QSST documents should avoid dangerous provisions.

Many boilerplate provisions are common in gift and testamentary trust instruments. A careful review should be made of these provisions if a trust is intended to be a qualified subchapter S trust (QSST) eligible to hold S stock. For example, a common provision in a grandchildren trust instrument providing separate shares or subtrusts for each grandchild involves an afterborn beneficiary clause that proportionately reduces each subtrust or trust share in order to add additional subtrusts or trust shares for afterborn grandchildren. Rev. Rul. 89-45 expressed the IRS view that this clause was a potential violation of Sec. 1361(d)(3)(A)(ii), which states that any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary.

The American Bar Association has sponsored legislation that would solve this problem, by permitting corpus distributions from a QSST to recipients other than the current income beneficiary. Until such legislation is enacted, however, the careful tax adviser will recommend that the trust agreement be reformed (in a judicial proceeding or otherwise) to eliminate the afterborn beneficiary clause. Such action is particularly appropriate if in fact no additional grandchildren are anticipated. The tax adviser will of course be sensitive to the generation-skipping transfer tax (GSTT) complications of a grandchildren trust, and the need for careful planning to allocate the $1 million GST exemption of the donor or decedent.

Another problem area involves a special power of appointment held by the QSST's current income beneficiary. The Service apparently treats the existence of the special power also as a potential distribution of corpus to a person other than the income beneficiary, during the lifetime of the income beneficiary. See IRS Letter Ruling 8952014, in which the beneficiary released a special power, in order to obtain a favorable QSST ruling. Note that a general power of appointment does not create a QSST problem; the exercise usually will be to or for the QSST income beneficiary. However, exercise of a general power, in contrast to a special power, involves a taxable gift under Sec. 2514(b).

Spendthrift clauses are commonplace in trusts. Most clauses are activated when the beneficiary attempts to assign his beneficial interest in the trust or files for bankruptcy. Sometimes the clause shifts the beneficial interest in the trust to another person. Other versions of the clause prevent a sale of the beneficial interest or require the trustee to accumulate income during the period of the beneficiary's financial distress. Still others direct that income distributions be made "for" the beneficiary, e.g., by payments to third parties, who provide goods or services to the beneficiaries.

IRS Letter Ruling 9035048 indicated that a spendthrift clause that could shift the beneficial interest to another party will prevent a trust from achieving QSST status. In addition, a mandatory accumulation of income may be precarious unless the clause takes the form of a deemed direction by the beneficiary to accumulate the income for his benefit. A clause permitting distributions for the beneficiary should be acceptable.

Finally, some trust agreements have an "in terrorem" provision, which shifts the beneficial interest in the trust to another party, e.g., a marital gift trust for the donor's spouse that diverts to another beneficiary in the event of the spouse's divorce. The potential distribution of this trust will also violate Sec. 1361(d)(3)(A)(iii), which requires that the income interest to the current income beneficiary not terminate until the earlier of the beneficiary's death or termination of the trust.