Using a trust installment obligation to acquire S stock.

Often, owners of S corporations desire to "freeze" the value of their estates attributable to S stock by transferring the stock to lineal descendants or trusts created for the descendants' benefit. To do this the current owner of the S stock must either give or sell the stock at its current fair market value. If the owner desires to make a transfer but does not want to make a gift of the S stock, an installment sale will often be used. In many instances, the stockholder feels that the transferee should not hold the stock outright. He may also desire that the stock be transferred in a transaction that provides generation skipping tax benefits. In either of these circumstances, the individual currently holding the S stock usually establishes a trust, which then purchases the stock from the current shareholder in exchange for an installment obligation.

Note that in all instances prior to the establishment of the trust and the consummation of the transaction, the stock's potential posttransfer appreciation must be considered in determining if the inclusion of the stock {and related earnings) in the transferor's estate at date of death value would be more detrimental from a tax standpoint than the inclusion in the transferor's estate of the installment principal payments, after-tax interest on the installment obligation and the related earnings from these assets (i.e., this type of transaction should only be contemplated with stock that has the potential for substantial future appreciation). At this time, it must also be considered whether the S corporation would need to distribute a sufficient amount of cash to the trust from which the necessary installment obligation payments could be made. The potential beneficiary's personal finances must also be examined; the beneficiary must have sufficient income and/or assets to pay any individual income tax associated with the income recognized from the S stock should the S corporation's distributions be insufficient to pay both the installment note payments and the related taxes.

A problem associated with using a trust in this situation is that generally only two types of trusts are allowed to hold S stock without terminating the corporation's S election: grantor trusts and qualified subchapter S trusts (QSSTs).

Grantor trusts

Many tax advisers believe that the individual desiring to sell the stock should not (in most instances) be the grantor when using a grantor trust in this type of transaction. Under the grantor trust rules, the stock may be subject to Sec. 2083, 2086 or 2038, and therefore be included in the grantor's estate at its date of death value. However, in Letter Ruling 9037011, the IRS concluded that an irrevocable trust was a grantor trust for income tax purposes, while at the same time concluding that the assets were not included in the grantor's estate when the grantor established a trust for the benefit of his four children with independent trustees, allowing the trustees to sprinkle income and corpus among the beneficiaries and empowering one of the trustees fin a nonfiduciary capacity and without the approval or consent of any person] to acquire any property held in the trust by substituting property of equivalent value. This type of trust may be the most attractive alternative when the individual transferring the S stock wants the trust to contain generation-skipping language [i.e, preventing the trust corpus from being subject to gift or estate tax in intermediate generations, and/or when the individual selling the S stock desires to further deplete his estate by paying the income tax associated with the trust income. However, if this type of trust is used, extreme care should be used in selecting the third party who will be given the power of substitution.

It is also possible for adult beneficiaries to establish their own grantor trusts to which the S stock could be sold. The trust dispositive provisions could be tailored to reflect the selling shareholder's desires. Note that a grantor trust of this nature would not place the trust assets beyond the reach of the grantor's [adult beneficiaries') creditors should they face financial difficulties.

There is another alternative available if --the adult descendants decide not to restrict their own grantor trust terms to comply with the selling shareholder's desires; --the selling shareholder is concerned with potential creditor claims against a trust beneficiary, or --the beneficiary is a minor who cannot establish a trust for his own benefit.

This type of trust follows Sec. 678, which allows a nongrantor to be treated as the owner of any portion of the trust with respect to which the nongrantor has the power to vest all the corpus or income in himself. By providing the individual with an immediate right to withdraw any assets placed into the trust for a limited period of time [a minimum period of 15 days) and by not having that individual exercise that right of withdrawal, the trust would continue as a grantor trust, with the beneficiary who has the withdrawal right being treated as the grantor. Note that with a sale, the right to withdraw the S stock (subject to the debt] should be given to the beneficiary for a limited period of time to ensure the income and expenses from the S corporation would be taxed on the beneficiary's individual income tax return under the grantor trust rules.

Neither a grantor trust established by an adult beneficiary nor a trust using Sec. 678 could contain generation-skipping tax provisions.

Qualified subchapter ,S trusts

Under Sec. 1361(d), strict limitations are imposed on a QSST, including the fact that the trust can have only one income beneficiary, the income beneficiary must receive the corpus if the trust terminates during his lifetime, and income must be (or be required to be) distributed currently. Because of these rules, an individual desiring to use a QSST must establish a separate trust for each beneficiary. These restrictions make it very cumbersome and inflexible, in part because the trust is prevented from being able to sprinkle income and corpus among a class of beneficiaries and/or accumulate income. At the same time, a QSST may be beneficial in that it could contain generation-skipping tax provisions, allowing transfers to be made to future generations after the current beneficiary's death, provided that when the transfer to future generations is made the trust is broken down into separate trusts for each then current beneficiary.

There is a complex computation to determine what amount of income is required to be distributed to the current income beneficiary and what amount of income is taxable to that beneficiary. The amount of income distributed to the QSST beneficiary is dependent on the characterization of the principal payment on the installment obligation for trust accounting purposes. This may create a further problem for QSSTs in this type of transaction.

As previously stated, a QSST must distribute (or be required to distribute) all of its "income" to the beneficiary. "Income" for this purpose is defined in Sec. 1361 as all income within the meaning of Sec. 6431b}. Additionally, principal payments on an installment note are most often charged against corpus. If there are not sufficient other assets in the QSST to make the principal payment, the trust may be required to borrow additional money to make the principal payment and income distributions; alternatively, the trust might be required to sell or distribute a portion of the stock contained in the trust to satisfy the debt. The issuance of additional debt by the QSST or the disposition of a portion of the stock held by the QSST is a problem that could recur annually throughout the life of the trust, with interest and principal payments on outstanding debt increasing or the number of shares of S stock held by the trust decreasing.

The issuance of additional debt and the related interest expense may be economically detrimental to the trust to the point that the required payment on the debt is more than the appreciation in the stock. This could result in the diminution of the overall value of the trust in each year of its existence, which would be contradictory to the purpose of the original transaction. If shares of stock are required to be disposed of by the trust to make the installment payments, the subsequent disposition would, most likely, create a capital gain at the trust level. Also, the subsequent dispositions may be made to the original owner [by sale or conveyance] placing the shares back in his estate [again contradictory to the purpose of the original transaction] or the shares may be sold to a third party to whom the original seller did not desire to make transfers, which might cause the number of shareholders to increase above 35 and terminate the S election. Ii either of these circumstances could exist, the use of a QSST for the acquisition of the S stock is not advisable.

Furthermore, if the principal payment would be required to be made by the trust from S earnings distributed to it because the trust does not own sufficient other assets to make the payment and the payment is charged to corpus, the trust would not be able to distribute all of its income, terminating the corporation's S election.

One possible solution is to have the trust charge principal payments made under the installment obligation against income. Sec. 643{b} states that "income" is determined by the trust instrument and applicable local law. Therefore, local law needs to be reviewed to determine the character of the payment; a provision should be included in the trust instrument specifically indicating that the principal payments on the installment obligation are to be made from trust income. This should reduce trust accounting income, thereby allowing the trust to make the principal payments and still comply with the income distribution rules of Sec. 1361.

Additionally, there is some uncertainty on how items of income and expenses from the QSST are reported on the trust's Federal fiduciary income tax return. Sec. 1361(d){1} states that a QSST will be treated as a grantor trust under Sec. 678(a), with the beneficiary of such trust being treated as the owner of that portion of the trust that consists of the S stock. Accordingly, S income, losses, deductions and credits are reflected on the beneficiary's individual income tax return. However, items of income and expense from assets other than the S stock would be taxed to the QSST at the trust level. Therefore, the QSST could be part grantor trust and part taxable trust.

Because of the various QSST rules, the amount of trust accounting income must be determined for purposes of the distribution to the beneficiary, with the understanding that all activity relating to the S corporation is to be reflected on the individual's income tax return and with all other trust income and expenses to be reflected on a fiduciary income tax return for the QSST. The example on page 648 illustrates how the QSST rules may be applied.

As the example illustrates, S distributions, and not S income per the Schedule K-1, should be used in computing accounting income for Sec. 6431b1 purposes. The $35,000 accounting income computed in the example is the amount required to be distributed to the beneficiary under the trust instrument. However, for tax purposes the beneficiary is required to reflect on his individual income tax return the total amount of S income indicated on the K-1 provided to the trust. Also, the interest income from other assets is required to be included in the computation of the trust's accounting income for purposes of the distribution to the beneficiary, reported as income on the trust's fiduciary income tax return, and distributed to the beneficiary (with the trust receiving a corresponding deduction).

There is also uncertainty as to how to report the S corporation activity on the trust's fiduciary income tax return. Because the QSST is treated as a grantor-type trust, it is the authors' belief that the S corporation activity is not reported on the face of the return but instead by attaching a copy of the S corporation% Schedule K-1 to the fiduciary income tax return, by attaching a footnote to the return indicating that the trust owns stock in the specific S corporation, and by attaching to the return a copy of the Schedule K1, reflecting the trust's allocable share of the S items. The statement should further indicate that the allocable share of the items is reflected on the beneficiary's individual income tax return, listing the beneficiary's name, address and social security number.

Although there are some problems and uncertainties, the use of grantor trusts and QSSTs has the potential to provide significant estate tax savings for owners of S corporations when stock is to be acquired by a trust through an installment sale.

From Richard J. Mikuta, LD., CPA, and Joseph A. Odzer, MST, CPA, Chicago, 111.