Treasury and the IRS have issued proposed regulations (REG-143326-05) on S corporation rules to reflect changes made by the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), and the Gulf Opportunity Zone Act of 2005, P.L. 109-135 (GO Zone Act). In particular, the proposed regulations provide guidance on S corporation family shareholder rules, the definitions of “powers of appointment” and “potential current beneficiaries” (PCBs) with regard to electing small business trusts (ESBTs), and the allowance of suspended losses to the spouse (or former spouse) of an S corporation shareholder. These provisions are discussed in greater detail below.
The proposed regulations also provide guidance on:
- The treatment of passive activity losses and at-risk amounts when a qualified subchapter S trust disposes of S stock;
- The availability of relief for an inadvertent invalid or terminated qualified subchapter S subsidiary (QSub) election;
- The ownership of bank stock by an IRA; and
- The treatment of a QSub as a regarded entity for information return purposes.
For tax years beginning after 2004, a husband and wife (and their estates) and all members of their family (and estates) are treated as one shareholder for purposes of the 100-shareholder limitation; this treatment is automatic and does not require an election.
“Members of a family” are defined as a common ancestor, any lineal descendant of the common ancestor, and any spouse (or former spouse) of the common ancestor or any such lineal descendant; adopted and foster children are included. An individual is not eligible to be a common ancestor if, on the applicable date, the individual is more than six generations removed from the youngest generation of shareholders who would otherwise be members of the family (without regard to the six-generation limitation). The date on which a person will be tested for qualification as a common ancestor is 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. For this purpose, the date the S election is made is the election’s effective date. The “six-generation” test is applied only for determining whether an individual meets the definition of a common ancestor and has no significance in limiting the number of generations that may hold stock and be treated as a single shareholder (i.e., lineal descendants more than six generations removed from the common ancestor will be treated as members of the family even if they acquire stock in the corporation after the testing date).
The regulations also provide guidance on the treatment of trusts and disregarded entities as members of a family.
Unexercised Powers of Appointment in ESBTs
Potential current beneficiaries (PCBs) are treated as shareholders for shareholder eligibility and permitted shareholder number purposes. The AJCA provided that, in determining an ESBT’s PCBs for any period, powers of appointment will be disregarded to the extent they are not exercised by the end of that period. In addition, the period during which an ESBT may dispose of S stock after an ineligible shareholder becomes a PCB is increased from 60 days to one year.
The regulations define “power of appointment” for purposes of the above provisions by reference to the definition for transfer tax purposes in Secs. 2041 and 2514 and the regulations thereunder. The regulations also provide that a power of appointment includes a power, regardless of by whom it is held, to add a beneficiary or class of beneficiaries to the class of potential current beneficiaries, but generally does not include a power held by a fiduciary who is not also a beneficiary of the trust to spray or sprinkle trust distributions among beneficiaries.
There have been questions as to whether the power of a trustee (or any other person who is not a beneficiary) to add persons to the class of current beneficiaries or to select from an unlimited class of charitable beneficiaries will be considered powers of appointment, and thus disregarded (to the extent not exercised) in determining the PCBs of an ESBT. The proposed regulations provide that all 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 PCB in determining the number of permissible shareholders (unless the power is actually exercised, in which case each charity that actually receives distributions will also be a PCB). A trust containing such a power is required to indicate the presence of the power in the election statement.
Note: This amended PCB definition applies only to powers to distribute to one or more members of a class of unnamed charities that is unlimited in number; it does not apply to a power to make distributions to or among particular named charities. In this case, each of such organizations is a PCB.
Transfer of Stock Between Spouses or Incident to Divorce
The AJCA amended Sec. 1366(d)(2) to provide that if S stock is transferred between spouses or incident to a divorce, any loss or deduction with respect to this stock that cannot be taken into account by the transferring shareholder in the year of transfer, because of basis limitations, shall be treated as incurred by the S corporation in the following tax year with regard to the transferee.
Under the proposed regulations, losses and deductions allocable to a transferor spouse for the tax year immediately preceding the year of transfer that are subject to the basis limitation rule will be treated as incurred by the corporation with respect to the transferor spouse in the tax year of transfer. The transferor spouse may use all losses and deductions carried over to the year of transfer, if the transferor spouse has sufficient basis in the transferor’s adjusted basis in stock or adjusted basis in the corporation’s debt to the transferor. If the transferor’s pro-rata share of the losses and deductions in the year of transfer exceeds the transferor’s basis in stock or the corporation’s debt to the transferor, the limitation must be allocated among the transferor spouse’s pro-rata share of each loss or deduction (including disallowed losses and deductions carried over from prior years).
Losses and deductions carried over to the year of transfer that are not used by the transferor spouse in such year will be prorated between the transferor spouse and the transferee spouse, based on their stock ownership at the beginning of the succeeding tax year. The proposed regulations contain two examples illustrating the allocation of suspended losses under these provisions.
While the proposed regulations are generally not effective until issued in final form, they do provide helpful guidance in determining the impact of recent legislative changes to subchapter S. The provisions relating to the definition of PCBs are especially helpful and should be taken into consideration when determining if the ownership of a corporation’s stock by a trust for which an ESBT election is to be made would adversely affect the corporation’s S status.
David J. Kautter, CPA Ernst & Young LLP Washington, DC
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
If you would like additional information about these items, contact Mr. Kautter at (202) 327-8878 or firstname.lastname@example.org.