[Federal Register Volume 65, Number 251 (Friday, December 29, 2000)]
[Proposed Rules]
[Pages 82963-82972]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-32191]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-251701-96]
RIN 1545-AU76


Electing Small Business Trust

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; notice of proposed rulemaking by 
cross reference to temporary regulations; and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations relating to the 
qualification and treatment of electing small business trusts (ESBTs). 
The proposed regulations interpret the rules added to the Internal 
Revenue Code (Code) by section 1302 of the Small Business Job 
Protection Act of 1996 and section 1601 of the Taxpayer Relief Act of 
1997. In addition, the text of the temporary regulations published 
elsewhere in this issue of the Federal Register also serves as the text 
of these proposed regulations with respect to an ESBT or a trust 
described in section 401(a) or section 501(c)(3) that is exempt from 
taxation under section 501(a) not being treated as a deferral entity 
for purposes of Sec. 1.444-2T. The proposed regulations affect S 
corporations and certain trusts that own S corporation stock. This 
document also provides notice of a public hearing on these regulations.

DATES: Written or electronic comments must be received by April 4, 
2001. Requests to speak (with outlines of oral comments to be 
discussed) at a public hearing scheduled for April 25, 2001, at 10 a.m. 
must be received by April 4, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-251701-96), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:M&SP:RU (REG-251701-96), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically via the 
Internet by selecting the ``Tax Regs'' option on the IRS Home Page, or 
by submitting comments directly to the IRS Internet site at http://
www.irs.gov/tax__regs/regslist.html. The public hearing will be held in 
the Internal Revenue Building Auditorium, 1111 Constitution Avenue, 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Bradford Poston or James A. Quinn, (202) 622-3060; concerning 
submissions and the hearing, Sonya M. Cruz, (202) 622-7190; (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information in this notice of proposed 
rulemaking have been reviewed and approved by the Office of Management 
and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 
3507) under control numbers 1545-1523 and 1545-1591.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR Part 1) relating to S corporations and electing 
small business trusts (ESBTs). Section 1302 of the Small Business Job 
Protection Act of 1996, Public Law 104-188 (110 Stat. 1755) (August 20, 
1996) (the 1996 Act), amended sections 641 and 1361 of the Code to 
permit an ESBT to be an S corporation shareholder. Further amendments 
were made to section 1361(e) by the Taxpayer Relief Act of 1997, Public 
Law 105-34 (111 Stat. 1601(c)(1)) (August 5, 1997). Prior section 
641(d) was redesignated as section 641(c) by the Internal Revenue 
Service Restructuring and Reform Act of 1998, Public Law 105-206 (112 
Stat. 6007(f)(2)) (July 22, 1998).

Explanation of Provisions

Overview

    Prior to the 1996 Act, the only trusts that were permitted S 
corporation shareholders were wholly-owned grantor trusts, voting 
trusts, certain grantor trusts after the grantor's death, and qualified 
subchapter S trusts (QSSTs). These trusts are not taxed at the trust 
level, and the deemed owner or owners are taxed directly on the tax 
items of the trusts, except for certain testamentary trusts described 
in Sec. 1.1361-1(j)(7)(ii). QSSTs are required to have a single income 
beneficiary, and all of the income must be currently distributed to 
such beneficiary. The 1996 Act created ESBTs to allow more flexibility 
in the types of trusts that are permitted S corporation shareholders 
and, in particular, to facilitate family financial planning. H. Rep. 
No. 586, 104th Cong., 2d Sess. 82 (1996), S. Rep. No. 281, 104th Cong., 
2d Sess. 46 (1996). Unlike a QSST, an ESBT may have multiple 
beneficiaries and may also accumulate trust income.
    Section 1361(e)(1) defines the term electing small business trust 
as any trust if: (1) The trust does not have as a beneficiary any 
person other than an individual, an estate, or an organization 
described in section 170(c)(2) through (5); (2) no interest in the 
trust was acquired by purchase; and (3) an election has been made with 
respect to the trust.
    Section 1361(c)(2)(B)(v) provides that, for purposes of section 
1361(b)(1) (the S corporation shareholder limitations), each potential 
current beneficiary of an ESBT will be treated as a shareholder. During 
any period that there is no potential current beneficiary of an ESBT, 
the trust shall be treated as the shareholder.

ESBT Beneficiaries

    Notice 97-49 (1997-2 C.B. 304) clarifies the definitions of 
beneficiary (for purposes of section 1361(e)(1)(A)(i)) and potential 
current beneficiary (for purposes of section 1361(e)(2)) and also 
clarifies the treatment of ESBT distributions. The proposed 
regulations, when finalized, will modify and replace the rules of 
Notice 97-49.

Beneficiary

    The proposed regulations provide guidance as to who is an ESBT 
beneficiary. Generally, a beneficiary includes any person who has a 
present, remainder, or reversionary interest in the trust other than a 
remote, contingent interest. If an ESBT makes distributions to another 
trust (the distributee trust), the distributee trust is not treated as 
a

[[Page 82964]]

beneficiary of the ESBT. However, the beneficiaries of the distributee 
trust will be counted as beneficiaries of the ESBT. Persons whose 
future beneficial interest is so remote as to be negligible are not 
beneficiaries. Generally, when the probability that a person will 
receive any distribution from the trust is less than 5 percent, at a 
particular time, that person's interest would be so remote as to be 
negligible. Finally, the term beneficiary does not include a person in 
whose favor a power of appointment may be exercised until the power is 
actually exercised.

Interests Acquired by Purchase

    The proposed regulations provide guidance regarding the prohibition 
on acquiring an interest in an ESBT by purchase. The proposed 
regulations provide that the prohibition applies if any portion of a 
beneficiary's basis in the beneficiary's interest is determined under 
section 1012. Thus, a part-gift, part-sale of a beneficial interest 
will terminate the trust's status as an ESBT. Beneficiaries may not 
purchase interests in the trust, but the ESBT itself is allowed to 
purchase S corporation stock.

Grantor Trusts

    The proposed regulations provide that a trust, all or a portion of 
which is treated as owned by an individual under subpart E, part I, 
subchapter J, chapter 1 of the Internal Revenue Code (Code) (a grantor 
trust), may elect to be an ESBT. The Treasury Department and the IRS 
believe that Congress did not intend to preclude this type of trust, 
which is a common family estate planning tool, from electing ESBT 
status. The proposed regulations provide rules for the treatment of 
grantor trusts electing ESBT status.

Potential Current Beneficiaries

    The proposed regulations provide that 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 principal or income of the 
trust. In general, a person who may receive a distribution from the 
ESBT under a currently exercisable power of appointment is a potential 
current beneficiary. In addition, in the case of an ESBT that is a 
grantor trust, the proposed regulations provide that the deemed owner 
of the grantor trust is also to be treated as a potential current 
beneficiary.
    Under the definitions set forth in the proposed regulations, a 
potential current beneficiary is not necessarily a beneficiary of the 
trust and vice versa. For example, a person in whose favor property 
could currently be appointed, but to whom no such appointment has been 
made, is a potential current beneficiary, but not a beneficiary. 
Conversely, a person who is a non-contingent remainder beneficiary of a 
non-grantor trust is a beneficiary, but not a potential current 
beneficiary.
    The proposed regulations provide special rules if current 
distributions can be made to a distributee trust. If the distributee 
trust does not qualify to be a shareholder of an S corporation under 
section 1361(c)(2)(A), then the trust is considered the potential 
current beneficiary and thus a shareholder. In that case, the 
corporation's S election terminates because the corporation has an 
ineligible shareholder. For this purpose, a trust is deemed to qualify 
to be a shareholder of an S corporation under section 1361(c)(2)(A) if 
it would be eligible to make a QSST or ESBT election if it owned S 
corporation stock.
    If the distributee trust does qualify to be a shareholder of an S 
corporation under section 1361(c)(2)(A), in general, the potential 
current beneficiaries of the distributing ESBT will include the 
potential current beneficiaries of the distributee trust. However, if 
the distributee trust is a former grantor trust prior to the owner's 
death (that is, a trust described in section 1361(c)(2)(A)(ii)), or is 
a trust receiving a distribution of S stock from a decedent's estate 
(that is, a trust described in section 1361(c)(2)(A)(iii)), the estate 
of the decedent is treated as the only potential current beneficiary of 
the trust . In no case will the same person be counted twice when 
determining the number of S corporation shareholders.

ESBT Election

    Notice 97-12 (1997-1 C.B. 385) provides the procedures for making 
the ESBT election. Under that notice, the ESBT election is required to 
contain certain information and representations, and is required to be 
filed with the service center where the S corporation files its income 
tax returns. These proposed regulations, when finalized, will modify 
and replace the rules in Notice 97-12.
    Under the proposed regulations, the trustee of an ESBT makes a 
single ESBT election by filing a statement with the service center 
where the ESBT files its Form 1041, U.S. Income Tax Return for Estates 
and Trusts. This procedure will be more convenient for taxpayers than 
the procedures of Notice 97-12 if the ESBT holds stock in more than one 
S corporation. No trust documents are required to be attached to the 
election statement.
    The proposed regulations provide that if a trust satisfies the ESBT 
requirements and makes an ESBT election, the trust will be treated as 
an ESBT for federal income tax purposes as of the effective date of the 
ESBT election. These effective dates generally follow the rules of 
Sec. 1.1361-1(j)(6)(iii) for qualified subchapter S trust (QSST) 
elections. Protective ESBT elections, which are intended to become 
effective only if the trust fails to satisfy the requirements for a 
trust described in section 1361(c)(2)(A)(i) through (iv), are 
prohibited. Unlike a protective QSST election, a protective ESBT 
election could result in a change in the incidence of taxation from the 
owner of the trust to the trust itself. If a trust fails to qualify as 
an eligible S corporation shareholder under section 1361(c)(2), and 
consequently the S corporation election is ineffective or terminated, 
relief may be available under section 1362(f) for an inadvertent 
ineffective S corporation election or an inadvertent S corporation 
termination.

Conversions of QSSTs and ESBTs

    Rev. Proc. 98-23 (1998-1 C.B. 662) provides procedures for the 
conversion of a QSST to an ESBT and an ESBT to a QSST. The proposed 
regulations, when finalized, will modify and replace the procedures of 
Rev. Proc. 98-23 and provide rules with respect to these conversions.
    The conversion procedure provided in the proposed regulations 
differs from that provided in Rev. Proc. 98-23, in that the election 
must be filed with the service center where the trust files its income 
tax return, as well as with the service center where the S corporation 
files its income tax return. The election must be filed in both service 
centers if the service center for the trust is different from the 
service center for the S corporation because QSST elections are filed 
with the service center where the S corporation files its income tax 
return and ESBT elections will be filed where the trust files its 
income tax return under the new procedures set forth in these proposed 
regulations, when finalized. The IRS and the Treasury Department 
specifically request comments on whether the rules for filing QSST 
elections similarly should be changed to permit the filing of a QSST 
election with the service center where the trust files its return 
rather than with the service center for the S corporation(s).

[[Page 82965]]

Consent to the S Corporation Election

    Notice 97-12 provides that, for purposes of the ESBT's consent to 
the S corporation election under section 1362(a), only the trustee 
needs to consent to the S corporation election because the ESBT is 
taxed on the S corporation's income and the trustee makes the ESBT 
election. These proposed regulations, when finalized, will modify and 
replace the rules in Notice 97-12.
    Under the proposed regulations, if the ESBT is also a grantor 
trust, the deemed owner must also consent to the S corporation election 
because such owner will be taxed on all or a portion of the S 
corporation's income. If there is more than one trustee, the trustee or 
trustees with authority to legally bind the trust must consent to the S 
corporation election.

ESBT Taxation

    The proposed regulations provide that, for federal income tax 
purposes, an ESBT consists of an S portion, a non-S portion, and in 
some instances a grantor portion. The items of income, deduction, and 
credit attributable to any portion of the ESBT treated as owned by a 
person under the grantor trust rules of subpart E, including S 
corporation stock and other property (the grantor portion), are taken 
into account on that individual's tax return pursuant to the normal 
rules applicable to grantor trusts. Other items of income, deduction, 
and credit are, pursuant to these proposed regulations, attributed to 
either the S portion, which includes the S corporation stock, or the 
non-S portion, which includes all other assets of the trust. The S 
portion is subject to tax under the special rules of section 641(c), 
while the non-S portion is subject to the normal trust taxation rules 
of subparts A through D of subchapter J.
    The proposed regulations provide that if an otherwise allowable 
deduction of the S portion is attributable to a charitable contribution 
paid by the S corporation, the contribution will be deemed to be paid 
by the S portion pursuant to the terms of the trust's governing 
instrument within the meaning of section 642(c)(1). The other 
requirements of section 642(c)(1) must also be met for the contribution 
to be deductible by the S portion, and the deduction is limited to the 
amount of the gross income of the S portion. If a payment is made to a 
charitable organization by the ESBT pursuant to the terms of its 
governing instrument, such payment is deductible, subject to the 
provisions of section 642(c)(1), to the extent it is paid from the 
gross income of the non-S portion of the trust. Thus, if the ESBT 
contributes S corporation stock to a charitable organization, no 
deduction is allowed under section 642(c)(1) because the contribution 
is not paid out of the gross income of the non-S portion.
    The proposed regulations provide guidance regarding the treatment 
of proceeds received by an ESBT from the sale of S corporation stock 
when income from the sale is reported on the installment method under 
section 453. The income recognized with respect to the installment 
proceeds is taken into account by the S portion. The interest on the 
installment obligation is taken into account by the non-S portion.
    The proposed regulations provide that if a trust holds S 
corporation stock and is already an eligible S corporation shareholder 
and the trust makes an ESBT election during the trust's taxable year, 
the electing trust will be treated as a separate taxpayer for purposes 
of allocating S corporation items under section 1377(a)(1). However, 
the ESBT election does not result in the prior trust being treated as 
terminating its entire interest in its S corporation stock for purposes 
of Sec. 1.1377-1(b), unless the prior trust is one described in section 
1361(c)(2)(A)(ii) or (iii). Therefore, the S corporation is generally 
not permitted to make the election to terminate the taxable year under 
section 1377(a)(2). The trust will be treated as a single taxpayer for 
purposes of determining the taxation of distributions from the trust. 
Thus, distributions made after the effective date of the ESBT election 
may still carry out distributable net income of the trust earned during 
the taxable year before the effective date of the ESBT election.
    The proposed regulations provide that for purposes of determining 
whether the exception to estimated taxes under section 6654(d)(1)(B) 
applies, the trust will not be considered a different taxpayer as a 
result of the ESBT election. Therefore, if the ESBT makes estimated tax 
payments equal to 100 percent of the prior year's tax liability, no 
penalties will apply.
    The proposed regulations provide that interest expenses paid on 
loans used to purchase the S corporation stock must be allocated to the 
S portion of the ESBT but are not deductible by the S portion because 
they are not administrative expenses.

ESBT Terminations

    The proposed regulations provide that generally a trustee must seek 
the consent of the Commissioner to revoke its ESBT election by 
obtaining a private letter ruling. However, the Commissioner's consent 
is granted for revocations that occur on the conversion of an ESBT to a 
QSST under the procedures set forth in the proposed regulations.
    The proposed regulations provide that if an ESBT fails to meet the 
definitional requirements of an ESBT under section 1361(e), the trust's 
ESBT status terminates immediately upon such failure to qualify. 
However, if an ESBT acquires an ineligible potential current 
beneficiary, the ESBT has 60 days in which to dispose of all of its S 
corporation stock to prevent termination of the S corporation election. 
If the S corporation stock is not disposed of within the 60-day period, 
then the S corporation election will terminate as of the first day that 
the ineligible person became a potential current beneficiary.
    Finally, the proposed regulations provide that an ESBT election 
generally is terminated if the ESBT fails to hold any S corporation 
stock. However, a trust will continue to be treated as an ESBT if it is 
reporting income from the sale of S corporation stock under the 
installment method of section 453.

Section 444 Elections

    The text of the temporary regulations published elsewhere in this 
issue of the Federal Register serves as the text of these proposed 
regulations with respect to an ESBT and a trust described in section 
401(a) or section 501(c)(3) that is exempt from taxation under section 
501(a). These temporary regulations provide that an ESBT and a trust 
described in section 401(a) or section 501(c)(3) that is exempt from 
taxation under section 501(a) are not deferral entities for purposes of 
Sec. 1.444-2T.

Proposed Effective Date

    The regulations regarding ESBTs under Sec. 1.641-1(d) through (k), 
Sec. 1.1361-1(h)(1)(vi), (h)(3)(i)(F), (j)(12), and (m), Sec. 1.1362-
6(b)(2)(iv), Sec. 1.1377-1(a)(2)(iii) and (c) Example 3 are proposed to 
apply on and after the date the final regulations are published in the 
Federal Register. The IRS and the Treasury Department have become aware 
of potentially abusive transactions involving ESBTs that assume the 
applicability of the rules of section 641(c) to the taxation of the 
grantor portion of such trusts. See Notice 2000-61, 2000-49 I.R.B. 1. 
Thus, the regulations regarding taxation of ESBTs under Sec. 1.641(c)-
1(a), (b) and (c) are proposed to be applicable for taxable years of 
ESBTs that end on and after the proposed regulations are published in 
the Federal Register.

[[Page 82966]]

Effect on Other Documents

    The following documents would be superseded as of the date the 
final regulations are published in the Federal Register:

Notice 97-12 (1997-1 C.B. 385).
Notice 97-49 (1997-2 C.B. 304).
Rev. Proc. 98-23 (1998-1 C.B. 662).

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in the regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that the estimated 
average burden per trust in complying with the collections of 
information in Sec. 1.1361-1(m) is 1 hour. Therefore, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. Pursuant to section 7805(f) of the Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are timely submitted to the IRS. The IRS and 
Treasury Department specifically request comments on the clarity of the 
proposed regulations and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for April 25, 2001, at 10:00 
a.m. in the Internal Revenue Building Auditorium, 1111 Constitution 
Avenue NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by April 4, 2001, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by April 4, 2001.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Bradford Poston and 
James A. Quinn of the Office of Associate Chief Counsel (Passthroughs 
and Special Industries), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805. * * *
    Section 1.444-4 is also issued under 26 U.S.C. 444(g).
    Par. 2. Section 1.444-4 is added to read as follows:


Sec. 1.444-4  Tiered structure.

    [The text of this proposed section is the same as the text of 
Sec. 1.444-4T published elsewhere in this issue of the Federal 
Register].
    Par. 3. Sections 1.641(c)-0 and 1.641(c)-1 are added to read as 
follows:


Sec. 1.641(c)-0  Table of contents.

    This section lists the following captions contained in 
Sec. 1.641(c)-1:


Sec. 1.641(c)-1  Electing small business trust.

(a) In general.
(b) Definitions.
    (1) Grantor portion.
    (2) S portion.
    (3) Non-S portion.
(c) Taxation of grantor portion.
(d) Taxation of S portion.
    (1) In general.
    (2) Section 1366 amounts.
    (3) Gains and losses on disposition of S stock.
    (4) State and local income taxes and administrative expenses.
(e) Tax rates and exemption of S portion.
    (1) Income tax rate.
    (2) Alternative minimum tax exemption.
(f) Taxation of non-S portion.
    (1) In general.
    (2) Dividend income under section 1368(c)(2).
    (3) Interest on installment obligations.
    (4) Charitable deduction.
(g) Allocation of state and local income taxes and administration 
expenses.
(h) Treatment of distributions from the trust.
(i) Termination or revocation of ESBT election.
(j) Effective date.
(k) Examples.

Sec. 1.641(c)-1  Electing small business trust.

    (a) In general. An electing small business trust (ESBT) within the 
meaning of section 1361(e) is treated as two separate trusts for 
purposes of determining income tax. The portion of an ESBT that 
consists of stock in one or more S corporations (the S portion) is 
treated as one trust. The portion of an ESBT that consists of all the 
other assets in the trust is treated as a separate trust. The grantor 
or another person may be treated as the owner of all or a portion of 
either or both such trusts under subpart E, part I, subchapter J, 
chapter 1 of the Internal Revenue Code. In addition, the non-S portion 
may consist of more than one share pursuant to section 663(c). See 
Sec. 1.1361-1(m) for the treatment of an ESBT as a single trust for 
administrative purposes.
    (b) Definitions--(1) Grantor portion. The grantor portion of an 
ESBT is the portion of the trust that is treated as owned by the 
grantor or another person under subpart E.
    (2) S portion. The S portion of an ESBT is the portion of the trust 
that consists of S corporation stock and that is not treated as owned 
by the grantor or another person under subpart E.
    (3) Non-S portion. The non-S portion of an ESBT is the portion of 
the trust that consists of all assets other than S corporation stock 
and that is not treated as owned by the grantor or another person under 
subpart E.
    (c) Taxation of grantor portion. The grantor or another person who 
is treated as the owner of a portion of the ESBT includes in computing 
taxable income items of income, deductions, and credits against tax 
attributable to that portion of the ESBT under section 671.
    (d) Taxation of S portion--(1) In general. The taxable income of 
the S portion is determined by taking into account only the items of 
income, loss, deduction, or credit specified in paragraphs (d)(2), (3), 
and (4) of this section, to the extent not attributable to the grantor 
portion.
    (2) Section 1366 amounts--(i) In general. The S portion takes into 
account the items of income, loss, deduction, or credit that are taken 
into account by an S corporation shareholder pursuant to section 1366 
and the regulations thereunder. Normal rules applicable to trusts apply 
in determining the extent to which any

[[Page 82967]]

loss, deduction, or credit may be taken into account in determining the 
taxable income of the S portion. See Sec. 1.1361-1(m)(3)(iv) for 
allocation of those items in the taxable year in which the ESBT 
election is made if, before the effective date of the election, the 
trust was a shareholder of the S corporation.
    (ii) Special rule for charitable contributions. If a deduction 
described in paragraph (d)(2)(i) of this section is attributable to a 
charitable contribution paid by the S corporation, the contribution 
will be deemed to be paid by the S portion pursuant to the terms of the 
trust's governing instrument within the meaning of section 642(c)(1). 
The other requirements of section 642(c)(1) must also be met for the 
contribution to be deductible in computing the taxable income of the S 
portion. Such a deduction cannot exceed the amount of gross income of 
the S portion.
    (iii) Multiple S corporations. If an ESBT owns stock in more than 
one S corporation, items of income, loss, deduction, or credit from all 
the S corporations are aggregated for purposes of determining the S 
portion's taxable income.
    (3) Gains and losses on disposition of S stock--(i) In general. The 
S portion takes into account any gain or loss from the disposition of S 
corporation stock. No deduction is allowed under section 1211(b)(1) and 
(2) for capital losses that exceed capital gains.
    (ii) Installment method. If income from the sale or disposition of 
stock in an S corporation is reported by the trust on the installment 
method, the income recognized under this method is taken into account 
by the S portion. See paragraph (f)(3) of this section for the 
treatment of interest on the installment obligation. See Sec. 1.1361-
1(m)(5)(ii) regarding treatment of a trust as an ESBT upon the sale of 
all S corporation stock using the installment method.
    (iii) Distributions in excess of basis. Gain recognized under 
section 1368(b)(2) from distributions in excess of the ESBT's basis in 
its S corporation stock is taken into account by the S portion.
    (4) State and local income taxes and administrative expenses--(i) 
In general. State and local income taxes and administrative expenses 
directly related to the S portion and those allocated to that portion 
in accordance with paragraph (g) are taken into account by the S 
portion.
    (ii) Special rule for certain interest. Interest paid by the trust 
on money borrowed by the trust to purchase stock in an S corporation is 
allocated to the S portion but is not a deductible administrative 
expense for purposes of determining the taxable income of the S 
portion.
    (e) Tax rates and exemption of S portion--(1) Income tax rate. 
Except for capital gains, the highest marginal trust rate provided in 
section 1(e) is applied to the taxable income of the S portion. See 
section 1(h) for the rates that apply to the S portion's net capital 
gain.
    (2) Alternative minimum tax exemption. The exemption amount of the 
S portion under section 55(d) is zero.
    (f) Taxation of non-S portion--(1) In general. The taxable income 
of the non-S portion is determined by taking into account all items of 
income, deduction, and credit to the extent not taken into account by 
either the grantor portion or the S portion. The items attributable to 
the non-S portion are taxed under subparts A through D of part I, 
subchapter J, chapter 1 of the Internal Revenue Code.
    (2) Dividend income under section 1368(c)(2). Any dividend income 
within the meaning of section 1368(c)(2) is includible in the gross 
income of the non-S portion.
    (3) Interest on installment obligations. If income from the sale or 
disposition of stock in an S corporation is reported by the trust on 
the installment method, the interest on the installment obligation is 
includible in the gross income of the non-S portion. See paragraph 
(d)(3)(ii) of this section for the treatment of income from such a sale 
or disposition.
    (4) Charitable deduction. For purposes of applying section 
642(c)(1) to payments made by the trust for a charitable purpose, the 
amount of gross income of the trust is limited to the gross income of 
the non-S portion. See paragraph (d)(2)(ii) of this section for special 
rules concerning charitable contributions paid by the S corporation 
that are deemed to be paid by the S portion.
    (g) Allocation of state and local income taxes and administration 
expenses. Whenever state and local income taxes or administration 
expenses relate to more than one portion of an ESBT, they must be 
allocated between or among the portions to which they relate. These 
items may be allocated in any manner that is reasonable in light of all 
the circumstances, including the terms of the governing instrument, 
local law, and the practice of the trustee with respect to the trust if 
it is reasonable and consistent. The taxes and expenses apportioned to 
each portion of the ESBT are taken into account by that portion.
    (h) Treatment of distributions from the trust. Distributions to 
beneficiaries from the S portion or the non-S portion, including 
distributions of the S corporation stock, are deductible under section 
651 or 661 in determining the taxable income of the non-S portion, and 
are included in the gross income of the beneficiaries under section 652 
or 662. However, the amount of the deduction or inclusion cannot exceed 
the amount of the distributable net income of the non-S portion. Items 
taken into account by the grantor portion or the S portion are excluded 
for purposes of determining the distributable net income of the non-S 
portion of the trust.
    (i) Termination or revocation of ESBT election. If the ESBT 
election of the trust terminates pursuant to Sec. 1.1361-1(m)(5) or the 
ESBT election is revoked pursuant to Sec. 1.1361-1(m)(6), the rules 
contained in this section are thereafter not applicable to the trust. 
If, upon termination or revocation, the S portion has a net operating 
loss under section 172; a capital loss carryover under section 1212; or 
deductions in excess of gross income; then any such loss, carryover, or 
excess deductions shall be allowed as a deduction, in accordance with 
the regulations under section 642(h), to the trust, or to the 
beneficiaries succeeding to the property of the trust if the entire 
trust terminates.
    (j) Effective date. This section generally is applicable on and 
after the date the final regulations are published in the Federal 
Register. However, paragraphs (a), (b) and (c) of this section are 
applicable for taxable years of ESBTs that end on and after December 
29, 2000.
    (k) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Comprehensive example. (i) Trust has a valid ESBT 
election in effect. Under section 678, B is treated as the owner of 
a portion of Trust consisting of a 10% undivided fractional interest 
in Trust. No other person is treated as the owner of any other 
portion of Trust under subpart E, part I, subchapter J. Trust owns 
stock in X, an S corporation, and in Y, a C corporation. During 
2000, Trust receives a distribution from X of $5,100, of which 
$5,000 is applied against Trust's adjusted basis in the X stock in 
accordance with section 1368(c)(1) and $100 is a dividend under 
section 1368(c)(2). Trust makes no distributions to its 
beneficiaries during the year.
    (ii) For 2000, Trust has the following items of income and 
deduction:

Ordinary income attributable to X under section 1366.........     $5,000
Dividend income from Y.......................................        900
Dividend from X representing C corporation earnings and              100
 profits.....................................................
                                                              ----------
    Total trust income.......................................      6,000

[[Page 82968]]

 
Charitable contributions attributable to X under section 1366        300
Trustee fees.................................................        200
State and local income taxes.................................        100
 

    (iii) Trust's items of income and deduction are divided into a 
grantor portion, an S portion, and a non-S portion for purposes of 
determining the taxation of those items. Income is allocated to each 
portion as follows:
    B must take into account the items of income attributable to the 
grantor portion, that is, 10% of each item, as follows:

Ordinary income from X.......................................       $500
Dividend income from Y.......................................         90
Dividend income from X.......................................         10
                                                              ----------
    Total grantor portion income.............................        600
 

    The total income of the S portion is $4,500, determined as 
follows:

Ordinary income from X $.....................................     $5,000
Less: Grantor portion........................................      (500)
                                                              ----------
    Total S portion income...................................      4,500
 

    The total income of the non-S portion is $900 determined as 
follows:

Dividend income from Y (less grantor portion)................       $810
Dividend income from X (less grantor portion)................         90
                                                              ----------
    Total non-S portion income...............................        900
 

    (iv) The administrative expenses and the state and local income 
taxes relate to all three portions and under state law would be 
allocated ratably to the $6,000 of trust income. Thus, these items 
would be allocated 10% (600/6000) to the grantor portion, 75% (4500/
6000) to the S portion and 15% (900/6000) to the non-S portion.
    (v) B must take into account the following deductions 
attributable to the grantor portion of the trust:

Charitable contributions from X..............................        $30
Trustee fees.................................................         20
                                                              ----------
State and local income taxes.................................         10
 

    (vi) The taxable income of the S portion is $4,005, determined 
as follows:

Ordinary income from X.......................................     $4,500
Less: Charitable contributions from X (less grantor portion).      (270)
    75% of trustee fees......................................      (150)
    75% of state and local income taxes......................       (75)
                                                              ----------
Taxable income of S portion..................................      4,005
 

    (vii) The taxable income of the non-S portion is $755, 
determined as follows:

Dividend income from Y.......................................       $810
Dividend income from X.......................................         90
    Total non-S portion income...............................        900
Less: 15 % of trustee fees...................................       (30)
    15% state and local income taxes.........................       (15)
    Personal exemption.......................................      (100)
Taxable income of non-S portion..............................        755
 

    Example 2. Sale of S stock. Trust has a valid ESBT election in 
effect and owns stock in X, an S corporation. No person is treated 
as the owner of any portion of Trust under subpart E, part I, 
subchapter J. In 2001, Trust sells all of its stock in X and 
recognizes a capital gain of $5,000. This gain is taken into account 
by the S portion and is taxed using the appropriate capital gain 
rate found in section 1(h).
    Example 3. (i) Sale of S stock for an installment note. Assume 
the same facts as in Example 2, except that Trust sells its stock in 
X for a $400,000 installment note payable with stated interest over 
ten years. After the sale, Trust does not own any S corporation 
stock.
    (ii) Loss on installment sale. Assume Trust's basis in its X 
stock was $500,000. Therefore, Trust sustains a capital loss of 
$100,000 on the sale. Upon the sale, the S portion terminates and 
the excess loss, after being netted against the other items taken 
into account by the S portion, is made available to the entire trust 
as provided in section 641(c)(4).
    (iii) Gain on installment sale. Assume Trust's basis in its X 
stock was $300,000 and that the $100,000 gain will be recognized 
under the installment method of section 453. Interest income will be 
recognized annually as part of the installment payments. The portion 
of the $100,000 gain recognized annually is taken into account by 
the S portion. However, the annual interest income is includible in 
the gross income of the non-S portion.
    Example 4. Charitable lead annuity trust. Trust is a charitable 
lead annuity trust which is not treated as owned by the grantor or 
another person under subpart E. Trust acquires stock in X, an S 
corporation, and elects to be an ESBT. During the taxable year, 
pursuant to its terms, Trust pays $10,000 to a section 170(c)(2) 
charitable organization. The non-S portion of Trust receives an 
income tax deduction for the charitable contribution under section 
642(c) only to the extent the amount is paid out of the gross income 
of the non-S portion. To the extent the amount is paid from the S 
portion, no charitable deduction is available to the S portion.
    Example 5. ESBT distributions. (i) As of January 1, 2000, Trust 
owns stock in X, a C corporation. No portion of Trust is treated as 
owned by the grantor or another person under subpart E. X elects to 
be an S corporation effective January 1, 2001, and Trust elects to 
be an ESBT effective January 1, 2001. For 2001, Trust's share of X's 
section 1366 items is $5,000 of ordinary income. For the year, Trust 
has no other income and no expenses or state or local taxes. On 
February 1, 2001, X makes an $8,000 distribution to Trust, of which 
$3,000 is treated as a dividend from accumulated earnings and 
profits under section 1368(c)(2) and the remainder is applied 
against Trust's basis in the X stock under section 1368(b). The 
trustee of Trust makes a distribution of $4,000 to Beneficiary 
during 2001.
    (ii) For 2001, Trust has $5,000 of taxable income in the S 
portion. This income is taxed to Trust at the maximum rate provided 
in section 1(e). Trust also has $3,000 of distributable net income 
(DNI) in the non-S portion. The non-S portion of Trust receives a 
distribution deduction under section 661(a) of $3,000, which 
represents the amount distributed to the beneficiary during the year 
($4,000), not to exceed the amount of DNI ($3,000). The beneficiary 
must include this amount in gross income under section 662(a). As a 
result, the non-S portion has no taxable income.

    Par. 4. Section 1.1361-0 is amended by adding entries for 
Sec. 1.1361-1(j)(12) and (m) to read as follows:


Sec. 1.1361-0  Table of contents.

* * * * *
 1.1361-1  S corporation defined.
* * * * *
    (j) * * *
    (12) Converting a QSST to an ESBT.
* * * * *
    (m) Electing small business trust (ESBT).
    (1) Definition.
    (2) ESBT election.
    (3) Effect of ESBT election.
    (4) Potential current beneficiaries.
    (5) ESBT terminations.
    (6) Revocation of ESBT election.
    (7) Converting an ESBT to a QSST.
    (8) Effective date.
    (9) Examples.
* * * * *
    Par. 5. Section 1.1361-1 is amended by:
    1. Adding paragraphs (h)(1)(vi), (h)(3)(i)(F), and (j)(12).
    2. Adding a sentence to the end of paragraph (k)(2)(i).
    3. Adding paragraph (m).
    The additions read as follows:


Sec. 1.1361-1  S corporation defined.

* * * * *
    (h) * * * (1) * * *
    (vi) Electing small business trusts. An electing small business 
trust (ESBT) under section 1361(e). See paragraph (m) of this section 
for rules concerning ESBTs including the manner of making the election 
to be an ESBT under section 1361(e)(3).
* * * * *
    (3) * * * (i) * * *
    (F) If S corporation stock is held by an ESBT, each potential 
current beneficiary is treated as a shareholder. However, if for any 
period there is no potential current beneficiary of the ESBT, the ESBT 
is treated as the shareholder during such period. See paragraph (m)(4) 
of this section for the definition of potential current beneficiary.
* * * * *
    (j) * * *
    (12) Converting a QSST to an ESBT. For a trust that wishes to 
convert from a QSST to an ESBT, the consent of the Commissioner is 
hereby granted to revoke the QSST election as of the effective date of 
the ESBT election, if all the following requirements are met:
    (i) The trust meets all of the requirements to be an ESBT under

[[Page 82969]]

paragraph (m)(1) of this section except for the requirement under 
paragraph (m)(1)(iv)(A) of this section that the trust not have a QSST 
election in effect.
    (ii) The trustee and the current income beneficiary of the trust 
sign the ESBT election. The ESBT election must be filed with the 
service center where the S corporation files its income tax return and 
also with the service center where the trust files its income tax 
return. This ESBT election must state at the top of the document 
``ATTENTION ENTITY CONTROL--CONVERSION OF A QSST TO AN ESBT PURSUANT TO 
SECTION 1.1361-1(j)'' and include all information otherwise required 
for an ESBT election under paragraph (m)(2) of this section. A separate 
election must be made with respect to the stock of each S corporation 
held by the trust.
    (iii) The trust has not converted from an ESBT to a QSST within the 
36-month period preceding the effective date of the new ESBT election.
    (iv) The date on which the ESBT election is to be effective cannot 
be more than 15 days and two months prior to the date on which the 
election is filed and cannot be more than 12 months after the date on 
which the election is filed. If an election specifies an effective date 
more than 15 days and two months prior to the date on which the 
election is filed, it will be effective 15 days and two months prior to 
the date on which it is filed. If an election specifies an effective 
date more than 12 months after the date on which the election is filed, 
it will be effective 12 months after the date it is filed.
    (k) * * *
    (2) * * * (i) * * * Paragraphs (h)(1)(vi), (h)(3)(i)(F), and 
(j)(12) of this section are applicable on and after the date the final 
regulations are published in the Federal Register.
* * * * *
    (m) Electing small business trust (ESBT)--(1) Definition--(i) 
General rule. An electing small business trust (ESBT) means any trust 
if it meets the following requirements: the trust does not have as a 
beneficiary any person other than an individual, an estate, or an 
organization described in section 170(c)(2) through (5); no interest in 
the trust has been acquired by purchase; and the trustee of the trust 
makes a timely ESBT election for the trust.
    (ii) Qualified beneficiaries--(A) In general. For purposes of this 
section, a beneficiary includes a person who has a present, remainder, 
or reversionary interest in the trust other than a remote, contingent 
interest within the meaning of paragraph (m)(1)(ii)(D) of this section.
    (B) Distributee trusts. Any person who has a beneficial interest in 
a distributee trust is a beneficiary of the ESBT. However, if the 
distributee trust is an organization described in section 170(c)(2) or 
(3), the distributee trust itself is the beneficiary of the ESBT. A 
distributee trust is a trust that is receiving or may receive a 
distribution from an ESBT, whether the rights to receive the 
distribution are fixed or contingent, or immediate or deferred.
    (C) Powers of appointment. A person in whose favor a power of 
appointment could be exercised is not a beneficiary of an ESBT until 
the holder of the power of appointment actually exercises the power in 
favor of such person.
    (D) Remote beneficiaries. A person whose interest in the trust is 
so remote as to be negligible is not a beneficiary of an ESBT. With 
respect to any portion of the trust, a person's interest in either the 
corpus or the income therefrom is, at any time, so remote as to be 
negligible when the probability that such person will ever receive a 
distribution from the trust is less than 5 percent, taking into 
consideration the interests of other entities and other individuals 
living at that time.
    (E) Nonresident aliens. A nonresident alien as defined in section 
7701(b)(1)(B) is an eligible beneficiary of an ESBT. However, see 
paragraph (m)(5)(iii) of this section if the nonresident alien is a 
potential current beneficiary of the ESBT.
    (iii) Interests acquired by purchase. A trust does not qualify as 
an ESBT if any interest in the trust has been acquired by purchase. If 
any portion of a beneficiary's basis in the beneficiary's interest in 
the trust is determined under section 1012, such interest has been 
acquired by purchase. The trust itself may acquire S corporation stock 
by purchase.
    (iv) Ineligible trusts. An ESBT does not include--
    (A) Any qualified subchapter S trust (as defined in section 
1361(d)(3)) if an election under section 1361(d)(2) applies with 
respect to any corporation the stock of which is held by the trust;
    (B) Any trust exempt from tax or not subject to tax under subtitle 
A; or
    (C) Any charitable remainder annuity trust or charitable remainder 
unitrust (as defined in section 664(d)).
    (2) ESBT election--(i) In general. The trustee of the trust must 
make the ESBT election by signing and filing, with the service center 
where the trust files its income tax return, a statement that meets the 
requirements of paragraph (m)(2)(ii) of this section. If there is more 
than one trustee, the trustee or trustees with authority to legally 
bind the trust must sign the election statement. Only one ESBT election 
is made for the trust, regardless of the number of S corporations whose 
stock is held by the ESBT.
    (ii) Election statement. The election statement must include--
    (A) The name, address, and taxpayer identification number of the 
trust, the potential current beneficiaries, and the S corporations in 
which the trust currently owns stock;
    (B) An identification of the election as an ESBT election made 
under section 1361(e)(3);
    (C) The first date on which the trust owned stock in each S 
corporation;
    (D) The date on which the election is to become effective (not 
earlier than 15 days and two months before the date on which the 
election is filed); and
    (E) Representations signed by the trustee stating that--
    (1) The trust meets the definitional requirements of section 
1361(e)(1); and
    (2) All potential current beneficiaries of the trust meet the 
shareholder requirements of section 1361(b)(1).
    (iii) Due date for ESBT election. The ESBT election must be filed 
within the time requirements prescribed in paragraph (j)(6)(iii) of 
this section for filing a qualified subchapter S trust (QSST) election. 
If the trust and the corporation file their tax returns with the same 
service center, the trustee may attach the ESBT election to the Form 
2553, ``Election by a Small Business Corporation,'' in the case of a 
newly electing S corporation.
    (iv) Election by a trust described in section 1361(c)(2)(A)(ii) or 
(iii). A trust that is a qualified S corporation shareholder under 
section 1361(c)(2)(A)(ii) or (iii) may elect ESBT treatment at any time 
during the 2-year period described in those sections or the 16-day-and-
2-month period beginning on the date after the end of the 2-year 
period. If the trust makes an ineffective ESBT election, the trust will 
continue to qualify as an eligible S corporation shareholder for the 
remainder of the period described in section 1361(c)(2)(A)(ii) or 
(iii).
    (v) No protective election. A trust cannot make a protective ESBT 
election that would be effective in the event the trust fails to meet 
the requirements for an eligible trust described in section 
1361(c)(2)(A)(i) through (iv). If a trust attempts to make a protective 
ESBT election and fails to qualify as an eligible S corporation 
shareholder under section 1361(c)(2)(A)(i) through (iv), the S 
corporation election will be ineffective or will terminate because the 
corporation will have an ineligible shareholder. Relief may be 
available under section 1362(f) for an inadvertent ineffective S 
corporation election or an

[[Page 82970]]

inadvertent S corporation election termination.
    (3) Effect of ESBT election--(i) General rule. If a trust makes a 
valid ESBT election, the trust will be treated as an ESBT for purposes 
of chapter 1 of the Internal Revenue Code as of the effective date of 
the ESBT election.
    (ii) Employer Identification Number. An ESBT has only one employer 
identification number (EIN). If an existing trust makes an ESBT 
election, the trust continues to use the EIN it currently uses.
    (iii) Taxable year. If an ESBT election is effective on a day other 
than the first day of the trust's taxable year, the ESBT election does 
not cause the trust's taxable year to close. The trust files one tax 
return for the taxable year.
    (iv) Allocation of S corporation items. If an ESBT election is 
effective on a day other than the first day of the trust's taxable 
year, and the trust held S corporation stock and was an eligible S 
corporation shareholder under section 1361(c)(2)(A)(i) through (iv) 
prior to the effective date of the ESBT election, the S corporation 
items are allocated between the two eligible trusts under section 
1377(a). For purposes of section 1377(a), the first day the ESBT is a 
shareholder is the effective date of the ESBT election, and the last 
day the other trust is a shareholder is the day before the effective 
date of the ESBT election. See Sec. 1.1377-1(a)(2)(iii).
    (v) Estimated taxes. If an ESBT election is effective on a day 
other than the first day of the trust's taxable year, the trust is 
considered one trust for purposes of estimated taxes under section 
6654.
    (4) Potential current beneficiaries--(i) In general. For purposes 
of determining whether a corporation is a small business corporation 
within the meaning of section 1361(b)(1), each potential current 
beneficiary of an ESBT generally is treated as a shareholder of the 
corporation. Subject to the provisions of this section (m)(4), a 
potential current beneficiary generally is, with respect to any period, 
any person who at any time during such period is entitled to, or in the 
discretion of any person may receive, a distribution from the principal 
or income of the trust.
    (ii) Grantor trusts. If all or a portion of an ESBT is treated as 
owned by a person under subpart E, part I, subchapter J, chapter 1 of 
the Internal Revenue Code, such owner is a potential current 
beneficiary in addition to persons described in paragraph (m)(4)(i) of 
this section.
    (iii) Special rule for dispositions of stock. Notwithstanding the 
provisions of paragraph (m)(4)(i) of this section, if a trust disposes 
of all of its S corporation stock, any person who first met the 
definition of a potential current beneficiary during the 60-day period 
ending on the date of such disposition is not a potential current 
beneficiary with respect to that corporation.
    (iv) Distributee trusts--(A) In general. This paragraph (m)(4)(iv) 
contains the rules for determining who are the potential current 
beneficiaries of an ESBT if a distributee trust becomes entitled to, or 
at the discretion of any person may receive, a distribution from 
principal or income of an ESBT. A distributee trust does not include a 
trust that is not currently in existence. For this purpose, a trust is 
not currently in existence if the trust has no assets and no items of 
income, loss, deduction, or credit. Thus, if a trust instrument 
provides for a trust to be funded at some future time, the future trust 
is not a distributee trust.
    (B) If the distributee trust is not a trust described in section 
1361(c)(2)(A), then the distributee trust is the potential current 
beneficiary of the ESBT and the corporation's S corporation election 
terminates.
    (C) If the distributee trust is a trust described in section 
1361(c)(2)(A), the persons who would be its potential current 
beneficiaries (as defined in paragraph (m)(4)(i) and (ii) of this 
section) if the distributee trust were an ESBT are treated as the 
potential current beneficiaries of the ESBT. Notwithstanding the 
preceding sentence, however, if the distributee trust is a trust 
described in section 1361(c)(2)(A)(ii) or (iii), the estate described 
in section 1361(c)(2)(B) (ii) or (iii) is treated as the potential 
current beneficiary of the ESBT for the 2-year period for which such 
trust is permitted as a shareholder.
    (D) For the purposes of paragraph (m)(4)(iv)(C) of this section, a 
trust will be deemed to be described in section 1361(c)(2)(A) if such 
trust would be eligible to make a QSST election under section 1361(d) 
or an ESBT election under section 1361(e) if it owned S corporation 
stock.
    (v) Contingent distributions. A person who is entitled to receive a 
distribution only after a specified time or upon the occurrence of a 
specified event (such as the death of the holder of a power of 
appointment) is not a potential current beneficiary until such time or 
the occurrence of such event.
    (vi) Current powers of appointment. A person to whom a distribution 
is or may be made during a period pursuant to a power of appointment is 
a potential current beneficiary. Thus, if any person has a general 
lifetime power of appointment over the trust, the corporation's S 
corporation election will terminate because the number of potential 
current beneficiaries will exceed the 75-shareholder limit of section 
1361(b)(1)(A).
    (vii) Number of shareholders. Each potential current beneficiary of 
the ESBT, as defined in paragraphs (m)(4)(i) through (vi) of this 
section, is counted as a shareholder of any S corporation whose stock 
is owned by the ESBT. During any period in which the ESBT has no 
potential current beneficiaries, the ESBT is counted as the 
shareholder. A person is counted as only one shareholder of an S 
corporation even though that person may be treated as a shareholder of 
the S corporation by direct ownership and through one or more eligible 
trusts described in section 1361(c)(2)(A). Thus, for example, if a 
person owns stock in an S corporation and is a potential current 
beneficiary of an ESBT that owns stock in the same S corporation, that 
person is counted as one shareholder of the S corporation. Similarly, 
if a husband owns stock in an S corporation and his wife is a potential 
current beneficiary of an ESBT that owns stock in the same S 
corporation, such husband and wife will be counted as one shareholder 
of the S corporation.
    (viii) Miscellaneous. Payments made to a third party on behalf of a 
beneficiary are considered to be payments made directly to the 
beneficiary. The right of a beneficiary to assign the beneficiary's 
interest to a third party does not result in the third party being a 
potential current beneficiary until that interest is actually assigned.
    (5) ESBT terminations--(i) Ceasing to meet ESBT requirements. A 
trust ceases to be an ESBT on the first day the trust fails to meet the 
definition of an ESBT under section 1361(e). The last day the trust is 
treated as an ESBT is the day before the date on which the trust fails 
to meet the definition of an ESBT.
    (ii) Disposition of S stock. In general, a trust ceases to be an 
ESBT on the first day following the day the trust disposes of all S 
corporation stock. However, if the trust is using the installment 
method to report income from the sale or disposition of its stock in an 
S corporation, the trust ceases to be an ESBT on the day following the 
earlier of the day the last installment payment is received by the 
trust or the day the trust disposes of the installment obligation.
    (iii) Potential current beneficiaries that are ineligible 
shareholders. If a potential current beneficiary of an ESBT is not an 
eligible shareholder of a small business corporation within the

[[Page 82971]]

meaning of section 1361(b)(1), the S corporation election terminates. 
For example, the S corporation election will terminate if a nonresident 
alien becomes a potential current beneficiary of an ESBT. Such a 
potential current beneficiary is treated as an ineligible shareholder 
beginning on the day such person becomes a potential current 
beneficiary, and the S corporation election terminates on that date. 
However, see the special rule of paragraph (m)(4)(ii) of this section. 
If the S corporation election terminates, relief may be available under 
section 1362(f).
    (6) Revocation of ESBT election. An ESBT election may be revoked 
only with the consent of the Commissioner. The application for consent 
to revoke the election must be submitted to the Internal Revenue 
Service in the form of a letter ruling request under the appropriate 
revenue procedure.
    (7) Converting an ESBT to a QSST. For a trust that wishes to 
convert from an ESBT to a QSST, the consent of the Commissioner is 
hereby granted to revoke the ESBT election as of the effective date of 
the QSST election, if all the following requirements are met:
    (i) The trust meets all of the requirements to be a QSST under 
section 1361(d).
    (ii) The trustee and the current income beneficiary of the trust 
sign the QSST election. The QSST election must be filed with the 
service center where the S corporation files its income tax return and 
also with the service center where the trust files its income tax 
return. This QSST election must state at the top of the document 
``ATTENTION ENTITY CONTROL--CONVERSION OF AN ESBT TO A QSST PURSUANT TO 
SECTION 1.1361-1(m)'' and include all information otherwise required 
for a QSST election under Sec. 1.1361-1(j)(6). A separate election must 
be made with respect to the stock of each S corporation held by the 
trust.
    (iii) The trust has not converted from a QSST to an ESBT within the 
36-month period preceding the effective date of the new QSST election.
    (iv) The date on which the QSST election is to be effective cannot 
be more than 15 days and two months prior to the date on which the 
election is filed and cannot be more than 12 months after the date on 
which the election is filed. If an election specifies an effective date 
more than 15 days and two months prior to the date on which the 
election is filed, it will be effective 15 days and two months prior to 
the date on which it is filed. If an election specifies an effective 
date more than 12 months after the date on which the election is filed, 
it will be effective 12 months after the date it is filed.
    (8) Effective date. This paragraph (m) is applicable on and after 
the date the final regulations are published in the Federal Register.
    (9) Examples. The provisions of this paragraph (m) are illustrated 
by the following examples in which it is assumed, unless otherwise 
specified, that all noncorporate persons are citizens or residents of 
the United States:
    Example 1. (i) ESBT election with section 663(c) separate 
shares. On January 1, 2000, M contributes S corporation stock to 
Trust for the benefit of M's three children A, B, and C. Pursuant to 
section 663(c), each of Trust's separate shares for A, B, and C will 
be treated as separate trusts for purposes of determining the amount 
of distributable net income (DNI) in the application of sections 661 
and 662. On January 15, 2000, the trustee of Trust files a valid 
ESBT election for Trust effective January 1, 2000. Trust will be 
treated as a single ESBT and will have a single S portion taxable 
under section 641(c).
    (ii) ESBT acquires stock of an additional S corporation. On 
February 15, 2000, Trust acquires stock of an additional S 
corporation. Because Trust is already an ESBT, Trust does not need 
to make an additional ESBT election.
    (iii) Section 663(c) shares of ESBT convert to separate QSSTs. 
Effective January 1, 2001, A, B, C, and Trust's trustee elect to 
convert each separate share of Trust into a separate QSST pursuant 
to paragraph (m)(7) of this section. They file a separate election 
for each S corporation the stock of which is held by Trust for each 
separate share. Each separate share will be treated as a separate 
QSST.
    Example 2. (i) Invalid potential current beneficiary. Effective 
January 1, 2000, Trust makes a valid ESBT election. On January 1, 
2001, A, a nonresident alien, becomes a potential current 
beneficiary of Trust. Trust does not dispose of all of its S 
corporation stock within 60 days after January 1, 2001. As of 
January 1, 2001, A is a potential current beneficiary of Trust, and 
therefore is treated as a shareholder of the S corporation. Because 
A is not an eligible shareholder of an S corporation under section 
1361(b)(1), the S corporation election of any corporation in which 
Trust holds stock terminates effective January 1, 2001. Relief may 
be available under section 1362(f).
    (ii) Invalid potential current beneficiary and disposition of S 
stock. Assume the same facts as in Example 2 (i) except that within 
60 days after January 1, 2001, trustee of Trust disposes of all 
Trust's S corporation stock. A is not considered a potential current 
beneficiary of Trust and therefore is not treated as an S 
corporation shareholder of any S corporation in which Trust 
previously held stock.
    Example 3. Subpart E trust. M transfers stock in X, an S 
corporation, and other assets to Trust, for the benefit of B and B's 
siblings. M retains no powers or interest in Trust. Under section 
678(a), B is treated as the owner of a portion of Trust which 
includes a portion of the X stock. No beneficiary has acquired any 
portion of his or her interest in Trust by purchase and Trust is not 
an ineligible trust under paragraph (m)(1)(iv) of this section. 
Trust is eligible to make an ESBT election.
    Example 4. Determining ESBT beneficiaries. Trust holds stock in 
an S corporation and makes an ESBT election. Trust's instrument 
provides that income is to be paid to A for A's life. Upon A's death 
the remainder interest is to be paid to a separate trust for the 
benefit of A's three children. If on A's death none of A's children 
is alive, then the remainder is to be paid to A's ten grandchildren. 
If on A's death none of A's children or grandchildren is alive, the 
remainder will be paid to State exclusively for public purposes. A, 
A's children, and A's grandchildren are all beneficiaries of Trust. 
Assuming the probability that State will ever receive any 
distribution from Trust is less than 5 percent, State is not 
considered a beneficiary for purposes of paragraph (m)(1)(ii) of 
this section. If the probability that State will receive a 
distribution from Trust ever equals or exceeds 5 percent, State 
would then be considered a beneficiary of the ESBT. Because State is 
an organization described in section 170(c)(1), rather than section 
170(c)(2) through (5), State would be an ineligible beneficiary and 
the corporation's S corporation election would terminate.
    Example 5. Potential current beneficiaries and distributee 
trusts. (i) Distributee trust holding S corporation stock. Trust-1 
has a valid ESBT election in effect. The trustee of Trust-1 has the 
power to distribute to A directly or to any trust created for the 
benefit of A. On January 1, 2000, M creates Trust-2 for the benefit 
of A. Also on January 1, 2000, the trustee of Trust-1 distributes 
some S corporation stock to Trust-2. The current income beneficiary 
of Trust-2 makes a timely and effective election to treat Trust-2 as 
a QSST. Because Trust-2 is a valid S corporation shareholder, the 
distribution to Trust-2 does not terminate the ESBT election of 
Trust-1. Trust-2 itself will not be counted toward the 75-
shareholder limit of section 1361(b)(1)(A). Additionally, because A 
is already counted as an S corporation shareholder because of A's 
status as a potential current income beneficiary of Trust-1, A is 
not counted again by reason of A's status as the deemed owner of 
Trust-2.
    (ii) Distributee trust not holding S corporation stock. Assume 
the same facts as in paragraph (i) of this Example 5 except that no 
S corporation stock is distributed to Trust-2. Because Trust-2 would 
be eligible to make a QSST election or an ESBT election if it owned 
S corporation stock, under paragraph (m)(4)(iv)(D) of this section 
it is deemed to be a trust described in section 1361(c)(2)(A). Under 
paragraph (m)(4)(iv)(C) of this section, the potential current 
beneficiaries of Trust-2 are considered the potential current 
beneficiaries of Trust-1. Because A, the potential current 
beneficiary of Trust-2, is already a potential current beneficiary 
of Trust-1, A is not counted twice for purposes of the 75-
shareholder limit of the S corporation.
    Example 6. Potential current beneficiaries and distributee 
trust. (i) Distributee trust that

[[Page 82972]]

would itself qualify as an ESBT. Trust-1 holds stock in X, an S 
corporation, and has a valid ESBT election in effect. Under the 
terms of the governing instrument of Trust-1, the trustee has 
discretion to make distributions to A, B and Trust-2, a trust for 
the benefit of A and B's children, C, D and E. Trust-2 would qualify 
to be an ESBT, but it owns no S corporation stock and has made no 
ESBT election. Under paragraph (m)(4)(iv) of this section, Trust-2's 
potential current beneficiaries are treated as the potential current 
beneficiaries of Trust-1 and are counted as shareholders for 
purposes of section 1361(b)(1). Thus, A, B, C, D and E are potential 
current beneficiaries of Trust-1 and are counted as shareholders for 
the purposes of section 1361(b)(1). Trust-2 itself will not be 
counted as a shareholder of Trust-1 for purposes of section 
1361(b)(1).
    (ii) Distributee trust that would not qualify as an ESBT. Assume 
the same facts as in Example 6 (i) except that D is a non-resident 
alien. Trust-2 would not be eligible to make an ESBT or QSST 
election if it owned S corporation stock and therefore Trust-2 is a 
potential current beneficiary of Trust-1. Since Trust-2 is not an 
eligible shareholder, X's S corporation election terminates.
    (iii) Distributee trust that is a section 1361(c)(2)(A)(ii) 
trust. Assume the same facts as in Example 6 (i) except that Trust-2 
is a trust treated as owned by A under section 676 because A had the 
power to revoke Trust-2 at any time prior to A's death. On January 
1, 2001, A dies. Because Trust-2 is a trust described in section 
1361(c)(2)(A)(ii) during the 2-year period beginning on the day of 
A's death, under paragraph (m)(4)(iv)(C) of this section, Trust-2's 
only potential current beneficiary is the person listed in section 
1361(c)(2)(B)(ii), A's estate.
    Example 7. Potential current beneficiaries and powers of 
appointment. M creates Trust for the benefit of A. A also has a 
current power to appoint income or principal to anyone except A, A's 
creditors, A's estate, and A's estate's creditors. The potential 
current beneficiaries of Trust will be A and all other persons 
except for A's creditors, A's estate, and A's estate's creditors. 
This number will exceed the 75-shareholder limit of section 
1361(b)(1)(A). If Trust holds S corporation stock, the corporation's 
S election will terminate.

    Par. 6. Section 1.1362-6 is amended by revising paragraph 
(b)(2)(iv) to read as follows:


Sec. 1.1362-6  Election and consents.

* * * * *
    (b) * * *
    (2) * * *
    (iv) Trusts. In the case of a trust described in section 
1361(c)(2)(A) (including a trust treated under section 1361(d)(1)(A) as 
a trust described in section 1361(c)(2)(A)(i) and excepting an electing 
small business trust described in section 1361(c)(2)(A)(v) (ESBT)), 
only the person treated as the shareholder for purposes of section 
1361(b)(1) must consent to the election. When stock of the corporation 
is held by a trust, both husband and wife must consent to any election 
if the husband and wife have a community interest in the trust 
property. See paragraph (b)(2)(i) of this section for rules concerning 
community interests in S corporation stock. In the case of an ESBT, the 
trustee and the owner of any portion of the trust that consists of the 
stock in one or more S corporations under subpart E, part I, subchapter 
J, chapter 1 of the Internal Revenue Code must consent to the S 
corporation election. If there is more than one trustee, the trustee or 
trustees with authority to legally bind the trust must consent to the S 
corporation election.
* * * * *
    Par. 7. Section 1.1362-7 is amended by adding a sentence to the end 
of paragraph (a) to read as follows:


Sec. 1.1362-7  Effective date.

    (a) * * * Section 1.1362-6(b)(2)(iv) is applicable on and after the 
date the final regulations are published in the Federal Register.
* * * * *
    Par. 8. Section 1.1377-1 is amended by:
    1. Adding paragraph (a)(2)(iii).
    2. Adding Example 3 to paragraph (c).
    The additions read as follows:


Sec. 1.1377-1  Pro rata share.

    (a) * * *
    (2) * * *
    (iii) Electing small business trust (ESBT) election. If an ESBT 
election is effective on a day other than the first day of trust's 
taxable year, and the trust was already an eligible S corporation 
shareholder under a different provision of section 1361(c)(2), then 
section 1377 applies to allocate S corporation income between the two 
types of trusts. The first day the ESBT is treated as an S corporation 
shareholder is the effective date of the ESBT election. The ESBT 
election does not result in the prior trust being treated as 
terminating its entire interest in its S corporation stock for purposes 
of paragraph (b) of this section, unless the prior trust was described 
in section 1361(c)(2)(A)(ii) or (iii).
* * * * *
    (c) * * *

    Example 3. Effect of conversion of a qualified subchapter S 
trust (QSST) to an electing small business trust (ESBT). (i) On 
January 1, 2000, Trust receives 100% of the stock of S corporation. 
Trust's current income beneficiary makes a timely QSST election 
under section 1361(d)(2), effective January 1, 2000. Later, the 
trustee and current income beneficiary of Trust elect pursuant to 
Sec. 1.1361-1(j)(12), to terminate the QSST election and convert to 
an ESBT, effective July 1, 2002. In 2002, Trust's pro rata share of 
S corporation's nonseparately computed income is $100,000.
    (ii) For purposes of computing the income allocable to the QSST 
and to the ESBT, Trust is treated as a QSST through June 30, 2002, 
and Trust is treated as an ESBT beginning July 1, 2002. Pursuant to 
section 1377(a)(1), the pro rata share of S corporation income 
allocated to the QSST is $49,589 ($100,000  x  181 days/365 days), 
and the pro rata share of S corporation income allocated to the ESBT 
is $50,411 ($100,000  x  184 days/365 days).

    Par. 9. Section 1.1377-3 is revised to read as follows:


Sec. 1.1377-3  Effective date.

    Section 1.1377-1 and 1.1377-2 apply to taxable years of an S 
corporation beginning after December 31, 1996, except that Sec. 1.1377-
1(a)(2)(iii) and (c) Example 3 are applicable on and after the date the 
final regulations are published in the Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 00-32191 Filed 12-28-00; 8:45 am]
BILLING CODE 4830-01-U