Divorce trust terms preserve S corporation and ESBT status

Plain-English summary

A divorcing couple proposed moving S corporation stock from one spouse's grantor trust into a single trust that would internally account for equal shares for each spouse. The trust agreement gave the spouses different distribution arrangements, but it did not alter the rights attached to the corporation's stock. The IRS ruled that the agreement therefore would not create a prohibited second class of S corporation stock under section 1361(b)(1)(D). It also ruled that the divorce-related transfer would receive section 1041 gift and carryover-basis treatment, so the consideration one spouse provided for lifetime distribution rights would not be a purchase that disqualified the trust from electing small business trust status.

Ruling snapshot

• Question: Would a divorce trust's distribution provisions create a second class of S corporation stock or prevent the trust from qualifying as an ESBT?
• Outcome: Approved, provided the stock transfer occurs within six years of final judgment and the executed trust remains materially identical to the submitted terms.
• Key authorities: IRC §§ 1012, 1041, and 1361(b), (c), and (e); Treas. Reg. §§ 1.1041-1T and 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201834009 Third Party Communication: None
Release Date: 8/24/2018 Date of Communication: Not Applicable
Index Number: 1361.03-03
Person To Contact:
-------------------------------------------------------- --------------------------ID No. --------------
------------------------------- Telephone Number:
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------------------------------------ Refer Reply To:
CC:PSI:B01
PLR-134980-17
Date:
May 18, 2018

LEGEND:

A = ---------------------------------------------------------------------------------------------------------
-------------------------

B = ---------------------------------------------------------------------------------------------------------
------------------------

X = ---------------------------------------------------------------------------------------------------------
------------------------

Trust = ----------------------------------------------------------

State = ---------------

Date 1 = ---------------------------

Date 2 = --------------------
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Date 3 = -------------------

Dear ----------------

This responds to a letter dated October 24, 2017, and subsequent information,
submitted on behalf of A, B, and X, requesting rulings under §§ 1361(b)(1)(D) and
1361(e) of the Internal Revenue Code (the Code).

Facts

The information submitted states that A and B were married on Date 1, and are in the
process of finalizing the division of assets as a result of their divorce. One such marital
asset of A and B are shares of stock in X, an S corporation. The shares of X stock are
currently held by a revocable trust of which A is the grantor (A’s grantor trust).

The State court presiding of the divorce of A and B issued a divorce decree on Date 2,
as modified by an order dated Date 3 (together, the “Decree”). A key part of the Decree
is a requirement that A cause A’s grantor trust to transfer all of the shares of X stock it
holds to Trust, the beneficiaries of which are A and B with certain agreed-upon
provisions. A and B negotiated the terms of the Trust and both signed the agreement
setting forth the Trust’s terms. The Decree orders that the transfer of the shares of X
stock to the Trust is subject to the prior approval of the tax issues by the IRS.

Other than a nominal amount of cash, the Trust will be funded only with the shares of X
stock currently held by A’s grantor trust. The Trust agreement provides that the principal
purpose of the Trust is to set forth and govern all incidents of ownership and control of
the X stock owned by the Trust. The Trust is a single trust. However, for administrative
purposes only, the property held in Trust will be accounted for internally in two separate
shares (each a “Share” and together the “Shares”), one for A, and one for B. Each
Share holds 50% of the X stock held in Trust. . In connection with the divorce, B
provided consideration for B’s lifetime distribution rights under the Trust, but provided no
consideration for any remainder interest in the Trust.

The X stock is subject to certain liabilities and the Trust may assume certain liabilities.
A, B, and X represent that the sum of the amount of liabilities to be assumed by the
Trust, plus the amount of the liabilities to which the property to be transferred to the
Trust is subject, will not exceed the total of the adjusted basis of the property
transferred.

Some or all distributions received by the Trust from X will be used by the trustee of
Trust to make required payments on the liabilities against which the X stock is pledged,
and those payments will be made equally from A’s share and B’s share. In exchange
for B agreeing to have the liabilities be paid from B’s Share, A’s Share will issue to B’s
Share a promissory note for amounts paid out of B’s share with respect to the liabilities.
Additionally, although distributions from X to Trust will be applied equally to each share,
A will have a right to certain distributions from Trust that will not be shared by B.

The trustee of the Trust intends to elect to treat the Trust as an electing small business
trust (ESBT) under § 1361(e).

Taxpayer requests that we rule as follows:

(1) X will not be considered to have a second class of stock in violation of
§ 1361(b)(1)(D) solely as a result of the provisions in the Trust agreement.

(2) The consideration provided by B for B’s lifetime distribution rights in connection with
the divorce does not prevent the Trust from qualifying as an ESBT under
§ 1361(e)(1)(C).

Ruling 1:

Section 1361(b)(1) provides that the term “small business corporation” means a
domestic corporation which is not an ineligible corporation and which does not (A) have
more than 100 shareholders, (B) 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, (C) have a nonresident alien as a shareholder, and (D) have more
than one class of stock.

Section 1.1361-1(l)(1) provides, in part, that a corporation is generally treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds.

Section 1.1361-1(l)(2)(i) provides that the determination of whether all outstanding
shares of stock confer identical rights to distribution and liquidation proceeds is made
based on the corporate charter, articles of incorporation, bylaws, applicable state laws,
and binding agreements relating to distribution and liquidation proceeds (collectively,
governing provisions). A commercial contractual agreement, such as a lease,
employment agreement, or loan agreement, is not a binding agreement relating to
distribution and liquidation proceeds and thus is not a governing provision unless a
principal purpose of the agreement is to circumvent the one class of stock requirement
of § 1361(b)(1)(D) and § 1.1361-1(l). Although a corporation is not treated as having
more than one class of stock so long as the governing provisions provide for identical
distribution and liquidation rights, any distributions (including actual, constructive, or
deemed distributions) that differ in timing or amount are to be given appropriate tax
effect in accordance with the facts and circumstances.

Trust Agreement is not a governing provision that is required to be taken into account
under § 1.1361-1(l)(2)(i). Accordingly, the Trust Agreement is disregarded in
determining whether the outstanding shares of X stock confer identical rights to
distributions and liquidation proceeds. Therefore, X will not be considered as having
more than one class of stock under § 1361(b)(1)(D), as a result of the Trust Agreement.

Ruling 2:

Section 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an electing small
business trust (“ESBT”) may be an S corporation shareholder.

Section 1361(e) provides that an ESBT means any trust if (i) such trust does not have
as a beneficiary any person other than (I) an individual, (II) an estate, (III) an
organization described in § 170(c)(1) which holds a contingent interest in such trust and
is not a potential current beneficiary, (ii) no interest in such trust was acquired by
purchase, and (iii) an election under § 1361(e) applies to such trust.

Section 1361(e)(1)(C) provides that for purposes of § 1361(e)(1)(C) provides that for
purposes of §1361(e)(1)(A) the term “purchase” means any acquisition if the basis of
the property acquired in determined under § 1012.

Section 1012(a) provides that the basis of property shall be the cost of such property,
except as otherwise provided in this subchapter and subchapters C (related to
corporate distributions and adjustments), K (related to partners and partnerships, and P
(related to capital gains and losses).

Section 1041(a) provides that no gain or loss shall be recognized on a transfer of
property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former
spouse, but only if the transfer is incident to the divorce.

Section 1041(b) provides that, in the case of any transfer of property described in
§ 1041(a), the property shall be treated as acquired by the transferee by gift, and the
basis of the transferee in the property shall be the adjusted basis of the transferor.

Section 1041(c) provides that for purposes of § 1041(a)(2), a transfer of property is
incident to the divorce if the transfer occurs (1) within one year after the date on which
the marriage ceases, or (2) is related to the cessation of the marriage.

Section 1041(e) provides that § 1041(a) shall not apply to the transfer of property in
trust to the extent that (1) the sum of the amount of the liabilities assumed, plus the
amount of the liabilities to which the property is subject, exceeds (2) the total of the
adjusted basis of the property transferred. Proper adjustment shall be made under
§ 1041(b) in the basis of the transferee in such property to take into account gain
recognized.

Section 1.1041-1T(b), Q&A-7, of the Temporary Income Tax Regulations provides that
a transfer of property is related to the cessation of the marriage if the transfer is
pursuant to a divorce or separation instrument, as defined in § 71(b)(2), and the transfer
occurs not more than six years after the date on which the marriage ceases. A divorce
or separation instrument includes a modification or amendment to such decree or
instrument.

A is causing A’s grantor trust to transfer the shares of X stock to the Trust pursuant to
the divorce Decree, and the amount of the liabilities assumed plus the liabilities that the
property transferred is subject to does not exceed the adjusted basis of the property
transferred.

Accordingly, based on the facts submitted and representations made, provided that the
transfer of the shares of X stock to the Trust occurs within six years of the entry of final
judgment and the terms of the Trust as executed by A and B remain materially identical
to those submitted, we conclude that § 1041(a) applies and A and B will not recognize
any gain or loss on the transfer of the shares of X stock from A’s grantor trust to the
Trust.

Further, § 1041(b) applies such that the transfer is treated as a gift under § 1041(b). As
such, B’s acquisition of B’s lifetime distribution rights in the Trust for consideration is not
a purchase within § 1361(e) because the sale is not governed by § 1012(a).
Accordingly, B’s acquisition of B’s distribution rights will not disqualify Trust from being
an ESBT.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, we neither express nor imply any opinion concerning the
application of § 682 to the Trust and whether the Trust is a grantor trust under § 671.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to X's authorized representatives.

Sincerely,

Faith P. Colson
Senior Counsel, Branch 1
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes