $900
Liquidating proceeds                            $1,000
Less basis
 (pre-sale basis of
 $800 + increase
 for $900 gain
 recognized)                                    (1,700)
Total gain/(loss)                 $900          $ (700)

As Example 1 illustrates, the trust incurs a capital loss of $700; since the trust has no capital gains, the capital loss does not generate a current benefit. However, if J was the direct shareholder, he could offset part of his $900 gain (which is treated as a capital gain) with the $700 capital loss.

This result typically arises when the shareholder's stock basis exceeds the corporation's basis in its assets. However, with proper planning, this result can be avoided and the loss attributable to the stock and the gain on the sale of the assets will both be taxable at the trust level. In such case, the loss attributable to the stock may be used to the extent the gain on the sale of the assets is a capital gain.

Based on the IRS's position in Letter Ruling 9721020, gains and losses on both the stock and the assets will be taxable at the trust level if the assets are distributed to the shareholders in a liquidating distribution prior to their sale to the unrelated party. The letter ruling involves a complete liquidation of a corporation, with an in-kind distribution of its assets to a QSST. It is assumed in the ruling that the corporation would recognize Sec. 336 gain on the liquidating distribution of its assets. The ruling also assumes that as a result of the liquidation, a loss will be recognized under Sec. 331 on the stock held by the trust. As was the case in Example 1, the loss attributable to the stock is taxable to the trust. In addition, the ruling holds that because the gain is a Sec. 336 gain on a liquidating distribution of assets, such gain is also taxable to the trust. According to the ruling, the Sec. 336 gain is one of the tax consequences of a disposition of stock by the QSST for which the QSST is not treated as the beneficiary of the stock. Consequently, a corporation contemplating the sale of its assets may avoid the adverse consequences in Example 1 by distributing the assets to the shareholders before they are sold.

Alternatively, the intended results could be achieved by structuring the asset sale as an installment sale. In this scenario, the corporation receives an installment note in exchange for its assets. Subsequently, the corporation distributes the note in a Sec. 331 liquidation. Pursuant to Sec. 453B(h), the corporation recognizes no gain on the distribution of the obligation. Further, pursuant to Sec. 453(h), an S shareholder treats the payments under the note as receipts for payment of the stock. As the following example illustrates, the use of the installment sale provisions may enable the shareholders to avoid a capital loss at the trust level.

Example 2: The facts are the same as in Example 1, except that S receives a $1,000 installment note in exchange for its assets and distributes the note toe in a Sec. 331 liquidation. On Jan. 1, 1997, J receives full payment on the note. The tax consequences are:

                                    J       Trust

Corporate gain
 on asset sale
 passed through
 to shareholder                    $0
Liquidating proceeds
 (installment
 note receipts)                              $1,000
Less basis                                     (800)
Total gain/(loss)                  $0        $  200

The character of the $200 gain would be determined by reference to the nature of the assets being sold.

In summary, Regs. Sec. 1.1361-1(j)(8) may generate some unexpected consequences in a transaction that involves the disposition of stock held by a QSST. However, with proper planning, the transaction can be structured to ensure that the trust is not allocated capital losses at the expense of increased capital gains at the individual beneficiary level.

FROM LOUIS A. PANOUTSOS, CPA, OAK BROOK, ILL.