Proposed Regulations Facilitate Estate Planning For S Corps
By Louis A. Mezzullo,
Esq.
Luce, Forward, Hamilton & Scripps, Rancho Santa Fe, CA
Introduction
The American Jobs Creation Act of 2004 (the “2004 Act”)
and the Gulf Opportunity Zone Act of 2005 (the “2005 Act”)
made several changes to the requirements for electing and maintaining
S corporation status that deal specifically with the number of
permitted shareholders and eligible S corporation shareholders. The
IRS issued proposed regulations on September 27, 2007, addressing a
number of changes made by the 2004 and 2005 Acts. Among other changes
made by those two acts, the proposed regulations deal with the
provision that allows members of a family to be treated as one
shareholder for purposes of determining the number of shareholders and
the provision that disregards unexercised powers of appointment in
identifying potential current beneficiaries of an electing small
business trust (ESBT).
Family Shareholder Rule
Currently, an S corporation may have only 100 shareholders. In
addition to the family shareholder rule discussed below, a husband and
wife and their estates are treated as one shareholder, although this
rule is subsumed in the family shareholder rule. The 2004 Act added
the family shareholder rule, but required an election to be made. The
2005 Act eliminated the requirement that an election had to be made to
treat family members as one shareholder.
Although under the “six generation” test, only six
generations of family members may be treated as one shareholder, the
proposed regulations apply this test only once. The family shareholder
rule treats the lineal descendants of a “common ancestor”
and their spouses as one shareholder. Under the
“six-generation” test, the common ancestor must not be
more than six generations removed from the youngest generation of
shareholders who would otherwise be members of the family. This
determination is made on the latest of: (1) the date the S election is
made; (2) the earliest date an individual who is “a member of
the family” holds stock in the S corporation; or (3) October 22,
2004. Because the six generation test is applied only on that date,
once the test is satisfied, family members in additional generations
may acquire stock and the family will still be treated as one
shareholder. Note that the family shareholder rule only applies for
purposes of determining the number of shareholders, but not for any
other purpose, including whether there are ineligible shareholders,
such as nonresident aliens.
Potential Current Beneficiaries
Once a trust makes an ESBT election, each potential current
beneficiary of the ESBT is considered to be a shareholder for purposes
of determining if the corporation satisfies the general S corporation
shareholder requirements under §1361(b)(1). If there is no
potential current beneficiary at any time, the trust itself is treated
as the shareholder.
As amended by the 2004 Act, §1361(e)(2) provides that a
potential current beneficiary is “with respect to any period,
any person who at any time during such period is entitled to, or at
the discretion of any person may receive, a distribution from the
principal or income of the trust (determined without regard to any
power of appointment to the extent such power remains unexercised at
the end of such period).” The parenthetical was added by the
2004 Act. Regulations issued before the 2004 Act had taken the
position that all possible appointees of a power of appointment had to
be considered potential current beneficiaries, making it difficult for
many trusts to qualify as ESBTs.
As a result of the 2004 Act amendment, after 2004, a person is not
a potential current beneficiary of an ESBT if that person is only
entitled to a distribution from the ESBT via the exercise of a power
of appointment (as long as the power remains unexercised). Under the
proposed regulations issued on September 27, 2007, a power of
appointment is defined in the same manner as for estate and gift tax
purposes; that is, “the power to appropriate or consume the
principal of the trust or the power to affect the beneficial enjoyment
of trust property or its income by altering, amending, or revoking the
trust instrument or terminating the trust.” In addition, for
purposes of determining potential current beneficiaries, a power of
appointment also includes a power, regardless of by whom held, to add
a beneficiary or class of beneficiaries to the class of current
beneficiaries. Generally, a power held by a fiduciary who is not also
a beneficiary of the trust to spray or sprinkle trust distributions
among beneficiaries is not treated as a power of appointment. However,
the members of a class of unnamed charities permitted to receive
distributions under a discretionary distribution power held by a
fiduciary that is not a power of appointment will be considered,
collectively, to be a single potential current beneficiary for
purposes of determining the number of permissible shareholders.
However, if the power is actually exercised, each charity that
actually receives distributions will also be a potential current
beneficiary.
The 2004 Act extended the period from 60 days to one year during
which an ESBT may safely dispose of stock after an ineligible
shareholder becomes a potential current beneficiary. See Prop. Regs.
§§1.1361-1(e)(3) and 1.1361-1(m)(2)(4)(vi).
For more information, in the Tax Management Portfolios, see
Mezzullo, 809 T.M., Estate Planning for Owners of Closely Held
Business Interests, and in Tax Practice Series, see ¶6130,
Simple and Complex Trusts.
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