New ESBT rules receive mixed reviews.

In 1996, Congress enacted Sec. 1361(e) to allow electing small business trusts (ESBTs) with more than one beneficiary to be qualified S corporation shareholders. Tax advisers welcomed this addition to the Code, which provided an additional planning tool for S stock ownership. However, Sec. 1361(e) has several conditions that make it difficult to use.

In December 2000, the IRS issued several proposed regulations that addressed the new provision's key issues. However, many tax advisers were unsatisfied with the outcome, hoping that the Service would provide a more useful approach in final regulations. Unfortunately, the regulations finalized in May 2002 (TD 8994) have fallen short of expectations.

PCBs

Most had hoped the IRS would have addressed the treatment of potential current beneficiaries (PCBs). Under Sec. 1361(e)(2), a PCB is defined as, "with respect to any period, any person who at any time during such period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust." The proposed regulations interpreted this definition to include anyone who had a present, remainder or reversionary interest in an ESBT, although anyone with an interest that had only a remote possibility of receiving anything from the trust was not included in that group. The proposed regulations specified further that anyone who qualified under the PCB definition would be treated as a shareholder in computing the 75-shareholder limit for an S corporation.

Unfortunately, the final regulations did not significantly alter the proposed regulations' definition, except to replace the exception relating to remote interests with a provision that allows a state or other U.S. political subdivision to hold a contingent interest in the trust without being a PCB. Commentators had responded to the proposed regulations with several alternative treatments of PCBs, but the Service's responses tended to rely heavily on a precise reading of Sec. 1361.

Many had suggested that the regulations should allow temporary waivers of a power of appointment to limit PCBs at any given time. This would have been especially beneficial for making charitable contributions from an ESBT. Charities not receiving current distributions could have temporarily waived their rights to any trust distributions, creating the potential to limit the number of charitable organizations treated as PCBs at any given point.

The IRS, however, decided this approach would be inappropriate, based on its interpretation of the statute. The Service believed that because the waiver would be temporary in nature, it could be revoked at any time, meaning the waiver would be of no substance and the entity exercising the waiver could still effectively receive a distribution from the trust. The IRS felt that taking this position would be contrary to the intent of Congress when it defined PCB under Sec. 1361. Many tax advisers noted that permanent waivers would probably be allowed, although this generally will not assist in using an ESBT as a planning tool.

Others had suggested that ESBT beneficiaries who were not beneficiaries of a trust's S stock portion should not be included as PCBs, but the IRS denied the request due to a lack of legislative authority.

Another argument was that the PCB definition should be governed by the traditional definition of beneficiary. However, the Service again followed a strict reading of the statute. Because the term "PCB" was defined under Sec. 1361(e)(2), but was not specifically required or defined to have the same meaning as a beneficiary for trust purposes, a permissible entity can be a PCB without being a beneficiary.

Grantor Trusts

One of the positive provisions retained by the final regulations is the ability of grantor trusts to make a valid ESBT election, even though a potential downside exists in making that election.

Under Sec. 671, grantor trusts are taxed in two separate parts--the main portion of the trust and any portion under the control of the deemed owner (i.e., the grantor). The final ESBT regulations take this statutory provision one step further and require separate reporting for the S portion, the grantor portion and the remainder. This step adds to the complexity of determining which portion the deemed owner owns.

Commentators have made various suggestions as to how to tax grantor trusts, but the IRS decided ultimately to base the method on the standing rules for taxing grantor trusts, not on the ESBT rules. Oddly enough, an ESBT is already taxed at the highest trust rate, meaning that the separate reporting should not be very different from a combined filing, but the Service apparently had other reasons for wanting separate reporting.

Charitable Contributions 

Several other provisions in the regulations met with opposition. The treatment of charitable contributions may prove to be one of the most troublesome. Under the regulations, any charitable contribution made by an S corporation is limited in its deductibility. First, for the contribution to be deductible at all, it must be made from gross income, not from the principal of the trust's S portion. Thus, any contribution of S stock will not result in a deduction to the trust or the corporation because it was not paid out of their gross income.

Second, the contribution must also not be allocated to any of the trust's unrelated businesses, as required by Sec. 681. If an S corporation does not meet these requirements, the charitable contribution becomes a nondeductible expense to the trust's S portion.

Interest expense paid to finance the purchase of S stock by an ESBT also retains an unfavorable treatment under the final regulations. Because the expense is directly related to the ESBT S corporation, the IRS has assigned it to the trust's S portion.

The regulations would allow the expense as a deduction if the deduction was an administrative expense. The IRS and Treasury denied this treatment, because they believe that administrative expenses "do not include expenses incurred to acquire additional assets." The interest expense is thus treated as a nondeductible expense.

Other Issues

Several other items of note in the regulations were expected. The regulations again follow the statute by requiring that no interest in the ESBT may be obtained by purchase. Sec. 444 regulations were updated to allow S corporations with a fiscal year-end to have an ESBT as a shareholder. Any previously existing ESBTs required to file a termination of election for a fiscal year can retroactively elect to reenact the fiscal-year election, although this was discouraged as overly cumbersome.

Although the ESBT rules are far from perfect, the Service has provided regulations that do make the ESBT a useful planning tool in certain circumstances. For an ESBT to be beneficial, tax planners need to determine whether a taxpayer wants to be able to retain control of a portion of an S corporation, while at the same time establishing an instrument to transfer ownership to family, friends or both. If so, a grantor ESBT may be a valid option. Advisers need to follow the PCB regulations cautiously when designing powers of appointment to avoid the 75-shareholder limit.

Second, the tax bracket of individual(s) wishing to create a trust is important; because an ESBT is taxed at the highest trust rate, if the individual is not currently paying tax in the highest tax bracket, the benefits of the trust format may be overridden by the increased tax burden.

Third, advisers would be wise to consider the overall desired goals of setting up a trust. If the goals are mainly charitable, the treatment of charities as PCBs, as well as the difficulty in using S charitable deductions, may make the ESBT a poor choice. Because an S corporation can deduct charitable contributions to the extent they do not exceed S gross income, charitable giving is possible, but unwieldy.

FROM DAVID J. HOLETS, SOUTH BEND, IN