PricewaterhouseCoopers Suggests Changes to Proposed ESBT Regs

BACKGROUND

[2] Prior to the enactment of the Small Business Job Protection Act of 1996 ("SBJPA"), small business corporation ("S corporation") shareholders were limited in what type of trusts they could utilize for purposes of family financial planning. Prior to SBJPA, S corporation shareholders could only transfer their S corporation stock to wholly-owned grantor trusts, voting trusts, certain grantor trusts after the grantor's death or Qualified Subchapter S Trusts ("QSSTs"). Often times, the requirements of these types of trusts were incompatible with S corporation shareholders' family financial planning objectives. For example, a QSST can only have one income beneficiary and the trust's income is required to be distributed to such beneficiary on an annual basis.

[3] Congress provided additional flexibility to S corporation shareholders, with respect to family financial planning, when it enacted Section 1302 of SBJPA by creating the Electing Small Business Trust ("ESBT"). An ESBT is permitted to have more than one income beneficiary and is not required to distribute trust income.

[4] Congress was concerned that S corporation shareholders would utilize ESBTs to reduce overall tax liabilities of the flow through income from S corporations. To eliminate this perceived abuse, Congress also enacted Code section 641(c) in the SBJPA requiring ESBTs to pay income tax on the flow through earnings from an S corporation at the trust level and at the highest marginal individual income tax rate (i.e., currently 39.1%).

[5] On December 29, 2000, the IRS issued proposed regulations providing guidance on the qualification and treatment of ESBTs.

COMMENTS ON TAXATION OF GRANTOR TRUSTS

[6] The proposed regulations confirm that a grantor trust is eligible to make an ESBT election. The Preamble to the proposed regulations states that the Treasury Department and the IRS believe that Congress did not intend to preclude this type of trust from electing to be an ESBT. The proposed regulations, however, mandate that the flow-through income from the S corporation be taxed at the grantor level and not at the ESBT level.

[7] As previously stated, Congress believed that S corporation shareholders may attempt to minimize income tax from the income flowing through the S corporation by utilizing ESBTs. As such, Congress enacted Code section 641(c) requiring that "FOR PURPOSES OF THIS CHAPTER, (A) the portion of any ESBT which consists of stock in 1 or more S corporations shall be treated as a separate trust, and (B) the amount of the tax imposed by this chapter on such separate trust shall be determined with the modifications of paragraph (2)." The phrase "FOR PURPOSES OF THIS CHAPTER" refers to chapter 1 of the Code -- Normal Taxes and Surtaxes -- which includes the taxation of grantor trusts under Code sections 671 through 678.

[8] The legislative history to SBJPA clearly suggests that Congress intended ANY trust which makes an ESBT election to pay tax at the trust (and not the grantor) level. ¹ This belief is consistent with a plain reading of the statute listed above. The position advanced in the proposed regulations whereby a trust may be required to calculate tax on its income utilizing three different methodologies (i.e., the grantor portion, the ESBT portion, and the non-S portion) only complicates an already administratively difficult compliance process.

[9] We believe the Treasury Department should reflect Congress' intent in its regulations by requiring grantor trusts that make ESBT elections to pay the tax at the trust level and not at the grantor level.

PROPOSED EFFECTIVE DATES

[10] The proposed regulations are generally effective on and after the date and final reuglations are published in the Internal Revenue Bulletin. The preamable to the proposed regulations states that the IRS adn the Treasury Department have become aware of potentially abusive transactions (involving Guam-based trusts) which are detailed in IRS Notice 2000-61, 2000-49 I.R.B. 1. Therefore, the proposed regulations contain a retroactive effective date for grantor trusts making ESBT elections (specifically, those trusts described in proposed sections 1.641(c)-1(a), (b) and (c)) to taxable years ending on and after December 29, 2000. The IRS and the Treasury Department believe the retroactive effective date will minimize the abuses outlined in IRS Notice 2000-61.

[11] We believe, however, that the retroactive effective date described above negatively affects taxpayers that have relied on a plain reading of the statute in ordering their family financial planning affairs. As such, we believe that the retroactive effective date should only apply to the abusive transactions described in IRS Notice 2000-61 and not to grantor trust taxpayers that have elected ESBT status and paid federal income tax (i.e., those taxpayers not utilizing Guam-based trust tax abuses).

[12] We appreciate this opportunity to comment on the proposed ESBT regulations. If you have any questions you may contact me at (202) 414-4423.

Sincerely,