[Federal Register Volume 68, Number 137 (Thursday, July 17, 2003)]
[Rules and Regulations]
[Pages 42251-42254]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-18040]


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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9078]
RIN 1545-AY76


Qualified Subchapter S Trust Election for Testamentary Trusts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

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

DATES: Effective Date:
    These regulations are effective July 17, 2003.
    Applicability Date: For dates of applicability of these 
regulations, see Sec.  1.1361-1(k)(2)(i) and (ii).

FOR FURTHER INFORMATION CONTACT: Concerning the final regulations, 
Deane M. Burke, (202) 622-3070 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document amends section 1361 of the Income Tax Regulations (26 
CFR part 1) regarding a qualified subchapter S trust (QSST) election 
for testamentary trusts and the definition of testamentary trusts.
    On August 24, 2001, a notice of proposed rulemaking (REG-106431-01, 
2001-2 C.B. 272) relating to QSST elections for testamentary trusts and 
the period for which former qualified subpart E trusts and testamentary 
trusts may be permitted shareholders under section 1361 was published 
in the Federal Register (66 FR 44565). No public hearing was requested. 
Comments responding to the proposed regulations were received. After 
consideration of the comments, the proposed regulations are adopted as 
revised by this Treasury decision.
    Section 1361(a) defines an S corporation as a small business 
corporation for which an election under section 1362(a) is in effect 
for the year. Section 1361(b) provides, in part, that a small business 
corporation is a domestic corporation that is not an ineligible 
corporation and that does not have as a shareholder a person (other 
than an estate, a trust described in section 1361(c)(2), or an 
organization described in section 1361(c)(6)) who is not an individual. 
Under section 1361(c)(2), qualified subpart E trusts and testamentary 
trusts are permitted S corporation shareholders. A qualified subpart E 
trust is a trust, all of which is treated (under subpart E of part I of 
subchapter J, chapter 1) as owned by an individual who is a citizen or 
resident of the United States. A qualified subpart E trust that 
continues in existence after the death of the deemed owner (former 
qualified subpart E trust) is a permitted shareholder, but only for the 
2-year period beginning on the day of the deemed owner's death. A 
testamentary trust is a trust to which S corporation stock is 
transferred pursuant to the terms of a will, but only for the 2-year 
period beginning on the day the stock is transferred to the trust.

Summary of Comments and Explanation of Provisions

    These final regulations are substantially the same as the proposed 
regulations, but reflect certain revisions based on the comments that 
were received. The revisions are discussed below.
    The proposed regulations provide that a former qualified subpart E 
trust is a permitted shareholder of an S corporation for the 2-year 
period beginning on the day of the deemed owner's death. In addition, 
the proposed regulations provide that a testamentary trust is also a 
permitted shareholder of an S corporation for the 2-year period 
beginning on the day the stock is transferred to the testamentary 
trust. If a former qualified subpart E trust or a testamentary trust 
continues to own stock after the expiration of the 2-year period during 
which it is a permitted shareholder, the corporation's S election will 
terminate unless the trust otherwise qualifies as a permitted 
shareholder. The trust might otherwise qualify as a permitted 
shareholder if, for example, the trust is a QSST that has an election 
under section 1361(d)(2) in effect at the end of the 2-year period (an 
electing QSST).
    One commentator suggested that certain sections of the proposed 
regulations should be clarified because those sections indicate that if 
a former qualified subpart E trust or a testamentary trust continues to 
own stock of an S corporation after the 2-year period and is not 
otherwise a qualified subpart E trust or an electing QSST, the trust is 
not a permitted shareholder. The commentator noted that a former 
qualified subpart E trust or a testamentary trust that continues to own 
stock after the 2-year period could also be a permitted shareholder if 
the trust is an electing small business trust (ESBT) at the end of the 
2-year period. The sections of the proposed regulations for which the 
commentator suggested clarification, however, address rules regarding 
QSSTs. Section 1.1361-1(m) of the Income Tax Regulations addresses 
rules regarding ESBTs. The final regulations clarify that if a former 
qualified subpart E trust or a testamentary trust continues to own 
stock of an S corporation after the 2-year period and is not otherwise 
a qualified subpart E trust, an electing QSST, or an ESBT, the trust is 
not a permitted shareholder. Additionally, the final regulations 
clarify that a QSST or an ESBT election may be made for a former 
qualified subpart E trust or a testamentary trust that qualifies as a 
QSST or an ESBT.
    Another commentator suggested that after August 5, 1997, the 
effective date of section 645, a testamentary trust should also include 
a trust that receives S corporation stock from a qualified revocable 
trust (QRT) for which an election under section 645 has been made (an 
electing trust). Under section 645, an electing trust is treated and 
taxed as part of the decedent's estate (and not as a separate trust) 
for purposes of subtitle A of the Code for all taxable years of the 
estate during the section 645 election period. The section 645 election 
period begins on the date of the decedent's death and generally 
terminates on the day before the applicable date described in section 
645(b)(2). Section 1.645-1(h)(1) provides that on the close of the last 
day of the election period the share comprising the electing trust is 
deemed to be distributed to a new trust.

[[Page 42252]]

    Thus, according to the commentator, the final regulations should 
clarify that testamentary trusts include trusts to which S corporation 
stock is transferred pursuant to the terms of the electing trust during 
the section 645 election period as well as new trusts to which S 
corporation stock is deemed to be distributed at the end of the section 
645 election period. The commentator noted that the purpose of section 
645 is to create parity between electing trusts and wills. In 
furtherance of this purpose, the commentator reasoned that if an 
electing trust transfers or is deemed to distribute S corporation stock 
to a new trust, the new trust should be a permitted shareholder for the 
2-year period beginning on the day the stock is transferred or deemed 
distributed to the new trust. The final regulations adopt the 
commentator's suggestion to clarify that a testamentary trust also 
includes a trust that receives S corporation stock from an electing 
trust.
    The IRS is considering issuing guidance on whether a trust that has 
a QSST or an ESBT election in effect may make an election under section 
645.

Effective Date

    Except where otherwise specifically provided, these final 
regulations are applicable on and after July 17, 2003. In addition, the 
IRS will not challenge the treatment of certain testamentary trusts 
that receive S corporation stock from an electing trust under section 
645 as permitted shareholders of the S corporation for periods after 
August 5, 1997, and before the earlier of July 17, 2003, or the 
effective date of any QSST or ESBT election for the trust.

Special Analyses

    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 also has been 
determined that section 533(b) of the Administrative Procedures Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, the notice of 
proposed rulemaking preceding these regulations was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Deane M. Burke, Office 
of the Associate Chief Counsel (Passthroughs & Special Industries). 
However, other personnel from the IRS and the Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.1361-1 is amended as follows:
0
1. Paragraphs (b)(1)(ii), (f), (h)(1)(ii), (h)(1)(iv), (h)(3)(i)(B), 
(h)(3)(i)(D), (h)(3)(ii)(A), (h)(3)(ii)(B), (j)(6)(iii)(C), (j)(7)(ii), 
the fourth and last sentences of paragraph (k)(1) Example 2(ii), (k)(1) 
Examples 3 and 4(iii), and (k)(2)(i) are revised.
0
2. The undesignated paragraph following paragraph (h)(3)(i)(B) is 
removed.
0
3. Paragraph (j)(6)(iii)(D) is redesignated as paragraph 
(j)(6)(iii)(E).
0
4. New paragraph (j)(6)(iii)(D) is added.
0
5. Paragraph (k)(2)(ii) is redesignated as paragraph (k)(2)(iii).
0
6. New paragraph (k)(2)(ii) is added.
    The revisions and additions read as follows:


Sec.  1.1361-1  S corporation defined.

* * * * *
    (b)* * * (1)* * *
    (ii) As a shareholder, a person (other than an estate, a trust 
described in section 1361(c)(2), or, for taxable years beginning after 
December 31, 1997, an organization described in section 1361(c)(6)) who 
is not an individual;
* * * * *
    (f) Shareholder must be an individual or estate. Except as 
otherwise provided in paragraph (e)(1) of this section (relating to 
nominees), paragraph (h) of this section (relating to certain trusts), 
and, for taxable years beginning after December 31, 1997, section 
1361(c)(6) (relating to certain exempt organizations), a corporation in 
which any shareholder is a corporation, partnership, or trust does not 
qualify as a small business corporation.
* * * * *
    (h)* * * (1)* * *
    (ii) Subpart E trust ceasing to be a qualified subpart E trust 
after the death of deemed owner. A trust that was a qualified subpart E 
trust immediately before the death of the deemed owner and that 
continues in existence after the death of the deemed owner, but only 
for the 2-year period beginning on the day of the deemed owner's death. 
A trust is considered to continue in existence if the trust continues 
to hold the stock pursuant to the terms of the will or the trust 
agreement, or if the trust continues to hold the stock during a period 
reasonably necessary to wind up the affairs of the trust. See Sec.  
1.641(b)-3 for rules concerning the termination of trusts for federal 
income tax purposes.
* * * * *
    (iv) Testamentary trusts. A trust (other than a qualified subpart E 
trust, an electing QSST, or an electing small business trust) to which 
S corporation stock is--
    (A) Transferred pursuant to the terms of a will, but only for the 
2-year period beginning on the day the stock is transferred to the 
trust except as otherwise provided in paragraph (h)(3)(i)(D) of this 
section; or
    (B) Transferred pursuant to the terms of an electing trust as 
defined in Sec.  1.645-1(b)(2) during the election period as defined in 
Sec.  1.645-1(b)(6), or deemed to be distributed at the close of the 
last day of the election period pursuant to Sec.  1.645-1(h)(1), but in 
each case only for the 2-year period beginning on the day the stock is 
transferred or deemed distributed to the trust except as otherwise 
provided in paragraph (h)(3)(i)(D) of this section.
* * * * *
    (3)* * * (i)* * *
    (B) If stock is held by a trust defined in paragraph (h)(1)(ii) of 
this section, the estate of the deemed owner is generally treated as 
the shareholder as of the day of the deemed owner's death. However, if 
stock is held by such a trust in a community property state, the 
decedent's estate is the shareholder only of the portion of the trust 
included in the decedent's gross estate (and the surviving spouse 
continues to be the shareholder of the portion of the trust owned by 
that spouse under the applicable state's community property law). The 
estate ordinarily will cease to be treated as the shareholder upon the 
earlier of the transfer of the stock by the trust or the expiration of 
the 2-year period beginning on the day of the deemed owner's death. If 
the trust qualifies and becomes an electing QSST, the beneficiary and 
not the estate is treated as the shareholder as of the

[[Page 42253]]

effective date of the QSST election, and the rules provided in 
paragraph (j)(7) of this section apply. If the trust qualifies and 
becomes an ESBT, the shareholders are determined under paragraphs 
(h)(3)(i)(F) and (h)(3)(ii) of this section as of the effective date of 
the ESBT election, and the rules provided in paragraph (m) of this 
section apply.
* * * * *
    (D) If stock is transferred or deemed distributed to a testamentary 
trust described in paragraph (h)(1)(iv) of this section (other than a 
qualified subpart E trust, an electing QSST, or an ESBT), the estate of 
the testator is treated as the shareholder until the earlier of the 
transfer of that stock by the trust or the expiration of the 2-year 
period beginning on the day that the stock is transferred or deemed 
distributed to the trust. If the trust qualifies and becomes an 
electing QSST, the beneficiary and not the estate is treated as the 
shareholder as of the effective date of the QSST election, and the 
rules provided in paragraph (j)(7) of this section apply. If the trust 
qualifies and becomes an ESBT, the shareholders are determined under 
paragraphs (h)(3)(i)(F) and (h)(3)(ii) of this section as of the 
effective date of the ESBT election, and the rules provided in 
paragraph (m) of this section apply.
* * * * *
    (ii)* * *
    (A) If stock is held by a trust as defined in paragraph (h)(1)(ii) 
of this section (other than an electing QSST or an ESBT), the trust is 
treated as the shareholder. If the trust continues to own the stock 
after the expiration of the 2-year period, the corporation's S election 
will terminate unless the trust is otherwise a permitted shareholder.
    (B) If stock is transferred or deemed distributed to a testamentary 
trust described in paragraph (h)(1)(iv) of this section (other than a 
qualified subpart E trust, an electing QSST, or an ESBT), the trust is 
treated as the shareholder. If the trust continues to own the stock 
after the expiration of the 2-year period, the corporation's S election 
will terminate unless the trust otherwise qualifies as a permitted 
shareholder.
* * * * *
    (j)* * *
    (6)* * *
    (iii)* * *
    (C) If a trust ceases to be a qualified subpart E trust, satisfies 
the requirements of a QSST, and intends to become a QSST, the QSST 
election must be filed within the 16-day-and-2-month period beginning 
on the date on which the trust ceases to be a qualified subpart E 
trust. If the estate of the deemed owner of the trust is treated as the 
shareholder under paragraph (h)(3)(i) of this section, the QSST 
election may be filed at any time, but no later than the end of the 16-
day-and-2-month period beginning on the date on which the estate of the 
deemed owner ceases to be treated as a shareholder.
    (D) If a testamentary trust is a permitted shareholder under 
paragraph (h)(1)(iv) of this section, satisfies the requirements of a 
QSST, and intends to become a QSST, the QSST election may be filed at 
any time, but no later than the end of the 16-day-and-2-month period 
beginning on the day after the end of the 2-year period.
* * * * *
    (7) * * *
    (ii) If, upon the death of an income beneficiary, the trust 
continues in existence, continues to hold S corporation stock but no 
longer satisfies the QSST requirements, is not a qualified subpart E 
trust, and does not qualify as an ESBT, then, solely for purposes of 
section 1361(b)(1), as of the date of the income beneficiary's death, 
the estate of that income beneficiary is treated as the shareholder of 
the S corporation with respect to which the income beneficiary made the 
QSST election. The estate ordinarily will cease to be treated as the 
shareholder for purposes of section 1361(b)(1) upon the earlier of the 
transfer of that stock by the trust or the expiration of the 2-year 
period beginning on the day of the income beneficiary's death. During 
the period that the estate is treated as the shareholder for purposes 
of section 1361(b)(1), the trust is treated as the shareholder for 
purposes of sections 1366, 1367, and 1368. If, after the 2-year period, 
the trust continues to hold S corporation stock and does not otherwise 
qualify as a permitted shareholder, the corporation's S election 
terminates. If the termination is inadvertent, the corporation may 
request relief under section 1362(f).
* * * * *
    (k)(1)* * *

    Example 2. * * *
    (ii) * * * A's estate will cease to be treated as the 
shareholder for purposes of section 1361(b)(1) upon the earlier of 
the transfer of the Corporation M stock by the trust (other than to 
A's estate), the expiration of the 2-year period beginning on the 
day of A's death, or the effective date of a QSST or ESBT election 
if the trust qualifies as a QSST or ESBT. * * * If no QSST or ESBT 
election is made effective upon the expiration of the 2-year period, 
the corporation ceases to be an S corporation, but the trust 
continues as the shareholder of a C corporation.
* * * * *
    Example 3. (i) 2-year rule under section 1361(c)(2)(A)(ii) and 
(iii). F owns stock of Corporation P, an S corporation. In addition, 
F is the deemed owner of a qualified subpart E trust that holds 
stock in Corporation O, an S corporation. F dies on July 1, 2003. 
The trust continues in existence after F's death but is no longer a 
qualified subpart E trust. On August 1, 2003, F's shares of stock in 
Corporation P are transferred to the trust pursuant to the terms of 
F's will. Because the stock of Corporation P was not held by the 
trust when F died, section 1361(c)(2)(A)(ii) does not apply with 
respect to that stock. Under section 1361(c)(2)(A)(iii), the last 
day on which the trust could be treated as a permitted shareholder 
of Corporation P is July 31, 2005 (that is, the last day of the 2-
year period that begins on the date of the transfer from the estate 
to the trust). With respect to the shares of stock in Corporation O 
held by the trust at the time of F's death, section 
1361(c)(2)(A)(ii) applies and the last day on which the trust could 
be treated as a permitted shareholder of Corporation O is June 30, 
2005 (that is, the last day of the 2-year period that begins on the 
date of F's death).
    (ii) Section 645 electing trust and successor trust. Assume the 
same facts as in paragraph (i) of this Example 3, except that F's 
trust is a qualified revocable trust for which a valid section 645 
election is made on October 1, 2003 (electing trust). Because under 
section 645 the electing trust is treated and taxed for purposes of 
subtitle A of the Code as part of F's estate, the trust may continue 
to hold the O stock pursuant to Sec.  1361(b)(1)(B), without causing 
the termination of Corporation O's S election, for the duration of 
the section 645 election period. However, on January 1, 2004, during 
the election period, the shares of stock in Corporation O are 
transferred pursuant to the terms of the electing trust to a 
successor trust. Because the successor trust satisfies the 
definition of a testamentary trust under paragraph (h)(1)(iv) of 
this section, the successor trust is a permitted shareholder until 
the earlier of the expiration of the 2-year period beginning on 
January 1, 2004, or the effective date of a QSST or ESBT election 
for the successor trust.
    Example 4. * * *
    (iii) QSST when a person other than the current income 
beneficiary may receive trust corpus. Assume the same facts as in 
paragraph (i) of this Example 4, except that the events occur in 
2003 and H dies on November 1, 2003, and the trust does not qualify 
as an ESBT. Under the terms of the trust, after H's death, L is the 
income beneficiary of the trust and the trustee is authorized to 
distribute trust corpus to L as well as to J. The trust ceases to be 
a QSST as of November 1, 2003, because corpus distributions may be 
made to someone other than L, the current (successive) income 
beneficiary. Under section 1361(c)(2)(B)(ii), H's estate (and not 
the trust) is considered to be the shareholder for purposes of 
section 1361(b)(1) for the 2-year period beginning on November 1, 
2003. However, because the trust continues in existence after H's 
death and will receive any distributions from the corporation, the 
trust (and not H's estate) is treated as the shareholder for 
purposes of

[[Page 42254]]

sections 1366, 1367, and 1368, during that 2-year period. After the 
2-year period, the S election terminates and the trust continues as 
a shareholder of a C corporation. If the termination is inadvertent, 
Corporation Q may request relief under section 1362(f). However, the 
S election would not terminate if the trustee distributed all 
Corporation Q shares to L, J, or both on or before October 31, 2005, 
(the last day of the 2-year period) assuming that neither L nor J 
becomes the 76th shareholder of Corporation Q as a result of the 
distribution.
* * * * *
    (2) * * * (i) In general. Paragraph (a) of this section, and 
paragraphs (c) through (k) of this section (as contained in the 26 CFR 
edition revised April 1, 2003) apply to taxable years of a corporation 
beginning after July 21, 1995. For taxable years beginning on or before 
July 21, 1995, to which paragraph (a) of this section and paragraphs 
(c) through (k) of this section (as contained in the 26 CFR edition 
revised April 1, 2003) do not apply, see Sec.  18.1361-1 of this 
chapter (as contained in the 26 CFR edition revised April 1, 1995). 
However, paragraphs (h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii), and (j)(12) 
of this section (as contained in the 26 CFR edition revised April 1, 
2003) are applicable for taxable years beginning on and after May 14, 
2002. Otherwise, paragraphs (b)(1)(ii), (f), (h)(1)(ii), (h)(1)(iv), 
(h)(3)(i)(B), (h)(3)(i)(D), (h)(3)(ii)(A), (h)(3)(ii)(B), 
(j)(6)(iii)(C), (j)(6)(iii)(D), (j)(7)(ii), and (k)(1) Example 2(ii) 
fourth and last sentences, Example 3, and Example 4(iii) of this 
section apply on and after July 17, 2003.
    (ii) Transition rules. Taxpayers may apply paragraph (h)(1)(iv)(B) 
of this section on and after December 24, 2002, and before July 17, 
2003, to treat a trust as a testamentary trust, but not during any 
period for which a QSST or ESBT election was in effect for the trust. 
In addition, the Internal Revenue Service will not challenge the 
treatment of a trust described in paragraph (h)(1)(iv)(B) of this 
section as a permitted shareholder of an S corporation for periods 
after August 5, 1997, and before the earlier of July 17, 2003, or the 
effective date of any QSST or ESBT election for that trust.
* * * * *

Robert E. Wenzel,
Deputy Commissioner for Services and Enforcement.
    Approved: July 9, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-18040 Filed 7-16-03; 8:45 am]
BILLING CODE 4830-01-P