Using a trust installment obligation to acquire S stock.

• Author: Mikuta, Richard J.

Often, owners of S corporations desire to "freeze" the value of their estates attributable to S stock by transferring the stock to lineal descendants or trusts created for the descendants' benefit. To do this the current owner of the S stock must either give or sell the stock at its current fair market value. If the owner desires to make a transfer but does not want to make a gift of the S stock, an installment sale will often be used. In many instances, the stockholder feels that the transferee should not hold the stock outright. He may also desire that the stock be transferred in a transaction that provides generation skipping tax benefits. In either of these circumstances, the individual currently holding the S stock usually establishes a trust, which then purchases the stock from the current shareholder in exchange for an installment obligation.

Note that in all instances prior to the establishment of the trust and the consummation of the transaction, the stock's potential posttransfer appreciation must be considered in determining if the inclusion of the stock {and related earnings) in the transferor's estate at date of death value would be more detrimental from a tax standpoint than the inclusion in the transferor's estate of the installment principal payments, after-tax interest on the installment obligation and the related earnings from these assets (i.e., this type of transaction should only be contemplated with stock that has the potential for substantial future appreciation). At this time, it must also be considered whether the S corporation would need to distribute a sufficient amount of cash to the trust from which the necessary installment obligation payments could be made. The potential beneficiary's personal finances must also be examined; the beneficiary must have sufficient income and/or assets to pay any individual income tax associated with the income recognized from the S stock should the S corporation's distributions be insufficient to pay both the installment note payments and the related taxes.

A problem associated with using a trust in this situation is that generally only two types of trusts are allowed to hold S stock without terminating the corporation's S election: grantor trusts and qualified subchapter S trusts (QSSTs).

Grantor trusts

Many tax advisers believe that the individual desiring to sell the stock should not (in most instances) be the grantor when using a grantor trust in this type of transaction. Under the grantor trust rules, the stock may be subject to Sec. 2083, 2086 or 2038, and therefore be included in the grantor's estate at its date of death value. However, in Letter Ruling 9037011, the IRS concluded that an...