Liquidation gain allocable to QSST shares.

Sec. 1361(d) (1) (B) and Regs. Sec. 1.1361-1(j)(7)(i) provide that a beneficiary of a qualified subchapter S trust (QSST) is treated as the owner of that portion of the trust that consists of S stock. Generally, this means that all S income (including gains and losses on the sale of assets) attributable to shares held by a QSST is taxed to the QSST's income beneficiary. However, under Regs. Sec. 1.1361-1(j)(8), the income beneficiary is not treated as the owner of S stock "in determining and attributing the federal income tax consequences of a disposition of the stock by the QSST." In other words, gain or loss on a sale of S stock by a QSST is taxed to the QSST, not to the income beneficiary. This regulation was adopted in 1995 to change the result of Rev. Rul. 92-84, which held that the income beneficiary must recognize the gain on the sale of S stock held by a QSST even if the sales proceeds were allocable to corpus and not to income.

The invalidation of Rev. Rul. 92-84 occurred largely as a result of practitioners' concern about the sale of stock by a QSST in an installment sale when, under state law, the gain on the stock sale was allocable to the trust corpus. If the income beneficiary were treated as the owner of the installment obligation, he would likely have disposed of the installment note in favor of the trust. The result would be that all of the gain would be accelerated under Sec. 453B(a) and recognized immediately by the income beneficiary.

TD 8600, announcing the new regulation, stated that the IRS and Treasury determined that the income beneficiary of a QSST, who was a Sec. 678 deemed owner of the S stock solely by reason of Sec. 1361(d)(1), should not be treated as the owner of the consideration received by a QSST on its disposition of S stock. The language seems to imply that the tax obligation relative to the gain on the disposition of S stock should fall on the taxpayer that retains the sales proceeds. Under Rev. Rul. 92-84, sales proceeds were normally allocated to the trust corpus, while the tax on the capital gain was payable by the income beneficiary. While trusts may permit the trustee to distribute principal to the income beneficiary, when such provisions are not present there is a disconnection between the taxpayer that realized the gain and the taxpayer responsible for the tax.

In Letter Ruling 9721020, the IRS discussed a related issue involving an actual, in-kind liquidation of an S corporation with QSST shareholders. At issue was whether the gain triggered by the liquidating distribution under Sec. 336 was properly taxed to the QSST or the income beneficiary. It is important to note that, in this particular case, the QSST incurred a capital loss as a result of the liquidation, which was increased as a result of additional basis for the Sec. 336 gain. A finding that the income beneficiary should be charged with the Sec. 336 gain while the trust had a capital loss would have been a harsh result.

The ruling stated:

Because any [sections] 336 gain or loss is triggered by the liquidating distribution, it constitutes one of the tax consequences of a disposition of stock by the QSST for which the QSST beneficiary is not treated as the owner of stock. Therefore, the [sections] 336 gain or loss should be allocated to the QSST as owner of the stock who reports all tax consequences relating to a stock sale under [sections] 1.1361-1(j)(8).

In Letter Ruling 9828006, the Service went one step further. The factual situation was that all S shareholders (including two QSSTs) sold their shares and consented to a Sec. 338(h) (10) election. Accordingly, the corporation was treated as though it sold its assets and then liquidated. The issue was whether the gain on the deemed sale of assets was properly recognized by the QSST shareholders or their income beneficiaries. The IRS ruled:

[a] gain or loss resulting from a [sections] 338(h)(10) election constitutes one of the tax consequences of a disposition of stock by the QSST for which the QSST beneficiary is not treated as the owner of stock. Therefore, any corporate gain or loss resulting from an election under [sections] 338(h)(10) should be allocated to the QSST as owner of the stock who reports all tax consequences relating to a stock sale under [sections] 1.1361-1(j)(8).

There was some doubt as to whether the IRS would treat actual gains on the sales of assets as belonging to the QSST when the sales were part of a liquidation plan. The Service's failure to take this step could have created a situation in which similar transactions were taxed differently.

In the latest decision, the IRS took the final step; in Letter Ruling 9905011, the Service ruled that the gain on the sale of assets accomplished under a plan of complete liquidation was taxable to the QSST and not the income beneficiary. It ruled that the liquidation plan resulted in the disposition of stock by the QSST; any gain recognized as a result of the plan was properly allocated to the trust.

After this ruling, no matter how the owners of an S corporation dispose of the underlying business, a QSST shareholder should be taxed similarly. If it sells its stock with no Sec. 338 election, it is taxed on the gain on that sale under Regs. Sec. 1.1361-1(j)(8). If it sells its stock with a Sec. 338 election, the passthrough gain on the deemed assets sale is taxed to the QSST under Letter Ruling 9828006. If the corporation liquidates and the shareholders sell the assets, the passthrough Sec. 338 gain is taxed to the QSST under Letter Ruling 9721020; if the corporation sells its assets after adopting a complete liquidation plan, the passthrough gain from the sale is taxed to the QSST under Letter Ruling 9905011.

FROM CHUCK ORR, J.D., CPA, Iowa CITY, IA