Power to make distributions to nonexistent trusts does not make them potential current ESBT beneficiaries.

Many trusts allow a trustee, at his discretion, to make distributions either directly to a beneficiary or in trust for such beneficiary. The effect of this power in determining the potential current beneficiaries of a trust intending to be an electing small business trust (ESBT) was unclear when no trusts had been identified or created to receive such distributions. In Letter Ruling 9930035, the IRS ruled a trustee's power to make distributions in trust is disregarded in determining the potential current beneficiaries of the mast, when no trusts have been identified or exist to receive such distributions.

For a trust to qualify as an ESBT, in addition to meeting other requirements, it may only have, as beneficiaries, individuals, estates and Certain charitable organizations. In addition, all potential current beneficiaries must be eligible S shareholders. Under Sec. 1361(e) (2), the term "potential-current beneficiary" means, 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 trust's principal or income.

In Notice 97-49, the Service provided that the term "beneficiary" did not include a distributee trust (other than a trust described in Sec. 170(c)(2) or (3)), but did include those persons who had a beneficial interest in the property held by the distributee trust. A distributee trust is a trust that is receiving or may receive a distribution from an intended ESBT, whether the rights to receive the distribution are fixed or contingent, or immediate or deferred. However, this rule does not apply in determining the trust's potential current beneficiaries. Instead, under the notice, if a distributee trust became entitled to, or at the discretion of any person might receive, a distribution from the principal or income of an intended ESBT, the distributee trust would be a potential current beneficiary. Thus, the S election of the corporation whose stock is held by the ESBT will terminate if the distributee trust itself does not qualify as an eligible S shareholder (e.g., as an ESBT, a grantor trust or a qualified subchapter S trust).

In the letter ruling, the trustee of a trust intending to qualify as an ESBT was given the power to make certain distributions either directly to or in mast for the benefit of any of the grantors, their children or issue or both. The IRS ruled that for purposes of determining the trust's potential current beneficiaries, this was a power to make a distribution. It also ruled, however, that because no trusts had been identified or were currently in existence, the trustee's power to make distributions in mast is disregarded for purposes of determining the potential current beneficiaries. If, however, a distributee trust is identified or comes into existence in any period, the distributee mast will become a potential current beneficiary and the S election will terminate, unless the distributee trust is an eligible S shareholder.

The Service also ruled that the power given the trustee to divide the trust into sub-trusts did not affect the trust's qualification as an ESBT, provided that, the division of the trust would not be considered a sale or exchange under Sec. 1001.

FROM LAURA MACDONOUGH, WASHINGTON, DC