PLR 200729014: Eight trusts may hold S corporation stock if grantor is their owner

Plain-English summary

An individual sold S corporation stock to eight separate trusts and retained the power to substitute trust property with property of equal value. The trusts asked whether they were eligible S corporation shareholders before the individual relinquished that power. The IRS said the individual would count as their owner if the substitution power was exercisable in a nonfiduciary capacity. If that factual condition and the other eligibility requirements were met, the trusts were permitted shareholders during the stated period. The IRS left the factual determination about the power's operation for examination of the relevant tax returns.

Ruling snapshot

• Question: Could the eight trusts hold S corporation stock while their grantor held a substitution power?
• Outcome: Mixed: eligibility was conditional, and the central factual determination was deferred.
• 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: 200729014
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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Telephone Number:
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--------------------------------------------- Refer Reply To:
CC:PSI:B03
PLR-117316-06
Date:
March 27, 2007

Legend:

X = ---------------------------
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Trust Agreement = -----------------------------------------------------------------------
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Trust1 = -----------------------------------------------------------------------
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Trust2 = -----------------------------------------------------------------------
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Trust3 = -----------------------------------------------------------------------
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Trust4 = -----------------------------------------------------------------------
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Trust5 = -----------------------------------------------------------------------
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Trust6 = -----------------------------------------------------------------------
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Trust7 = -----------------------------------------------------------------------
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Trust8 = -----------------------------------------------------------------------
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A = --------------------------
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State1 = ------------------

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

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

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

Date3 = -----------------------

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.
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FACTS

The information submitted states that X was incorporated in State1 on Date1. X made a timely S corporation election effective Date1.

On Date2, A, a United States citizen, executed the Trust Agreement under State2 law. By its terms the Trust Agreement created sub-trusts Trust1, Trust2, Trust3, Trust4, Trust5, Trust6, Trust7, and Trust8 (the Sub-Trusts), each with a single current beneficiary. Under the terms of Section III of the Trust Agreement, shares of the trust assets were apportioned as separate and distinct trusts but physical separation of the assets was not required. A, the Grantor 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, A sold X stock to each of the Sub- Trusts.

Section XIV of the Trust Agreement provides that the trust is irrevocable.
Section IV of the Trust Agreement provides that A retains 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 Trust Agreement states that the substitution power granted to the power holder is exercisable in a non-fiduciary capacity.

Section VII of the Trust 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 was treated on his federal income tax returns as the owner of the X stock transferred to the respective Sub-Trusts from Date3 through Date4. Effective one day later, on Date5, A irrevocably relinquished his power to substitute trust assets with respect to the Sub-Trusts.

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

The beneficiaries of the Sub-Trusts 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.
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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.

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 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 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
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A will be treated as the owner of the Sub-Trusts under § 675(4)(C). Provided that the circumstances indicate that the power of administration is exercisable in a nonfiduciary capacity, A will be treated as the owner of the Sub-Trusts under §§ 675 and 678(b).

Accordingly, the Sub-Trusts 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