PLR 200729010: Successive trusts receive conditional S shareholder ruling

Plain-English summary

A married couple held S corporation shares through subtrusts under one trust agreement and then through successor subtrusts after a merger. They retained a power to substitute trust property with property of equivalent value during both holding periods. The IRS concluded that the couple would be treated as owners, and the trusts would be permitted S corporation shareholders if otherwise eligible, if the power was exercisable in a nonfiduciary capacity. The IRS deferred deciding that factual issue until examination of the parties' returns. The ruling therefore states a condition for eligibility rather than a final finding that the condition was met.

Ruling snapshot

• Question: Could the original and successor subtrusts hold S corporation shares during their respective periods?
• Outcome: Mixed: eligibility depends on a factual condition left for examination.
• Key authorities: IRC §§ 675(4)(C), 678(b), 1361(c)(2)(A)(i); Treas. Reg. § 1.675-1(a)(4)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200729010
Third Party Communication: None
Release Date: 7/20/2007
Date of Communication: Not Applicable
Index Number: 1361.03-01
Person To Contact:
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Refer Reply To:
CC:PSI:B03
PLR-117310-06
Date:
March 27, 2007

Legend:

X = ---------------------------------------------------
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TrustA Agreement = ------------------------------------------------------------------------
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TrustA1 = -----------------------------------------------------------------------
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TrustA2 = ------------------------------------------------------------------------
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TrustA3 = ------------------------------------------------------------------------
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TrustA4 = ------------------------------------------------------------------------
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TrustA5 = -----------------------------------------------------------------------
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TrustB Agreement = ---------------------------------------------------------
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TrustB1 = -----------------------------------------------------------------------
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TrustB2 = -----------------------------------------------------------------------
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TrustB3 = -----------------------------------------------------------------------
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TrustB4 = -----------------------------------------------------------------------
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TrustB5 = -----------------------------------------------------------------------
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TrustB6 = -----------------------------------------------------------------------
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A = --------------------------
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B = -----------------------------
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State1 = ------------------

State2 = ------------------

Date1 = --------------------------

Date2 = ------------------------

Date3 = --------------------------
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Date4 = --------------------------

Date5 = --------------------------

Dear --------------------:

This letter responds to your letter dated March 20, 2006, and subsequent correspondence requesting a ruling on behalf of X that, pursuant to § 1362(c)(2)(A)(i) of the Internal Revenue Code, certain trusts qualify as shareholders of an S corporation.

FACTS

The information submitted states that X was incorporated in State1 on Date2. X made a timely S corporation election effective Date2.

On Date1, A and B, United States citizens and husband and wife, executed TrustA Agreement under State2 law. The TrustA Agreement created sub-trusts, TrustA1, TrustA2, TrustA3, TrustA4, and TrustA5. Under the terms of Section III of the TrustA Agreement, shares of the trust assets were apportioned as separate and distinct trusts but physical separation of the assets was not required. A and B, the Grantors of the trust, authorized the Trustee to “mingle and commingle investments, but wishes it understood that Grantor is creating independent trusts for all purposes.” On Date2, TrustA1, TrustA2, TrustA3, TrustA4, and TrustA5 acquired X corporation stock.

Section XIV of the TrustA Agreement provides that the trust is irrevocable.
Section IV of the TrustA Agreement provides that A and B retain the right and power to acquire or reacquire any trust property and substitute other property of equivalent value without incurring liability to a trust beneficiary or other party. The TrustA Agreement states that the substitution power granted to the power holder is exercisable in a non- fiduciary capacity.

Section VII of the TrustA Agreement provides each beneficiary of the respective sub-trusts the right to appoint to himself a proportionate share of additions made to the sub-trust each year. The amount appointed cannot exceed the amount excludable for gift tax purposes in any calendar year.

On Date3, A and B, United States citizens and husband and wife, executed TrustB Agreement under State2 law. The TrustB Agreement created sub-trusts, TrustB1, TrustB2, TrustB3, TrustB4, TrustB5, and TrustB6. Under the terms of Section
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III of the TrustB Agreement, shares of the trust assets were apportioned as separate and distinct trusts but physical separation of the assets was not required. A and B, the Grantors of the trust, authorized the Trustee to “mingle and commingle investments, but wishes it understood that Grantor is creating independent trusts for all purposes.” On Date3, the sub-trusts created under TrustA Agreement merged under State2 law into the sub-trusts created under TrustB Agreement. The X corporation stock held by the TrustA Agreement sub-trusts was transferred to the TrustB Agreement sub-trusts on Date3.

Section XIV of the TrustB Agreement provides that the trust is irrevocable.
Section IV of the TrustB Agreement provides that A and B retain the right and power to acquire or reacquire any trust property and substitute other property of equivalent value without incurring liability to a trust beneficiary or other party. The TrustB Agreement states that the substitution power granted to the power holder is exercisable in a non- fiduciary capacity.

Section VII of the TrustB Agreement provides each beneficiary of the respective sub-trusts the right to appoint to himself a proportionate share of additions made to the sub-trust each year. The amount appointed cannot exceed the amount excludable for gift tax purposes in any calendar year.

A and B were treated on their joint federal income tax returns as owners of the X corporation stock transferred to the sub-trusts created under the TrustA Agreement and merged into the sub-trusts created under the TrustB Agreement from the time of the stock transfers through Date4. Effective one day later, on Date5, A and B irrevocably relinquished their power to substitute trust assets with respect to TrustB Agreement sub-trusts.

Elections were made to treat each of the TrustB Agreement sub-trusts as electing small business trusts under § 1361(e)(1)(A), effective Date5.

The beneficiaries of the sub-trusts created under TrustA Agreement and TrustB Agreement received timely notification of their withdrawal rights and no beneficiary has exercised those rights.

LAW AND ANALYSIS

Section 1361(a)(1) provides that the term S corporation means, with respect to any taxable year, a small business corporation for which an election under § 1362(a) is in effect for such year.

Section 1361(b)(1)(B) provides that a small business corporation may not have as a shareholder a person (other than an estate, a trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an individual.
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Section 1361(c)(1)(A)(i) provides that for purpose of § 1361(b)(1)(A) a husband and wife shall be treated as one shareholder.

Section 1361(c)(2)(A)(i) provides that for purposes of § 1361(b)(1)(B), a trust all of which is treated (under subpart E of part I of subchapter J of chapter I) as owned by an individual who is a citizen or resident of the United States may be a shareholder in an S corporation. The deemed owner of the trust shall be treated as the shareholder under § 1361(c)(2)(B)(i).

Section 1.1361-1(e)(2) of the Income Tax Regulations provides that for purposes of § 1.1361-1(e)(1), stock owned by a husband and wife is treated as if owned by one shareholder, regardless of the form in which they own the stock. For example, if husband and wife are owners of a subpart E trust, they will be treated as one individual. Both husband and wife must be U.S. citizens or residents.

Section 675(4) provides that the grantor shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. Section 675(4)(C) provides that “power of administration” means, among other things, a power to reacquire the trust corpus by substituting other property of an equivalent value.

Section 1.675-1(a)(4) (iii)(flush language) provides, in part, that if a power is not exercisable by a person as trustee, the determination of whether the power is exercisable in a fiduciary or nonfiduciary capacity depends on all of the terms of the trust and the circumstances surrounding its creation and administration.

Section 678(a) provides that a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which (1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or (2) the person has previously partially released or otherwise modified such a power and after the release or modifications retains such control as would cause a grantor to be treated as the owner of such portion of the trust within the principles of §§ 671 to 677, inclusive.

Section 678(b) provides that § 678(a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust is otherwise treated as the owner under the provisions of subpart E other than § 678.

CONCLUSION

Based solely on the facts and representations submitted, we conclude that the circumstances surrounding the administration of the sub-trusts created under the TrustA
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Agreement and the TrustB Agreement will determine whether the power of administration is exercisable in a fiduciary or nonfiduciary capacity. This is a question of fact, the determination of which must be deferred until the federal income tax returns of the parties involved have been examined by the Internal Revenue Service office where the returns are filed. Therefore, we cannot determine at this time whether A and B will be treated as the owners of the sub-trusts created under the TrustA Agreement and the TrustB Agreement under § 675(4)(C). Provided that the circumstances indicate that the power of administration is exercisable in a nonfiduciary capacity, A and B will be treated as the owners of the sub-trusts created under the TrustA Agreement and the TrustB Agreement under §§ 675 and 678(b).

Accordingly, the sub-trusts created under the TrustA Agreement were permitted shareholders in X, an S corporation, under § 1361(c)(2)(A)(i), if otherwise eligible, from Date2 until Date3; the sub-trusts created under the TrustB Agreement were permitted shareholders in X, an S corporation, under § 1361(c)(2)(A)(i), if otherwise eligible, from Date3 through Date4.

Except as expressly provided herein, we express or imply no opinion concerning the federal tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, we express or imply no opinion concerning whether X is otherwise eligible to be an S corporation for federal tax purposes.

In accordance with a power of attorney on file with this office, a copy of this letter is being sent to X’s authorized representative.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

Sincerely,

/s/

James A. Quinn
Senior Technician Reviewer (Acting)
Branch 2
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)
A copy of this letter
A copy for § 6110 purposes