[Federal Register Volume 67, Number 93 (Tuesday, May 14, 2002)]
[Rules and Regulations]
[Pages 34388-34401]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-11791]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8994]
RIN 1545-AU76


Electing Small Business Trust

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final regulations relating to the 
qualification and treatment of electing small business trusts (ESBTs). 
The final regulations interpret the rules added to the Internal Revenue 
Code (Code) by section 1302 of the Small Business Job Protection Act of 
1996, section 1601 of the Taxpayer Relief Act of 1997, and section 316 
of the Community Renewal Tax Relief Act of 2000. In addition, the final 
regulations provide that an ESBT, or a trust described in section 
401(a) of the Code or section 501(c)(3) of the Code and exempt from 
taxation under section 501(a) of the Code, is not treated as a deferral 
entity for purposes of Sec. 1.444-2T. The final regulations affect S 
corporations and certain trusts that own S corporation stock.

DATES: Effective Date: These regulations are effective May 14, 2002.
    Dates of Applicability: The regulations regarding ESBTs under 
Sec. 1.641(c)-1(d) through (k), (l) Examples 2-5, Sec. 1.1361-
1(h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii), (j)(12), and (m), Sec. 1.1362-
6(b)(2)(iv), Sec. 1.1377-1(a)(2)(iii) and (c) Example 3 apply for 
taxable years beginning on and after May 14, 2002. The regulations 
regarding taxation of ESBTs under Sec. 1.641(c)-1(a), (b), (c), and (l) 
Example 1 are applicable for taxable years of ESBTs that end on and 
after December 29, 2000. The regulations under Sec. 1.444-4 are 
applicable to taxable years beginning on or after December 29, 2000.

FOR FURTHER INFORMATION CONTACT: Concerning the final regulations, 
Bradford Poston or James A. Quinn, (202) 622-3060; specifically 
concerning Sec. 1.444-4, Michael F. Schmit, (202) 622-4960 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information in these final regulations have been 
reviewed and, pending receipt and evaluation of public comments, 
approved by the Office of Management and Budget in accordance with the 
Paperwork Reduction Act (44 U.S.C. 3507) and assigned control number 
1545-1591.
    The collections of information in these final regulations are in 
Sec. 1.1361-1(j)(12), Sec. 1.1361-1(m), and Sec. 1.444-4(c). The 
information required by Sec. 1.1361-1(j)(12) and Sec. 1.1361-1(m) is 
needed to allow trusts to elect to be ESBTs and to allow for the 
conversion of a qualified subchapter S trust (QSST) to an ESBT and the 
conversion of an ESBT to a QSST. The likely respondents are trusts.
    The information required by Sec. 1.444-4(c) is needed to allow 
certain S corporations to reinstate their previous taxable year that 
was terminated under Sec. 1.444-2T. The likely respondents are 
businesses and other for-profit institutions.
    Comments on the collections of information should be sent to the 
Office of Management and Budget, Attn.: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503 with copies to the Internal Revenue Service, 
Attn.: IRS Reports Clearance Officer, W:CAR:MP:FP:S, Washington, DC 
20224. Comments on the collection of information should be received by 
July 15, 2002. Comments are specifically requested concerning:
    Whether the collections of information are necessary for the proper 
performance of the functions of the Internal Revenue Service, including

[[Page 34389]]

whether the information will have practical utility;
    The accuracy of the estimated burden associated with the 
collections of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the collections of information may 
be minimized, including through the application of automated collection 
techniques or other forms of information technology; and
    Estimates of capital or start-up costs of operation, maintenance, 
and purchase of service to provide information.
    The burden contained in Sec. 1.444-4 is reflected in the burden of 
Form 8716.
    Estimated total annual reporting burden: 7,500 hours.
    Estimated annual burden per respondent: 1 hour.
    Estimated number of respondents: 7,500.
    Estimated annual frequency of responses: On occasion.
    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

    On December 29, 2000, proposed regulations (REG-251701-96) were 
published in the Federal Register (65 FR 82963) containing 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), and the Community Renewal Tax Relief Act of 2000, 
Public Law 106-554 (114 Stat. 2763) (December 21, 2000). 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).
    On December 29, 2000, proposed and temporary regulations were also 
published in the Federal Register (65 FR 82963) and (65 FR 82926) 
containing amendments to the Income Tax Regulations (26 CFR part 1) 
relating to the election of a taxable year other than the required 
taxable year.
    A public hearing was held on the proposed and temporary regulations 
on April 25, 2001. Written comments were received on the proposed and 
temporary regulations. The proposed regulations, with certain changes 
in response to the comments, are adopted as final regulations, and the 
temporary regulations are removed.

Summary of Comments and Explanation of Revisions

Beneficiaries and Potential Current Beneficiaries

    For a trust to qualify as an electing small business trust (ESBT) 
and as a shareholder in a subchapter S corporation, only certain types 
of persons are permitted to be beneficiaries of the trust. Once a trust 
makes the ESBT election, each potential current beneficiary (PCB) of 
the trust is treated as a shareholder of the S corporation. Thus, the 
identity of the beneficiaries affects whether a trust can be an ESBT, 
while the identity and number of PCBs affect whether the corporation 
can be a S corporation. It is possible under certain circumstances for 
a person to be a PCB, as that term is defined in section 1361(e)(2) and 
the proposed regulations, without being a beneficiary, as that term is 
defined in the proposed regulations. For example, a person who may 
receive a distribution from an ESBT under a currently exercisable power 
of appointment is a PCB but is not treated as a beneficiary until the 
power is actually exercised.
    Some commentators expressed concerns about the possible adverse 
effects of the definition of PCBs, especially in situations involving 
potential recipients of a currently exercisable power of appointment. 
Some commentators suggested that a person should have to meet the 
definition of a beneficiary before the person could be considered a 
PCB. Commentators also suggested that a person who may receive a 
distribution under a currently exercisable power of appointment should 
not be treated as a PCB until exercise of the power. Several 
commentators suggested that a temporary waiver or release of a broad 
power of appointment should be sufficient to limit the number of PCBs 
during a period of time.
    The final regulations do not change the basic definition of PCBs. 
While there is no statutory definition of beneficiary in section 
1361(e), there is a statutory definition of PCB. Under section 
1361(e)(2), a PCB is, ``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.'' The IRS and the Treasury Department believe that it would 
be inconsistent with this statutory definition not to treat a person as 
a PCB until an actual distribution is made to that person pursuant to 
the exercise of a power of appointment. The final regulations provide 
that an attempt to temporarily waive, release, or limit a power of 
appointment would not be effective to limit the PCBs because of 
uncertainty as to the effectiveness of a temporary waiver, release, or 
limitation on the power of appointment under state law and the 
potential to manipulate a temporary waiver, release, or limitation on a 
power of appointment to avoid the S corporation shareholder limitation 
rules. However, a permanent release of a power of appointment that is 
effective under local law may reduce the number of PCBs of an ESBT.
    Another commentator suggested that the separate share provisions of 
section 663(c) should apply so that beneficiaries or PCBs of the share 
holding the assets other than the S corporation stock would not be 
counted as beneficiaries or PCBs of the S portion. There is no 
authority to ignore beneficiaries and PCBs of a portion of a trust 
holding assets other than S corporation stock. The statutory 
definitions of an ESBT and of a PCB look to all the persons who are 
beneficiaries or PCBs of the trust, not just the S portion. In 
addition, the separate share provisions of section 663(c) are not 
applicable because they generally apply only for purposes of allocating 
distributable net income under sections 661 and 662.
    Two commentators requested guidance on what period of time is 
considered in determining who are PCBs in light of the statutory 
definition. They suggested that period means any moment in time. Thus, 
if an event occurs during a taxable year that changes who the PCBs are, 
the PCBs before and after the event would not be counted cumulatively 
for purposes of the 75-shareholder limit. The shareholder limitation in 
section 1361(b)(1)(A) means that an S corporation may not have more 
than 75 shareholders at any particular time

[[Page 34390]]

during the taxable year. See Rev. Rul. 78-390 (1978-2 C.B. 220). The 
final regulations clarify that a person is treated as a shareholder of 
the S corporation at any moment in time when that person is entitled 
to, or in the discretion of any person may, receive a distribution of 
principal or income of the trust. The final regulations also provide 
that a person who, after the exercise of a power of appointment, 
receives only a future interest in the trust is not a PCB.
    One commentator was concerned about the statement in the proposed 
regulations that if a person holds a general lifetime power of 
appointment, the corporation will exceed the 75-shareholder limit and 
thus the corporation's S election will terminate. The commentator 
pointed out that a beneficiary's power to withdraw assets from a trust 
is considered a general power of appointment but the beneficiary is the 
only one who can receive those assets. The final regulations clarify 
that the potential recipients of current distributions pursuant to an 
exercise of the power are considered, not whether the power is a 
general or special power of appointment.
    The proposed regulations provide that a person with a future 
beneficial interest is not a beneficiary of an ESBT if that interest is 
so remote as to be negligible. This provision permitted trusts to 
qualify as ESBTs even though there was a remote possibility that all 
the named beneficiaries would die and the trust assets would escheat to 
the state, an impermissible beneficiary of an ESBT. The Community 
Renewal Tax Relief Act of 2000 eliminated this potential problem by 
changing the statutory definition of permissible beneficiaries to 
include an organization described in section 170(c)(1) that holds a 
contingent interest in the trust and is not a PCB. The final 
regulations, therefore, remove the provision regarding remote 
beneficiaries and the accompanying example.

Interests in Trust Acquired by Purchase

    Two commentators requested clarification on whether a trust is 
eligible to be an ESBT if it acquires property in a part-gift, part-
sale transaction, such as a gift of encumbered property or a net gift, 
in which the donor transfers property to a trust provided the trust 
pays the resulting gift tax. Section 1361(e)(1)(A)(ii) provides that a 
trust is eligible to be an ESBT only if ``no interest in the trust was 
acquired by purchase.'' Section 1361(e)(1)(C) defines purchase as ``any 
acquisition if the basis of the property acquired is determined under 
section 1012.'' The proposed regulations provide that if any portion of 
a beneficiary's basis in the beneficiary's interest is determined under 
section 1012, the beneficiary's interest was acquired by purchase. The 
final regulations clarify that the prohibition on purchases applies to 
purchases of a beneficiary's interest in the trust, not to purchases of 
property by the trust. A net gift of a beneficial interest in a trust, 
where the donee pays the gift tax, would be treated as a purchase of a 
beneficial interest under these rules, while a net gift to the trust 
itself, where the trustee of the trust pays the gift tax, would not.

Grantor Trusts

    Most commentators praised the position in the proposed regulations 
that a trust, all or a portion of which is treated as owned by an 
individual (deemed owner) under subpart E, part I, subchapter J, 
chapter 1 of the Code (grantor trust), may elect to be an ESBT. One 
commentator, however, suggested that grantor trusts should not be 
permitted to make ESBT elections. The final regulations continue to 
provide that a grantor trust may elect to be an ESBT.
    The proposed regulations provide that if a grantor trust makes an 
ESBT election, the trust consists of a grantor portion, an S portion, 
and a non-S portion. The items of income, deduction, and credit 
attributable to the grantor portion are taxed to the deemed owner of 
that portion. The S portion is taxed 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.
    Commentators made several suggestions regarding the taxation of a 
grantor trust that elects to be an ESBT. Some suggested that the 
taxation rules of section 641(c) should override the grantor trust 
rules of section 671, and thus all tax items attributable to the 
trust's shares in the S corporation should be taxed to the trust, not 
the deemed owner. Some suggested the grantor trust rules should not 
apply to any tax items of a trust that makes an ESBT election. 
According to these commentators, this approach would eliminate 
administrative complexity in determining what portion of the trust is 
treated as owned by the deemed owner. Others suggested that the trustee 
should be permitted to elect to have all items attributable to the S 
corporation taxed to the trust, not to the deemed owner. Others 
suggested that none of the S items should be taxed to the deemed owner 
but that ESBTs should be subject to additional reporting requirements 
to ensure the collection of the proper tax. Another suggested that the 
deemed owner should be taxed on the items from an ESBT only if the 
deemed owner is treated as owning the entire trust, not just a portion 
of the trust. Other commentators agreed with the taxation regime set 
forth in the proposed regulations.
    The IRS and the Treasury Department believe that the qualification 
and taxation of ESBTs are two separate issues and that the proposed 
regulations take the correct position regarding the taxation of grantor 
trusts that make ESBT elections. Section 1361(e)(1) expands the 
permissible shareholders of an S corporation to include trusts that 
meet the definition of an ESBT. Grantor trusts are not excluded from 
the definition of an ESBT and, therefore, are permitted to make ESBT 
elections. Making an ESBT election, however, does not alter the long 
established treatment of tax items attributable to the portion of a 
trust treated as owned by the grantor or another. Section 671 requires 
that items of income, deduction, and credit attributable to the portion 
of the trust treated as owned by a grantor or another must be taken 
into account by that deemed owner. Only remaining items of the trust 
are subject to the provisions of subparts A through D of subchapter J. 
The special taxation rules for ESBTs are contained in subpart A and, 
therefore, only apply to any portion of the trust that is not treated 
as owned by the grantor or another under subpart E.
    As pointed out by one of the commentators, the issue of determining 
what portion, if any, of a trust is treated as owned by the grantor or 
another has existed for years in a much broader context than in the 
application of the ESBT rules. The special taxation rules of section 
641(c) would apply only to S items, while normal trust taxation rules 
clearly apply to non-S items. As a result, taxing all the S items to 
the trust would not eliminate the need to determine what portion of the 
trust is a grantor trust and the resulting administrative difficulties 
with respect to the non-S tax items of the trust.
    Some commentators requested clarification of the effect of an ESBT 
election by a grantor trust. One commentator suggested that if a 
wholly-owned grantor trust makes an ESBT election, only the deemed 
owner should be treated as the shareholder of the S corporation. 
Another commentator made a similar suggestion where the grantor has 
retained the power to amend or revoke the trust or to make gifts from

[[Page 34391]]

the trust. The IRS and the Treasury Department believe that the 
definitional and qualification requirements of section 1361(e) apply to 
any trust that makes an ESBT election irrespective of whether it is a 
grantor trust. Therefore, the final regulations continue to provide 
that the deemed owner is treated as a PCB along with others who meet 
the definition of a PCB.

Charitable Contributions

    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 and will be deductible if the other requirements of section 
642(c)(1) are met. Several commentators requested clarification 
concerning the other requirements of section 642(c)(1), the application 
of the limitations under section 681, and the election to treat 
charitable payments made after the close of a taxable year as made 
during the taxable year. One commentator suggested that the S portion 
should be entitled to a deduction for its share of any charitable 
contribution made by the S corporation because it is a separately 
stated item under section 1366 that the S portion takes into account 
under section 641(c)(2)(C)(i).
    Section 641(c)(2)(C) specifies the items of income, loss, 
deduction, or credit that the S portion is required to take into 
account in determining its tax. These items include items required to 
be taken into account under section 1366, that is, the trust's pro rata 
share of the S corporation's items passed through to it as a 
shareholder. Both section 641(c)(2)(C) and section 1366(a) reference 
items that must be taken into account but do not themselves provide the 
authority to include in income, deduct from income, or claim a credit 
with respect to those items. That authority comes from other Code 
sections. A charitable contribution made by an S corporation is 
required to be a separately stated item under section 1366 because 
whether the item is deductible depends on the identity of the 
shareholder and the provisions of the Code applicable to charitable 
contributions made by that type of shareholder. Thus, for an individual 
shareholder, the contribution is deductible only in accordance with the 
provisions of section 170, while for a trust or estate, the 
contribution is deductible only in accordance with the provisions of 
section 642(c).
    The final regulations continue to provide that the S portion's 
share of a charitable contribution made by the S corporation is 
deductible only if it meets the requirements of section 642(c)(1). The 
final regulations clarify how those requirements apply to such a 
contribution. If a contribution is paid from the S corporation's gross 
income, the contribution will be deemed to be paid by the S portion 
pursuant to the terms of the trust's governing instrument. The 
limitations of section 681, regarding unrelated business income, apply 
to determine whether the contribution is deductible by the S portion. 
The final regulations also clarify that the charitable contribution is 
deductible by the S portion, if at all, only in the year that it is an 
item required to be taken into account by the trust under section 1366. 
The trustee may not make the election to treat a contribution made by 
the S corporation after the close of the taxable year as made during 
the taxable year. This election is available only for charitable 
payments actually made by the trust, not for the trust's share of 
contributions made by another entity.
    One commentator suggested that if the trust contributes S 
corporation stock to a charitable organization, the S portion should be 
entitled to a charitable deduction with respect to the contribution. 
Deductions available to the S portion are limited by section 
641(c)(2)(C) to S corporation items required to be taken into account 
under section 1366 and the S portion's share of state and local income 
taxes and administrative expenses. Charitable contributions by the 
trust are not items included in the list of items that may be taken 
into account by the S portion under section 641(c)(2)(C).
    Therefore, the final regulations do not change the rule that no 
deduction is available to either the S portion or the non-S portion 
with respect to a contribution of S corporation stock to charity.

Interest Paid on Loans To Acquire S Corporation Stock

    The proposed regulations provide that interest expense incurred by 
the trust to purchase S corporation stock is allocated to the S portion 
but is not an administrative expense. Therefore, the interest is not an 
allowable deduction of the S portion under section 641(c)(2)(C)(iii). 
Several commentators suggested that the interest should be deductible. 
Some thought the interest should be allocated to the non-S portion and 
deducted under the investment interest limitations of section 163(d). 
Others thought the interest should be allocated to the S portion but 
should be considered a deductible administrative expense. One 
commentator suggested that if the shareholders are required to buy the 
stock of a departing shareholder pursuant to the terms of a stock 
purchase agreement, any interest expense incurred as a result of 
financing the stock purchase with a loan should be deductible when paid 
by an ESBT. Another commentator suggested that if interest paid on a 
loan to acquire S corporation stock is not deductible, it should be 
added to the basis of the acquired stock.
    Because the purchase of S corporation stock increases the S 
portion, rather than the non-S portion, of the trust, interest expenses 
incurred in the purchase should be allocated to the S portion. These 
interest expenses would be deductible by the S portion only if they are 
``administrative expenses'' under section 641(c)(2)(C)(iii). The IRS 
and the Treasury Department believe that, for purposes of section 
641(c)(2)(C)(iii), ``administrative expenses'' include the traditional 
expenses necessary for the management and preservation of trust assets, 
but do not include expenses incurred to acquire additional assets. The 
final regulations, therefore, continue to provide that, in all cases, 
interest incurred to purchase S corporation stock is a nondeductible 
expense allocable to the S portion. Because there is no authority to 
permit nondeductible interest expenses to increase the basis of assets, 
the final regulations do not adopt this suggestion.

Tax Credit Carryovers

    Section 641(c)(4) and the proposed regulations provide that if a 
trust is no longer an ESBT, any loss carryover or excess deductions of 
the S portion that are referred to in section 642(h) are taken into 
account by the entire trust or by the beneficiaries if the entire trust 
terminates. One commentator suggested that any tax credit carryovers of 
the S portion should receive similar treatment. Section 641(c)(4) 
permits the entire trust to take into account only those items 
specified in section 642(h), which does not include tax credit 
carryovers. The S portion's tax credit carryovers and any other items 
not listed in section 642(h) are forfeited once the trust is no longer 
an ESBT, just as they are upon the termination of a trust or estate. 
The final regulations, therefore, do not adopt the commentator's 
suggestion.

Distributions From the ESBT

    One commentator suggested that the tax treatment of distributions 
to

[[Page 34392]]

beneficiaries in the proposed regulations is inconsistent with section 
641(c)(1)(A), which provides that the portion of an ESBT consisting of 
the S corporation stock is treated as a separate trust. The proposed 
regulations provide that distributions to beneficiaries from the S 
portion or the non-S portion, including distributions of the S 
corporation stock, are, to the extent of the distributable net income 
of the non-S portion, deductible under section 651 or 661 in 
determining the taxable income of the non-S portion, and are includible 
in the gross income of the beneficiaries under section 652 or 662. The 
commentator recommended that, because the S portion and the non-S 
portion are treated as separate trusts, the source of the distribution 
should determine its tax treatment.
    The final regulations do not adopt the commentator's suggestion 
because section 641(c)(3) provides that section 641(c) does not affect 
the taxation of any distribution from the trust except for the 
exclusion of the S portion items from the distributable net income of 
the entire trust. Thus, the rules otherwise applicable to trust 
distributions apply to ESBTs.

ESBT Election

    The proposed regulations provide that the ESBT election is filed 
with the service center where the trust files its income tax returns. 
The election to be a qualified subchapter S trust (QSST) is filed with 
the service center where the S corporation files its income tax 
returns. The preamble to the proposed regulations requested comments on 
whether the rules for filing the QSST election should be changed so the 
election is filed with the service center where the trust files its 
returns. One commentator suggested there should be consistent filing 
locations for QSST elections, ESBT elections, and conversions from QSST 
to ESBT or ESBT to QSST. The commentator, therefore, suggested that all 
these documents be filed with the service center(s) where the trust and 
the S corporation file their returns.
    The final regulations provide that the ESBT election and the 
election to convert from an ESBT to a QSST or from a QSST to an ESBT 
are all filed with the service center where the S corporation files its 
income tax returns. Thus, the rule in the final regulations will 
establish a consistent filing location for QSST and ESBT elections and 
conversions.
    One commentator suggested that grantor trusts should be permitted 
to make protective ESBT elections in light of the uncertain status of 
some trusts that may be grantor trusts under section 674. The IRS and 
the Treasury Department continue to believe that a conditional ESBT 
election that only becomes effective in the event the trust is not a 
wholly-owned grantor trust should not be available. A conditional ESBT 
election should not be allowed because the ESBT election must have a 
fixed effective date. If, in the absence of a conditional ESBT 
election, the trust is an ineligible shareholder, relief under section 
1362(f) may be available for an S corporation. In addition, a trust 
that qualifies as an ESBT may make an ESBT election notwithstanding 
that the trust is a wholly-owned grantor trust.

Expedited Section 1362(f) Relief

    In several contexts, commentators requested some form of expedited 
relief if an S corporation's election is inadvertently ineffective or 
is inadvertently terminated. In all these situations, the S corporation 
may seek relief under section 1362(f). The facts and circumstances of a 
particular situation are considered in determining whether relief is 
available, and the procedures for obtaining this relief are well 
established.

Effect Under Section 1377 of Change in Status of a Trust

    A commentator suggested that a trust's conversion to an ESBT should 
result in a complete termination of the trust's interest in the S 
corporation for purposes of section 1377(a)(2) because the incidence of 
taxation with respect to S corporation items will change as a result of 
the ESBT election. The proposed regulations provide that the election 
would result in a termination only if, prior to the election, the trust 
was described in section 1361(c)(2)(A)(ii) or (iii). The commentator 
also recommended that the regulations address the conversion from an 
ESBT to another type of trust and the availability of an election under 
Sec. 1.1368-1(g) to treat the S corporation's taxable year as two 
separate years in the case of a qualifying disposition.
    The final regulations do not adopt the suggestion that all 
conversions of a trust to an ESBT should be treated as a complete 
termination of the trust's interest in the S corporation for purposes 
of section 1377(a)(2). The final regulations expand on the rule in the 
proposed regulations to cover all types of conversions. Under this 
rule, conversion of a trust to an ESBT or a QSST does not result in the 
prior trust terminating its entire interest in the S corporation, 
unless the prior trust was described in section 1361(c)(2)(A)(ii) or 
(iii). When a trust described in section 1361(c)(2)(A)(ii) or (iii) 
converts to an ESBT or a QSST, the shareholders of the S corporation 
under section 1361(c)(2)(B) change from the estate of the deemed owner 
or testator to the PCBs of the ESBT, or the current income beneficiary 
of the QSST. When a trust changes from a wholly-owned grantor trust or 
QSST to an ESBT or from an ESBT to a QSST, the individuals who are 
shareholders of the S corporation under section 1361(c)(2)(B) remain 
the same. The election to terminate the taxable year provided in 
section 1377(a)(2) applies to the termination of a shareholder's 
interest in the S corporation.
    Accordingly, it is appropriate to treat the conversion of a trust 
described in section 1361(c)(2)(A)(ii) or (iii) to an ESBT or QSST as a 
termination of the prior trust's interest in the S corporation, but not 
to treat other conversions to an ESBT or QSST as terminations. The 
election under Sec. 1.1368-1(g) is also not available because the 
conversion of the trust is not a qualifying disposition.

Section 444 Elections

    One commentator suggested that the final regulations permit an S 
corporation to retroactively reinstate a section 444 election that it 
had treated as terminated by operation of Sec. 1.444-2T(a) (prior to 
the issuance of the temporary regulations) as a result of an ESBT or 
certain tax-exempt trusts becoming a shareholder of the corporation 
under the auspices of the 1996 Act. The commentator believes that 
failure to provide such relief would result in inequitable treatment of 
such S corporations because, under the rules of section 444, once their 
elections are terminated, they are precluded from again making a 
section 444 election.
    The IRS and the Treasury Department believe that it is appropriate 
to allow S corporations under these circumstances to request that the 
IRS disregard the termination and permit the S corporation to continue 
to use the same fiscal year that it used previously under section 444. 
However, for reasons of administrative convenience, and in order to 
reduce the burden on taxpayers of having to file amended returns and 
make retroactive payments under section 7519, the prior termination 
will be disregarded only at the S corporation's request, and on a 
prospective basis.
    The final regulations provide a procedure for such requests. To 
illustrate the procedure, assume that, prior to 1997, an S corporation 
had made a section 444 election to use a taxable year ending on 
September 30th.

[[Page 34393]]

On January 1, 1997, an ESBT acquired a shareholder interest in the S 
corporation. The S corporation treated its 444 election as terminated 
under Sec. 1.444-2T(a) as a result of the ESBT's shareholder interest. 
The S corporation changed to its required taxable year for the short 
period beginning October 1, 1996, and ending December 31, 1996, and 
filed Form 1120S, ``U.S. Income Tax Return for an S Corporation,'' on 
the basis of a calendar year for all subsequent taxable years.
    Under the final regulations, the S corporation may request that the 
IRS disregard the prior termination by filing Form 8716, ``Election to 
Have a Tax Year Other Than a Required Tax Year,'' with the appropriate 
Service Center by October 15, 2002, and by designating on the form 
``CONTINUATION OF SECTION 444 ELECTION UNDER Sec. 1.444-4.'' The Form 
8716 must indicate that under the S corporation's prior section 444 
election, it used a taxable year ending September 30th. The request 
will be effective for the taxable year beginning January 1, 2002. No 
amended returns, no retroactive payments under section 7519, and no 
returns under Sec. 1.7519-2T(a) for previous years in which the S 
corporation used its required year are required as a result of the 
request. Moreover, the S corporation need not make a required payment 
under section 7519 for its taxable year ending September 30, 2002; its 
first required payment for the taxable year beginning October 1, 2002, 
is due on May 15, 2003. The S corporation will be required to file a 
return under Sec. 1.7519-2T for each taxable year beginning on or after 
January 1, 2002.

Effective Dates

    The portion of the regulations involving the taxation of the 
grantor, S, and non-S portions of an ESBT was proposed to be applicable 
for taxable years of ESBTs that end on or after December 29, 2000, the 
date that the proposed regulations were published in the Federal 
Register. The remainder of the regulations involving ESBTs was proposed 
to be applicable on or after the date that final regulations are 
published in the Federal Register. Several commentators expressed 
concerns about the proposed applicability with regard to the taxation 
of the grantor portion of an ESBT. One commentator suggested that the 
proposed effective date discriminated against trusts with a situs in 
Guam. Others suggested that the rules regarding taxation of the grantor 
portion should not be applicable before the date the final regulations 
are published. One commentator suggested that these rules should only 
apply either to trusts created after the final regulations are 
published or after a substantial transition period.
    The IRS and the Treasury Department believe that the applicable 
date for the rules concerning the taxation of an ESBT with a grantor 
portion is reasonable and appropriate. These rules do not discriminate 
against trusts with a particular situs because they apply to all trusts 
wherever situated. In the case of a grantor trust that made an ESBT 
election, the tax treatment of the grantor portion set forth in the 
proposed regulations may be different from the tax treatment that the 
trust and the grantor had thought was available. The proposed 
regulations, however, were published before the end of the 2000 taxable 
year and before income from that taxable year was required to be 
included on any person's income tax return. Thus, prior to the filing 
of income tax returns for 2000, it was known that the income from the 
grantor portion of the trust was to be taken into account by the deemed 
owner, not by the trust. In some situations, the trust, rather than the 
deemed owner, may have made estimated tax payments. Recognizing that 
the payment of estimated tax by the trust might subject the deemed 
owner to a penalty for underpayment of estimated taxes, the IRS and the 
Treasury Department provided relief by issuing Notice 2001-25 (2001-13 
I.R.B. 941). That Notice provides procedures for a trust to elect to 
have its estimated tax payments credited to the account of the deemed 
owner and provides that, for purposes of calculating any underpayment 
of estimated tax, income attributable to the S corporation was to be 
taken into account on the last day of the deemed owner's 2000 taxable 
year.
    Some commentators were concerned that existing ESBTs with currently 
exercisable, broad powers of appointments have resulted in S 
corporations exceeding the shareholder limit and have caused the 
termination of the S corporations' elections. The regulations regarding 
the definition of PCBs are applicable only for taxable years of ESBTs 
that begin on or after May 14, 2002. Therefore, persons who may receive 
a distribution from an ESBT pursuant to a currently exercisable power 
of appointment will not be considered PCBs of the ESBT until the first 
day of the ESBT's first taxable year that begins on or after May 14, 
2002, and the S corporation's election will not terminate before that 
date. In addition, under section 1361(e)(2) if the trust disposes of 
all its stock in the S corporation within 60 days after that date, the 
persons, who would first meet the definition of PCBs on that date, will 
not be PCBs and the S corporation's status will not be affected.
    One commentator was concerned by the applicability date of the 
regulations involving the deductibility of state and local income taxes 
and administrative expenses. Section 641(c)(2)(C)(iii) provides that 
the S portion may take into account its allocable share of state and 
local income taxes and administrative expenses, but only to the extent 
provided in the regulations. The commentator noted that before final 
regulations are issued there is no authority for an ESBT to deduct any 
of these items. Therefore, the commentator requested that trusts be 
allowed to rely on the regulatory provisions regarding these items for 
taxable years beginning after December 31, 1996. The effective date 
provisions have been modified based on this suggestion.

Additional Provisions

    The final regulations clarify that the basis of S corporation stock 
in the S portion must be adjusted in accordance with section 1367 and 
the regulations thereunder. If the ESBT owns stock in more than one S 
corporation, the adjustments to the basis in the S corporation stock of 
each S corporation must be determined separately.

Effect on Other Documents

    The following documents are superseded for taxable years of ESBTs 
beginning on and after May 14, 2002.

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 Analysis

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collections 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 (1) the 
estimated average burden per trust in complying with the collections of 
information in Sec. 1.1361-1(m) is 1 hour, and (2) the requirement for 
S corporations to comply with Sec. 1.444-4(c) will affect very few 
taxpayers and the associated burden is minimal. Therefore, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C.

[[Page 34394]]

chapter 6) is not required. Pursuant to section 7805(f) of the Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on the regulations' impact on small 
business.

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 
the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART I--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.

    (a) Electing small business trusts. For purposes of Sec. 1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is treated as an electing small 
business trust under section 1361(e). An S corporation with an electing 
small business trust as a shareholder may make an election under 
section 444. This paragraph is applicable to taxable years beginning on 
and after December 29, 2000; however, taxpayers may voluntarily apply 
it to taxable years of S corporations beginning after December 31, 
1996.
    (b) Certain tax-exempt trusts. For purposes of Sec. 1.444-2T, 
solely with respect to an S corporation shareholder, the term deferral 
entity does not include a trust that is described in section 401(a) or 
501(c)(3), and is exempt from taxation under section 501(a). An S 
corporation with a trust as a shareholder that is described in section 
401(a) or section 501(c)(3), and is exempt from taxation under section 
501(a) may make an election under section 444. This paragraph is 
applicable to taxable years beginning on and after December 29, 2000; 
however taxpayers may voluntarily apply it to taxable years of S 
corporations beginning after December 31, 1997.
    (c) Certain terminations disregarded--(1) In general. An S 
corporation that is described in this paragraph (c)(1) may request that 
a termination of its election under section 444 be disregarded, and 
that the S corporation be permitted to resume use of the year it 
previously elected under section 444, by following the procedures of 
paragraph (c)(2) of this section. An S corporation is described in this 
paragraph if the S corporation is otherwise qualified to make a section 
444 election, and its previous election was terminated under 
Sec. 1.444-2T(a) solely because--
    (i) In the case of a taxable year beginning after December 31, 
1996, a trust that is treated as an electing small business trust 
became a shareholder of such S corporation; or
    (ii) In the case of a taxable year beginning after December 31, 
1997, a trust that is described in section 401(a) or 501(c)(3), and is 
exempt from taxation under section 501(a) became a shareholder of such 
S corporation.
    (2) Procedure--(i) In general. An S corporation described in 
paragraph (c)(1) of this section that wishes to make the request 
described in paragraph (c)(1) of this section must do so by filing Form 
8716, ``Election To Have a Tax Year Other Than a Required Tax Year,'' 
and typing or printing legibly at the top of such form--``CONTINUATION 
OF SECTION 444 ELECTION UNDER Sec. 1.444-4.'' In order to assist the 
Internal Revenue Service in updating the S corporation's account, on 
Line 5 the Box ``Changing to'' should be checked. Additionally, the 
election month indicated must be the last month of the S corporation's 
previously elected section 444 election year, and the effective year 
indicated must end in 2002.
    (ii) Time and place for filing Form 8716. Such form must be filed 
on or before October 15, 2002, with the service center where the S 
corporation's returns of tax (Forms 1120S) are filed. In addition, a 
copy of the Form 8716 should be attached to the S corporation's short 
period Federal income tax return for the first election year beginning 
on or after January 1, 2002.
    (3) Effect of request--(i) Taxable years beginning on or after 
January 1, 2002. An S corporation described in paragraph (c)(1) of this 
section that requests, in accordance with this paragraph, that a 
termination of its election under section 444 be disregarded will be 
permitted to resume use of the year it previously elected under section 
444, commencing with its first taxable year beginning on or after 
January 1, 2002. Such S corporation will be required to file a return 
under Sec. 1.7519-2T for each taxable year beginning on or after 
January 1, 2002. No payment under section 7519 will be due with respect 
to the first taxable year beginning on or after January 1, 2002. 
However, a required payment will be due on or before May 15, 2003, with 
respect to such S corporation's second continued section 444 election 
year that begins in calendar year 2002.
    (ii) Taxable years beginning prior to January 1, 2002. An S 
corporation described in paragraph (c)(1) of this section that 
requests, in accordance with this paragraph, that a termination of its 
election under section 444 be disregarded will not be required to amend 
any prior Federal income tax returns, make any required payments under 
section 7519, or file any returns under Sec. 1.7519-2T, with respect to 
taxable years beginning on or after the date the termination of its 
section 444 election was effective and prior to January 1, 2002.
    (iii) Section 7519: required payments and returns. The Internal 
Revenue Service waives any requirement for an S corporation described 
in paragraph (c)(1) of this section to file the federal tax returns and 
make any required payments under section 7519 for years prior to the 
taxable year of continuation as described in paragraph (c)(3)(i) of 
this section, if for such years the S corporation filed its federal 
income tax returns on the basis of its required taxable year.


Sec. 1.444-4T  [Removed]

    Par. 3. Section 1.444-4T is removed.
    Par. 4. 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 major 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.

[[Page 34395]]

    (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) Adjustments to basis of stock in the S portion under section 
1367.
    (g) Taxation of non-S portion.
    (1) In general.
    (2) Dividend income under section 1368(c)(2).
    (3) Interest on installment obligations.
    (4) Charitable deduction.
    (h) Allocation of state and local income taxes and 
administration expenses.
    (i) Treatment of distributions from the trust.
    (j) Termination or revocation of ESBT election.
    (k) Effective date.
    (l) 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 chapter 1 of the Internal Revenue Code. The portion of an 
ESBT that consists of stock in one or more S corporations 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. The ESBT is treated as a single trust for 
administrative purposes, such as having one taxpayer identification 
number and filing one tax return. See Sec. 1.1361-1(m).
    (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. Rules otherwise applicable to trusts 
apply in determining the extent to which any 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 of the S corporation in which the trust is an ESBT for 
part of the year and an eligible shareholder under section 
1361(a)(2)(A)(i) through (iv) for the rest of the year.
    (ii) Special rule for charitable contributions. If a deduction 
described in paragraph (d)(2)(i) of this section is attributable to an 
amount of the S corporation's gross income that is paid by the S 
corporation for a charitable purpose specified in section 170(c) 
(without regard to section 170(c)(2)(A)), 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 
limitations of section 681, regarding unrelated business income, apply 
in determining whether the contribution is deductible in computing the 
taxable 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 (g)(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 (h) 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) Adjustments to basis of stock in the S portion under section 
1367. The basis of S corporation stock in the S portion must be 
adjusted in accordance with section 1367 and the regulations 
thereunder. If the ESBT owns stock in more than one S corporation, the 
adjustments to the basis in the S corporation stock of each S 
corporation must be determined separately with respect to each S 
corporation. Accordingly, items of income, loss, deduction, or credit 
of an S corporation that are taken into account by the ESBT under 
section 1366 can only result in an adjustment to the basis of the stock 
of that S corporation and cannot affect the basis in the stock of the 
other S corporations held by the ESBT.
    (g) 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. The non-S portion 
may consist of more than one share pursuant to section 663(c).
    (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.

[[Page 34396]]

    (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.
    (h) 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, 
applicable 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.
    (i) 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 includible 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 of income, loss, deduction, or credit 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.
    (j) 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.
    (k) Effective date. This section generally is applicable for 
taxable years of ESBTs beginning on and after May 14, 2002. However, 
paragraphs (a), (b), (c), and (l) Example 1 of this section are 
applicable for taxable years of ESBTs that end on and after December 
29, 2000. ESBTs may apply paragraphs (d)(4) and (h) of this section for 
taxable years of ESBTs beginning after December 31, 1996.
    (l) 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. 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 profits     $100
Total trust income.............................................   $6,000
 
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. In 2003, Trust 
sells all of its stock in X to a person who is unrelated to Trust 
and its beneficiaries and realizes 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

[[Page 34397]]

$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 charitable 
organization described in section 170(c)(2). 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 by distributing S corporation 
stock, no charitable deduction is available to the S portion.
    Example 5. ESBT distributions. (i) As of January 1, 2002, 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, 2003, and Trust elects to 
be an ESBT effective January 1, 2003. On February 1, 2003, 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 2003. For 2003, 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.
    (ii) For 2003, 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 Beneficiary during the year 
($4,000), not to exceed the amount of DNI ($3,000). Beneficiary must 
include this amount in gross income under section 662(a). As a 
result, the non-S portion has no taxable income. *COM019*

    Par. 5. 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.

* * * * *


Sec. 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) Examples.
    (9) Effective date.
* * * * *

    Par. 6. Section 1.1361-1 is amended by:
    1. Adding paragraphs (h)(1)(vi) and (h)(3)(i)(F).
    2. Adding a sentence to the beginning of paragraph (h)(3)(ii) 
introductory text.
    3. Adding paragraph (j)(12).
    4. Adding a sentence to the end of paragraph (k)(2)(i).
    5. 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.
* * * * *
    (ii) * * * See Sec. 1.641(c)-1 for the rules for the taxation of an 
ESBT. * * *
* * * * *
    (j) * * *
    (12) Converting a QSST to an ESBT. For a trust that seeks 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 
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. 
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 on the day that is 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 on the day that is 12 
months after the date it is filed.
    (k) * * *
    (2) * * *
    (i) * * * Paragraphs (h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii), and 
(j)(12) of this section are applicable for taxable years beginning on 
and after May 14, 2002.
* * * * *
    (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, an 
organization described in section 170(c)(2) through (5), or an 
organization described in section 170(c)(1) that holds a contingent 
interest in such trust and is not a potential current beneficiary; 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.
    (B) Distributee trusts. A distributee trust is the beneficiary of 
the ESBT only if the distributee trust is an organization described in 
section 170(c)(2) or (3). In all other situations, any person who has a 
beneficial interest in a distributee trust

[[Page 34398]]

is a beneficiary of the ESBT. A distributee trust is a trust that 
receives 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) Nonresident aliens. A nonresident alien as defined in section 
7701(b)(1)(B) is an eligible beneficiary of an ESBT. However, see 
paragraph (m)(4)(i) and (m)(5)(iii) of this section if the nonresident 
alien is a potential current beneficiary of the ESBT (which would 
result in an ineligible shareholder and termination of the S 
corporation election).
    (iii) Interests acquired by purchase. A trust does not qualify as 
an ESBT if any interest in the trust has been acquired by purchase. 
Generally, if a person acquires an interest in the trust and thereby 
becomes a beneficiary of the trust as defined in paragraph 
(m)(1)(ii)(A), and any portion of the basis in the acquired interest in 
the trust is determined under section 1012, such interest has been 
acquired by purchase. This includes a net gift of a beneficial interest 
in the trust, in which the person acquiring the beneficial interest 
pays the gift tax. The trust itself may acquire S corporation stock or 
other property by purchase or in a part-gift, part-sale transaction.
    (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 S corporation 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. If any one 
of several trustees can legally bind the trust, only one trustee needs 
to sign the election statement. Generally, only one ESBT election is 
made for the trust, regardless of the number of S corporations whose 
stock is held by the ESBT. However, if the ESBT holds stock in multiple 
S corporations that file in different service centers, the ESBT 
election must be filed with all the relevant service centers where the 
corporations file their income tax returns. This requirement applies 
only at the time of the initial ESBT election; if the ESBT later 
acquires stock in an S corporation which files its income tax return at 
a different service center, a new ESBT election is not required.
    (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.
    (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 nevertheless 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 conditional ESBT 
election that would be effective only 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 such a 
conditional ESBT election and it 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 inadvertent S corporation election 
termination. In addition, a trust that qualifies as an ESBT may make an 
ESBT election notwithstanding that the trust is a wholly-owned grantor 
trust.
    (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 termination of the 
ESBT election (including a termination caused by a conversion of the 
ESBT to a QSST) other than on the last day of the trust's taxable year 
also does not cause the trust's taxable year to close. In either case, 
the trust files one tax return for the taxable year.
    (iv) Allocation of S corporation items. If, during the taxable year 
of an S corporation, a trust is an ESBT for part of the year and an 
eligible shareholder under section 1361(c)(2)(A)(i) through (iv) for 
the rest of the year, the S corporation items are allocated between the 
two types of trusts under section 1377(a). 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 paragraph (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. A person is treated as a shareholder of the S 
corporation at any moment in time when that person is entitled to, or 
in the discretion of any person may, receive a distribution of 
principal or income of the trust. No

[[Page 34399]]

person is treated as a potential current beneficiary solely because 
that person holds any future interest in 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 and thus is not a shareholder of 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 currently 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 paragraphs (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 during which such 
trust would be 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 qualify for 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) Currently exercisable powers of appointment--(A) In general. 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 lifetime power of appointment that would 
permit distributions from the trust to be made to more than 75 persons, 
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). Also, the S corporation 
election will terminate if the currently exercisable power of 
appointment allows distributions to be made to an ineligible 
shareholder as defined in section 1361(b)(1)(B) and (C).
    (B) Waiver or release. If the holder of a power of appointment 
permanently releases the power in a manner that is valid under 
applicable local law, the persons that would be potential current 
beneficiaries solely because of the power will not be potential current 
beneficiaries after the effective date of the release. An attempt to 
temporarily waive, release, or limit a currently exercisable power of 
appointment will be ignored in determining who are potential current 
beneficiaries of the trust.
    (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, the husband and wife will be counted as one shareholder of 
the S corporation.
    (viii) Miscellaneous. Payments made by an ESBT 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 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)(iii) 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 seeks 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:

[[Page 34400]]

    (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. 
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 QSST 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 on the day that is 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 on the day that is 12 
months after the date it is filed.
    (8) 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, 2003, 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, 2003, the trustee of Trust files a valid 
ESBT election for Trust effective January 1, 2003. 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, 2003, 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, 2004, 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. For each separate share, they 
file a separate election for each S corporation whose stock is held 
by Trust. Each separate share will be treated as a separate QSST.
    Example 2. (i) Invalid potential current beneficiary. Effective 
January 1, 2003, Trust makes a valid ESBT election. On January 1, 
2004, 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, 2004. As of 
January 1, 2004, 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, 2004. 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, 2004, 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 a 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 that 
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. Subpart E trust continuing after grantor's death. On 
January 1, 2003, M transfers stock in X, an S corporation, and other 
assets to Trust. Under the terms of Trust, the trustee of Trust has 
complete discretion to distribute the income or principal to M 
during M's lifetime and to M's children upon M's death. During M's 
life, M is treated as the owner of Trust under section 677. The 
trustee of Trust makes a valid election to treat Trust as an ESBT 
effective January 1, 2003. On March 28, 2004, M dies. Under 
applicable local law, Trust does not terminate on M's death. Trust 
continues to be an ESBT after M's death, and no additional ESBT 
election needs to be filed for Trust after M's death.
    Example 5. Potential current beneficiaries and distributee trust 
holding S corporation stock. Trust-1 has a valid ESBT election in 
effect. The trustee of Trust-1 has the power to make distributions 
to A directly or to any trust created for the benefit of A. On 
January 1, 2003, M creates Trust-2 for the benefit of A. Also on 
January 1, 2003, the trustee of Trust-1 distributes some S 
corporation stock to Trust-2. A, as 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.
    Example 6. Potential current beneficiaries and distributee trust 
not holding S corporation stock. (i) Distributee trust that 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 Trust-1, the trustee has discretion to make distributions 
to A, B, and Trust-2, a trust for the benefit of 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 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 or a 
QSST. Assume the same facts as in paragraph (i) of this Example 6 
except that D is a nonresident 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 paragraph (i) of this Example 6 
except that Trust-2 is a trust treated as owned by A under section 
676 because A has the power to revoke Trust-2 at any time prior to 
A's death. On January 1, 2003, 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. Thus, B and 
A's estate are potential current beneficiaries of Trust-1 and are 
counted as shareholders for purposes of section 1361(b)(1).
    Example 7. Potential current beneficiaries and powers of 
appointment. M creates Trust for the benefit of A. A also has a 
currently exercisable power to appoint income or principal to anyone 
except A, A's creditors, A's estate, and the creditors of A's 
estate. The potential current beneficiaries of Trust will be A and 
all other persons except for A's creditors, A's estate, and the 
creditors of A's estate. 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.

    (9) Effective date. This paragraph (m) is applicable for taxable 
years of ESBTs beginning on and after May 14, 2002.

    Par. 7. Section 1.1362-6 is amended by revising paragraph 
(b)(2)(iv) to read as follows:


Sec. 1.1362-6  Election and consents.

* * * * *

[[Page 34401]]

    (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. 8. Section 1.1362-7 is amended by:
    1. Revising the section heading.
    2. Adding a sentence to the end of paragraph (a).
    The revision and addition read as follows:


Sec. 1.1362-7  Effective dates.

    (a) * * * Section 1.1362-6(b)(2)(iv) is applicable for taxable 
years beginning on and after May 14, 2002.
* * * * *

    Par. 9. Section 1.1377-0 is amended by adding an entry for 
Sec. 1.1377-1(a)(2)(iii) to read as follows:


Sec. 1.1377-0  Table of contents.

* * * * *


Sec. 1.1377-1  Pro rata share.

    (a) * * *
    (2) * * *
    (iii) Shareholder trust conversions.
* * * * *

    Par. 10. 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) Shareholder trust conversions. If, during the taxable year of 
an S corporation, a trust that is an eligible shareholder of the S 
corporation converts from a trust described in section 
1361(c)(2)(A)(i), (ii), (iii), or (v) for the first part of the year to 
a trust described in a different subpart of section 1361(c)(2)(A)(i), 
(ii), or (v) for the remainder of the year, the trust's share of the S 
corporation items is allocated between the two types of trusts. The 
first day that a qualified subchapter S trust (QSST) or an electing 
small business trust (ESBT) is treated as an S corporation shareholder 
is the effective date of the QSST or ESBT election. Upon the 
conversion, the trust is not treated as terminating its entire interest 
in the S corporation for purposes of paragraph (b) of this section, 
unless the trust was a trust described in section 1361(c)(2)(A)(ii) or 
(iii) before the conversion.
* * * * *
    (c) * * *
    Example 3. Effect of conversion of a qualified subchapter S 
trust (QSST) to an electing small business trust (ESBT). (i) On 
January 1, 2003, Trust receives stock of S corporation. Trust's 
current income beneficiary makes a timely QSST election under 
section 1361(d)(2), effective January 1, 2003. Subsequently, 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, 2004. The taxable year of S corporation 
is the calendar year. In 2004, 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, 2004, and Trust is 
treated as an ESBT beginning July 1, 2004. Pursuant to section 
1377(a)(1), the pro rata share of S corporation income allocated to 
the QSST is $49,727 ($100,000 x 182 days/366 days), and the pro rata 
share of S corporation income allocated to the ESBT is $50,273 
($100,000 x 184 days/366 days).

    Par. 11. Section 1.1377-3 is revised to read as follows:


Sec. 1.1377-3  Effective dates.

    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 for taxable years 
beginning on and after May 14, 2002.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 12. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


    Par. 13. In Sec. 602.101, paragraph (b) is amended by adding an 
entry for 1.444-4 and revising the entry for 1.1361-1 in numerical 
order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

 
------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                      *      *      *      *      *
1.444-4.................................................       1545-1591
 
                      *      *      *      *      *
1.1361-1................................................       1545-0731
                                                               1545-1591
 
                      *      *      *      *      *
------------------------------------------------------------------------


    Approved: May 3, 2002.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Pamela Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-11791 Filed 5-13-02; 8:45 am]
BILLING CODE 4830-01-P