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Friday, April 26, 2024

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GiftLaw Note: Sacha Swain owns 100% of the stock of Xai, Inc. and Yai, Inc. Both Xai and Yai are S Corporations. Sacha wants to transfer her Xai and Yai stock to a qualified charitable remainder trust (CRT). Can she do this?

Section 664 and corresponding regulations set forth the requirements of a CRT. To qualify as a CRT, a trust must meet the definition of and function exclusively as a CRT from creation. Section 1361 and corresponding regulations set forth the requirements of an S Corporation. A trust may only own S Corporation stock if it is a grantor trust, a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT).

The IRS ruled that the CRT rules and the rules that allow trusts to own S Corporation stock are in conflict. The result is that a single trust cannot qualify both as a CRT and as a proper S Corporation shareholder (by virtue of being a grantor trust or QSST). As a result, Sacha's CRT cannot qualify as a proper S Corporation shareholder to own Xai and Yai stock. The result is that Sacha can contribute her Xai and Yai stock to a CRT; but if she does, Xai and Yai will lose their S Corporation status and be reclassified as C Corporations.

Editor's Note: Letter Ruling 8922014 focuses on whether a CRT may qualify as a grantor trust or QSST. ESBTs were not introduced until after this Letter Ruling was issued. Section 1361(e) explicitly states that a charitable remainder trust is not an eligible ESBT. The result of this Letter Ruling and Section 1361(e) is that a CRT may not own S Corporation stock.

An alternative option for a donor such as Sacha who owns an S Corporation and wishes to fund a CRT is for the S Corporation itself to create a CRT and fund the CRT with its assets. In this case, the donor still owns the S Corporation stock, the CRT owns assets (which it can subsequently sell), and the CRT payments are made to the S Corporation and then passed through to the S Corporation shareholders who own the stock.

PRIVATE RULING 8922014

DATE: February 28, 1989

On September 15, 1988, and previous correspondence you asked us to rule whether a proposed charitable remainder unitrust will qualify as a charitable remainder trust under section 664 of the Internal Revenue Code and as a qualified subchapter S trust under section 1361(D)(3) of the Code.

The facts submitted are as follows:

A owns one hundred percent (100%) of the stock in X Corporation and also owns stock in Y Corporation. Both corporations are "S corporations" as defined in section 1361(a)(1) of the Internal Revenue Code. A proposes to transfer his stock in the two S corporations to a charitable remainder unitrust described in section 664(d)(3) of the Code.

The charitable remainder trust would pay to A, for his lifetime, the lesser of trust income or 10% of the net fair market value of the trust assets valued as of the first day of each taxable year. If the trust income for any taxable year exceeds the unitrust amount, the payment to the income beneficiary will also include such excess income to the extent the aggregate of the amounts paid to an income beneficiary in prior years is less than 10% of the aggregate net fair market value of the trust assets for such years.

At the taxpayer's death, such amounts would be paid to a successor beneficiary in such amounts and proportions as the trustee in its absolute discretion should determine. The taxpayer reserves the power, exercisable by will, to revoke the interest of the successor income beneficiary. At the termination of the trust, the trust corpus would be paid to M Charity.

Section 1.664-1(a)(1)(i) of the Income Tax Regulations provides that a charitable remainder trust is a trust which provides for a specified distribution, at least annually to one or more beneficiaries, for life, or for a term of years, with an irrevocable remainder interest to be held for the benefit of, or paid over to, qualified charities.

Under the definition of a charitable remainder unitrust contained in section 664(d)(2) or (3) of the Code, the specified amount distributed may be the lessor of (1) a fixed percentage (not less than 5%) of the net fair market value of the trust assets valued annually, or (2) the amount of trust income. Any amount of trust income which is in excess of the fixed percentage must be paid to the beneficiary to the extent that the aggregate of amounts paid in prior years was less than the aggregate of the amounts described in (1).

Section 1.664-1(a)(4) of the regulations provides that in order for a trust to qualify as a charitable remainder trust, it must meet the definition of an function exclusively as a charitable remainder trust from its creation. A trust is deemed created at the earliest time that neither the grantor nor any other person is treated as the owner of the entire trust under the grantor trust provisions (sections 671-679 of the Code). For purposes of this rule, neither the grantor or his spouse will be treated as owner merely because the grantor or the spouse is named as a recipient.

Section 664(c) of the Code provides that, generally, a trust meeting the definition of a charitable remainder trust is exempt from federal income tax. The unitrust amount required to be distributed is taxable to the beneficiary under the rules contained in section 664(b) of the Code and section 1.664-1(d) of the regulations. Section 664(a) and the regulations thereunder provide that these provisions apply notwithstanding the other provisions of subchapter J (sections 641-692) of the Code.

Section 1361(d) of the Code permits certain qualifying subchapter S trusts (QSSTs) to be S corporation shareholders. The beneficiary of a trust otherwise meeting the definition of a qualified subchapter S trust contained in section 1361(d)(3) must elect to be treated under section 678(a) as the owner of the portion of the trust consisting of S corporation stock. See section 1361(d)(1) of the Code.

A beneficiary electing under section 1361(d) of the Code to be treated as owner of the portion of the trust consisting of stock, agrees to be taxed on all items of income relating to that stock. See section 671 of the Code. As a result of the QSST election, the beneficiary, rather than the trust, is treated as the taxable owner of the stock. This election ensures that the trust represents only one S corporation shareholder, and guarantees that all income earned by the trust relating to the stock is taxed to the trust's beneficiary.

In contrast, under section 664(b) of the Code, the beneficiary of an income interest in a charitable remainder unitrust is only taxable on the unitrust amount. Tax is imposed on the income beneficiary only to the extent of the unitrust amount received and only to the extent the amount represents taxable income. Any other income is taxed to the trust and thus is, in general, tax exempt under section 664(c), because the income is being held for the benefit of charity.

Thus, section 664 and section 1361 of the Code contemplate two distinct systems of taxation. Section 1361 allows a trust meeting certain detailed requirements to qualify as an S corporation shareholder if the trust beneficiary elects tax treatment under the grantor trust provisions. Section 664 applies to an arrangement meeting equally detailed requirements and provides favorable tax treatment in lieu of the other provisions of subchapter J. Under section 664(a) the charitable remainder unitrust provisions would override the tax treatment attending a QSST election. Thus, if the section 1361 election were allowed, an essential element of section 1361(d), imposing section 678 tax consequences on the beneficiary, would be avoided. The trust would represent, in effect, two owners of the S corporation stock: the income beneficiary who is taxed on the income to the extent received, and the trust whose income is not taxed because it is earmarked for charity. This consequence is contrary to the operation of section 1361(d). Therefore, a charitable remainder unitrust cannot qualify as an S corporation shareholder under that section.

The inconsistency between the two systems of taxation for the two different trust arrangements is further highlighted by postulating a different situation. If a QSST election were permitted, and grantor trust treatment applied so that the trust beneficiary were to be taxed on all trust income deriving from the stock, then the trust would not function exclusively as a charitable remainder unitrust. Accordingly, all charitable deductions for transfers to the trust would be disallowed and the trust would not be tax exempt. See section 1.664-1(a)(4), ex 2, of the regulations. It is apparent that imposing the grantor trust provisions on the section 664 scheme of taxation would severely frustrate the intent and effect of the charitable remainder trust provisions.

Accordingly, we conclude that the trust arangements described in sections 664 and 1361(d) are mutually exclusive. A charitable remainder unitrust cannot qualify as a quaified subchapter S trust under section 1361(d), and a qualified subchapter S trust cannot qualify under section 664.

In view of the ruling above, we have not considered whether the trust you submitted would otherwise meet the requirements of section 664 of the Code and regulations.

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

Assistant Chief Counsel
George Masnik
Assistant to the Chief
Branch 4
Enclosures
Copy for section 6110 purposes

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