[Federal Register Volume 66, Number 165 (Friday, August 24, 2001)]
[Proposed Rules]
[Pages 44565-44568]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-21353]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106431-01]
RIN 1545-AY76


Qualified Subchapter S Trust Election for Testamentary Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to a 
qualified subchapter S trust election for testamentary trusts under 
section 1361 of the Internal Revenue Code. The Small Business Job 
Protection Act of 1996 and the Taxpayer Relief Act of 1997 made changes 
to the applicable law. These proposed regulations affect S corporations 
and their shareholders.

DATES: Written or electronic comments and requests for a public hearing 
must be received by November 23, 2001.

ADDRESSES: Send submissions to: CC:IT&A:RU (REG-106431-01), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may also be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:IT&A:RU (REG-106431-01), 
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.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Deane M. Burke, (202) 622-3070; concerning submissions of comments, 
Sonya Cruse, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document proposes to amend section 1361 of the Income Tax 
Regulations (26 CFR part 1) regarding a qualified subchapter S trust 
(QSST) election for testamentary trusts.
    Section 1361(a) defines an S corporation as a small business 
corporation for which an election under section 1362(a) is in effect 
for the year. Section 1361(b) provides, in part, that a small business 
corporation is a domestic corporation which is not an ineligible 
corporation and which does not have as a shareholder a person (other 
than a trust described in section 1361(c)(2)) who is not an individual. 
Under section 1361(c)(2), subpart E trusts and testamentary trusts are 
permitted S corporation shareholders. A qualified subpart E trust is a 
trust, all of which is treated (under subpart E of part I of subchapter 
J, chapter 1) as owned by an individual who is a citizen or resident of 
the United States. A qualified subpart E trust that continues in 
existence after the death of the deemed owner (former qualified subpart 
E trust) is a permitted shareholder, but only for the 2-year period 
beginning on the day of the deemed owner's death. A testamentary trust 
is a trust to which S corporation stock is transferred pursuant to the 
terms of a will, but only for the 2-year period beginning on the day 
the stock is transferred to it.
    Section 1303 of the Small Business Job Protection Act of 1996, 
Public Law 104-188 (110 Stat. 1779) (August 20, 1996) (1996 Act) 
amended section 1361 for taxable years beginning after December 31, 
1996. Prior to the 1996 Act, a former qualified subpart E trust was a 
permitted shareholder for a 60-day period beginning on the day of the 
deemed owner's death. However, if the entire corpus of the trust was 
includible in the gross estate of the deemed owner, the trust was a 
permitted shareholder for a 2-year period beginning on the day of the 
deemed owner's death. Under the regulations, special rules applied if 
the trust consisted of community property. A testamentary trust was a 
permitted shareholder of an S corporation for a 60-day period beginning 
on the day that the S corporation stock was transferred to the trust.
    After the 1996 Act, both a testamentary trust and a former 
qualified subpart E trust, whether or not the entire corpus is included 
in the deemed owner's gross estate, are permitted shareholders for a 2-
year period. Because the entire corpus of a former qualified subpart E 
trust is not required to be included in the deemed owner's estate, it 
is no longer relevant whether the trust consists of community property 
for purposes of the trust's qualifying as a permitted shareholder for a 
2-year period. However, whether a former qualified subpart E trust 
consists of community property is still relevant for purposes of 
determining the shareholders of S corporation stock held by the trust.

Explanation of Provisions

A. Incorporation of Changes From the 1996 Act

    The proposed regulations incorporate changes from the 1996 Act 
regarding section 1361 to provide that a testamentary trust may be a 
permitted shareholder for a 2-year period. The proposed regulations 
also provide that a former qualified subpart E trust is a permitted 
shareholder for a 2-year period whether or not the entire corpus is 
included in the deemed owner's gross estate. The proposed regulations 
thus eliminate the special rules for determining whether trusts 
consisting of community property qualify for the 2-year period.
    The proposed regulations also incorporate additional changes made 
to section 1361 by the 1996 Act. Section 1302 of the 1996 Act added a 
new type of trust, the electing small business trusts (ESBTs), to the 
types of trusts permitted to be S corporation shareholders under 
section 1361(c)(2). Section 1601(c) of the Taxpayer Relief Act of 1997, 
Public Law 105-34 (111 Stat. 1086) (August 5, 1997) made technical 
amendments to section 1361 affecting ESBTs and S corporation 
shareholders. A notice of proposed rulemaking (REG-251701-96, 2001-4 
I.R.B. 396) regarding ESBTs was published in the Federal Register (65 
FR 82963) on December 29, 2000. The proposed regulations refer to ESBTs 
and provide that certain former qualified subpart E trusts and 
testamentary trusts can continue as permitted shareholders after the 
end of the 2-year period by becoming ESBTs.
    Section 1316 of the 1996 Act allowed certain exempt organizations 
to be S corporation shareholders for taxable years beginning after 
December 31, 1997, and section 1301 increased the number of permissible 
S corporation shareholders from 35 to 75. The proposed amendments 
incorporate these additional changes.

B. QSST Election for Testamentary Trusts

    Section 1.1361-1(j)(6)(iii)(C) of the Income Tax Regulations 
provides guidance regarding when a QSST election is made for a former 
qualified subpart E trust that also satisfies the requirements of a 
QSST. Under the provision, a QSST election may be made for a former 
qualified subpart E trust at any time, but no later than the end of

[[Page 44566]]

the 16-day-and-2-month period beginning on the date on which the estate 
of the deemed owner ceases to be treated as a shareholder (as late as 
the end of the 2-year period). Thus, a former qualified subpart E trust 
can continue as a permitted shareholder after the end of the 2-year 
period by electing to be a QSST.
    Section 1.1361-1(h)(3)(ii)(B) provides that if a testamentary trust 
continues to own S corporation stock after the expiration of the 60-day 
period (now 2-year period), the corporation's S election will terminate 
unless the trust otherwise qualifies as a permitted shareholder. The 
trust otherwise qualifies as a permitted shareholder if it satisfies 
the requirements of a QSST under section 1361(d)(3) and the trust 
income beneficiary makes a timely QSST election under section 
1361(d)(2). The regulations, promulgated before 1996, do not address 
when a QSST election may be made for a testamentary trust during its 2-
year period as a permitted shareholder. The IRS and the Treasury 
Department believe that the regulations should provide guidance similar 
to that for former qualified subpart E trusts clarifying when an income 
beneficiary of a testamentary trust may make a QSST election.
    Accordingly, the proposed regulations clarify that a current income 
beneficiary of a testamentary trust that satisfies the QSST 
requirements may make a QSST election at any time during the 2-year 
period that the trust is a permitted shareholder or the 16-day-and-2-
month period beginning on the date after the 2-year period ends. Under 
this provision, a testamentary trust continues as a permitted 
shareholder after the end of the 2-year period by becoming an electing 
QSST. Once the trust becomes an electing QSST, the beneficiary is 
treated as the shareholder of the S corporation as of the effective 
date of the QSST election.

Proposed Effective Date

    The regulations are proposed to apply on and after the date that 
final regulations are published in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. It also has been determined that section 533(b) of the 
Administrative Procedures Act (5 U.S.C. chapter 5) does not apply to 
these regulations, and because these regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue 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 Request for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic and written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and the Treasury Department specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying. A public hearing will be scheduled if requested 
in writing by any person that timely submits written comments. If a 
public hearing is scheduled, notice of the date, time, and place for 
the public hearing will be published in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is Deane M. 
Burke, Office of the Associate Chief Counsel (Passthroughs & Special 
Industries). However, other personnel from the IRS and the 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 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1361-1 is amended as follows:
    1. Revising paragraphs (b)(1)(ii), (f), (h)(1)(ii), (h)(1)(iv), 
(h)(3)(i)(B), and (h)(3)(i)(D). (The undesignated paragraph following 
paragraph (h)(3)(i)(B) is removed.)
    2. Revising the second sentence of paragraph (h)(3)(ii)(A).
    3. Revising paragraphs (h)(3)(ii)(B) and (j)(6)(iii)(C).
    4. Redesignating paragraph (j)(6)(iii)(D) as paragraph 
(j)(6)(iii)(E).
    5. Adding new paragraph (j)(6)(iii)(D).
    6. Revising paragraph (j)(7)(ii).
    7. Revising the fourth sentence of paragraph (k)(1) Example 2(ii).
    8. Revising paragraph (k)(1) Examples 3 and 4(iii).
    9. Adding a sentence to the end of paragraph (k)(2)(i).
    The revisions and additions read as follows:


Sec. 1.1361-1  S corporation defined.

* * * * *
    (b) * * *(1)* * *
    (ii) As a shareholder, a person (other than an estate, a trust 
described in section 1361(c)(2), or, for taxable years beginning after 
December 31, 1997, an organization described in section 1361(c)(6)) who 
is not an individual;
* * * * *
    (f) Shareholder must be an individual or estate. Except as 
otherwise provided in paragraph (e)(1) of this section (relating to 
nominees), paragraph (h) of this section (relating to certain trusts), 
and, for taxable years beginning after December 31, 1997, section 
1361(c)(6) (relating to certain exempt organizations), a corporation in 
which any shareholder is a corporation, partnership, or trust does not 
qualify as a small business corporation.
* * * * *
    (h)* * *(1)* * *
    (ii) Subpart E trust ceasing to be a qualified subpart E trust 
after the death of deemed owner. A trust which was a qualified subpart 
E trust immediately before the death of the deemed owner and which 
continues in existence after the death of the deemed owner, but only 
for the 2-year period beginning on the day of the deemed owner's death. 
A trust is considered to continue in existence if the trust continues 
to hold the stock of the S corporation during the period of 
administration of the decedent's estate or if, after the period of 
administration, the trust continues to hold the stock pursuant to the 
terms of the will or the trust agreement. See Sec. 1.641(b)-3 for rules 
concerning the termination of estates and trusts for federal income tax 
purposes.
* * * * *
    (iv) Testamentary trusts. A trust (other than a qualified subpart E 
trust, an electing QSST, or an electing small business trust (ESBT)) to 
which S corporation stock is transferred pursuant to the terms of a 
will, but only for the 2-year period beginning on the day the stock is 
transferred to the trust.
* * * * *
    (3)* * *
    (i)* * *
    (B) If stock is held by a trust defined in paragraph (h)(1)(ii) of 
this section, the

[[Page 44567]]

estate of the deemed owner is generally treated as the shareholder as 
of the day of the deemed owner's death. However, if stock is held by 
such a trust in a community property state, the decedent's estate is 
the shareholder only of the portion of the trust included in the 
decedent's gross estate (and the surviving spouse continues to be the 
shareholder of the portion of the trust owned by that spouse under the 
applicable state's community property law). The estate ordinarily will 
cease to be treated as the shareholder upon the earlier of the transfer 
of that stock by the trust or the expiration of the 2-year period 
beginning on the day of the deemed owner's death. If the trust 
qualifies and becomes an electing QSST, the beneficiary and not the 
estate is treated as the shareholder as of the effective date of the 
QSST election, and the rules provided in paragraph (j)(7) of this 
section apply. If the trust qualifies and becomes an ESBT, the 
shareholders are determined under provisions of REG-251701-96 in 2001-4 
I.R.B. 396 (see Sec. 601.601(d)(2) of this chapter) as of the effective 
date of the ESBT election.
* * * * *
    (D) If stock is transferred to a testamentary trust described in 
paragraph (h)(1)(iv) of this section (other than a qualified subpart E 
trust, an electing QSST, or an ESBT), the estate of the testator is 
treated as the shareholder until the earlier of the transfer of that 
stock by the trust or the expiration of the 2-year period beginning on 
the day that the stock is transferred to the trust. If the trust 
qualifies and becomes an electing QSST, the beneficiary and not the 
estate is treated as the shareholder as of the effective date of the 
QSST election, and the rules provided in paragraph (j)(7) of this 
section apply. If the trust qualifies and becomes an ESBT, the 
shareholders are determined under provisions of REG-251701-96 in 2001-4 
I.R.B. 396 (see Sec. 601.601(d)(2) of this chapter) as of the effective 
date of the ESBT election.
* * * * *
    (ii)* * *
    (A)* * * If the trust continues to own the stock after the 
expiration of the 2-year period, the corporation's S election will 
terminate unless the trust is otherwise a permitted shareholder.* * *
    (B) If stock is transferred to a testamentary trust described in 
paragraph (h)(1)(iv) of this section (other than a qualified subpart E 
trust, an electing QSST, or an ESBT), the trust is treated as the 
shareholder. If the trust continues to own the stock after the 
expiration of the 2-year period, the corporation's S election will 
terminate unless the trust otherwise qualifies as a permitted 
shareholder. If the trust qualifies as a QSST described in section 
1361(d) and the income beneficiary of the trust makes a timely QSST 
election, the beneficiary and not the trust is treated as the 
shareholder from the effective date of the QSST election.
* * * * *
    (j) * * *
    (6) * * *
    (iii) * * *
    (C) If a trust ceases to be a qualified subpart E trust but also 
satisfies the requirements of a QSST, the QSST election must be filed 
within the 16-day-and-2-month period beginning on the date on which the 
trust ceases to be a qualified subpart E trust. If the estate of the 
deemed owner of the trust is treated as the shareholder under paragraph 
(h)(3)(i) of this section, the QSST election may be filed at any time, 
but no later than the end of the 16-day-and-2-month period beginning on 
the date on which the estate of the deemed owner ceases to be treated 
as a shareholder.
    (D) If a testamentary trust is a permitted shareholder under 
paragraph (h)(1)(iv) of this section and also satisfies the 
requirements of a QSST, the QSST election may be filed at any time, but 
no later than the end of the 16-day-and-2-month period beginning on the 
date after the end of the 2-year period.
* * * * *
    (7) * * *
    (ii) If, upon the death of an income beneficiary, the trust 
continues in existence, continues to hold S corporation stock but no 
longer satisfies the QSST requirements, and is not a qualified subpart 
E trust, then, solely for purposes of section 1361(b)(1), as of the 
date of the income beneficiary's death, the estate of that income 
beneficiary is treated as the shareholder of the S corporation with 
respect to which the income beneficiary made the QSST election. The 
estate ordinarily will cease to be treated as the shareholder for 
purposes of section 1361(b)(1) upon the earlier of the transfer of that 
stock by the trust or the expiration of the 2-year period beginning on 
the day of the income beneficiary's death. During the period that the 
estate is treated as the shareholder for purposes of section 
1361(b)(1), the trust is treated as the shareholder for purposes of 
sections 1366, 1367, and 1368. If, after the 2-year period, the trust 
continues to hold S corporation stock, the corporation's S election 
terminates. If the termination is inadvertent, the corporation may 
request relief under section 1362(f).
* * * * *
    (k)(1) * * *

    Example 2. * * *
    (ii) * * * A's estate will cease to be treated as the 
shareholder for purposes of section 1361(b)(1) upon the earlier of 
the transfer of the Corporation M stock by the trust (other than to 
A's estate), the expiration of the 2-year period beginning on the 
day of A's death, or the effective date of a QSST election if the 
trust qualifies as a QSST.* * *
* * * * *
    Example 3. 2-year rule under section 1361(c)(2)(A)(ii) and 
(iii). F owns stock of Corporation P, an S corporation. In addition, 
F is the deemed owner of a qualified subpart E trust that holds 
stock in Corporation O, an S corporation. F dies on July 1, 2001. 
The trust continues in existence after F's death but is no longer a 
qualified subpart E trust. On August 1, 2001, F's shares of stock in 
Corporation P are transferred to the trust pursuant to the terms of 
F's will. Because the stock of Corporation P was not held by the 
trust when F died, section 1361(c)(2)(A)(ii) does not apply with 
respect to that stock. Under section 1361(c)(2)(A)(iii), the last 
day on which F's estate could be treated as a permitted shareholder 
of Corporation P is July 31, 2003, (that is, the last day of the 2-
year period that begins on the date of the transfer from the estate 
to the trust). With respect to the shares of stock in Corporation O 
held by the trust at the time of F's death, section 
1361(c)(2)(A)(ii) applies and the last day on which F's estate could 
be treated as a permitted shareholder of Corporation O is June 30, 
2003, (that is, the last day of the 2-year period that begins on the 
date of F's death).
    Example 4. * * *
    (iii) QSST when a person other than the current income 
beneficiary may receive trust corpus. Assume the same facts as in 
paragraph (i) of this Example 4, except that H dies on November 1, 
2001. Under the terms of the trust, after H's death, L is the income 
beneficiary of the trust and the trustee is authorized to distribute 
trust corpus to L as well as to J. The trust ceases to be a QSST as 
of November 1, 2001, because corpus distributions may be made to 
someone other than L, the current (successive) income beneficiary. 
Under section 1361(c)(2)(B)(ii), H's estate (and not the trust) is 
considered to be the shareholder for purposes of section 1361(b)(1) 
for the 2-year period beginning on November 1, 2001. However, 
because the trust continues in existence after H's death and will 
receive any distributions from the corporation, the trust (and not 
H's estate) is treated as the shareholder for purposes of sections 
1366, 1367, and 1368, during that 2-year period. After the 2-year 
period, the S election terminates and the trust continues as a 
shareholder of a C corporation. If the termination is inadvertent, 
Corporation Q may request relief under section 1362(f). However, the 
S election would not terminate if the trustee distributed all 
Corporation Q shares to L, J, or both before October 31, 2003, (the 
last day of the 2-year period) assuming that neither L nor J becomes 
the

[[Page 44568]]

76th shareholder of Corporation Q as a result of the distribution.

* * * * *
    (2) * * * (i) * * * In addition, paragraphs (h)(1)(ii), (h)(1)(iv), 
(h)(3)(i)(B), (h)(3)(i)(D), (h)(3)(ii)(A) second sentence, 
(h)(3)(ii)(B), (j)(6)(iii)(C), (j)(6)(iii)(D), (j)(7)(ii), and (k)(1) 
Example 2(ii) fourth sentence, Example 3, and Example 4(iii) of this 
section apply on and after the date that final regulations are 
published in the Federal Register.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-21353 Filed 8-23-01; 8:45 am]
BILLING CODE 4830-01-P