We thought we would pass on an interesting issue one of our clients raised with us last week, which we suspect may have come up in your practices. A trust reporting as a Qualified Subchapter S Trust (“QSST”) failed to make required distributions, and the question then became what to do about it.
Under §1361(d)(3)(B), one of the requirements for a trust to qualify as a QSST is that “all of the income…of which [i.e., the trust] is distributed (or required to be distributed) currently.” In examining tax sources, we ran across PLR 202405003, in which the trustee of a QSST had the right to make discretionary distributions of income failed to do so for numerous years. The IRS ruled that the S corporation’s election terminated on the first day of the first taxable year beginning after the first taxable year for which the trust failed to distribute its income. However, the IRS then provided inadvertent termination relief. Of course, our client was not anxious to pay the $43,700 toll charge to obtain a ruling or the attendant professional fees. Should it?
The conclusion we reached was no. Keep in mind that §1361(d)(3)(B) permits QSST status for a trust if “all of the income (within the meaning of section 643(b)) of which is distributed (or required to be distributed)” (emphasis added). Note the use of the word “or.” In the PLR, distributions of income were not required, rather they were discretionary. In our client’s situation, the trust agreement required that the distributions of income be made in the event of a QSST election (a common provisions in many trust agreements that contemplate the receipt of S corporation stock). Is this a distinction with a difference?
In the single class of stock arena, Reg. §1.1361-1(l)(2)(i) provides that there are not two classes of stock when distributions differ in timing or amount “so long as the governing provisions provide for identical distribution and liquidation rights…”. Also, in Rev. Proc. 2022-19, 2022-41 IRB 282, a revenue procedure providing inadvertent termination relief for S corporations and QSubs, the IRS indicated the following in Section 3.02:
The foregoing essentially indicates that there is not a second class of stock when disproportionate distributions are made because each shareholder has an enforceable right to the QSST pro rata distribution. Similarly, a trust provision requiring a distribution of net income to a beneficiary should be regarded as having the same type of right, so that the failure of a trustee to make the distributions should be ignored for QSST eligibility purposes.
Of course, most tax professionals upon discovery of the failure to make the required distributions would recommend that the trust make corrective distributions. However, making such distributions would not eliminate the issue, if the IRS would regard the failure to have made the required distributions timely as causing loss of QSST status. Unfortunately, Rev. Proc. 2022-19 does not provide for automatic relief for the QSST misstep described above. Nevertheless, one might speculate that most taxpayers would avoid obtaining a ruling. However, keep in mind that if your client becomes involved in a transaction in which the client’s S corporation stock is being sold, the purchaser’s due diligence might discover the issue and lead to (1) the transaction falling apart, (2) the purchaser requiring a favorable PLR be obtained, resulting in a delay in closing of the transaction, or (3) causing difficult negotiations as to a required indemnity and potential security for the indemnity.
We often share interesting client matters at our Tax Planning Forum® and Fundamentals of Flow-Through® programs. We hope that you will consider attending either or both of these virtual or in-person programs or our new Fundamentals QAS self-study program. Registration is in full swing, and we encourage you to register soon, especially if you are interested in either of our in-person programs in Las Vegas (which are coming up next week) or Orlando. Space is limited.
