S-Corp Trusts in Estate Planning: Drafting Grantor, Testamentary, - - PowerPoint PPT Presentation

S-Corp Trusts in Estate Planning: Drafting Grantor, Testamentary, Qualified Sub S and Electing Small Business Trusts

Navigating Interest Expense and NII Issues and Overcoming Challenges to Maintain Tax Attributes

Today’s faculty features:

1pm East ern | 12pm Cent ral | 11am Mount ain | 10am Pacific TUES DAY, JULY 29, 2014

Presenting a live 90-minute teleconference with interactive Q&A

Langdon T . Owen, Jr., S hareholder, Parsons Kinghorn Harris, S alt Lake City Louis Vlahos, Partner, Farrell Fritz, Uniondale, N.Y .

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Some S-Corporation Estate Planning and Estate Administration Issues

Langdon Owen Parsons Kinghorn Harris, pc (801) 363-4300 lto@pkhlawyers.com

T he S-E le c tio n

 (i) no mo re tha n 100 sha re ho lde rs,  (ii) a ll sha re ho lde rs a re

 individua ls (o the r tha n no nre side nt a lie ns o r, in mo st

c a se s, the ir spo use s),

 de c e de nts’ e sta te s, b a nkruptc y e sta te s,  c e rta in limite d kinds o f trusts,  c e rta in c ha ritie s, o r  the c o rpo ra tio n’ s sto c k ma y b e 100% o wne d b y a no the r

S-c o rpo ra tio n

 (iii) the re is o nly o ne c la ss o f sto c k.

 As lo ng a s the e c o no mic s a re the sa me (suc h a s rig hts to

divide nds o r liq uida ting distrib utio ns), the re ma y b e diffe re nt c la sse s va rying o nly a s to vo ting rig hts.

6

Use o f T rusts, g e ne ra lly

 Mo re re stric tive tha n with L

L Cs

 F

• rc e d to fit the pla n to the b e st a va ila b le

trust type

 F

a ilure to pla n pro pe rly c a n de stro y the S- e le c tio n

 Ofte n will ha ve a g re e me nts a mo ng

sha re ho lde rs to re stric t tra nsa c tio ns je o pa rdizing the e le c tio n

7

T ype s o f a va ila b le trusts

 a vo ting trust  a g ra nto r trust  a trust with a de e me d o wne r o the r tha n the

g ra nto r

 a will re c ipie nt trust, tha t is, a te sta me nta ry

trust re c e iving the sto c k pursua nt to the will

 c e rta in ta x-e xe mpt trusts suc h a s fo r q ua lifie d

pla ns o r fo r c e rta in c ha ritie s

 a q ua lifie d sub c ha pte r S trust o r QSST  a n e le c ting sma ll b usine ss trust o r E

SBT

8

No ne le c tive T rusts

 Vo ting trust: ma y b e use ful in e sta b lishing

ma na g e me nt c o ntro l o ve r the c o rpo ra tio n

 Gra nto r trusts: trusts whe re so me

sig nific a nt po we r is re se rve d b y the g ra nto r (o r the g ra nto r’ s spo use )

 the g ra nto r is ta xe d o n the trust’ s inc o me

9

Use ful Gra nto r T rust T ype s

 re vo c a b le e sta te pla nning trusts  “de fe c tive ” irre vo c a b le trusts inte ntio na lly

c re a te d to ha ve o ne o r mo re o f the pro sc rib e d po we rs in the g ra nto r; de e me d o wne r trusts a re tre a te d simila rly

 g ra nto r-re ta ine d a nnuity trusts o r g ra nto r-

re ta ine d unitrusts (GRAT s a nd GRUT s)

 c ha rita b le re ma inde r trusts, ho we ve r,

c a nno t b e g ra nto r trusts a nd still q ua lify

10

Gra nto r trust e ffe c ts

 Ho lding pe rio ds fo r no n e le c tive trusts

 g ra nto r trusts ma y c o ntinue to ho ld the S-c o rp

sto c k fo r up to two ye a rs a fte r the de a th o f de e me d o wne r, the g ra nto r.

 A will re c ipie nt trust o nly q ua lifie s a s a

sha re ho lde r fo r two ye a rs b e g inning o n the da y the sto c k is tra nsfe rre d to it fro m the e sta te .

 I

f a de c e de nt’ s e sta te is unre a so na b ly pro lo ng e d, the e sta te is de e me d te rmina te d a fte r the e xpira tio n o f a re a so na b le pe rio d fo r a dministra tio n. T he e sta te is the n tre a te d a s a trust.

11

Gra nto r T rust E ffe c ts, c o nt’ d

 Re sults if no t distrib ute d time ly

 I

f trust is no t dispo se d o f prio r to e nd o f the two -ye a r pe rio d, the S e le c tio n will b e disq ua lifie d.

 Ma y time ly e le c t a fo rm o f e le c tive trust to

ma inta in S e le c tio n

 T

he e sta te o f the g ra nto r (de e me d

• wne r) will b e tre a te d a s the sto c kho lde r

prio r to distrib utio n.

12

E le c tive T rusts

 QSST

• r E

SBT trusts re q uire the filing o f spe c ia l e le c tio ns

 QSST

is, e sse ntia lly, a sing le b e ne fic ia ry trust

 ma rita l trusts  mino r g ift trusts  c ha rita b le re ma inde r trusts  Othe r trusts fo r sing le b e ne fic ia rie s

13

QSST Qua lific a tio n

 a c tua lly distrib ute inc o me to o nly o ne c urre nt

inc o me b e ne fic ia ry, o r b e re q uire d to distrib ute to b ut o ne b e ne fic ia ry

 inc o me b e ne fic ia ry must b e a U.S. Citize n o r

re side nt

 during the life o f the c urre nt inc o me

b e ne fic ia ry, the re will b e b ut o ne c urre nt inc o me b e ne fic ia ry (se pa ra te sha re s c a n wo rk)

14

QSST Qua lific a tio n, c o nt’ d

 must re q uire a ny princ ipa l distrib ute d

during the c urre nt inc o me b e ne fic ia ry’ s life time must o nly g o to tha t b e ne fic ia ry

 inc o me inte re st te rmina te s o n the e a rlie r

• f de a th o r the te rmina tio n o f the trust

 distrib utio n o f the e ntire trust to the c urre nt

b e ne fic ia ry if the trust te rmina te s while the c urre nt inc o me b e ne fic ia ry is a live

15

QSST E le c tio n

 Curre nt inc o me be ne fic iar

y must time ly e le c t QSST

tre a tme nt, g e ne ra lly within two mo nths a nd 16 da ys a fte r the sto c k is tra nsfe rre d to the trust, o r a fte r the S e le c tio n is e ffe c tive if the S e le c tio n is ma de while the trust ho lds the sto c k

 se pa ra te QSST

e le c tion is re quire d for e ac h S- c orp he ld b y the trust

 c o ntinue s in e ffe c t fo r suc c e ssive b e ne fic ia rie s,

unle ss the b e ne fic ia ry a ffirma tive ly re fuse s c o nse nt

 c urre nt inc o me b e ne fic ia ry ma y unila te ra lly

te rmina te the S e le c tio n b y re fusing c o nse nt; o the r sha re ho lde rs c a nno t (so lve b y a g re e me nt)

16

Slide Intentionally Left Blank

E SBT

 E

SBT is a multiple b e ne fic ia ry trust

 ma y sprinkle o r a c c umula te inc o me

 c re dit-she lte r trusts  g ra nto r trusts with multiple b e ne fic ia rie s

whic h c o ntinue a fte r the de a th o f the g ra nto r

18

E SBT Qua lific a tio n

 o nly individua ls, e sta te s, o r c e rta in c ha ritie s a s

b e ne fic ia rie s

 Be ne fic ia rie s inc lude pre se nt, re ve rsio na ry, o r

re ma inde r b e ne fic ia rie s

 o the r trusts a re lo o ke d thro ug h a nd the ir

b e ne fic ia rie s a re tre a te d a s the b e ne fic ia rie s

 po te ntia l re c ipie nts unde r a n e xe rc ise o f a po we r

• f a ppo intme nt a re no t tre a te d a s b e ne fic ia rie s

(fo r this purpo se ) until e xe rc ise d

 no nre side nt a lie ns a re pe rmitte d a s e lig ib le , b ut

no t a s po te ntia l c urre nt b e ne fic ia rie s (se e b e lo w)

 No ta x e xe mpt trusts o r CRAT

s o r CRUT s

19

E SBT Qua lific a tio n, c o nt’ d

 No inte re st in the trust ma y b e a c q uire d b y

purc ha se

 T

he truste e must e le c t E SBT tre a tme nt, g e ne ra lly two mo nths a nd 16 da ys a fte r the sto c k is tra nsfe rre d to the E SBT

 Only one e le c tion pe r

tr ust is ne e de d unle ss

diffe re nt I RS se rvic e c e nte rs a re invo lve d

 I

f it is a g ra nto r trust, the de e me d o wne r must c o nse nt (e .g ., a n irre vo c a b le g ra nto r trust)

 E

SBT ma y c o nve rt to a QSST

 o the rwise , the e le c tio n is irre vo c a b le a nd

pro te c tive e le c tio ns a re no t a llo wa b le

20

E SBT e ffe c ts

 E

a c h “po te ntia l c urre nt b e ne fic ia ry” is tre a te d a s a sha re ho lde r fo r the 100 sha re ho lde r limit



if no ne , the trust itse lf is the sha re ho ld e r fo r this

 A “po te ntia l c urre nt b e ne fic ia ry” is a ny pe rso n who a t a ny

time during the pe rio d is e ntitle d to , o r in the disc re tio n o f a ny pe rso n ma y re c e ive , a distrib utio n fro m the princ ipa l o r inc o me o f the trust



une xe rc ise d po we rs o f a ppo intme nt ma y b e d isre g a rd e d



the time to d ispo se o f sto c k a fte r a n ine lig ib le sha re ho ld e r b e c o me s a po te ntia l c urre nt b e ne fic ia ry is o ne ye a r



if sha re s b e c o me se pa ra te sha re s, e a c h inc o me b e ne fic ia ry c a n ma ke a n e le c tio n to re vo ke the E SBT e le c tio n fo r the se pa ra te sha re fo r tha t b e ne fic ia ry a nd tre a t it a s a QSST

21

E SBT E ffe c ts, c o n’ d

 T

he re a re thre e po rtio ns with diffe ring ta x tre a tme nt:

 a g ra nto r po rtio n,  a no ng ra nto r po rtio n, whic h in turn is sub divide d into

 a no n-S po rtio n a nd  a n S po rtio n

 T

he g ra nto r po rtio n is the pa rt tre a te d a s o wne d b y a g ra nto r o r de e me d o wne r unde r the g ra nto r trust rule s,

 this po rtio n is ta xe d to suc h g ra nto r o r de e me d o wne r  it ma y inc lude b o th S-c o rp sto c k o r o the r a sse ts

22

E SBT E ffe c ts, c o nt’ d

 no n-S po rtio n is the po rtio n o f the a sse ts,

• the r tha n S-c o rp sto c k, no t tre a te d a s a

g ra nto r po rtio n

 tre a te d a s a se pa ra te trust using no rma l

trust ta x rule s

 divide nds fro m the S-c o rp a nd inte re st o n

the sa le o f S-c o rp sto c k a re inc ludib le in inc o me o f this se pa ra te trust

23

E SBT E ffe c ts, c o nt’ d

 S po rtio n is the po rtio n c o nsisting o f S-c o rp sto c k no t tre a te d

a s a g ra nto r po rtio n, tre a te d a s a se pa ra te trust



ta ke s into a c c o unt spe c ifie d ite ms (“S po rtio n ite ms”) a g g re g a te d fro m a ll S-c o rps o f whic h it o wns sto c k



E xc e pt fo r c a pita l g a ins, the se ite ms a re ta xe d a t the hig he st trust ma rg ina l ra te s, with no e xe mptio n fo r a lte rna tive minimum ta x purpo se s, a nd a re no t inc lud e d in inc o me b y a ny b e ne fic ia ry, b ut a re inc lud e d in the o ve ra ll a c tua l trust’ s d istrib uta b le ne t inc o me (DNI), b ut a re no t d e d uc tib le fro m it.



Disa d va nta g e in ke e ping o ut o f b e ne fic ia ry lo we r b ra c ke ts



Hig he st trust ta x b ra c ke t o the r tha n c a pita l g a in

 T

he ta xa tio n o f distrib utio ns sta ys the sa me fo r the o ve ra ll a c tua l trust, so tha t the DNI o f the trust wo uld fo llo w a distrib utio n to the b e ne fic ia ry a nd b e ta xe d to the b e ne fic ia ry with a c o rre spo nding de duc tio n fo r the no n-S po rtio n

24

E SBT E ffe c ts, Co n’ d



IRC 641(c ): T he o nly ite ms o f inc o me , lo ss, d e d uc tio n, o r c re d it to b e ta ke n into a c c o unt [b y the E SBT ]a re the fo llo wing :



(i) T he ite ms re q uire d to b e ta ke n into a c c o unt und e r se c tio n 1366.



(ii) Any g a in o r lo ss fro m the d ispo sitio n o f sto c k in a n S c o rpo ra tio n.



(iii) T

• the e xte nt pro vid e d in re g ula tio ns, Sta te o r lo c a l inc o me

ta xe s o r a d ministra tive e xpe nse s to the e xte nt a llo c a b le to ite ms d e sc rib e d in c la use s (i) a nd (ii).



(iv) Any inte re st e xpe nse pa id o r a c c rue d o n ind e b te d ne ss inc urre d to a c q uire sto c k in a n S c o rpo ra tio n.



No d e d uc tio n o r c re d it sha ll b e a llo we d fo r a ny a mo unt no t d e sc rib e d in this pa ra g ra ph, a nd no ite m d e sc rib e d in this pa ra g ra ph sha ll b e a ppo rtio ne d to a ny b e ne fic ia ry.

25

E SBT E ffe c ts, c ha rita b le c o ntrib utio ns

 I

f a n S c o rpo ra tio n ma ke s c ha rita b le do na tio ns, a pro ra ta sha re pa sse s thro ug h to the E SBT a nd the sha re is tre a te d a s c o ntrib ute d b y the S po rtio n, sub je c t to de duc tio n limita tio ns.

 I

f the E SBT do na te s S sto c k to c ha rity, ne ithe r the S po rtio n no r the no n-S po rtio n g e ts a de duc tio n.

26

Pla nning Co nside ra tio ns

 Pe rso na l Re pre se nta tive s ne e d to c o nside r

distrib utio ns to q ua lifying sto c k ho lde rs a nd no t ke e ping e sta te o pe n so lo ng a s to b e tre a te d a s a trust

 T

ruste e s ne e d to c o nside r E SBT e le c tio n

 Ca n sa ve the S e le c tio n a nd pro vide fa mily

fle xib ility, b ut a t the c o st o f b a d ta x re sults a nd muc h c o mple xity

 Be ne fic ia rie s ne e d to c o nside r QSST

e le c tio n

 Be tte r ta x re sults, le ss fa mily fle xib ility

27

Pla nning Co nside ra tio ns, c o nt’ d

 All sha re ho lde rs ne e d to c o nside r sha re ho lde r a g re e me nts



T

• ma inta in the e le c tio n (e .g ., no d isq ua lifying sha re ho ld e rs)



Assure o nly pro pe r trusts (o r no ne a t a ll) a re sha re ho ld e rs



Assure fa ir d istrib utio n po lic ie s, tre a tme nt o n sa le o f sto c k (e .g ., b o o k c lo sing ).

 Pla nne rs ne e d to c o nside r whe the r o the r fo rms o f

• rg a niza tio n a re supe rio r o ve ra ll; impo rta nt fa c to rs inc lude :



Ste p up b a sis a t d e a th (insid e a nd o utsid e b a sis),



spe c ia l a llo c a tio ns a nd c la sse s o f inte re st,



a ny kind o f trust c a n b e use d ,



c ha rg ing o rd e r c re d ito r pro te c tio n,



c ha rita b le pla nning ,



po ssib le mo d e st se lf e mplo yme nt ta x sa ving with S-c o rp., pa ssive inc o me ,



sta te ta xa tio n

28

Slide Intentionally Left Blank

PRESENTED BY: Louis Vlahos

Planning for S Corp. Trusts and the NII Surtax

Tuesday, July 29th, 2014

• S. corps. v. LLCs: S corps. suffer from a number of

deficiencies.

• Many S corps. out there, though.
• Many C corps. that probably should be S corps.
• S corp. advantage over C corp. on sale of assets.
• S corp. advantage over C corp. on Section 1411

surtax.

S Corps.

Planning for S Corp. Trusts and the NII Surtax 31

• Portfolio-type income; e.g., C corp. dividends;

sale/redemption of C corp. stock – subject to tax without regard to shareholder’s participation in business.

• S corp. shareholder that materially participates in

business may avoid the surtax.

• S corp. shareholder that does not so participate:

taxable on Section 1366 share of income; Section 1368 gain on distribution in respect of stock; Section 302(b) redemption and 1001 sale of stock.

S Corp. and Section 1411

32 Planning for S Corp. Trusts and the NII Surtax

• Planning point for estate of deceased shareholder of S

corp.

• Section 1014 basis step-up for stock (no inside basis

adjustment as for an LLC under Section 754).

• Sale of assets; Section 1366 gain flow-through; Section

1367 basis adjustment.

• Liquidation of S corp. in year of asset sale; create
• ffsetting loss.
• E.g., PLR 9218019.
• Section 2036 and non-taxable estates – bring trust into

gross estate for basis step-up.

Post-Death Planning and Inter-vivos Trusts

33 Planning for S Corp. Trusts and the NII Surtax

• 2013 brought increased OI rate (39.6%),

increased capital gain rate (20%), and 3.8% surtax

• n NII. P.L. 112-240; P.L. 111-152, respectively.
• NII includes: interest, dividend, royalty, rent, etc.;

IRC 1411(c)(1); Reg. 1.1411-4(a).

• Importantly: it also includes income from a T/B

that is passive as to the taxpayer, and gain from the disposition of property unless held in a non- passive T/B. IRC 1411(c)(1)(A)(iii); Reg. 1.1411- 4(a)(1)(iii).

Section 1411 Overview

34 Planning for S Corp. Trusts and the NII Surtax

• Passive T/B – look to Section 469 rules. IRC

1411(c)(2)(A); Reg. 1.1411-5.

• S. corp.: passive v. non-passive determination is

made at shareholder level. IRC 1411(c)(2)(A);

• Reg. 1.1411-4(b)(2)(i); Reg. 1.1411-4(c); Reg.

1.1411-4(d)(4).

• Sale of S Corp. stock: include gain in NII to extent
• f gain that would be taken into account on sale of

corp.’s assets. Reg. 1.1411-4(d)(4); Prop. Reg. 1.1411-7.

S Corp. Income and NII

35 Planning for S Corp. Trusts and the NII Surtax

• Individual TPs: surtax imposed on lesser of

(a) NII for the year, or (b) excess of modified AGI for the year over “threshold amount” ($200,000 for single TP). IRC 1411(b)(1).

• Trust: surtax imposed on lesser of (a)

undistributed NII for the year, or (b) excess of (i) trust’s AGI over (ii) dollar amount for highest trust bracket ($12,150 for 2014). IRC 1411(a)(2). Note the difference.

NII Thresholds

36 Planning for S Corp. Trusts and the NII Surtax

• Undistributed NII is reduced by NII included in

distributions to beneficiaries that are deductible under Section 651 or Section 661. Reg. 1.1411-3(e).

• Beneficiaries deemed to receive proportionate

taxable amount of each item of DNI (ratio of distribution amount to DNI amount).

• Same proportionate amount of trust’s NII. Reg.

1.1411-4(e).

• Limited application to most S corp. trusts, as we will

see.

Trust NII

37 Planning for S Corp. Trusts and the NII Surtax

• Consider threshold at which surtax applies for

individual beneficiaries vs. trust.

• Incentive for trust to make distributions -- get

income to a beneficiary who has less income,

• r who is below the threshold.
• Distribute income-producing property?
• Remember grantor’s purpose for the trust, and

the dispositive scheme - tax tail should not wag the dog.

Trust Planning for NII -- in General

38 Planning for S Corp. Trusts and the NII Surtax

• IRC 1366 pass-through – includes share of corp.’s NII.
• Is the S corp. engaged in T/B?
• Passive or not? Determined at shareholder level.
• Reg. 1.1411-4(b)(2).
• Does shareholder materially participate? Reg. 1.1411-

5.

• Look to IRC 469: “regular, continuous and substantial”
• May vary from shareholder to shareholder – we’ll come

back to this.

S Corp. and Material Participation

Planning for S Corp. Trusts and the NII Surtax 39

• Non-passive status determination is made at trust-level.
• IRC 1366 allocation (income or gain); 1368 distribution;

1001 stock sale.

• Less obvious scenarios: IRC 302(b), 338(h)(10), 336(e).
• Plan in advance for the surtax.
• Adjust shareholder’s level of authority/participation; shift

equity to lower-income family members; use other investments to offset NII.

Trust as S corp. Shareholder: possible NII “events”

Planning for S Corp. Trusts and the NII Surtax 40

• IRC 1411 points us to IRC 469’s rules.
• Recent Regulations under IRC 1411 failed

to elaborate. See T.D. 9644.

• IRS punted: said the issue is best

addressed in IRC 469 Regulations.

• Regulations project in the works?

Material Participation by Trusts

Planning for S Corp. Trusts and the NII Surtax 41

• Some IRS rulings and two Court decisions – that’s

all folks.

• Practically speaking, the absence of much

authority has not been an issue.

• If a trust has not had losses, characterization did

not make a difference in most cases.

• That changed with 2013 and the IRC 1411 NII

surtax.

Existing Guidance as to Trust Participation?

Planning for S Corp. Trusts and the NII Surtax 42

• Passive vs. non-passive character must now

be considered.

• Interests in a family business are often

transferred in trust (e.g., to protect against spendthrifts, creditors, spouse, etc.)

• If S corp. is not engaged in T/B, the tax

applies.

• If S corp. is engaged in T/B, surtax applies if

trust does not materially participate in T/B.

Planning for S Corp. Trusts and the NII Surtax 43

• Apply Section 469 rules to trust – but how?
• Several factors to consider, including: type
• f trust, tax elections made in respect of the

trust, trustee’s participation in the T/B, grantor’s participation, beneficiary’s participation.

Planning for S Corp. Trusts and the NII Surtax 44

• IRC 469(h): a taxpayer materially participates

if involved in operations of the T/B on a “regular, continuous and substantial basis”

• Individuals: Regulation 1.469-5T provides

several alternative tests (e.g., 500 hours per year)

• Applied to each business activity of the S corp.
• Grouping activities may help.

Material Participation

Planning for S Corp. Trusts and the NII Surtax 45

• Trusts are subject to the 469 material

participation rules. IRC 469(a)(2).

• Not clear how the material participation

rules apply to trusts.

• Reg. 1.469-5T(g): “reserved” as to trusts.
• Rely on the base test: “regular, . . .” ?

Section 469 and Trusts

Planning for S Corp. Trusts and the NII Surtax 46

• Grantor Trust – shares are deemed owned by grantor. IRC

671; IRC 1361(c).

• Trust’s share of S corp. income is taxed to grantor.

Regulation 1.1361-1(h)(3).

• Same applies for IRC 1411 surtax. Regulation 1.1411-

3(b)(1).

• Material participation is determined at grantor-level.
• Many business owners use grantor trusts to leverage their
• gifts. Rev. Rul. 2004-64.

Trust Material Participation in an S corp.? Who “owns” the stock?

Planning for S Corp. Trusts and the NII Surtax 47

• Treated as a grantor trust, with the

beneficiary as the deemed owner. Reg. 1.1361-1(j)(8); Sec. 678.

• Applies for pass-through of distributive

share of S corp. income; not for sale of S

• corp. stock
• Material participation by trust – determined

at beneficiary-level. FSA 200106018.

QSST

Planning for S Corp. Trusts and the NII Surtax 48

• Character of income is determined and

taxed at trust level. Reg. 1.1361-1(h)(3)(ii);

• Reg. 1.1361-1(m); IRC. 641(c); Reg.

1.641(c)-1.

• Material participation is determined at the

trust level (not the beneficiary or grantor).

ESBT

Planning for S Corp. Trusts and the NII Surtax 49

• The S corp.’s income flows through to the trust as

a s/h. Reg. 1.1361-1(h)(3)(ii).

• The character of the income carries through to the

beneficiary where the trust distributes DNI. Sec. 662(b).

• If the trust is passive as to the S corp.’s T/B, then

the income is passive as to the beneficiary, apparently without regard to the beneficiary’s personal involvement.

Former grantor trust or testamentary trust

Planning for S Corp. Trusts and the NII Surtax 50

• Note that a former grantor trust, a

testamentary trust, and a former QSST (beneficiary died) may be S corp. shareholders for only two years.

• Their “material participation” status may also

change, depending upon whether they can make a QSST or ESBT election.

Planning for S Corp. Trusts and the NII Surtax 51

• Reg. 1.1361-1(j)(8): the trust – not the

beneficiary – is taxed on the gain from the sale of S corp. stock

• Application to IRC 1411 surtax?
• Prop. Reg. 1.1411-7(a)(4)(C) tests material

participation at the trust-level for purposes

• f characterizing the gain as passive or not

QSST – sale of stock

Planning for S Corp. Trusts and the NII Surtax 52

• In the case of a grantor trust, the test is

applied to the grantor-owner. If the grantor is active, so is the trust’s income

• The same is true as to the beneficiary of a

QSST who is treated as the owner of the trust under Sec. 678.

• Other S corp. trusts? More difficult issue.

How to determine material participation?

Planning for S Corp. Trusts and the NII Surtax 53

• Code and Regs are silent
• Senate Report to ’86 Act (No. 99-313): does trustee

materially participate?

• Mattie Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex.

2003)

• Trust operated business using employees and

agents

• IRS: only activities of trustees are relevant, and only

in their capacity as such.

• Court disagreed with IRS.

Authorities re Trust Participation

Planning for S Corp. Trusts and the NII Surtax 54

• Court: look to trustees, plus agents and

employees of trust

• Who conducted business on behalf of trust?
• Those activities, in the aggregate, were

regular, continuous and substantial.

• IRS has not acquiesced to Carter.

Planning for S Corp. Trusts and the NII Surtax 55

Slide Intentionally Left Blank

• IRS continues to argue that material

participation for a non-grantor trust is determined only by reference to activities of trustee as such

• Points to S. Rep. No. 99- 313, at 735 (1986)
• TAM 200733023
• PLR 201029014
• CCA 201244017

IRS’s Position

Planning for S Corp. Trusts and the NII Surtax 57

• TAM 201317010
• S Corp.; one trustee was president of Qsub (a

disregarded entity); was also the only other shareholder of the S corp. parent.

• As trustee, this individual was responsible only for

the voting or selling of the trust’s S corp. shares

• Was not granted other discretionary power over

the trust assets or with respect to the operation or management of the trust.

• The other trustee was not involved in the

business.

Planning for S Corp. Trusts and the NII Surtax 58

• IRS: the time spent as an officer of the Qsub
• corp. did not count toward the trust’s

material participation

• The special trustee could not differentiate

the time spent in the various capacities

• In any event, the special trustee was not

vested with discretionary power to act on behalf of the trust

• No material participation by trust.

Planning for S Corp. Trusts and the NII Surtax 59

• Trust argued that its activities were not

passive

• It owned properties directly and through its

wholly-owned (disregarded) LLC

• Three of six trustees were employed full-time

by LLC; two of these trustees personally

• wned minority interests in the properties
• LLC also had non-trustee employees

Aragona Trust, 142 T.C. No. 9 (2014)

Planning for S Corp. Trusts and the NII Surtax 60

• Taxpayer: trust qualifies as real estate

professional – IRC 469(c)(7) exception to passive loss rules

• IRS: trust cannot perform “personal”

services

• Court: trustee managed assets for the

beneficiaries of the trust

• Under state law, the trustees were not

relieved of fiduciary duties by acting through a business entity owned by the trust

Planning for S Corp. Trusts and the NII Surtax 61

• Court rejected IRS position that employee-
• wner-trustees acted for themselves, not for

the trust and its beneficiaries

• Their combined interest was a minority and

was never greater than the trust’s

• Their interests as owners were compatible

with trust’s

Planning for S Corp. Trusts and the NII Surtax 62

• Not clear if IRS will appeal
• Parties have not yet agreed to tax

calculation

• Time extended to July 30
• Once court enters its decision, 90 days for

IRS to appeal. T.C. Rule 190; Sec. 7483

Future of Aragona case

Planning for S Corp. Trusts and the NII Surtax 63

• Will IRS appeal? Nonacquiescence?
• Will Regs be forthcoming under Sec. 469?
• Under the court’s decision, the work in the

business performed by individual trustees should count toward the trust’s material participation

• Selection of the trustee, therefore, may be an

important consideration; e.g. should the trustee be employed in the S corp?

Post-Aragona?

Planning for S Corp. Trusts and the NII Surtax 64

• A lot of questions remain unanswered
• Court did not rule as to the activities of the non-

trustee employees (of the LLC)

• Would it make a difference if the trustees were

employed by of an S corp., rather than by a disregarded entity?

• Must at least one-half the trustee be active

participants (as in Aragona)?

• What if the trustees personally owned a majority

interest?

Open Items

Planning for S Corp. Trusts and the NII Surtax 65

• In general, trust will want its business income to be active
• The active S corp. shareholder can create a grantor trust
• The owner’s participation should cause the income to be

nonpassive

• Several ways to achieve grantor trust status without inclusion

in gross estate; see, e.g., PLR 9543050 (Sec. 674), PLR 9525032 (Sec. 675)

• Beware of Administration proposals to better “coordinate” the

income and transfer tax rules for grantor trusts (2015 budget proposal)

Planning

Planning for S Corp. Trusts and the NII Surtax 66

• QSST vs ESBT – consider beneficiary’s

participation in the S corporation

• Consider granting Sec. 678 withdrawal

power to beneficiary? Beware lapse and gift under Sec. 2514.

Planning for S Corp. Trusts and the NII Surtax 67

• Non-grantor trust or ESBT – selection of

trustee may impact application of surtax

• Consider someone who is active in S

corporation’s business

• At least one-half of trustees should be active
• They should not personally own a majority of

the corporation

• Remember: If ESBT is subject to the surtax,

it cannot use distributions to beneficiaries to reduce its surtax

Planning for S Corp. Trusts and the NII Surtax 68

• Given its recent posture, IRS is not likely to agree

that a non-grantor trust materially participates unless the trustee is active as such

• Trustee should take affirmative action toward

achieving such status

• If participation in multiple capacities, instrument

should not excuse trustee from fiduciary responsibility

• Consider a “special trustee” whose responsibility is

limited to the business – give that trustee decision- making authority (see 2013 TAM)

Planning for S Corp. Trusts and the NII Surtax 69

• Again: Don’t let tax tail wag the dog
• Keep the surtax in perspective – it’s not the

end of the world

• Be mindful of grantor’s dispositive plan
• The above choices may have other

consequences (tax and other)

Planning for S Corp. Trusts and the NII Surtax 70

• Remember: Burden is on the taxpayer
• Maintain accurate and contemporaneous

records of trustee participation

• Bound to see more litigation in this area

Planning for S Corp. Trusts and the NII Surtax 71

Thank You.

Planning for S Corp. Trusts and the NII Surtax 72

• Mr. Louis Vlahos

Farrell Fritz, P.C. 1320 RXR Plaza Uniondale, NY 11556 LVlahos@farrellfritz.com (516)227-0639 http://www.taxlawforchb.com http://www.farrellfritz.com