QSST regs create trap for the unwary.

• Author: Hills, Marvin D.
• Position: Qualified subchapter S trust

The IRS finalized regulations on July 21, 1995 on qualified sub-chapter S trusts (QSSTs). In the regulations, the Service addressed the question of whether gain on the sale of S stock by a QSST (which causes termination of QSST status) is taxable to the beneficiary or to the trust. The IRS had previously stated in Rev. Rul. 92-84 that die gain would be taxed to die beneficiary. In the final regulations, however, the Service reversed this position, stating that the gain will instead be taxed to die trust. This new position may have the apparently unintended effect of forcing certain S corporations to sell the stock, rather than the assets, of the business.

Background

Even though a QSST is irrevocable, it is nevertheless treated as h grantor trust for income tax purposes under Secs. 678 and 1361(d)(1)(B). Under the general grantor trust rules (Sec. 671), the earnings of the S corporation are taxable to the trust beneficiary, rather than to the trust itself. Grantor trust status applies, however, only as long as the trust holds S stock (Sec. 1361(d)(1)(B). Thus, whenever a QSST sells its S stock, the issue of whether the gain (or loss) on the sale of the stock is taxable to the beneficiary or to the trust becomes the proverbial "chicken or the egg" question. If grantor trust status terminates immediately before the sale, the gain is taxable to the trust, if grantor trust status instead does not terminate until immediately after the sale, the gain is taxable to the beneficiary.

Logic would seem to indicate that it is the sale of the stock that causes the grantor trust status to terminate. Thus, the sale would be considered to occur immediately before the termination of grantor trust status, and the gain or loss on the sale would be taxable to die beneficiary.

Proposed and Final Regulations

Proposed regulations did not address this issue. Apparently, the only practitioner comment submitted on this topic focused on a slightly different issue, i.e., the disparity that occurs if a QSST sells S stock on an installment basis, recognizing gain over time as the payments are received. In that situation, treating the gain as taxable to the beneficiary would not be proper, since the trust is receiving the installment payments. Apparently, the IRS also focused on this aspect, and added Regs. Sec. 1.1361-1(j)(8) to the final regulations, providing that die gain on the sale of the S stock is always taxable to the trust.

Potential Tax Trap

This change can...