Liquidation gain allocable to QSST shares.

• Author: Orr, Chuck
• Position: Qualified Subchapter S trust; taxation

Sec. 1361(d) (1) (B) and Regs. Sec. 1.1361-1(j)(7)(i) provide that a beneficiary of a qualified subchapter S trust (QSST) is treated as the owner of that portion of the trust that consists of S stock. Generally, this means that all S income (including gains and losses on the sale of assets) attributable to shares held by a QSST is taxed to the QSST's income beneficiary. However, under Regs. Sec. 1.1361-1(j)(8), the income beneficiary is not treated as the owner of S stock "in determining and attributing the federal income tax consequences of a disposition of the stock by the QSST." In other words, gain or loss on a sale of S stock by a QSST is taxed to the QSST, not to the income beneficiary. This regulation was adopted in 1995 to change the result of Rev. Rul. 92-84, which held that the income beneficiary must recognize the gain on the sale of S stock held by a QSST even if the sales proceeds were allocable to corpus and not to income.

The invalidation of Rev. Rul. 92-84 occurred largely as a result of practitioners' concern about the sale of stock by a QSST in an installment sale when, under state law, the gain on the stock sale was allocable to the trust corpus. If the income beneficiary were treated as the owner of the installment obligation, he would likely have disposed of the installment note in favor of the trust. The result would be that all of the gain would be accelerated under Sec. 453B(a) and recognized immediately by the income beneficiary.

TD 8600, announcing the new regulation, stated that the IRS and Treasury determined that the income beneficiary of a QSST, who was a Sec. 678 deemed owner of the S stock solely by reason of Sec. 1361(d)(1), should not be treated as the owner of the consideration received by a QSST on its disposition of S stock. The language seems to imply that the tax obligation relative to the gain on the disposition of S stock should fall on the taxpayer that retains the sales proceeds. Under Rev. Rul. 92-84, sales proceeds were normally allocated to the trust corpus, while the tax on the capital gain was payable by the income beneficiary. While trusts may permit the trustee to distribute principal to the income beneficiary, when such provisions are not present there is a disconnection between the taxpayer that realized the gain and the taxpayer responsible for the tax.

In Letter Ruling 9721020, the IRS discussed a related issue involving an actual, in-kind liquidation of an S corporation with QSST...