QTIP election as a QSST.

A client is the surviving spouse and the beneficiary of a trust left to him in his predeceased spouse's will. A qualified terminable interest property (QTIP) election under Sec. 2056(b)(7) was made for the trust. The QTIP trust was funded by the residue of his wife's estate some six months earlier and included S stock that she had previously owned. The client wants to elect to have the QTIP trust become a qualified subchapter S trust (QSST). Can the client make a timely QSST election?

There is some confusion as to exactly when a QSST election may be made for a QTIP trust created under a will. Sec. 1361 (d) (2) (B) (iii) states that the QSST election shall be made in such manner and form, and at such time, as the Secretary may prescribe. Thus, advisers should refer to regulations to determine the timing of the QSST election.

Regs. Sec. 1.1361-1(j)(4) provides that, if S stock is transferred to a trust and a QTIP election under Sec. 2056(b)(7) is made, the income beneficiary may make the QSST election if the trust otherwise meets the requirements for becoming a QSST.

Regs. Sec. 1.1361-1(j)(6)(iii)(a) provides that, if S stock is transferred to a trust, the QSST election must be made within the 16-day-and-2-month period beginning on the day that the stock is transferred to the trust. This rule was established because, under many circumstances, if the QSST election is not made right after the stock is transferred to the trust, unless the trust is a permitted shareholder, the S corporation will have an ineligible shareholder that would cause it to terminate.

Under Sec. 1361(c) (2) (A) (iii), however, a trust holding S stock transferred to it under the terms of a will is a permitted S shareholder, but only for the two-year period beginning on the day on which such stock is transferred. Thus, unlike some other trusts, a trust created by a will is automatically an eligible S shareholder for the two-year period after the stock is transferred. Other forms of trust may also be eligible shareholders under other provisions of the Code. If not (and if they can qualify), they will have to make a timely QSST election to become an eligible shareholder.

Example 1 of Regs. Sec. 1.1361-1(k)(1) illustrates the situation in which a decedent's S stock is transferred to a marital trust under the terms of an inter vivos trust. A QTIP election was made for the marital trust. The example concludes that the QSST election must be made by the end of the 16-day-and-2-month period beginning on the date the estate ceases to be treated as a shareholder for the QTIP trust to become a permitted S shareholder. (This trust was created by another trust, rather than by the will.)

Example 3 of Regs. Sec. 1.1361-1(k)(1) illustrates the rule for a permitted shareholder under Sec. 1361(c)(2)(iii), when a decedent's S stock is transferred to a trust under his will. In this case, the 16-day-and-2-month period begins at the end of the 60-day period following the transfer of the S stock to the trust. (The 60-day period was changed to a two-year period by the Small Business Job Protection Act of 1996.)

Thus, under the wording of the applicable regulations, there is some question as to whether the QSST election must be made within the 16-day-and-2-month period beginning on the day the S stock is transferred to the trust or whether the QSST election can be made after the expiration of the two-year period following the transfer of the stock to the testamentary trust for which a QTIP election has been made.

The regulations do not expressly address this question. However, it appears that, in making a QSST election, the standard rule is that the election must be made within the 16-day-and-2-month period following the period in which the applicable entity ceases to be an eligible S shareholder. Unlike some other entities, a trust created by a will is an eligible shareholder for a two-year period. Consequently, the beneficiary of a QTIP trust created by a will may make the QSST election within the 16-day-and-2-month period following the two-year period after which the S stock was transferred to the trust.

The IRS intends to clarify this rule when it updates the QSST regulations.

FROM LEE DUNN, J.D., NEW BERN, NC