Archive for December, 2011

For owners of closely held businesses, such as S corporations, the sale to an intentionally defective grantor trust (IDGT) has developed into one of the most effective techniques to freeze the value of the owner’s estate and transfer any future appreciation in the S corporation to future generations. In the midst of an extended recession that has seen asset values fall sharply across all asset classes, including closely held S corporations, and with interest rates near historic lows, many estate planning attorneys have advised clients that, notwithstanding the current uncertainty regarding the estate, gift, and generation-skipping transfer taxes in 2010, now is the time to take advantage of this tremendous wealth transfer opportunity because most agree that estate and generation-skipping transfer taxes will return in some form in either 2010 or 2011. This article will briefly outline the basic structure of a sale of S corporation stock to an IDGT transaction, but the article’s main focus will be on the often overlooked income tax consequences of selecting among the various types of trusts that can own S corporation stock.

In structuring the sale of S corporation stock to an IDGT, attorneys often draft the terms of the trust with three primary considerations: (1) intentionally violate one or more of the grantor trust rules under IRC §§ 673 to 677 to ensure the trust is treated as a grantor trust for income tax purposes; (2) avoid retaining any powers that could cause the assets of the trust to be included in the grantor’s estate under IRC §§ 2036 to 2038; and (3) ensure that the grantor’s desired positive scheme is created, with particular attention to extending the duration of the trust to as many future generations as possible. This last consideration is often the determining factor in whether the trust that ultimately owns the S corporation stock (on termination of grantor trust status) is an electing small business trust (ESBT) or a qualified subchapter S trust (QSST). Because both ESBTs and QSSTs are permitted S corporation shareholders, attorneys sometimes ignore the potential income tax differences between such trusts in drafting the dispositive terms of the initial trust used in the sale. Although this issue may not come to light during the lifetime of the grantor (that is, while the trust is a grantor trust), it can have a dramatic effect on the total assets available to the grantor’s intended beneficiaries once the grantor is deceased. Specifically, since a 2006 legislative change, the treatment of any interest expense paid on indebtedness incurred to acquire stock in an S corporation (which would be paid as part of a promissory note received in a sale of S corporation stock to a defective grantor trust transaction) is substantially different in QSSTs and ESBTs, and attorneys should be mindful of this difference in drafting trusts to be used in a sale to an IDGT transaction and in making S corporation trust elections for trusts that hold S corporation stock acquired with debt.

An IDGT is an irrevocable trust that is treated as owned by the grantor for income tax purposes but not for estate tax purposes. A sale of assets to an IDGT in exchange for a promissory note is a popular estate freezing technique, which can allow future growth of the sold assets to occur outside of the estate of the grantor. In addition, because the grantor pays the income tax on the income generated by the assets held by the trust, these payments are essentially tax-free gifts to the beneficiaries of the IDGT. For an in-depth discussion of the intricacies of a sale of assets to an IDGT, see Louis A. Mezzullo, Freezing Techniques: Installment Sales to Grantor Trusts, 14 Prob. & Prop. 16, Tan./Feb. 2000. As a brief synopsis, an installment sale of assets to an IDGT typically follows these steps: (1) the grantor first establishes an IDGT; (2) the grantor funds the IDGT with a small amount of “seed money” (10% to 20% of the value of the assets sold is often cited as adequate coverage) and/ or the grantor obtains personal guarantees (typically from the IDGT beneficiaries); and (3) the grantor enters into an installment sale agreement with the IDGT trustee, in which the grantor seIls S corporation stock to the IDGT in exchange for a promissory note with an interest rate equal to the Applicable Federal Rate.
The growth of the S corporation stock sold to the IDGT is now outside the estate of the grantor and any S corporation dividend paid will be paid to the IDGT. The IDGT will use cash flow from the S corporation stock to service the promissory note payments due to the grantor, and the grantor now has an established cash flow in the form of the interest and possibly principal payments. So long as the growth rate of the S corporation stock sold to the IDGT exceeds the interest rate of the promissory note, the grantor has effectively transferred such excess growth from her estate to the IDGT. The assets in the IDGT should not be brought back into the grantor’s estate even if she dies during the term of the promissory note. In addition, the grantor is able to leverage her GST exemption because the allocation is made for only the small initial gift to the IDGT, even though significantly more assets may ultimately make up the IDGT’s equity.
In the current economic environment, asset values are depressed and interest rates are at historic lows. The result of this confluence of events is that the value of the S corporation stock may be lower than it was a couple years ago, while the interest rate required to be charged on the promissory note will be near historic lows, creating an extremely low threshold for asset growth to make the transaction successful.  S corporations are corporations that satisfy all of the requirements of IRC§ 1361 and make an election to be treated as an S corporation. Among the various limitations on S corporations, the corporation must be a domestic corporation and must not have as a shareholder a person who is not an individual, an estate during the period of administration, a trust of a specified type, and (in taxable years beginning after 1997) an exempt organization of a specified type.  The specified trusts include • a voting trust; • a grantor trust or a former grantor trust for the two-year period beginning on the day of the deemed owner’s death; • a trust treated under IRC§ 678 as owned by an individual other than the grantor; • aQSST; • a testamentary trust for stock transferred to it under to the terms of a will (a “will recipient trust”) or an IRe § 645 electing trust, but only for the two-year period
beginning on the day on which the stock is transferred to the trust; and an ESBT. In the context of a sale to an IDGT, the initial trust that purchases the S corporation stock is a grantor trust and thus an eligible S corporation shareholder. ollowing the death of the grantor, there is a two-year” grace” period for the trust before it must make an election to be treated as a different type of eligible S corporation shareholder. Typically, once the two-year period following the
death of the grantor has ended, the trust owning the S corporation stock or successor subtrusts will elect to be treated as a QSST or as an ESBT, depending on the terms of the trust. As a result, the remainder of this article will focus primarily on the income tax differences between QSSTs and ‘ ESBTs.  A QSST is a trust that satisfies the following requirements: (1) all income of the trust is distributed or is required to be distributed currently to one individual who is a U.S. citizen or resident; (2) during the life of the current income beneficiary, there is only one income beneficiary; (3) if the trust distributes any trust principal during the life of the current income beneficiary, it can only be distributed to that current income beneficiary; (4) the current income beneficiary’S income interest in the trust must terminate on the earlier of the current income beneficiary’s death or the termination of the trust; and (5) if the trust terminates during the lifetime
of the current income beneficiary, all of the trust assets will be distributed to that income beneficiary.
An election to treat the trust as a QSST and to treat the income beneficiary as the owner of the trust’s S corporation stock must be made by the income beneficiary (not the trustee) within two months and 15 days after the trust’s receipt of the S corporation stock. Similarly, a QSST election must be made within two months and 15 days from (1)
the date that the grantor trust ceases being a grantor trust (or the two-year grace period following the death of the grantor) or (2) the end of the two-year period for a testamentary trust.
The requirements for an ESBT are not as restrictive as those for a QSST. An ESBT can have multiple beneficiaries, and the trust income can be accumulated and/ or sprinkled among multiple trust beneficiaries. A trust is eligible to be an ESBT if it is a domestic trust that does not have as a beneficiary any person other than an individual, an estate,
or certain charitable organizations. An election to treat the trust as an ESBT must be made by the trustee of the trust (rather than the beneficiary of the trust in the QSST context), and the trustee must make the
election within the same time constraints imposed on a QSST election for the election to be timely.

IRC §136<1(d)(1)(B) essentially creates two portions within a QSST, with one portion consisting of income, deductions, and credits related to the S corporation (the S Portion) and one portion consisting of all
other income, deductions, and credits (the Non-S Portion). The QSST’s income beneficiary is treated as the owner of the S Portion for most income tax purposes. Thus, the current income beneficiary will report the QSST’s share of the S corporation’s income tax items (such as income, deductions, and credits) directly. All of the QSST’s Non-S Portion will be reported by the trustee and taxable under the rules of Subchapter J. ESBTs also use the S Portion/Non- S Portion concept for income tax purposes, with one significant reporting difference. The S Portion of an ESBT is taxed as a
separate trust, the tax attributes of which cannot be merged or commingled with the tax attributes of the Non-S Portion. The primary difference between QSST income taxation and ESBT income taxation is in the treatment of the S Portion of the income tax items. For a QSST, the S Portion is taxable to the current income beneficiary of the
trust, whereas for an ESBT, the S Portion is taxable to the trust. For the ESBT, the S Portion is taxed under special ESBT rules. lRC §§ 641(c)(2)(A) and 641(c)(2)(B) state that for the S Portion, an ESBT must pay the tax at the highest marginal rate for trusts and estates and receives no personal exemption or standard deduction. The Non-S Portion is taxed under the same rules as all other trusts. After understanding the differences between the taxation of the S Portion and the Non-S Portion of various trusts owning S corporation stock, it is important to determine which income tax items of each trust belong in each Portion. For most items, this determination is easy. The S corporation will send a Form 1120S Schedule K -1 to each of the S corporation’s shareholders, in- cluding the trust. The Schedule K-1 will detail the S corporation’s income, deductions, and credits attributable to the shareholder. These items are all attributable to the trust’s S Portion. As a default, all other income, deductions, and credits make up the trust’s Non-S Portion. Congress, however, has created special carveouts of tax items that are not found on the S corporation’s Schedule  K-1 but that are attributed to the S Portion nonetheless. For QSSTs, Treas. Reg. § 1.1361-10)(8) states that the trust will be treated as the
shareholder for purposes of the income tax treatment of the sale of the S corporation stock held by the QSST. Thus, the
capital gain on the disposition of the S corporation stock by the QSST will be in the Non-S Portion. On contemplation
this makes sense, because the disposition of the stock is an action taken by the trust and not by the S corporation itself.
The Code and the Regulations are silent on the issue of the deduction for interest on acquisition indebtedness of the QSST related to the trust’s purchase of S corporation stock. Because this is similar to the disposition of the S corporation stock, however, it is probable that the deduction for interest on acquisition indebtedness is in the Non-S Portion, too.
Moreover, as explained in the next paragraph, Congress has explicitly treated this deduction and the treatment of the
disposition of the S corporation stock differently in the ESBT context, and one can assume that if Congress intended for QSSTs to have the same treatment, it would have acted accordingly. The authors have confirmed in informal conversations with the Internal Revenue Service (lRS) that the lRS concurs with the analysis outlined above. For ESBTs, lRC § 641(c)(2)(C)(ii) states that any gain or loss from the disposition of stock in the S corporation shall be attributed to the S Portion. In addition,lRC § 641(c)(2)(C)(iv) states that the deduction for interest on acquisition indebtedness of the ESBT related to the trust’s purchase of the S corporation stock also shall be attributed to the S Portion. The acquisition indebtedness interest deduction is only includable in the S Portion for taxable years beginning after December 31, 2006. Treas. Reg. § 1.641(c)-1(d), which states that such interest is attributed to the S Portion but is not a deductible administrative expense for the S Portion, has not been updated to reflect the congressional change in 2006, and is applicable only for tax years before December 31, 2006. Thus, for ESBTs, the gain or loss on the disposition of the S corporation stock and the interest deduction related to the acquisition of the S corporation stock are both includable in the S Portion, which is the opposite result of the QSST rules, which include both items in the Non-S Portion.

In drafting a trust to be used in a sale of S corporation stock, most attorneys will follow the grantor’s desired dispositive scheme. Often little attention is paid to the ultimate income taxation of the trust at the outset because the trust will ini- tially be a grantor trust, taxed entirely to the grantor, regardless of the dispositive scheme and without an election. On determination of grantor trust status, typical- ly as a result of the death of the grantor, the attorney, the trustee, and potentially the beneficiary or beneficiaries will confer and make a decision to have the successor or resulting trust treated as a QSST or an ESBT. Occasionally, because of the terms of the trust, either election will be permissible. In this scenario, the preference, before Congress allowed an ESBT to deduct the acquisition indebtedness interest in the S Portion, was often to make a QSST election to allow for the S corporation income to be taxed at the individual beneficiary’s income tax rates rather than the highest marginal income tax rate mandated under the ESBT rules. To illustrate the different income tax consequences of a trust electing to be treated as a QSST or an ESBT it is helpful to walk through some examples.Before the 2006 legislative change to ESBTs, attorneys drafting a trust to be used
in a sale to an IDGT would guide grantors to draft trust dispositive schemes in a way that allowed for a future QSST election knowing that such an election could be income tax advantageous in the future.
Now that the ESBT has certain income tax advantages not available to the QSST, however, the choice is no longer obvious. By drafting a trust to allow for a future QSST election, the attorney allows the
trustee to make the proper election deci- sion in the future when more facts are known. The downside to this is that a trust with terms that allow for a QSST election will be relatively restrictive and inflexible. The trust can have only one beneficiary, and if there is a reason to not make distri- butions to that beneficiary (for example, the beneficiary is a spendthrift or has sub- stance abuse issues), the trustee must still make income distributions. Instead, if the income tax situation will be more efficient as an ESBT, the attorney can draft the trust without the limitations imposed by the Code for QSSTs.After a 2006 legislative change by Congress, the treatment of interest paid on the indebtedness related to the acquisition of S corporation stock and of the disposition of S corporation stock by a trust is significantly different between QSSTs and ESBTs. As a result, attorneys drafting trusts for use in a sale to an IDGT transaction, which will likely have interest payments related to promissory notes issued in consideration for the purchase of the S corporation stock, must take into account whether the trust will be more tax efficient as a QSST or an ESBT once grantor trust status terminates. In addition, attorneys should review QSST elections made before 2007 to determine if it would be more tax efficient to convert the QSST to an ESBT.

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