Split-interest trusts as S shareholders.

The IRS in Rev. Rul. 92-48 held that a charitable remainder trust could not be a qualified subchapter S trust (QSST) even though the annuitant in a charitable remainder annuity trust (CRAT) or unitrust holder in a charitable remainder unitrust trust (CRUT) was a single current income beneficiary. Subpart E treatment under the deemed grantor trust reporting rules for a QSST was incompatible with the income-sourcing and other provisions of Sec. 664.

However, the Service has concluded in two letter rulings that an irrevocable trust that is treated as a grantor trust because the donor of the trust has reserved an administrative power in a nonfiduciary capacity to substitute trust assets (as described in Sec. 674(4)(C)) was a permissible shareholder under Sec. 1361(c)(2)(A)(i).

Letter Ruling 9227013 considered irrevocable trusts in which each grantor reserved for himself a lifetime power to substitute other property of equivalent value in the trust without the approval or consent of any other person, including the trustees. The power of substitution was not assignable and would lapse at any time after the trust no longer held stock if the grantors together owned more than 20% of the corporation. The letter ruling noted that on lapse of this Sec. 675 power the grantor trust would become a QSST, since each trust provided that its single beneficiary had made the QSST election under Sec. 1361(d)(2) and that all of the income of each trust was distributed at least annually to the single beneficiary. Of particular interest, the letter ruling relied on the case of Est. of/ordahl 65 TC 92 (1975), acq. 1977-1 CB 1, to hold that the asset substitution power did not constitute a Sec. 2038 power that would require inclusion of the trust property in the donor's estate.

Letter Ruling 9227023 considered separate irrevocable GRATs for a 10-year term created by married grantors with their children named as the remainder parties of each trust. Each grantor reserved a personal right and power, exercisable in a nonfiduciary capacity, to substitute assets in the original trust and later in the subtrusts established for the remainder parties after the 10-year term.

The letter ruling concluded under Regs. Sec. 1.675-1(b)(4)(iii) that the trusts should quality as permitted S shareholders under the grantor trust provision oi Sec. 1362(c)(2)(A)(i). The letter ruling cautioned however that the circumstances surrounding administration of the trust would determine whether the two grantors held their powers of administration in a nonfiduciary capacity. This was a question of fact and its determination would be deferred until the tax returns of the parties were examined by the district director.

Irrevocable trusts can also qualify as grantor trusts and hence as permitted trust S shareholders by including in the trust a reversion to the grantor or a general power of appointment in a grantor, contingent on the grantor's death within the term of the grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT). However, if this technique is employed and the grantor's death does occur, the entire value of the trust fund at that time may be included in the grantors estate. The estate tax exclusion available under the Jordahll case will not apply.

A grantor trust owned by the trust beneficiaries can be achieved if the trust is funded with S stock (or cash to purchase the stock) whose value equals, or is smaller than, the Crummey withdrawal power amount held by each beneficiary. This amount usually is correlated with the $10,000 annual gift tax exclusion amount. See IRS Letter Ruling 9232013.

From David Gerson, CPA, New York, N.Y.