Disposition of stock by a QSST.

• Author: Panoutsos, Louis A.
• Position: Qualified subchapter S trust

Generally, when a qualified subchapter S trust (QSST) owns S stock, the trust beneficiary is treated as the stock's owner for Federal income tax purposes, and as the party to whom the trust's share of S income and deductions pass through. There is one principal exception to this general rule: Under Regs. Sec. 1.1361-1(j)(8), a QSST beneficiary will not be treated as the owner of the stock in determining the Federal income tax consequences of its disposition by a QSST. If the disposition is a sale, the QSST election terminates as to the stock sold, and any gain or loss recognized on the sale belongs to the trust, not the income beneficiary. As illustrated in the following example, this exception is a trap for the unwary that may generate adverse tax consequences on a disposition of QSST stock.

Example 1: On Dec. 31,1996, S corporation S sells its assets to an unrelated party for $1,000 and distributes the proceeds in a liquidating distribution. S's basis in its assets is $100. S's sole shareholder is a QSST and J is the beneficiary His basis in the stock is $800 The tax consequences of the transaction to the trust and to J are:

J Trust Corporate gain on asset sale passed through to shareholder $900 Liquidating proceeds $1,000 Less basis (pre-sale basis of $800 + increase for $900 gain recognized) (1,700) Total gain/(loss) $900 $ (700)

As Example 1 illustrates, the trust incurs a capital loss of $700; since the trust has no capital gains, the capital loss does not generate a current benefit. However, if J was the direct shareholder, he could offset part of his $900 gain (which is treated as a capital gain) with the $700 capital loss.

This result typically arises when the shareholder's stock basis exceeds the corporation's basis in its assets. However, with proper planning, this result can be avoided and the loss attributable to the stock and the gain on the sale of the assets will both be taxable at the trust level. In such case, the loss attributable to the stock may be used to the extent the gain on the sale of the assets is a capital gain.

Based on the IRS's position in Letter Ruling 9721020, gains and losses on both the stock and the assets will be taxable at the trust level if the assets are distributed to the shareholders in a liquidating distribution prior to their sale to the unrelated party. The letter ruling involves a complete liquidation of a corporation, with an in-kind distribution of its assets to a QSST. It is assumed in the...