[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1361-1]

[Page 684-710]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1361-1  S corporation defined.

    (a) In general. For purposes of this title, with respect to any 
taxable year--
    (1) The term S corporation means a small business corporation (as 
defined in paragraph (b) of this section) for which an election under 
section 1362(a) is in effect for that taxable year.
    (2) The term C corporation means a corporation that is not an S 
corporation for that taxable year.
    (b) Small business corporation defined--(1) In general. For purposes 
of subchapter S, chapter 1 of the Code and the regulations thereunder, 
the term small business corporation means a domestic corporation that is 
not an ineligible corporation (as defined in section 1361(b)(2)) and 
that does not have--
    (i) More than 75 shareholders (35 for taxable years beginning before 
January 1, 1997);
    (ii) As a shareholder, a person (other than an estate, a trust 
described in section 1361(c)(2), or, for taxable years beginning after 
December 31, 1997, an organization described in section 1361(c)(6)) who 
is not an individual;
    (iii) A nonresident alien as a shareholder; or
    (iv) More than one class of stock.
    (2) Estate in bankruptcy. The term estate, for purposes of this 
paragraph, includes the estate of an individual in a case under title 11 
of the United States Code.
    (3) Treatment of restricted stock. For purposes of subchapter S, 
stock that is issued in connection with the performance of services 
(within the meaning of Sec. 1.83-3(f)) and that is substantially 
nonvested (within the meaning of Sec. 1.83-3(b)) is not treated as 
outstanding stock of the corporation, and the holder of that stock is 
not treated as a shareholder solely by reason of holding the stock, 
unless the holder makes an election with respect to the stock under 
section 83(b). In the event of such an election, the stock is treated as 
outstanding stock of the corporation, and the holder of the stock is 
treated as a shareholder for purposes of subchapter S. See paragraphs 
(l) (1) and (3) of this section for rules for determining whether 
substantially nonvested stock with respect to which an election under 
section 83(b) has been made is treated as a second class of stock.
    (4) Treatment of deferred compensation plans. For purposes of 
subchapter S, an instrument, obligation, or arrangement is not 
outstanding stock if it--

[[Page 685]]

    (i) Does not convey the right to vote;
    (ii) Is an unfunded and unsecured promise to pay money or property 
in the future;
    (iii) Is issued to an individual who is an employee in connection 
with the performance of services for the corporation or to an individual 
who is an independent contractor in connection with the performance of 
services for the corporation (and is not excessive by reference to the 
services performed); and
    (iv) Is issued pursuant to a plan with respect to which the employee 
or independent contractor is not taxed currently on income.

A deferred compensation plan that has a current payment feature (e.g., 
payment of dividend equivalent amounts that are taxed currently as 
compensation) is not for that reason excluded from this paragraph 
(b)(4).
    (5) Treatment of straight debt. For purposes of subchapter S, an 
instrument or obligation that satisfies the definition of straight debt 
in paragraph (l)(5) of this section is not treated as outstanding stock.
    (6) Effective date provision. Section 1.1361-1(b) generally applies 
to taxable years of a corporation beginning on or after May 28, 1992. 
However, a corporation and its shareholders may apply this Sec. 1.1361-
1(b) to prior taxable years. In addition, substantially nonvested stock 
issued on or before May 28, 1992, that has been treated as outstanding 
by the corporation is treated as outstanding for purposes of subchapter 
S, and the fact that it is substantially nonvested and no section 83(b) 
election has been made with respect to it will not cause the stock to be 
treated as a second class of stock.
    (c) Domestic corporation. For purposes of paragraph (b) of this 
section, the term domestic corporation means a domestic corporation as 
defined in Sec. 301.7701-5 of this chapter, and the term corporation 
includes an entity that is classified as an association taxable as a 
corporation under Sec. 301.7701-2 of this chapter.
    (d) Ineligible corporation--(1) General rule. Except as otherwise 
provided in this paragraph (d), the term ineligible corporation means a 
corporation that is--
    (i) For taxable years beginning on or after January 1, 1997, a 
financial institution that uses the reserve method of accounting for bad 
debts described in section 585 (for taxable years beginning prior to 
January 1, 1997, a financial institution to which section 585 applies 
(or would apply but for section 585(c)) or to which section 593 
applies);
    (ii) An insurance company subject to tax under subchapter L;
    (iii) A corporation to which an election under section 936 applies; 
or
    (iv) A DISC or former DISC.
    (2) Exceptions. See the special rules and exceptions provided in 
sections 6(c) (2), (3) and (4) of Public Law 97-354 that are applicable 
for certain casualty insurance companies and qualified oil corporations.
    (e) Number of shareholders--(1) General rule. A corporation does not 
qualify as a small business corporation if it has more than 75 
shareholders (35 for taxable years beginning prior to January 1, 1997). 
Ordinarily, the person who would have to include in gross income 
dividends distributed with respect to the stock of the corporation (if 
the corporation were a C corporation) is considered to be the 
shareholder of the corporation. For example, if stock (owned other than 
by a husband and wife) is owned by tenants in common or joint tenants, 
each tenant in common or joint tenant is generally considered to be a 
shareholder of the corporation. (For special rules relating to stock 
owned by husband and wife, see paragraph (e)(2) of this section; for 
special rules relating to restricted stock, see paragraphs (b) (3) and 
(6) of this section.) The person for whom stock of a corporation is held 
by a nominee, guardian, custodian, or an agent is considered to be the 
shareholder of the corporation for purposes of this paragraph (e) and 
paragraphs (f) and (g) of this section. For example, a partnership may 
be a nominee of S corporation stock for a person who qualifies as a 
shareholder of an S corporation. However, if the partnership is the 
beneficial owner of the stock, then the partnership is the shareholder, 
and the corporation does not qualify as a small business corporation. In 
addition, in the case of stock held for a minor under a uniform gifts to 
minors or

[[Page 686]]

similar statute, the minor and not the custodian is the shareholder. For 
purposes of this paragraph (e) and paragraphs (f) and (g) of this 
section, if stock is held by a decedent's estate, the estate (and not 
the beneficiaries of the estate) is considered to be the shareholder; 
however, if stock is held by a subpart E trust (which includes voting 
trusts), the deemed owner is considered to be the shareholder.
    (2) Special rules relating to stock owned by husband and wife. For 
purposes of paragraph (e)(1) of this section, stock owned by a husband 
and wife (or by either or both of their estates) is treated as if owned 
by one shareholder, regardless of the form in which they own the stock. 
For example, if husband and wife are owners of a subpart E trust, they 
will be treated as one individual. Both husband and wife must be U.S. 
citizens or residents, and a decedent spouse's estate must not be a 
foreign estate as defined in section 7701(a)(31). The treatment 
described in this paragraph (e)(2) will cease upon dissolution of the 
marriage for any reason other than death.
    (f) Shareholder must be an individual or estate. Except as otherwise 
provided in paragraph (e)(1) of this section (relating to nominees), 
paragraph (h) of this section (relating to certain trusts), and, for 
taxable years beginning after December 31, 1997, section 1361(c)(6) 
(relating to certain exempt organizations), a corporation in which any 
shareholder is a corporation, partnership, or trust does not qualify as 
a small business corporation.
    (g) Nonresident alien shareholder--(1) General rule. (i) A 
corporation having a shareholder who is a nonresident alien as defined 
in section 7701(b)(1)(B) does not qualify as a small business 
corporation. If a U.S. shareholder's spouse is a nonresident alien who 
has a current ownership interest (as opposed, for example, to a 
survivorship interest) in the stock of the corporation by reason of any 
applicable law, such as a state community property law or a foreign 
country's law, the corporation does not qualify as a small business 
corporation from the time the nonresident alien spouse acquires the 
interest in the stock. If a corporation's S election is inadvertently 
terminated as a result of a nonresident alien spouse being considered a 
shareholder, the corporation may request relief under section 1362(f).
    (ii) The following examples illustrate this paragraph (g)(1)(i):

    Example 1. In 1990, W, a U.S. citizen, married H, a citizen of a 
foreign country. At all times H is a nonresident alien under section 
7701(b)(1)(B). Under the foreign country's law, all property acquired by 
a husband and wife during the existence of the marriage is community 
property and owned jointly by the husband and wife. In 1996 while 
residing in the foreign country, W formed X, a U.S. corporation, and X 
simultaneously filed an election to be an S corporation. X issued all of 
its outstanding stock in W's name. Under the foreign country's law, X's 
stock became the community property of and jointly owned by H and W. 
Thus, X does not meet the definition of a small business corporation and 
therefore could not file a valid S election because H, a nonresident 
alien, has a current interest in the stock.
    Example 2. Assume the same facts as Example 1, except that in 1991, 
W and H filed a section 6013(g) election allowing them to file a joint 
U.S. tax return and causing H to be treated as a U.S. resident for 
purposes of chapters 1, 5, and 24 of the Internal Revenue Code. The 
section 6013(g) election applies to the taxable year for which made and 
to all subsequent taxable years until terminated. Because H is treated 
as a U.S. resident under section 6013(g), X does meet the definition of 
a small business corporation. Thus, the election filed by X to be an S 
corporation is valid.

    (2) Special rule for dual residents. [Reserved]
    (h) Special rules relating to trusts--(1) General rule. In general, 
a trust is not a permitted small business corporation shareholder. 
However, except as provided in paragraph (h)(2) of this section, the 
following trusts are permitted shareholders:
    (i) Qualified subpart E trust. A trust all of which is treated 
(under subpart E, part I, subchapter J, chapter 1) as owned by an 
individual (whether or not the grantor) who is a citizen or resident of 
the United States (a qualified subpart E trust). This requirement 
applies only during the period that the trust holds S corporation stock.
    (ii) Subpart E trust ceasing to be a qualified subpart E trust after 
the death of deemed owner. A trust that was a qualified subpart E trust 
immediately before the death of the deemed owner and that continues in 
existence after

[[Page 687]]

the death of the deemed owner, but only for the 2-year period beginning 
on the day of the deemed owner's death. A trust is considered to 
continue in existence if the trust continues to hold the stock pursuant 
to the terms of the will or the trust agreement, or if the trust 
continues to hold the stock during a period reasonably necessary to wind 
up the affairs of the trust. See Sec. 1.641(b)-3 for rules concerning 
the termination of trusts for federal income tax purposes.
    (iii) Electing qualified subchapter S trusts. A qualified subchapter 
S trust (QSST) that has a section 1361(d)(2) election in effect (an 
electing QSST). See paragraph (j) of this section for rules concerning 
QSSTs including the manner for making the section 1361(d)(2) election.
    (iv) Testamentary trusts. A trust (other than a qualified subpart E 
trust, an electing QSST, or an electing small business trust) to which S 
corporation stock is--
    (A) Transferred pursuant to the terms of a will, but only for the 2-
year period beginning on the day the stock is transferred to the trust 
except as otherwise provided in paragraph (h)(3)(i)(D) of this section; 
or
    (B) Transferred pursuant to the terms of an electing trust as 
defined in Sec. 1.645-1(b)(2) during the election period as defined in 
Sec. 1.645-1(b)(6), or deemed to be distributed at the close of the 
last day of the election period pursuant to Sec. 1.645-1(h)(1), but in 
each case only for the 2-year period beginning on the day the stock is 
transferred or deemed distributed to the trust except as otherwise 
provided in paragraph (h)(3)(i)(D) of this section.
    (v) Qualified voting trusts. A trust created primarily to exercise 
the voting power of S corporation stock transferred to it. To qualify as 
a voting trust for purposes of this section (a qualified voting trust), 
the beneficial owners must be treated as the owners of their respective 
portions of the trust under subpart E and the trust must have been 
created pursuant to a written trust agreement entered into by the 
shareholders, that--
    (A) Delegates to one or more trustees the right to vote;
    (B) Requires all distributions with respect to the stock of the 
corporation held by the trust to be paid to, or on behalf of, the 
beneficial owners of that stock;
    (C) Requires title and possession of that stock to be delivered to 
those beneficial owners upon termination of the trust; and
    (D) Terminates, under its terms or by state law, on or before a 
specific date or event.
    (vi) Electing small business trusts. An electing small business 
trust (ESBT) under section 1361(e). See paragraph (m) of this section 
for rules concerning ESBTs including the manner of making the election 
to be an ESBT under section 1361(e)(3).
    (2) Foreign trust. For purposes of paragraph (h)(1) of this section, 
in any case where stock is held by a foreign trust as defined in section 
7701(a)(31), the trust is considered to be the shareholder and is an 
ineligible shareholder. Thus, even if a foreign trust qualifies as a 
subpart E trust (e.g., a qualified voting trust), any corporation in 
which the trust holds stock does not qualify as a small business 
corporation.
    (3) Determination of shareholders--(i) General rule. For purposes of 
paragraph (b) of this section (qualification as a small business 
corporation), and, except as provided in paragraph (h)(3)(ii) of this 
section, for purposes of sections 1366 (relating to the pass-through of 
items of income, loss, deduction, or credit), 1367 (relating to 
adjustments to basis of shareholder's stock), and 1368 (relating to 
distributions), the shareholder of S corporation stock held by a trust 
that is a permitted shareholder under paragraph (h)(1) of this section 
is determined as follows:
    (A) If stock is held by a qualified subpart E trust, the deemed 
owner of the trust is treated as the shareholder.
    (B) If stock is held by a trust defined in paragraph (h)(1)(ii) of 
this section, the estate of the deemed owner is generally treated as the 
shareholder as of the day of the deemed owner's death. However, if stock 
is held by such a trust in a community property state, the decedent's 
estate is the shareholder only of the portion of the trust included in 
the decedent's gross estate (and the surviving spouse continues to be 
the shareholder of the portion of the trust owned by that spouse under 
the

[[Page 688]]

applicable state's community property law). The estate ordinarily will 
cease to be treated as the shareholder upon the earlier of the transfer 
of the stock by the trust or the expiration of the 2-year period 
beginning on the day of the deemed owner's death. If the trust qualifies 
and becomes an electing QSST, the beneficiary and not the estate is 
treated as the shareholder as of the effective date of the QSST 
election, and the rules provided in paragraph (j)(7) of this section 
apply. If the trust qualifies and becomes an ESBT, the shareholders are 
determined under paragraphs (h)(3)(i)(F) and (h)(3)(ii) of this section 
as of the effective date of the ESBT election, and the rules provided in 
paragraph (m) of this section apply.
    (C) If stock is held by an electing QSST, see paragraph (j)(7) of 
this section for the rules on who is treated as the shareholder.
    (D) If stock is transferred or deemed distributed to a testamentary 
trust described in paragraph (h)(1)(iv) of this section (other than a 
qualified subpart E trust, an electing QSST, or an ESBT), the estate of 
the testator is treated as the shareholder until the earlier of the 
transfer of that stock by the trust or the expiration of the 2-year 
period beginning on the day that the stock is transferred or deemed 
distributed to the trust. If the trust qualifies and becomes an electing 
QSST, the beneficiary and not the estate is treated as the shareholder 
as of the effective date of the QSST election, and the rules provided in 
paragraph (j)(7) of this section apply. If the trust qualifies and 
becomes an ESBT, the shareholders are determined under paragraphs 
(h)(3)(i)(F) and (h)(3)(ii) of this section as of the effective date of 
the ESBT election, and the rules provided in paragraph (m) of this 
section apply.
    (E) If stock is held by a qualified voting trust, each beneficial 
owner of the stock, as determined under subpart E, is treated as a 
shareholder with respect to the owner's proportionate share of the stock 
held by the trust.
    (F) If S corporation stock is held by an ESBT, each potential 
current beneficiary is treated as a shareholder. However, if for any 
period there is no potential current beneficiary of the ESBT, the ESBT 
is treated as the shareholder during such period. See paragraph (m)(4) 
of this section for the definition of potential current beneficiary.
    (ii) Exceptions. See Sec. 1.641(c)-1 for the rules for the taxation 
of an ESBT. Solely for purposes of section 1366, 1367, and 1368 the 
shareholder of S corporation stock held by a trust is determined as 
follows--
    (A) If stock is held by a trust as defined in paragraph (h)(1)(ii) 
of this section (other than an electing QSST or an ESBT), the trust is 
treated as the shareholder. If the trust continues to own the stock 
after the expiration of the 2-year period, the corporation's S election 
will terminate unless the trust is otherwise a permitted shareholder.
    (B) If stock is transferred or deemed distributed to a testamentary 
trust described in paragraph (h)(1)(iv) of this section (other than a 
qualified subpart E trust, an electing QSST, or an ESBT), the trust is 
treated as the shareholder. If the trust continues to own the stock 
after the expiration of the 2-year period, the corporation's S election 
will terminate unless the trust otherwise qualifies as a permitted 
shareholder.
    (i) [Reserved]
    (j) Qualified subchapter S trust--(1) Definition. A qualified 
subchapter S trust (QSST) is a trust (whether intervivos or 
testamentary), other than a foreign trust described in section 
7701(a)(31), that satisfies the following requirements:
    (i) All of the income (within the meaning of Sec. 1.643(b)-1) of 
the trust is distributed (or is required to be distributed) currently to 
one individual who is a citizen or resident of the United States. For 
purposes of the preceding sentence, unless otherwise provided under 
local law (including pertinent provisions of the governing instrument 
that are effective under local law), income of the trust includes 
distributions to the trust from the S corporation for the taxable year 
in question, but does not include the trust's pro rata share of the S 
corporation's items of income, loss, deduction, or credit determined 
under section 1366. See Sec. Sec. 1.651(a)-2(a) and 1.663(b)-1(a) for 
rules

[[Page 689]]

relating to the determination of whether all of the income of a trust is 
distributed (or is required to be distributed) currently. If under the 
terms of the trust income is not required to be distributed currently, 
the trustee may elect under section 663(b) to consider a distribution 
made in the first 65 days of a taxable year as made on the last day of 
the preceding taxable year. See section 663(b) and Sec. 1.663(b)-2 for 
rules on the time and manner for making the election. The income 
distribution requirement must be satisfied for the taxable year of the 
trust or for that part of the trust's taxable year during which it holds 
S corporation stock.
    (ii) The terms of the trust must require that--
    (A) During the life of the current income beneficiary, there will be 
only one income beneficiary of the trust;
    (B) Any corpus distributed during the life of the current income 
beneficiary may be distributed only to that income beneficiary;
    (C) The current income beneficiary's income interest in the trust 
will terminate on the earlier of that income beneficiary's death or the 
termination of the trust; and
    (D) Upon termination of the trust during the life of the current 
income beneficiary, the trust will distribute all of its assets to that 
income beneficiary.
    (iii) The terms of the trust must satisfy the requirements of 
paragraph (j)(1)(ii) of this section from the date the QSST election is 
made or from the effective date of the QSST election, whichever is 
earlier, throughout the entire period that the current income 
beneficiary and any successor income beneficiary is the income 
beneficiary of the trust. If the terms of the trust do not preclude the 
possibility that any of the requirements stated in paragraph (j)(1)(ii) 
of this section will not be met, the trust will not qualify as a QSST. 
For example, if the terms of the trust are silent with respect to corpus 
distributions, and distributions of corpus to a person other than the 
current income beneficiary are permitted under local law during the life 
of the current income beneficiary, then the terms of the trust do not 
preclude the possibility that corpus may be distributed to a person 
other than the current income beneficiary and, therefore, the trust is 
not a QSST.
    (2) Special rules--(i) If a husband and wife are income 
beneficiaries of the same trust, the husband and wife file a joint 
return, and each is a U.S. citizen or resident, the husband and wife are 
treated as one beneficiary for purposes of paragraph (j) of this 
section. If a husband and wife are treated by the preceding sentence as 
one beneficiary, any action required by this section to be taken by an 
income beneficiary requires joinder of both of them. For example, each 
spouse must sign the QSST election, continue to be a U.S. citizen or 
resident, and continue to file joint returns for the entire period that 
the QSST election is in effect.
    (ii)(A) Terms of the trust and applicable local law. The 
determination of whether the terms of a trust meet all of the 
requirements under paragraph (j)(1)(ii) of this section depends upon the 
terms of the trust instrument and the applicable local law. For example, 
a trust whose governing instrument provides that A is the sole income 
beneficiary of the trust is, nevertheless, considered to have two income 
beneficiaries if, under the applicable local law, A and B are considered 
to be the income beneficiaries of the trust.
    (B) Legal obligation to support. If under local law a distribution 
to the income beneficiary is in satisfaction of the grantor's legal 
obligation of support to that income beneficiary, the trust will not 
qualify as a QSST as of the date of distribution because, under section 
677(b), if income is distributed, the grantor will be treated as the 
owner of the ordinary income portion of the trust or, if trust corpus is 
distributed, the grantor will be treated as a beneficiary under section 
662. See Sec. 1.677(b)-1 for rules on the treatment of trusts for 
support and Sec. 1.662(a)-4 for rules concerning amounts used in 
discharge of a legal obligation.
    (C) Example. The following example illustrates the rules of 
paragraph (j)(2)(ii)(B) of this section:

    Example: F creates a trust for the benefit of F's minor child, G. 
Under the terms of the trust, all income is payable to G until the

[[Page 690]]

trust terminates on the earlier of G's attaining age 35 or G's death. 
Upon the termination of the trust, all corpus must be distributed to G 
or G's estate. The trust includes all of the provisions prescribed by 
section 1361(d)(3)(A) and paragraph (j)(1)(ii) of this section, but does 
not preclude the trustee from making income distributions to G that will 
be in satisfaction of F's legal obligation to support G. Under the 
applicable local law, distributions of trust income to G will satisfy 
F's legal obligation to support G. If the trustee distributes income to 
G in satisfaction of F's legal obligation to support G, the trust will 
not qualify as a QSST because F will be treated as the owner of the 
ordinary income portion of the trust. Further, the trust will not be a 
qualified subpart E trust because the trust will be subject to tax on 
the income allocable to corpus.

    (iii) If, under the terms of the trust, a person (including the 
income beneficiary) has a special power to appoint, during the life of 
the income beneficiary, trust income or corpus to any person other than 
the current income beneficiary, the trust will not qualify as a QSST. 
However, if the power of appointment results in the grantor being 
treated as the owner of the entire trust under the rules of subpart E, 
the trust may be a permitted shareholder under section 1361 (c)(2)(A)(i) 
and paragraph (h)(1)(i) of this section.
    (iv) If the terms of a trust or local law do not preclude the 
current income beneficiary from transferring the beneficiary's interest 
in the trust or do not preclude a person other than the current income 
beneficiary named in the trust instrument from being treated as a 
beneficiary of the trust under Sec. 1.643(c)-1, the trust will still 
qualify as a QSST. However, if the income beneficiary transfers or 
assigns the income interest or a portion of the income interest to 
another, the trust may no longer qualify as a QSST, depending on the 
facts and circumstances, because any transferee of the current income 
beneficiary's income interest and any person treated as a beneficiary 
under Sec. 1.643(c)-1 will be treated as a current income beneficiary 
for purposes of paragraph (j)(1)(ii) of this section and the trust may 
no longer meet the QSST requirements.
    (v) If the terms of the trust do not preclude a person other than 
the current income beneficiary named in the trust instrument from being 
awarded an interest in the trust by the order of a court, the trust will 
qualify as a QSST assuming the trust meets the requirements of 
paragraphs (j)(1) (i) and (ii) of this section. However, if as a result 
of such court order, the trust no longer meets the QSST requirements, 
the trust no longer qualifies as a QSST and the corporation's S election 
will terminate.
    (vi) A trust may qualify as a QSST even though a person other than 
the current income beneficiary is treated under subpart E as the owner 
of a part or all of that portion of a trust which does not consist of 
the S corporation stock, provided the entire trust meets the QSST 
requirements stated in paragraphs (j)(1) (i) and (ii) of this section.
    (3) Separate and independent shares of a trust. For purposes of 
sections 1361 (c) and (d), a substantially separate and independent 
share of a trust, within the meaning of section 663(c) and the 
regulations thereunder, is treated as a separate trust. For a separate 
share which holds S corporation stock to qualify as a QSST, the terms of 
the trust applicable to that separate share must meet the QSST 
requirements stated in paragraphs (j)(1) (i) and (ii) of this section.
    (4) Qualified terminable interest property trust. If property, 
including S corporation stock, or stock of a corporation that intends to 
make an S election, is transferred to a trust and an election is made to 
treat all or a portion of the transferred property as qualified 
terminable interest property (QTIP) under section 2056(b)(7), the income 
beneficiary may make the QSST election if the trust meets the 
requirements set out in paragraphs (j)(1) (i) and (ii) of this section. 
However, if property is transferred to a QTIP trust under section 
2523(f), the income beneficiary may not make a QSST election even if the 
trust meets the requirements set forth in paragraph (j)(1)(ii) of this 
section because the grantor would be treated as the owner of the income 
portion of the trust under section 677. In addition, if property is 
transferred to a QTIP trust under section 2523(f), the trust does not 
qualify as a permitted shareholder under section 1361(c)(2)(A)(i) and 
paragraph (h)(1)(i) of this section (a qualified subpart E

[[Page 691]]

trust), unless under the terms of the QTIP trust, the grantor is treated 
as the owner of the entire trust under sections 671 to 677. If the 
grantor ceases to be the income beneficiary's spouse, the trust may 
qualify as a QSST if it otherwise satisfies the requirements under 
paragraphs (j)(1) (i) and (ii) of this section.
    (5) Ceasing to meet the QSST requirements. If a QSST for which an 
election under section 1361(d)(2) has been made (as described in 
paragraph (j)(6) of this section) ceases to meet any of the requirements 
specified in paragraph (j)(1)(ii) of this section, the provisions of 
this paragraph (j) will cease to apply as of the first day on which that 
requirement ceases to be met. If such a trust ceases to meet the income 
distribution requirement specified in paragraph (j)(1)(i) of this 
section, but continues to meet all of the requirements in paragraph 
(j)(1)(ii) of this section, the provisions of this paragraph (j) will 
cease to apply as of the first day of the first taxable year beginning 
after the first taxable year for which the trust ceased to meet the 
income distribution requirement of paragraph (j)(1)(i) of this section. 
If a corporation's S election is inadvertently terminated as a result of 
a trust ceasing to meet the QSST requirements, the corporation may 
request relief under section 1362(f).
    (6) Qualified subchapter S trust election--(i) In general. This 
paragraph (j)(6) applies to the election provided in section 1361(d)(2) 
(the QSST election) to treat a QSST (as defined in paragraph (j)(1) of 
this section) as a trust described in section 1361(c)(2)(A)(i), and thus 
a permitted shareholder. This election must be made separately with 
respect to each corporation whose stock is held by the trust. The QSST 
election does not itself constitute an election as to the status of the 
corporation; the corporation must make the election provided by section 
1362(a) to be an S corporation. Until the effective date of a 
corporation's S election, the beneficiary is not treated as the owner of 
the stock of the corporation for purposes of section 678. Any action 
required by this paragraph (j) to be taken by a person who is under a 
legal disability by reason of age may be taken by that person's guardian 
or other legal representative, or if there be none, by that person's 
natural or adoptive parent.
    (ii) Filing the QSST election. The current income beneficiary of the 
trust must make the election by signing and filing with the service 
center with which the corporation files its income tax return the 
applicable form or a statement that--
    (A) Contains the name, address, and taxpayer identification number 
of the current income beneficiary, the trust, and the corporation;
    (B) Identifies the election as an election made under section 
1361(d)(2);
    (C) Specifies the date on which the election is to become effective 
(not earlier than 15 days and two months before the date on which the 
election is filed);
    (D) Specifies the date (or dates) on which the stock of the 
corporation was transferred to the trust; and
    (E) Provides all information and representations necessary to show 
that:
    (1) Under the terms of the trust and applicable local law--
    (i) During the life of the current income beneficiary, there will be 
only one income beneficiary of the trust (if husband and wife are 
beneficiaries, that they will file joint returns and that both are U.S. 
residents or citizens);
    (ii) Any corpus distributed during the life of the current income 
beneficiary may be distributed only to that beneficiary;
    (iii) The current beneficiary's income interest in the trust will 
terminate on the earlier of the beneficiary's death or upon termination 
of the trust; and
    (iv) Upon the termination of the trust during the life of such 
income beneficiary, the trust will distribute all its assets to such 
beneficiary.
    (2) The trust is required to distribute all of its income currently, 
or that the trustee will distribute all of its income currently if not 
so required by the terms of the trust.
    (3) No distribution of income or corpus by the trust will be in 
satisfaction of the grantor's legal obligation to support or maintain 
the income beneficiary.

[[Page 692]]

    (iii) When to file the QSST election. (A) If S corporation stock is 
transferred to a trust, the QSST election must be made within the 16-
day-and-2-month period beginning on the day that the stock is 
transferred to the trust. If a C corporation has made an election under 
section 1362(a) to be an S corporation (S election) and, before that 
corporation's S election is in effect, stock of that corporation is 
transferred to a trust, the QSST election must be made within the 16-
day-and-2-month period beginning on the day that the stock is 
transferred to the trust.
    (B) If a trust holds C corporation stock and that C corporation 
makes an S election effective for the first day of the taxable year in 
which the S election is made, the QSST election must be made within the 
16-day-and-2-month period beginning on the day that the S election is 
effective. If a trust holds C corporation stock and that C corporation 
makes an S election effective for the first day of the taxable year 
following the taxable year in which the S election is made, the QSST 
election must be made within the 16-day-and-2-month period beginning on 
the day that the S election is made. If a trust holds C corporation 
stock and that corporation makes an S election intending the S election 
to be effective for the first day of the taxable year in which the S 
election is made but, under Sec. 1.1362-6(a)(2), such S election is 
subsequently treated as effective for the first day of the taxable year 
following the taxable year in which the S election is made, the fact 
that the QSST election states that the effective date of the QSST 
election is the first day of the taxable year in which the S election is 
made will not cause the QSST election to be ineffective for the first 
year in which the corporation's S election is effective.
    (C) If a trust ceases to be a qualified subpart E trust, satisfies 
the requirements of a QSST, and intends to become a QSST, the QSST 
election must be filed within the 16-day-and-2-month period beginning on 
the date on which the trust ceases to be a qualified subpart E trust. If 
the estate of the deemed owner of the trust is treated as the 
shareholder under paragraph (h)(3)(i) of this section, the QSST election 
may be filed at any time, but no later than the end of the 16-day-and-2-
month period beginning on the date on which the estate of the deemed 
owner ceases to be treated as a shareholder.
    (D) If a testamentary trust is a permitted shareholder under 
paragraph (h)(1)(iv) of this section, satisfies the requirements of a 
QSST, and intends to become a QSST, the QSST election may be filed at 
any time, but no later than the end of the 16-day-and-2-month period 
beginning on the day after the end of the 2-year period.
    (E) If a corporation's S election terminates because of a late QSST 
election, the corporation may request inadvertent termination relief 
under section 1362(f). See Sec. 1.1362-4 for rules concerning 
inadvertent terminations.
    (iv) Protective QSST election when a person is an owner under 
subpart E. If the grantor of a trust is treated as the owner under 
subpart E of all of the trust, or of a portion of the trust which 
consists of S corporation stock, and the current income beneficiary is 
not the grantor, the current income beneficiary may not make the QSST 
election, even if the trust meets the QSST requirements stated in 
paragraph (j)(1)(ii) of this section. See paragraph (j)(6)(iii)(C) of 
this section as to when the QSST election may be made. See also 
paragraph (j)(2)(vi) of this section. However, if the current income 
beneficiary (or beneficiaries who are husband and wife, if both spouses 
are U.S. citizens or residents and file a joint return) of a trust is 
treated under subpart E as owning all or a portion of the trust 
consisting of S corporation stock, the current income beneficiary (or 
beneficiaries who are husband and wife, if both spouses are U.S. 
citizens or residents and file a joint return) may make the QSST 
election. See Example 8 of paragraph (k)(1) of this section.
    (7) Treatment as shareholder. (i) The income beneficiary who makes 
the QSST election and is treated (for purposes of section 678(a)) as the 
owner of that portion of the trust that consists of S corporation stock 
is treated as the shareholder for purposes of sections 1361(b)(1), 1366, 
1367, and 1368.

[[Page 693]]

    (ii) If, upon the death of an income beneficiary, the trust 
continues in existence, continues to hold S corporation stock but no 
longer satisfies the QSST requirements, is not a qualified subpart E 
trust, and does not qualify as an ESBT, then, solely for purposes of 
section 1361(b)(1), as of the date of the income beneficiary's death, 
the estate of that income beneficiary is treated as the shareholder of 
the S corporation with respect to which the income beneficiary made the 
QSST election. The estate ordinarily will cease to be treated as the 
shareholder for purposes of section 1361(b)(1) upon the earlier of the 
transfer of that stock by the trust or the expiration of the 2-year 
period beginning on the day of the income beneficiary's death. During 
the period that the estate is treated as the shareholder for purposes of 
section 1361(b)(1), the trust is treated as the shareholder for purposes 
of sections 1366, 1367, and 1368. If, after the 2-year period, the trust 
continues to hold S corporation stock and does not otherwise qualify as 
a permitted shareholder, the corporation's S election terminates. If the 
termination is inadvertent, the corporation may request relief under 
section 1362(f).
    (8) Coordination with grantor trust rules. If a valid QSST election 
is made, the income beneficiary is treated as the owner, for purposes of 
section 678(a), of that portion of the trust that consists of the stock 
of the S corporation for which the QSST election was made. However, 
solely for purposes of applying the preceding sentence to a QSST, an 
income beneficiary who is a deemed section 678 owner only by reason of 
section 1361(d)(1) will not be treated as the owner of the S corporation 
stock in determining and attributing the Federal income tax consequences 
of a disposition of the stock by the QSST. For example, if the 
disposition is a sale, the QSST election terminates as to the stock sold 
and any gain or loss recognized on the sale will be that of the trust, 
not the income beneficiary. Similarly, if a QSST distributes its S 
corporation stock to the income beneficiary, the QSST election 
terminates as to the distributed stock and the consequences of the 
distribution are determined by reference to the status of the trust 
apart from the income beneficiary's terminating ownership status under 
sections 678 and 1361(d)(1). The portions of the trust other than the 
portion consisting of S corporation stock are subject to subparts A 
through D of subchapter J of chapter 1, except as otherwise required by 
subpart E of the Internal Revenue Code.
    (9) Successive income beneficiary. (i) If the income beneficiary of 
a QSST who made a QSST election dies, each successive income beneficiary 
of that trust is treated as consenting to the election unless a 
successive income beneficiary affirmatively refuses to consent to the 
election. For this purpose, the term successive income beneficiary 
includes a beneficiary of a trust whose interest is a separate share 
within the meaning of section 663(c), but does not include any 
beneficiary of a trust that is created upon the death of the income 
beneficiary of the QSST and which is a new trust under local law.
    (ii) The application of this paragraph (j)(9) is illustrated by the 
following examples:

    Example 1. Shares of stock in Corporation X, an S corporation, are 
held by Trust A, a QSST for which a QSST election was made. B is the 
sole income beneficiary of Trust A. On B's death, under the terms of 
Trust A, J and K become the current income beneficiaries of Trust A. J 
and K each hold a separate and independent share of Trust A within the 
meaning of section 663(c). J and K are successive income beneficiaries 
of Trust A, and they are treated as consenting to B's QSST election.
    Example 2. Assume the same facts as in Example 1, except that on B's 
death, under the terms of Trust A and local law, Trust A terminates and 
the principal is to be divided equally and held in newly created Trust B 
and Trust C. The sole income beneficiaries of Trust B and Trust C are J 
and K, respectively. Because Trust A terminated, J and K are not 
successive income beneficiaries of Trust A. J and K must make QSST 
elections for their respective trusts to qualify as QSSTs, if they 
qualify. The result is the same whether or not the trustee of Trusts B 
and C is the same as the trustee of trust A.

    (10) Affirmative refusal to consent--(i) Required statement. A 
successive income beneficiary of a QSST must make an affirmative refusal 
to consent by signing and filing with the service center

[[Page 694]]

where the corporation files its income tax return a statement that--
    (A) Contains the name, address, and taxpayer identification number 
of the successive income beneficiary, the trust, and the corporation for 
which the election was made;
    (B) Identifies the refusal as an affirmative refusal to consent 
under section 1361(d)(2); and
    (C) Sets forth the date on which the successive income beneficiary 
became the income beneficiary.
    (ii) Filing date and effectiveness. The affirmative refusal to 
consent must be filed within 15 days and 2 months after the date on 
which the successive income beneficiary becomes the income beneficiary. 
The affirmative refusal to consent will be effective as of the date on 
which the successive income beneficiary becomes the current income 
beneficiary.
    (11) Revocation of QSST election. A QSST election may be revoked 
only with the consent of the Commissioner. The Commissioner will not 
grant a revocation when one of its purposes is the avoidance of Federal 
income taxes or when the taxable year is closed. The application for 
consent to revoke the election must be submitted to the Internal Revenue 
Service in the form of a letter ruling request under the appropriate 
revenue procedure. The application must be signed by the current income 
beneficiary and must--
    (i) Contain the name, address, and taxpayer identification number of 
the current income beneficiary, the trust, and the corporation with 
respect to which the QSST election was made;
    (ii) Identify the election being revoked as an election made under 
section 1361(d)(2); and
    (iii) Explain why the current income beneficiary seeks to revoke the 
QSST election and indicate that the beneficiary understands the 
consequences of the revocation.
    (12) Converting a QSST to an ESBT. For a trust that seeks to convert 
from a QSST to an ESBT, the consent of the Commissioner is hereby 
granted to revoke the QSST election as of the effective date of the ESBT 
election, if all the following requirements are met:
    (i) The trust meets all of the requirements to be an ESBT under 
paragraph (m)(1) of this section except for the requirement under 
paragraph (m)(1)(iv)(A) of this section that the trust not have a QSST 
election in effect.
    (ii) The trustee and the current income beneficiary of the trust 
sign the ESBT election. The ESBT election must be filed with the service 
center where the S corporation files its income tax return. This ESBT 
election must state at the top of the document ``ATTENTION ENTITY 
CONTROL--CONVERSION OF A QSST TO AN ESBT PURSUANT TO SECTION 1.1361-
1(j)'' and include all information otherwise required for an ESBT 
election under paragraph (m)(2) of this section. A separate election 
must be made with respect to the stock of each S corporation held by the 
trust.
    (iii) The trust has not converted from an ESBT to a QSST within the 
36-month period preceding the effective date of the new ESBT election.
    (iv) The date on which the ESBT election is to be effective cannot 
be more than 15 days and two months prior to the date on which the 
election is filed and cannot be more than 12 months after the date on 
which the election is filed. If an election specifies an effective date 
more than 15 days and two months prior to the date on which the election 
is filed, it will be effective on the day that is 15 days and two months 
prior to the date on which it is filed. If an election specifies an 
effective date more than 12 months after the date on which the election 
is filed, it will be effective on the day that is 12 months after the 
date it is filed.
    (k)(1) Examples. The provisions of paragraphs (h) and (j) of this 
section are illustrated by the following examples in which it is assumed 
that all noncorporate persons are citizens or residents of the United 
States:

    Example 1. (i) Terms of the trust. In 1996, A and A's spouse, B, 
created an intervivos trust and each funded the trust with separately 
owned stock of an S corporation. Under the terms of the trust, A and B 
designated themselves as the income beneficiaries and each, 
individually, retained the power to amend or revoke the trust with 
respect to the trust assets attributable to their respective trust 
contributions. Upon A's death, the trust is to be divided into two 
separate parts; one part attributable to the assets A contributed to

[[Page 695]]

the trust and one part attributable to B's contributions. Before the 
trust is divided, and during the administration of A's estate, all trust 
income is payable to B. The part of the trust attributable to B's 
contributions is to continue in trust under the terms of which B is 
designated as the sole income beneficiary and retains the power to amend 
or revoke the trust. The part attributable to A's contributions is to be 
divided into two separate trusts both of which have B as the sole income 
beneficiary for life. One trust, the Credit Shelter Trust, is to be 
funded with an amount that can pass free of estate tax by reason of A's 
available estate tax unified credit. The terms of the Credit Shelter 
Trust meet the requirements of section 1361(d)(3) as a QSST. The balance 
of the property passes to a Marital Trust, the terms of which satisfy 
the requirements of section 1361(d)(3) as a QSST and section 2056(b)(7) 
as QTIP. The appropriate fiduciary under Sec. 20.2056(b)-7(b)(3) is 
directed to make an election under section 2056(b)(7).
    (ii) Results after deemed owner's death. On February 3, 1997, A dies 
and the portion of the trust assets attributable to A's contributions 
including the S stock contributed by A, is includible in A's gross 
estate under sections 2036 and 2038. During the administration of A's 
estate, the trust holds the S corporation stock. Under section 
1361(c)(2)(B)(ii), A's estate is treated as the shareholder of the S 
corporation stock that was included in A's gross estate for purposes of 
section 1361(b)(1); however, for purposes of sections 1366, 1367, and 
1368, the trust is treated as the shareholder. B's part of the trust 
continues to be a qualified subpart E trust of which B is the owner 
under sections 676 and 677. B, therefore, continues to be treated as the 
shareholder of the S corporation stock in that portion of the trust. On 
May 13, 1997, during the continuing administration of A's estate, the 
trust is divided into separate trusts in accordance with the terms of 
the trust instrument. The S corporation stock that was included in A's 
gross estate is distributed to the Marital Trust and to the Credit 
Shelter Trust. A's estate will cease to be treated as the shareholder of 
the S corporation under section 1361(c)(2)(B)(ii) on May 13, 1997 (the 
date on which the S corporation stock was transferred to the trusts). B, 
as the income beneficiary of the Marital Trust and the Credit Shelter 
Trust, must make the QSST election for each trust by July 28, 1997 (the 
end of the 16-day-and-2-month period beginning on the date the estate 
ceases to be treated as a shareholder) to have the trusts become 
permitted shareholders of the S corporation.
    Example 2. (i) Qualified subpart E trust as shareholder. In 1997, A, 
an individual established a trust and transferred to the trust A's 
shares of stock of Corporation M, an S corporation. A has the power to 
revoke the entire trust. The terms of the trust require that all income 
be paid to B and otherwise meet the requirements of a QSST under section 
1361(d)(3). The trust will continue in existence after A's death. The 
trust is a qualified subpart E trust described in section 
1361(c)(2)(A)(i) during A's life, and A (not the trust) is treated as 
the shareholder for purposes of sections 1361(b)(1), 1366, 1367, and 
1368.
    (ii) Trust ceasing to be a qualified subpart E trust on deemed 
owner's death. Assume the same facts as paragraph (i) of this Example 2, 
except that A dies without having exercised A's power to revoke. Upon 
A's death, the trust ceases to be a qualified subpart E trust described 
in section 1361(c)(2)(A)(i). A's estate (and not the trust) is treated 
as the shareholder for purposes of section 1361(b)(1). A's estate will 
cease to be treated as the shareholder for purposes of section 
1361(b)(1) upon the earlier of the transfer of the Corporation M stock 
by the trust (other than to A's estate), the expiration of the 2-year 
period beginning on the day of A's death, or the effective date of a 
QSST or ESBT election if the trust qualifies as a QSST or ESBT. However, 
until that time, because the trust continues in existence after A's 
death and will receive any distributions with respect to the stock it 
holds, the trust is treated as the shareholder for purposes of sections 
1366, 1367, and 1368. If no QSST or ESBT election is made effective upon 
the expiration of the 2-year period, the corporation ceases to be an S 
corporation, but the trust continues as the shareholder of a C 
corporation.
    (iii) Trust continuing to be a qualified subpart E trust on deemed 
owner's death. Assume the same facts as paragraph (ii) of this Example 
2, except that the terms of the trust also provide that if A does not 
exercise the power to revoke before A's death, B will have the sole 
power to withdraw all trust property at any time after A's death. The 
trust continues to qualify as a qualified subpart E trust after A's 
death because, upon A's death, B is deemed to be the owner of the entire 
trust under section 678. Because the trust does not cease to be a 
qualified subpart E trust upon A's death, B (and not A's estate) is 
treated as the shareholder for purposes of sections 1361(b)(1), 1366, 
1367, and 1368. Since the trust qualifies as a QSST, B may make a 
protective QSST election under paragraph (j)(6)(iv) of this section.
    Example 3. (i) 2-year rule under section 1361(c)(2)(A)(ii) and 
(iii). F owns stock of Corporation P, an S corporation. In addition, F 
is the deemed owner of a qualified subpart E trust that holds stock in 
Corporation O, an S corporation. F dies on July 1, 2003. The trust 
continues in existence after F's death but is no longer a qualified 
subpart E trust. On August 1, 2003, F's shares of stock in Corporation P 
are transferred to the trust pursuant to the terms of F's will. Because 
the stock of

[[Page 696]]

Corporation P was not held by the trust when F died, section 
1361(c)(2)(A)(ii) does not apply with respect to that stock. Under 
section 1361(c)(2)(A)(iii), the last day on which the trust could be 
treated as a permitted shareholder of Corporation P is July 31, 2005 
(that is, the last day of the 2-year period that begins on the date of 
the transfer from the estate to the trust). With respect to the shares 
of stock in Corporation O held by the trust at the time of F's death, 
section 1361(c)(2)(A)(ii) applies and the last day on which the trust 
could be treated as a permitted shareholder of Corporation O is June 30, 
2005 (that is, the last day of the 2-year period that begins on the date 
of F's death).
    (ii) Section 645 electing trust and successor trust. Assume the same 
facts as in paragraph (i) of this Example 3, except that F's trust is a 
qualified revocable trust for which a valid section 645 election is made 
on October 1, 2003 (electing trust). Because under section 645 the 
electing trust is treated and taxed for purposes of subtitle A of the 
Code as part of F's estate, the trust may continue to hold the O stock 
pursuant to Sec. 1361(b)(1)(B), without causing the termination of 
Corporation O's S election, for the duration of the section 645 election 
period. However, on January 1, 2004, during the election period, the 
shares of stock in Corporation O are transferred pursuant to the terms 
of the electing trust to a successor trust. Because the successor trust 
satisfies the definition of a testamentary trust under paragraph 
(h)(1)(iv) of this section, the successor trust is a permitted 
shareholder until the earlier of the expiration of the 2-year period 
beginning on January 1, 2004, or the effective date of a QSST or ESBT 
election for the successor trust.
    Example 4. (i) QSST when terms do not require current distribution 
of income. Corporation Q, a calendar year corporation, makes an election 
to be an S corporation effective for calendar year 1996. On July 1, 
1996, G, a shareholder of Corporation Q, transfers G's shares of 
Corporation Q stock to a trust with H as its current income beneficiary. 
The terms of the trust otherwise satisfy the QSST requirements, but 
authorize the trustee in its discretion to accumulate or distribute the 
trust income. However, the trust, which uses the calendar year as its 
taxable year, initially satisfies the income distribution requirement 
because the trustee is currently distributing all of the income. On 
August 1, 1996, H makes a QSST election with respect to Corporation Q 
that is effective as of July 1, 1996. Accordingly, as of July 1, 1996, 
the trust is a QSST and H is treated as the shareholder for purposes of 
sections 1361(b)(1), 1366, 1367, and 1368.
    (ii) QSST when trust income is not distributed currently. Assume the 
same facts as in paragraph (i) of this Example 4, except that, for the 
taxable year ending on December 31, 1997, the trustee accumulates some 
trust income. The trust ceases to be a QSST on January 1, 1998, because 
the trust failed to distribute all of its income for the taxable year 
ending December 31, 1997. Thus, Corporation Q ceases to be an S 
corporation as of January 1, 1998, because the trust is not a permitted 
shareholder.
    (iii) QSST when a person other than the current income beneficiary 
may receive trust corpus. Assume the same facts as in paragraph (i) of 
this Example 4, except that the events occur in 2003 and H dies on 
November 1, 2003, and the trust does not qualify as an ESBT. Under the 
terms of the trust, after H's death, L is the income beneficiary of the 
trust and the trustee is authorized to distribute trust corpus to L as 
well as to J. The trust ceases to be a QSST as of November 1, 2003, 
because corpus distributions may be made to someone other than L, the 
current (successive) income beneficiary. Under section 
1361(c)(2)(B)(ii), H's estate (and not the trust) is considered to be 
the shareholder for purposes of section 1361(b)(1) for the 2-year period 
beginning on November 1, 2003. However, because the trust continues in 
existence after H's death and will receive any distributions from the 
corporation, the trust (and not H's estate) is treated as the 
shareholder for purposes of sections 1366, 1367, and 1368, during that 
2-year period. After the 2-year period, the S election terminates and 
the trust continues as a shareholder of a C corporation. If the 
termination is inadvertent, Corporation Q may request relief under 
section 1362(f). However, the S election would not terminate if the 
trustee distributed all Corporation Q shares to L, J, or both on or 
before October 31, 2005, (the last day of the 2-year period) assuming 
that neither L nor J becomes the 76th shareholder of Corporation Q as a 
result of the distribution.
    Example 5. QSST when current income beneficiary assigns the income 
interest to a person not named in the trust. On January 1, 1996, stock 
of Corporation R, a calendar year S corporation, is transferred to a 
trust that satisfies all of the requirements to be a QSST. Neither the 
terms of the trust nor local law preclude the current income 
beneficiary, K, from assigning K's income interest in the trust. K files 
a timely QSST election that is effective January 1, 1996. On July 1, 
1996, K assigns the income interest in the trust to N. Under applicable 
state law, the trustee is bound as a result of the assignment to 
distribute the trust income to N. Thus, the QSST will cease to qualify 
as a QSST under section 1361(d)(3)(A)(iii) because N's interest will 
terminate on K's death (rather than on N's death). Accordingly, as of 
the date of the assignment, the trust ceases to be a QSST and 
Corporation R ceases to be an S corporation.
    Example 6. QSST when terms fail to provide for distribution of trust 
assets upon termination during life of current income beneficiary. A

[[Page 697]]

contributes S corporation stock to a trust the terms of which provide 
for one income beneficiary, annual distributions of income, 
discretionary invasion of corpus only for the benefit of the income 
beneficiary, and termination of the trust only upon the death of the 
current income beneficiary. Since the trust can terminate only upon the 
death of the income beneficiary, the governing instrument fails to 
provide for any distribution of trust assets during the income 
beneficiary's life. The governing instrument's silence on this point 
does not disqualify the trust under section 1361(d)(3)(A) (ii) or (iv).
    Example 7. QSST when settlor of trust retains a reversion in the 
trust. On January 10, 1996, M transfers to a trust shares of stock in 
corporation X, an S corporation. D, who is 13 years old and not a lineal 
descendant of M, is the sole income beneficiary of the trust. On 
termination of the trust, the principal (including the X shares) is to 
revert to M. The trust instrument provides that the trust will terminate 
upon the earlier of D's death or D's 21st birthday. The terms of the 
trust satisfy all of the requirements to be a QSST except those of 
section 1361(d)(3)(A)(ii) (that corpus may be distributed during the 
current income beneficiary's life only to that beneficiary) and (iv) 
(that, upon termination of the trust during the life of the current 
income beneficiary, the corpus, must be distributed to that 
beneficiary). On February 10, 1996, M makes a gift of M's reversionary 
interest to D. Until M assigns M's reversion in the trust to D, M is 
deemed to own the entire trust under section 673(a) and the trust is a 
qualified subpart E trust. For purposes of section 1361(b)(1), 1366, 
1367, and 1368, M is the shareholder of X. The trust ceases to be a 
qualified subpart E trust on February 10, 1996. Assuming that, by virtue 
of the assignment to D of M's reversionary interest, D (upon his 21st 
birthday) or D's estate (in the case of D's death before reaching age 
21) is entitled under local law to receive the trust principal, the 
trust will be deemed as of February 10, 1996, to have satisfied the 
conditions of section 1361(d)(3)(A) (ii) and (iv) even though the terms 
of the trust do not explicitly so provide. D must make a QSST election 
by no later than April 25, 1996 (the end of the 16-day-and-2-month 
period that begins on February 10, 1996, the date on which the X stock 
is deemed transferred to the trust by M). See example (5) of Sec. 
1.1001-2(c) of the regulations.
    Example 8. QSST when the income beneficiary has the power to 
withdraw corpus. On January 1, 1996, F transfers stock of an S 
corporation to an irrevocable trust whose income beneficiary is F's son, 
C. Under the terms of the trust, C is given the noncumulative power to 
withdraw from the corpus of the trust the greater of $5,000 or 5 percent 
of the value of the corpus on a yearly basis. The terms of the trust 
meet the QSST requirements. Assuming the trust distributions are not in 
satisfaction of F's legal obligation to support C, the trust qualifies 
as a QSST. C (or if C is a minor, C's legal representative) must make 
the QSST election no later than March 16, 1996 (the end of the 16-day-
and-2-month period that begins on the date the stock is transferred to 
the trust).
    Example 9. (i) Filing the QSST election. On January 1, 1996, stock 
of Corporation T, a calendar year C corporation, is transferred to a 
trust that satisfies all of the requirements to be a QSST. On January 
31, 1996, Corporation T files an election to be an S corporation that is 
to be effective for its taxable year beginning on January 1, 1996. In 
order for the S election to be effective for the 1996 taxable year, the 
QSST election must be effective January 1, 1996, and must be filed 
within the period beginning on January 1, 1996, and ending March 16, 
1996 (the 16-day-and-2-month period beginning on the first day of the 
first taxable year for which the election to be an S corporation is 
intended to be effective).
    (ii) QSST election when the S election is filed late. Assume the 
same facts as in paragraph (i) of this Example 9, except that 
Corporation T's election to be an S corporation is filed on April 1, 
1996 (after the 15th day of the 3rd month of the first taxable year for 
which it is to be effective but before the end of that taxable year). 
Because the election to be an S corporation is not timely filed for the 
1996 taxable year, under section 1362(b)(3), the S election is treated 
as made for the taxable year beginning on January 1, 1997. The QSST 
election must be filed within the 16-day-and-2-month period beginning on 
April 1, 1996, the date the S election was made, and ending on June 16, 
1996.
    Example 10. (i) Transfers to QTIP trust. On June 1, 1996, A 
transferred S corporation stock to a trust for the benefit of A's spouse 
B, the terms of which satisfy the requirements of section 2523(f)(2) as 
qualified terminable interest property. Under the terms of the trust, B 
is the sole income beneficiary for life. In addition, corpus may be 
distributed to B, at the trustee's discretion, during B's lifetime. 
However, under section 677(a), A is treated as the owner of the trust. 
Accordingly, the trust is a permitted shareholder of the S corporation 
under section 1361(c)(2)(A)(i), and A is treated as the shareholder for 
purposes of sections 1361(b)(1), 1366, 1367, and 1368.
    (ii) Transfers to QTIP trust where husband and wife divorce. Assume 
the same facts as in paragraph (i) of this Example 10, except that A and 
B divorce on May 2, 1997. Under section 682, A ceases to be treated as 
the owner of the trust under section 677(a) because A and B are no 
longer husband and wife. Under section 682, after the divorce, B is the 
income beneficiary of the trust and corpus of the

[[Page 698]]

trust may only be distributed to B. Accordingly, assuming the trust 
otherwise meets the requirements of section 1361(d)(3), B must make the 
QSST election within 2 months and 15 days after the date of the divorce.
    (iii) Transfers to QTIP trust where no corpus distribution is 
permitted. Assume the same facts as in paragraph (i) of this Example 10, 
except that the terms of the trust do not permit corpus to be 
distributed to B and require its retention by the trust for distribution 
to A and B's surviving children after the death of B. Under section 677, 
A is treated as the owner of the ordinary income portion of the trust, 
but the trust will be subject to tax on gross income allocable to 
corpus. Accordingly, the trust does not qualify as an eligible 
shareholder of the S corporation because it is neither a qualified 
subpart E trust nor a QSST.

    (2) Effective date--(i) In general. Paragraph (a) of this section, 
and paragraphs (c) through (k) of this section (as contained in the 26 
CFR edition revised April 1, 2003) apply to taxable years of a 
corporation beginning after July 21, 1995. For taxable years beginning 
on or before July 21, 1995, to which paragraph (a) of this section and 
paragraphs (c) through (k) of this section (as contained in the 26 CFR 
edition revised April 1, 2003) do not apply, see Sec. 18.1361-1 of this 
chapter (as contained in the 26 CFR edition revised April 1, 1995). 
However, paragraphs (h)(1)(vi), (h)(3)(i)(F), (h)(3)(ii), and (j)(12) of 
this section (as contained in the 26 CFR edition revised April 1, 2003) 
are applicable for taxable years beginning on and after May 14, 2002. 
Otherwise, paragraphs (b)(1)(ii), (f), (h)(1)(ii), (h)(1)(iv), 
(h)(3)(i)(B), (h)(3)(i)(D), (h)(3)(ii)(A), (h)(3)(ii)(B), 
(j)(6)(iii)(C), (j)(6)(iii)(D), (j)(7)(ii), and (k)(1) Example 2(ii) 
fourth and last sentences, Example 3, and Example 4(iii) of this section 
apply on and after July 17, 2003.
    (ii) Transition rules. Taxpayers may apply paragraph (h)(1)(iv)(B) 
of this section on and after December 24, 2002, and before July 17, 
2003, to treat a trust as a testamentary trust, but not during any 
period for which a QSST or ESBT election was in effect for the trust. In 
addition, the Internal Revenue Service will not challenge the treatment 
of a trust described in paragraph (h)(1)(iv)(B) of this section as a 
permitted shareholder of an S corporation for periods after August 5, 
1997, and before the earlier of July 17, 2003, or the effective date of 
any QSST or ESBT election for that trust.
    (iii) Exception. If a QSST has sold or otherwise disposed of all or 
a portion of its S corporation stock in a tax year that is open for the 
QSST and the income beneficiary but on or before July 21, 1995, the QSST 
and the income beneficiary may both treat the transaction as if the 
beneficiary was the owner of the stock sold or disposed of, and thus 
recognize any gain or loss, or as if the QSST was the owner of the stock 
sold or disposed of as described in paragraph (j)(8) of this section. 
This exception applies only if the QSST and the income beneficiary take 
consistent reporting positions. The QSST and the income beneficiary must 
disclose by a statement on their respective returns (or amended 
returns), that they are taking consistent reporting positions.
    (l) Classes of stock--(1) General rule. A corporation that has more 
than one class of stock does not qualify as a small business 
corporation. Except as provided in paragraph (l)(4) of this section 
(relating to instruments, obligations, or arrangements treated as a 
second class of stock), a corporation is 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. 
Differences in voting rights among shares of stock of a corporation are 
disregarded in determining whether a corporation has more than one class 
of stock. Thus, if all shares of stock of an S corporation have 
identical rights to distribution and liquidation proceeds, the 
corporation may have voting and nonvoting common stock, a class of stock 
that may vote only on certain issues, irrevocable proxy agreements, or 
groups of shares that differ with respect to rights to elect members of 
the board of directors.
    (2) Determination of whether stock confers identical rights to 
distribution and liquidation proceeds--(i) In general. 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 law, and

[[Page 699]]

binding agreements relating to distribution and liquidation proceeds 
(collectively, the 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 section 1361(b)(1)(D) and this paragraph (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.
    (ii) State law requirements for payment and withholding of income 
tax. State laws may require a corporation to pay or withhold state 
income taxes on behalf of some or all of the corporation's shareholders. 
Such laws are disregarded in determining whether all outstanding shares 
of stock of the corporation confer identical rights to distribution and 
liquidation proceeds, within the meaning of paragraph (l)(1) of this 
section, provided that, when the constructive distributions resulting 
from the payment or withholding of taxes by the corporation are taken 
into account, the outstanding shares confer identical rights to 
distribution and liquidation proceeds. A difference in timing between 
the constructive distributions and the actual distributions to the other 
shareholders does not cause the corporation to be treated as having more 
than one class of stock.
    (iii) Buy-sell and redemption agreements--(A) In general. Buy-sell 
agreements among shareholders, agreements restricting the 
transferability of stock, and redemption agreements are disregarded in 
determining whether a corporation's outstanding shares of stock confer 
identical distribution and liquidation rights unless--
    (1) A principal purpose of the agreement is to circumvent the one 
class of stock requirement of section 1361(b)(1)(D) and this paragraph 
(l), and
    (2) The agreement establishes a purchase price that, at the time the 
agreement is entered into, is significantly in excess of or below the 
fair market value of the stock.

Agreements that provide for the purchase or redemption of stock at book 
value or at a price between fair market value and book value are not 
considered to establish a price that is significantly in excess of or 
below the fair market value of the stock and, thus, are disregarded in 
determining whether the outstanding shares of stock confer identical 
rights. For purposes of this paragraph (l)(2)(iii)(A), a good faith 
determination of fair market value will be respected unless it can be 
shown that the value was substantially in error and the determination of 
the value was not performed with reasonable diligence. Although an 
agreement may be disregarded in determining whether shares of stock 
confer identical distribution and liquidation rights, payments pursuant 
to the agreement may have income or transfer tax consequences.
    (B) Exception for certain agreements. Bona fide agreements to redeem 
or purchase stock at the time of death, divorce, disability, or 
termination of employment are disregarded in determining whether a 
corporation's shares of stock confer identical rights. In addition, if 
stock that is substantially nonvested (within the meaning of Sec. 1.83-
3(b)) is treated as outstanding under these regulations, the forfeiture 
provisions that cause the stock to be substantially nonvested are 
disregarded. Furthermore, the Commissioner may provide by Revenue Ruling 
or other published guidance that other types of bona fide agreements to 
redeem or purchase stock are disregarded.
    (C) Safe harbors for determinations of book value. A determination 
of book value will be respected if--
    (1) The book value is determined in accordance with Generally 
Accepted Accounting Principles (including permitted optional 
adjustments); or
    (2) The book value is used for any substantial nontax purpose.
    (iv) Distributions that take into account varying interests in stock 
during a taxable year. A governing provision does not,

[[Page 700]]

within the meaning of paragraph (l)(2)(i) of this section, alter the 
rights to liquidation and distribution proceeds conferred by an S 
corporation's stock merely because the governing provision provides 
that, as a result of a change in stock ownership, distributions in a 
taxable year are to be made on the basis of the shareholders' varying 
interests in the S corporation's income in the current or immediately 
preceding taxable year. If distributions pursuant to the provision are 
not made within a reasonable time after the close of the taxable year in 
which the varying interests occur, the distributions may be 
recharacterized depending on the facts and circumstances, but will not 
result in a second class of stock.
    (v) Special rule for section 338(h)(10) elections. If the 
shareholders of an S corporation sell their stock in a transaction for 
which an election is made under section 338(h)(10) and Sec. 
1.338(h)(10)-1, the receipt of varying amounts per share by the 
shareholders will not cause the S corporation to have more than one 
class of stock, provided that the varying amounts are determined in 
arm's length negotiations with the purchaser.
    (vi) Examples. The application of paragraph (l)(2) of this section 
may be illustrated by the following examples. In each of the examples, 
the S corporation requirements of section 1361 are satisfied except as 
otherwise stated, the corporation has in effect an S election under 
section 1362, and the corporation has only the shareholders described.

    Example 1. Determination of whether stock confers identical rights 
to distribution and liquidation proceeds. (i) The law of State A 
requires that permission be obtained from the State Commissioner of 
Corporations before stock may be issued by a corporation. The 
Commissioner grants permission to S, a corporation, to issue its stock 
subject to the restriction that any person who is issued stock in 
exchange for property, and not cash, must waive all rights to receive 
distributions until the shareholders who contributed cash for stock have 
received distributions in the amount of their cash contributions.
    (ii) The condition imposed by the Commissioner pursuant to state law 
alters the rights to distribution and liquidation proceeds conferred by 
the outstanding stock of S so that those rights are not identical. 
Accordingly, under paragraph (l)(2)(i) of this section, S is treated as 
having more than one class of stock and does not qualify as a small 
business corporation.
    Example 2. Distributions that differ in timing. (i) S, a 
corporation, has two equal shareholders, A and B. Under S's bylaws, A 
and B are entitled to equal distributions. S distributes $50,000 to A in 
the current year, but does not distribute $50,000 to B until one year 
later. The circumstances indicate that the difference in timing did not 
occur by reason of a binding agreement relating to distribution or 
liquidation proceeds.
    (ii) Under paragraph (l)(2)(i) of this section, the difference in 
timing of the distributions to A and B does not cause S to be treated as 
having more than one class of stock. However, section 7872 or other 
recharacterization principles may apply to determine the appropriate tax 
consequences.
    Example 3. Treatment of excessive compensation. (i) S, a 
corporation, has two equal shareholders, C and D, who are each employed 
by S and have binding employment agreements with S. The compensation 
paid by S to C under C's employment agreement is reasonable. The 
compensation paid by S to D under D's employment agreement, however, is 
found to be excessive. The facts and circumstances do not reflect that a 
principal purpose to D's employment agreement is to circumvent the one 
class of stock requirement of section 1361(b)(1)(D) and this paragraph 
(l).
    (ii) Under paragraph (l)(2)(i) of this section, the employment 
agreements are not governing provisions. Accordingly, S is not treated 
as having more than one class of stock by reason of the employment 
agreements, even though S is not allowed a deduction for the excessive 
compensation paid to D.
    Example 4. Agreement to pay fringe benefits. (i) S, a corporation, 
is required under binding agreements to pay accident and health 
insurance premiums on behalf of certain of its employees who are also 
shareholders. Different premium amounts are paid by S for each employee-
shareholder. The facts and circumstances do not reflect that a principal 
purpose of the agreements is to circumvent the one class of stock 
requirement of section 1361(b)(1)(D) and this paragraph (l).
    (ii) Under paragraph (l)(2)(i) of this section, the agreements are 
not governing provisions. Accordingly, S is not treated as having more 
than one class of stock by reason of the agreements. In addition, S is 
not treated as having more than one class of stock by reason of the 
payment of fringe benefits.
    Example 5. Below-market corporation-shareholder loan. (i) E is a 
shareholder of S, a corporation. S makes a below-market loan to E that 
is a corporation-shareholder loan to which section 7872 applies. Under 
section 7872, E is deemed to receive a distribution

[[Page 701]]

with respect to S stock by reason of the loan. The facts and 
circumstances do not reflect that a principal purpose of the loan is to 
circumvent the one class of stock requirement of section 1361(b)(1)(D) 
and this paragraph (l).
    (ii) Under paragraph (l)(2)(i) of this section, the loan agreement 
is not a governing provision. Accordingly, S is not treated as having 
more than one class of stock by reason of the below-market loan to E.
    Example 6. Agreement to adjust distributions for state tax burdens. 
(i) S, a corporation, executes a binding agreement with its shareholders 
to modify its normal distribution policy by making upward adjustments of 
its distributions to those shareholders who bear heavier state tax 
burdens. The adjustments are based on a formula that will give the 
shareholders equal after-tax distributions.
    (ii) The binding agreement relates to distribution or liquidation 
proceeds. The agreement is thus a governing provision that alters the 
rights conferred by the outstanding stock of S to distribution proceeds 
so that those rights are not identical. Therefore, under paragraph 
(l)(2)(i) of this section, S is treated as having more than one class of 
stock.
    Example 7. State law requirements for payment and withholding of 
income tax. (i) The law of State X requires corporations to pay state 
income taxes on behalf of nonresident shareholders. The law of State X 
does not require corporations to pay state income taxes on behalf of 
resident shareholders. S is incorporated in State X. S's resident 
shareholders have the right (for example, under the law of State X or 
pursuant to S's bylaws or a binding agreement) to distributions that 
take into account the payments S makes on behalf of its nonresident 
shareholders.
    (ii) The payment by S of state income taxes on behalf of its 
nonresident shareholders are generally treated as constructive 
distributions to those shareholders. Because S's resident shareholders 
have the right to equal distributions, taking into account the 
constructive distributions to the nonresident shareholders, S's shares 
confer identical rights to distribution proceeds. Accordingly, under 
paragraph (l)(2)(ii) of this section, the state law requiring S to pay 
state income taxes on behalf of its nonresident shareholders is 
disregarded in determining whether S has more than one class of stock.
    (iii) The same result would follow if the payments of state income 
taxes on behalf of nonresident shareholders are instead treated as 
advances to those shareholders and the governing provisions require the 
advances to be repaid or offset by reductions in distributions to those 
shareholders.
    Example 8. Redemption agreements. (i) F, G, and H are shareholders 
of S, a corporation. F is also an employee of S. By agreement, S is to 
redeem F's shares on the termination of F's employment.
    (ii) On these facts, under paragraph (l)(2)(iii)(B) of this section, 
the agreement is disregarded in determining whether all outstanding 
shares of S's stock confer identical rights to distribution and 
liquidation proceeds.
    Example 9. Analysis of redemption agreements. (i) J, K, and L are 
shareholders of S, a corporation. L is also an employee of S. L's shares 
were not issued to L in connection with the performance of services. By 
agreement, S is to redeem L's shares for an amount significantly below 
their fair market value on the termination of L's employment or if S's 
sales fall below certain levels.
    (ii) Under paragraph (l)(2)(iii)(B) of this section, the portion of 
the agreement providing for redemption of L's stock on termination of 
employment is disregarded. Under paragraph (l)(2)(iii)(A), the portion 
of the agreement providing for redemption of L's stock if S's sales fall 
below certain levels is disregarded unless a principal purpose of that 
portion of the agreement is to circumvent the one class of stock 
requirement of section 1361(b)(1)(D) and this paragraph (l).

    (3) Stock taken into account. Except as provided in paragraphs (b) 
(3), (4), and (5) of this section (relating to restricted stock, 
deferred compensation plans, and straight debt), in determining whether 
all outstanding shares of stock confer identical rights to distribution 
and liquidation proceeds, all outstanding shares of stock of a 
corporation are taken into account. For example, substantially nonvested 
stock with respect to which an election under section 83(b) has been 
made is taken into account in determining whether a corporation has a 
second class of stock, and such stock is not treated as a second class 
of stock if the stock confers rights to distribution and liquidation 
proceeds that are identical, within the meaning of paragraph (l)(1) of 
this section, to the rights conferred by the other outstanding shares of 
stock.
    (4) Other instruments, obligations, or arrangements treated as a 
second class of stock--(i) In general. Instruments, obligations, or 
arrangements are not treated as a second class of stock for purposes of 
this paragraph (l) unless they are described in paragraph (l)(5) (ii) or 
(iii) of this section. However, in no event are instruments, 
obligations, or arrangements described in paragraph (b)(4) of this 
section (relating to deferred compensation plans), paragraphs

[[Page 702]]

(l)(4)(iii) (B) and (C) of this section (relating to the exceptions and 
safe harbor for options), paragraph (l)(4)(ii)(B) of this section 
(relating to the safe harbors for certain short-term unwritten advances 
and proportionally-held debt), or paragraph (l)(5) of this section 
(relating to the safe harbor for straight debt), treated as a second 
class of stock for purposes of this paragraph (l).
    (ii) Instruments, obligations, or arrangements treated as equity 
under general principles--(A) In general. Except as provided in 
paragraph (l)(4)(i) of this section, any instrument, obligation, or 
arrangement issued by a corporation (other than outstanding shares of 
stock described in paragraph (l)(3) of this section), regardless of 
whether designated as debt, is treated as a second class of stock of the 
corporation--
    (1) If the instrument, obligation, or arrangement constituters 
equity or otherwise results in the holder being treated as the owner of 
stock under general principles of Federal tax law; and
    (2) A principal purpose of issuing or entering into the instrument, 
obligation, or arrangement is to circumvent the rights to distribution 
or liquidation proceeds conferred by the outstanding shares of stock or 
to circumvent the limitation on eligible shareholders contained in 
paragraph (b)(1) of this section.
    (B) Safe harbor for certain short-term unwritten advances and 
proportionately held obligations--(1) Short-term unwritten advances. 
Unwritten advances from a shareholder that do not exceed $10,000 in the 
aggregate at any time during the taxable year of the corporation, are 
treated as debt by the parties, and are expected to be repaid within a 
reasonable time are not treated as a second class of stock for that 
taxable year, even if the advances are considered equity under general 
principles of Federal tax law. The failure of an unwritten advance to 
meet this safe harbor will not result in a second class of stock unless 
the advance is considered equity under paragraph (l)(4)(ii)(A)(1) of 
this section and a principal purpose of the advance is to circumvent the 
rights of the outstanding shares of stock or the limitation on eligible 
shareholders under paragraph (l)(4)(ii)(A)(2) of this section.
    (2) Proportionately-held obligations. Obligations of the same class 
that are considered equity under general principles of Federal tax law, 
but are owned solely by the owners of, and in the same proportion as, 
the outstanding stock of the corporation, are not treated as a second 
class of stock. Furthermore, an obligation or obligations owned by the 
sole shareholder of a corporation are always held proportionately to the 
corporation's outstanding stock. The obligations that are considered 
equity that do not meet this safe harbor will not result in a second 
class of stock unless a principal purpose of the obligations is to 
circumvent the rights of the outstanding shares of stock or the 
limitation on eligible shareholders under paragraph (l)(4)(ii)(A)(2) of 
this section.
    (iii) Certain call options, warrants or similar instruments--(A) In 
general. Except as otherwise provided in this paragraph (l)(4)(iii), a 
call option, warrant, or similar instrument (collectively, call option) 
issued by a corporation is treated as a second class of stock of the 
corporation if, taking into account all the facts and circumstances, the 
call option is substantially certain to be exercised (by the holder or a 
potential transferee) and has a strike price substantially below the 
fair market value of the underlying stock on the date that the call 
option is issued, transferred by a person who is an eligible shareholder 
under paragraph (b)(1) of this section to a person who is not an 
eligible shareholder under paragraph (b)(1) of this section, or 
materially modified. For purposes of this paragraph (l)(4)(iii), if an 
option is issued in connection with a loan and the time period in which 
the option can be exercised is extended in connection with (and 
consistent with) a modification of the terms of the loan, the extension 
of the time period in which the option may be exercised is not 
considered a material modification. In addition, a call option does not 
have a strike price substantially below fair market value if the price 
at the time of exercise cannot, pursuant to the terms of the instrument, 
be substantially below the

[[Page 703]]

fair market value of the underlying stock at the time of exercise.
    (B) Certain exceptions. (1) A call option is not treated as a second 
class of stock for purposes of this paragraph (l) if it is issued to a 
person that is actively and regularly engaged in the business of lending 
and issued in connection with a commercially reasonable loan to the 
corporation. This paragraph (l)(4)(iii)(B)(1) continues to apply if the 
call option is transferred with the loan (or if a portion of the call 
option is transferred with a corresponding portion of the loan). 
However, if the call option is transferred without a corresponding 
portion of the loan, this paragraph (l)(4)(iii)(B)(1) ceases to apply. 
Upon that transfer, the call option is tested under paragraph 
(l)(4)(iii)(A) (notwithstanding anything in that paragraph to the 
contrary) if, but for this paragraph, the call option would have been 
treated as a second class of stock on the date it was issued.
    (2) A call option that is issued to an individual who is either an 
employee or an independent contractor in connection with the performance 
of services for the corporation or a related corporation (and that is 
not excessive by reference to the services performed) is not treated as 
a second class of stock for purposes of this paragraph (l) if--
    (i) The call option is nontransferable within the meaning of Sec. 
1.83-3(d); and
    (ii) The call option does not have a readily ascertainable fair 
market value as defined in Sec. 1.83-7(b) at the time the option is 
issued.

If the call option becomes transferable, this paragraph 
(l)(4)(iii)(B)(2) ceases to apply. Solely for purposes of this paragraph 
(l)(4)(iii)(B)(2), a corporation is related to the issuing corporation 
if more than 50 percent of the total voting power and total value of its 
stock is owned by the issuing corporation.
    (3) The Commissioner may provide other exceptions by Revenue Ruling 
or other published guidance.
    (C) Safe harbor for certain options. A call option is not treated as 
a second class of stock if, on the date the call option is issued, 
transferred by a person who is an eligible shareholder under paragraph 
(b)(1) of this section to a person who is not an eligible shareholder 
under paragraph (b)(1) of this section, or materially modified, the 
strike price of the call option is at least 90 percent of the fair 
market value of the underlying stock on that date. For purposes of this 
paragraph (l)(4)(iii)(C), a good faith determination of fair market 
value by the corporation will be respected unless it can be shown that 
the value was substantially in error and the determination of the value 
was not performed with reasonable diligence to obtain a fair value. 
Failure of an option to meet this safe harbor will not necessarily 
result in the option being treated as a second class of stock.
    (iv) Convertible debt. A convertible debt instrument is considered a 
second class of stock if--
    (A) It would be treated as a second class of stock under paragraph 
(l)(4)(ii) of this section (relating to instruments, obligations, or 
arrangements treated as equity under general principles); or
    (B) It embodies rights equivalent to those of a call option that 
would be treated as a second class of stock under paragraph (l)(4)(iii) 
of this section (relating to certain call options, warrants, and similar 
instruments).
    (v) Examples. The application of this paragraph (l)(4) may be 
illustrated by the following examples. In each of the examples, the S 
corporation requirements of section 1361 are satisfied except as 
otherwise stated, the corporation has in effect an S election under 
section 1362, and the corporation has only the shareholders described.

    Example 1. Transfer of call option by eligible shareholder to 
ineligible shareholder. (i) S, a corporation, has 10 shareholders. S 
issues call options to A, B, and C, individuals who are U.S. residents. 
A, B, and C are not shareholders, employees, or independent contractors 
of S. The options have a strike price of $40 and are issued on a date 
when the fair market value of S stock is also $40. A year later, P, a 
partnership, purchases A's option. On the date of transfer, the fair 
market value of S stock is $80.
    (ii) On the date the call option is issued, its strike price is not 
substantially below the fair market value of the S stock. Under 
paragraph (l)(4)(iii)(A) of this section, whether a call option is a 
second class of stock must be redetermined if the call option is 
transferred by a person who is an eligible shareholder under paragraph 
(b)(1) of this section to a person who is not an eligible shareholder

[[Page 704]]

under paragraph (b)(1) of this section. In this case, A is an eligible 
shareholder of S under paragraph (b)(1) of this section, but P is not. 
Accordingly, the option is retested on the date it is transferred to D.
    (iii) Because on the date the call option is transferred to P its 
strike price is 50% of the fair market value, the strike price is 
substantially below the fair market value of the S stock. Accordingly, 
the call option is treated as a second class of stock as of the date it 
is transferred to P if, at that time, it is determined that the option 
is substantially certain to be exercised. The determination of whether 
the option is substantially certain to be exercised is made on the basis 
of all the facts and circumstances.
    Example 2. Call option issued in connection with the performance of 
services. (i) E is a bona fide employee of S, a corporation. S issues to 
E a call option in connection with E's performance of services. At the 
time the call option is issued, it is not transferable and does not have 
a readily ascertainable fair market value. However, the call option 
becomes transferable before it is exercised by E.
    (ii) While the option is not transferable, under paragraph 
(l)(4)(iii)(B)(2) of this section, it is not treated as a second class 
of stock, regardless of its strike price. When the option becomes 
transferable, that paragraph ceases to apply, and the general rule of 
paragraph (l)(4)(iii)(A) of this section applies. Accordingly, if the 
option is materially modified or is transferred to a person who is not 
an eligible shareholder under paragraph (b)(1) of this section, and on 
the date of such modification or transfer, the option is substantially 
certain to be exercised and has a strike price substantially below the 
fair market value of the underlying stock, the option is treated as a 
second class of stock.
    (iii) If E left S's employment before the option became 
transferable, the exception provided by paragraph (l)(4)(iii)(B)(2) 
would continue to apply until the option became transferable.

    (5) Straight debt safe harbor--(i) In general. Notwithstanding 
paragraph (l)(4) of this section, straight debt is not treated as a 
second class of stock. For purposes of section 1361(c)(5) and this 
section, the term straight debt means a written unconditional 
obligation, regardless of whether embodied in a formal note, to pay a 
sum certain on demand, or on a specified due date, which--
    (A) Does not provide for an interest rate or payment dates that are 
contingent on profits, the borrower's discretion, the payment of 
dividends with respect to common stock, or similar factors;
    (B) Is not convertible (directly or indirectly) into stock or any 
other equity interest of the S corporation; and
    (C) Is held by an individual (other than a nonresident alien), an 
estate, or a trust described in section 1361(c)(2).
    (ii) Subordination. The fact that an obligation is subordinated to 
other debt of the corporation does not prevent the obligation from 
qualifying as straight debt.
    (iii) Modification or transfer. An obligation that originally 
qualifies as straight debt ceases to so qualify if the obligation--
    (A) Is materially modified so that it no longer satisfies the 
definition of straight debt; or
    (B) Is transferred to a third party who is not an eligible 
shareholder under paragraph (b)(1) of this section.
    (iv) Treatment of straight debt for other purposes. An obligation of 
an S corporation that satisfies the definition of straight debt in 
paragraph (l)(5)(i) of this section is not treated as a second class of 
stock even if it is considered equity under general principles of 
Federal tax law. Such an obligation is generally treated as debt and 
when so treated is subject to the applicable rules governing 
indebtedness for other purposes of the Code. Accordingly, interest paid 
or accrued with respect to a straight debt obligation is generally 
treated as interest by the corporation and the recipient and does not 
constitute a distribution to which section 1368 applies. However, if a 
straight debt obligation bears a rate of interest that is unreasonably 
high, an appropriate portion of the interest may be recharacterized and 
treated as a payment that is not interest. Such a recharacterization 
does not result in a second class of stock.
    (v) Treatment of C corporation debt upon conversion to S status. If 
a C corporation has outstanding an obligation that satisfies the 
definition of straight debt in paragraph (l)(5)(i) of this section, but 
that is considered equity under general principles of Federal tax law, 
the obligation is not treated as a second class of stock for purposes of 
this section if the C corporation converts to S status. In addition, the 
conversion from C corporation status to S corporation status is not 
treated as an

[[Page 705]]

exchange of debt for stock with respect to such an instrument.
    (6) Inadvertent terminations. See section 1362(f) and the 
regulations thereunder for rules relating to inadvertent terminations in 
cases where the one class of stock requirement has been inadvertently 
breached.
    (7) Effective date. Section 1.1361-1(l) generally applies to taxable 
years of a corporation beginning on or after May 28, 1992. However, 
Sec. 1.1361-1(l) does not apply to: an instrument, obligation, or 
arrangement issued or entered into before May 28, 1992, and not 
materially modified after that date; a buy-sell agreement, redemption 
agreement, or agreement restricting transferability entered into before 
May 28, 1992, and not materially modified after that date; or a call 
option or similar instrument issued before May 28, 1992, and not 
materially modified after that date. In addition, a corporation and its 
shareholders may apply this Sec. 1.1361-1(l) to prior taxable years.
    (m) Electing small business trust (ESBT)--(1) Definition--(i) 
General rule. An electing small business trust (ESBT) means any trust if 
it meets the following requirements: the trust does not have as a 
beneficiary any person other than an individual, an estate, an 
organization described in section 170(c)(2) through (5), or an 
organization described in section 170(c)(1) that holds a contingent 
interest in such trust and is not a potential current beneficiary; no 
interest in the trust has been acquired by purchase; and the trustee of 
the trust makes a timely ESBT election for the trust.
    (ii) Qualified beneficiaries--(A) In general. For purposes of this 
section, a beneficiary includes a person who has a present, remainder, 
or reversionary interest in the trust.
    (B) Distributee trusts. A distributee trust is the beneficiary of 
the ESBT only if the distributee trust is an organization described in 
section 170(c)(2) or (3). In all other situations, any person who has a 
beneficial interest in a distributee trust is a beneficiary of the ESBT. 
A distributee trust is a trust that receives or may receive a 
distribution from an ESBT, whether the rights to receive the 
distribution are fixed or contingent, or immediate or deferred.
    (C) Powers of appointment. A person in whose favor a power of 
appointment could be exercised is not a beneficiary of an ESBT until the 
holder of the power of appointment actually exercises the power in favor 
of such person.
    (D) Nonresident aliens. A nonresident alien as defined in section 
7701(b)(1)(B) is an eligible beneficiary of an ESBT. However, see 
paragraph (m)(4)(i) and (m)(5)(iii) of this section if the nonresident 
alien is a potential current beneficiary of the ESBT (which would result 
in an ineligible shareholder and termination of the S corporation 
election).
    (iii) Interests acquired by purchase. A trust does not qualify as an 
ESBT if any interest in the trust has been acquired by purchase. 
Generally, if a person acquires an interest in the trust and thereby 
becomes a beneficiary of the trust as defined in paragraph 
(m)(1)(ii)(A), and any portion of the basis in the acquired interest in 
the trust is determined under section 1012, such interest has been 
acquired by purchase. This includes a net gift of a beneficial interest 
in the trust, in which the person acquiring the beneficial interest pays 
the gift tax. The trust itself may acquire S corporation stock or other 
property by purchase or in a part-gift, part-sale transaction.
    (iv) Ineligible trusts. An ESBT does not include--
    (A) Any qualified subchapter S trust (as defined in section 
1361(d)(3)) if an election under section 1361(d)(2) applies with respect 
to any corporation the stock of which is held by the trust;
    (B) Any trust exempt from tax or not subject to tax under subtitle 
A; or
    (C) Any charitable remainder annuity trust or charitable remainder 
unitrust (as defined in section 664(d)).
    (2) ESBT election--(i) In general. The trustee of the trust must 
make the ESBT election by signing and filing, with the service center 
where the S corporation files its income tax return, a statement that 
meets the requirements of paragraph (m)(2)(ii) of this section. If there 
is more than one trustee, the trustee or trustees with authority to 
legally bind the trust must sign the election statement. If any one of 
several trustees can legally bind the trust, only one trustee needs

[[Page 706]]

to sign the election statement. Generally, only one ESBT election is 
made for the trust, regardless of the number of S corporations whose 
stock is held by the ESBT. However, if the ESBT holds stock in multiple 
S corporations that file in different service centers, the ESBT election 
must be filed with all the relevant service centers where the 
corporations file their income tax returns. This requirement applies 
only at the time of the initial ESBT election; if the ESBT later 
acquires stock in an S corporation which files its income tax return at 
a different service center, a new ESBT election is not required.
    (ii) Election statement. The election statement must include--
    (A) The name, address, and taxpayer identification number of the 
trust, the potential current beneficiaries, and the S corporations in 
which the trust currently owns stock;
    (B) An identification of the election as an ESBT election made under 
section 1361(e)(3);
    (C) The first date on which the trust owned stock in each S 
corporation;
    (D) The date on which the election is to become effective (not 
earlier than 15 days and two months before the date on which the 
election is filed); and
    (E) Representations signed by the trustee stating that--
    (1) The trust meets the definitional requirements of section 
1361(e)(1); and
    (2) All potential current beneficiaries of the trust meet the 
shareholder requirements of section 1361(b)(1).
    (iii) Due date for ESBT election. The ESBT election must be filed 
within the time requirements prescribed in paragraph (j)(6)(iii) of this 
section for filing a qualified subchapter S trust (QSST) election.
    (iv) Election by a trust described in section 1361(c)(2)(A)(ii) or 
(iii). A trust that is a qualified S corporation shareholder under 
section 1361(c)(2)(A)(ii) or (iii) may elect ESBT treatment at any time 
during the 2-year period described in those sections or the 16-day-and-
2-month period beginning on the date after the end of the 2-year period. 
If the trust makes an ineffective ESBT election, the trust will continue 
nevertheless to qualify as an eligible S corporation shareholder for the 
remainder of the period described in section 1361(c)(2)(A)(ii) or (iii).
    (v) No protective election. A trust cannot make a conditional ESBT 
election that would be effective only in the event the trust fails to 
meet the requirements for an eligible trust described in section 
1361(c)(2)(A)(i) through (iv). If a trust attempts to make such a 
conditional ESBT election and it fails to qualify as an eligible S 
corporation shareholder under section 1361(c)(2)(A)(i) through (iv), the 
S corporation election will be ineffective or will terminate because the 
corporation will have an ineligible shareholder. Relief may be available 
under section 1362(f) for an inadvertent ineffective S corporation 
election or an inadvertent S corporation election termination. In 
addition, a trust that qualifies as an ESBT may make an ESBT election 
notwithstanding that the trust is a wholly-owned grantor trust.
    (3) Effect of ESBT election--(i) General rule. If a trust makes a 
valid ESBT election, the trust will be treated as an ESBT for purposes 
of chapter 1 of the Internal Revenue Code as of the effective date of 
the ESBT election.
    (ii) Employer Identification Number. An ESBT has only one employer 
identification number (EIN). If an existing trust makes an ESBT 
election, the trust continues to use the EIN it currently uses.
    (iii) Taxable year. If an ESBT election is effective on a day other 
than the first day of the trust's taxable year, the ESBT election does 
not cause the trust's taxable year to close. The termination of the ESBT 
election (including a termination caused by a conversion of the ESBT to 
a QSST) other than on the last day of the trust's taxable year also does 
not cause the trust's taxable year to close. In either case, the trust 
files one tax return for the taxable year.
    (iv) Allocation of S corporation items. If, during the taxable year 
of an S corporation, a trust is an ESBT for part of the year and an 
eligible shareholder under section 1361(c)(2)(A)(i) through (iv) for the 
rest of the year, the S corporation items are allocated between the two 
types of trusts under section 1377(a). See Sec. 1.1377-1(a)(2)(iii).

[[Page 707]]

    (v) Estimated taxes. If an ESBT election is effective on a day other 
than the first day of the trust's taxable year, the trust is considered 
one trust for purposes of estimated taxes under section 6654.
    (4) Potential current beneficiaries--(i) In general. For purposes of 
determining whether a corporation is a small business corporation within 
the meaning of section 1361(b)(1), each potential current beneficiary of 
an ESBT generally is treated as a shareholder of the corporation. 
Subject to the provisions of this paragraph (m)(4), a potential current 
beneficiary generally is, with respect to any period, any person who at 
any time during such period is entitled to, or in the discretion of any 
person may receive, a distribution from the principal or income of the 
trust. A person is treated as a shareholder of the S corporation at any 
moment in time when that person is entitled to, or in the discretion of 
any person may, receive a distribution of principal or income of the 
trust. No person is treated as a potential current beneficiary solely 
because that person holds any future interest in the trust.
    (ii) Grantor trusts. If all or a portion of an ESBT is treated as 
owned by a person under subpart E, part I, subchapter J, chapter 1 of 
the Internal Revenue Code, such owner is a potential current beneficiary 
in addition to persons described in paragraph (m)(4)(i) of this section.
    (iii) Special rule for dispositions of stock. Notwithstanding the 
provisions of paragraph (m)(4)(i) of this section, if a trust disposes 
of all of its S corporation stock, any person who first met the 
definition of a potential current beneficiary during the 60-day period 
ending on the date of such disposition is not a potential current 
beneficiary and thus is not a shareholder of that corporation.
    (iv) Distributee trusts--(A) In general. This paragraph (m)(4)(iv) 
contains the rules for determining who are the potential current 
beneficiaries of an ESBT if a distributee trust becomes entitled to, or 
at the discretion of any person, may receive a distribution from 
principal or income of an ESBT. A distributee trust does not include a 
trust that is not currently in existence. For this purpose, a trust is 
not currently in existence if the trust has no assets and no items of 
income, loss, deduction, or credit. Thus, if a trust instrument provides 
for a trust to be funded at some future time, the future trust is not 
currently a distributee trust.
    (B) If the distributee trust is not a trust described in section 
1361(c)(2)(A), then the distributee trust is the potential current 
beneficiary of the ESBT and the corporation's S corporation election 
terminates.
    (C) If the distributee trust is a trust described in section 
1361(c)(2)(A), the persons who would be its potential current 
beneficiaries (as defined in paragraphs (m)(4)(i) and (ii) of this 
section) if the distributee trust were an ESBT are treated as the 
potential current beneficiaries of the ESBT. Notwithstanding the 
preceding sentence, however, if the distributee trust is a trust 
described in section 1361(c)(2)(A)(ii) or (iii), the estate described in 
section 1361(c)(2)(B) (ii) or (iii) is treated as the potential current 
beneficiary of the ESBT for the 2-year period during which such trust 
would be permitted as a shareholder.
    (D) For the purposes of paragraph (m)(4)(iv)(C) of this section, a 
trust will be deemed to be described in section 1361(c)(2)(A) if such 
trust would qualify for a QSST election under section 1361(d) or an ESBT 
election under section 1361(e) if it owned S corporation stock.
    (v) Contingent distributions. A person who is entitled to receive a 
distribution only after a specified time or upon the occurrence of a 
specified event (such as the death of the holder of a power of 
appointment) is not a potential current beneficiary until such time or 
the occurrence of such event.
    (vi) Currently exercisable powers of appointment--(A) In general. A 
person to whom a distribution is or may be made during a period pursuant 
to a power of appointment is a potential current beneficiary. Thus, if 
any person has a lifetime power of appointment that would permit 
distributions from the trust to be made to more than 75 persons, the 
corporation's S corporation election will terminate because the number 
of potential current beneficiaries will exceed the 75-shareholder limit 
of section

[[Page 708]]

1361(b)(1)(A). Also, the S corporation election will terminate if the 
currently exercisable power of appointment allows distributions to be 
made to an ineligible shareholder as defined in section 1361(b)(1)(B) 
and (C).
    (B) Waiver or release. If the holder of a power of appointment 
permanently releases the power in a manner that is valid under 
applicable local law, the persons that would be potential current 
beneficiaries solely because of the power will not be potential current 
beneficiaries after the effective date of the release. An attempt to 
temporarily waive, release, or limit a currently exercisable power of 
appointment will be ignored in determining who are potential current 
beneficiaries of the trust.
    (vii) Number of shareholders. Each potential current beneficiary of 
the ESBT, as defined in paragraphs (m)(4)(i) through (vi) of this 
section, is counted as a shareholder of any S corporation whose stock is 
owned by the ESBT. During any period in which the ESBT has no potential 
current beneficiaries, the ESBT is counted as the shareholder. A person 
is counted as only one shareholder of an S corporation even though that 
person may be treated as a shareholder of the S corporation by direct 
ownership and through one or more eligible trusts described in section 
1361(c)(2)(A). Thus, for example, if a person owns stock in an S 
corporation and is a potential current beneficiary of an ESBT that owns 
stock in the same S corporation, that person is counted as one 
shareholder of the S corporation. Similarly, if a husband owns stock in 
an S corporation and his wife is a potential current beneficiary of an 
ESBT that owns stock in the same S corporation, the husband and wife 
will be counted as one shareholder of the S corporation.
    (viii) Miscellaneous. Payments made by an ESBT to a third party on 
behalf of a beneficiary are considered to be payments made directly to 
the beneficiary. The right of a beneficiary to assign the beneficiary's 
interest to a third party does not result in the third party being a 
potential current beneficiary until that interest is actually assigned.
    (5) ESBT terminations--(i) Ceasing to meet ESBT requirements. A 
trust ceases to be an ESBT on the first day the trust fails to meet the 
definition of an ESBT under section 1361(e). The last day the trust is 
treated as an ESBT is the day before the date on which the trust fails 
to meet the definition of an ESBT.
    (ii) Disposition of S stock. In general, a trust ceases to be an 
ESBT on the first day following the day the trust disposes of all S 
corporation stock. However, if the trust is using the installment method 
to report income from the sale or disposition of its stock in an S 
corporation, the trust ceases to be an ESBT on the day following the 
earlier of the day the last installment payment is received by the trust 
or the day the trust disposes of the installment obligation.
    (iii) Potential current beneficiaries that are ineligible 
shareholders. If a potential current beneficiary of an ESBT is not an 
eligible shareholder of a small business corporation within the meaning 
of section 1361(b)(1), the S corporation election terminates. For 
example, the S corporation election will terminate if a nonresident 
alien becomes a potential current beneficiary of an ESBT. Such a 
potential current beneficiary is treated as an ineligible shareholder 
beginning on the day such person becomes a potential current 
beneficiary, and the S corporation election terminates on that date. 
However, see the special rule of paragraph (m)(4)(iii) of this section. 
If the S corporation election terminates, relief may be available under 
section 1362(f).
    (6) Revocation of ESBT election. An ESBT election may be revoked 
only with the consent of the Commissioner. The application for consent 
to revoke the election must be submitted to the Internal Revenue Service 
in the form of a letter ruling request under the appropriate revenue 
procedure.
    (7) Converting an ESBT to a QSST. For a trust that seeks to convert 
from an ESBT to a QSST, the consent of the Commissioner is hereby 
granted to revoke the ESBT election as of the effective date of the QSST 
election, if all the following requirements are met:
    (i) The trust meets all of the requirements to be a QSST under 
section 1361(d).

[[Page 709]]

    (ii) The trustee and the current income beneficiary of the trust 
sign the QSST election. The QSST election must be filed with the service 
center where the S corporation files its income tax return. This QSST 
election must state at the top of the document ``ATTENTION ENTITY 
CONTROL--CONVERSION OF AN ESBT TO A QSST PURSUANT TO SECTION 1.1361-
1(m)'' and include all information otherwise required for a QSST 
election under Sec. 1.1361-1(j)(6). A separate QSST election must be 
made with respect to the stock of each S corporation held by the trust.
    (iii) The trust has not converted from a QSST to an ESBT within the 
36-month period preceding the effective date of the new QSST election.
    (iv) The date on which the QSST election is to be effective cannot 
be more than 15 days and two months prior to the date on which the 
election is filed and cannot be more than 12 months after the date on 
which the election is filed. If an election specifies an effective date 
more than 15 days and two months prior to the date on which the election 
is filed, it will be effective on the day that is 15 days and two months 
prior to the date on which it is filed. If an election specifies an 
effective date more than 12 months after the date on which the election 
is filed, it will be effective on the day that is 12 months after the 
date it is filed.
    (8) Examples. The provisions of this paragraph (m) are illustrated 
by the following examples in which it is assumed, unless otherwise 
specified, that all noncorporate persons are citizens or residents of 
the United States:

    Example 1. (i) ESBT election with section 663(c) separate shares. On 
January 1, 2003, M contributes S corporation stock to Trust for the 
benefit of M's three children A, B, and C. Pursuant to section 663(c), 
each of Trust's separate shares for A, B, and C will be treated as 
separate trusts for purposes of determining the amount of distributable 
net income (DNI) in the application of sections 661 and 662. On January 
15, 2003, the trustee of Trust files a valid ESBT election for Trust 
effective January 1, 2003. Trust will be treated as a single ESBT and 
will have a single S portion taxable under section 641(c).
    (ii) ESBT acquires stock of an additional S corporation. On February 
15, 2003, Trust acquires stock of an additional S corporation. Because 
Trust is already an ESBT, Trust does not need to make an additional ESBT 
election.
    (iii) Section 663(c) shares of ESBT convert to separate QSSTs. 
Effective January 1, 2004, A, B, C, and Trust's trustee elect to convert 
each separate share of Trust into a separate QSST pursuant to paragraph 
(m)(7) of this section. For each separate share, they file a separate 
election for each S corporation whose stock is held by Trust. Each 
separate share will be treated as a separate QSST.
    Example 2. (i) Invalid potential current beneficiary. Effective 
January 1, 2003, Trust makes a valid ESBT election. On January 1, 2004, 
A, a nonresident alien, becomes a potential current beneficiary of 
Trust. Trust does not dispose of all of its S corporation stock within 
60 days after January 1, 2004. As of January 1, 2004, A is a potential 
current beneficiary of Trust and therefore is treated as a shareholder 
of the S corporation. Because A is not an eligible shareholder of an S 
corporation under section 1361(b)(1), the S corporation election of any 
corporation in which Trust holds stock terminates effective January 1, 
2004. Relief may be available under section 1362(f).
    (ii) Invalid potential current beneficiary and disposition of S 
stock. Assume the same facts as in Example 2 (i) except that within 60 
days after January 1, 2004, trustee of Trust disposes of all Trust's S 
corporation stock. A is not considered a potential current beneficiary 
of Trust and therefore is not treated as a shareholder of any S 
corporation in which Trust previously held stock.
    Example 3. Subpart E trust. M transfers stock in X, an S 
corporation, and other assets to Trust for the benefit of B and B's 
siblings. M retains no powers or interest in Trust. Under section 
678(a), B is treated as the owner of a portion of Trust that includes a 
portion of the X stock. No beneficiary has acquired any portion of his 
or her interest in Trust by purchase, and Trust is not an ineligible 
trust under paragraph (m)(1)(iv) of this section. Trust is eligible to 
make an ESBT election.
    Example 4. Subpart E trust continuing after grantor's death. On 
January 1, 2003, M transfers stock in X, an S corporation, and other 
assets to Trust. Under the terms of Trust, the trustee of Trust has 
complete discretion to distribute the income or principal to M during 
M's lifetime and to M's children upon M's death. During M's life, M is 
treated as the owner of Trust under section 677. The trustee of Trust 
makes a valid election to treat Trust as an ESBT effective January 1, 
2003. On March 28, 2004, M dies. Under applicable local law, Trust does 
not terminate on M's death. Trust continues to be an ESBT after M's 
death, and no additional ESBT election needs to be filed for Trust after 
M's death.
    Example 5. Potential current beneficiaries and distributee trust 
holding S corporation stock.

[[Page 710]]

Trust-1 has a valid ESBT election in effect. The trustee of Trust-1 has 
the power to make distributions to A directly or to any trust created 
for the benefit of A. On January 1, 2003, M creates Trust-2 for the 
benefit of A. Also on January 1, 2003, the trustee of Trust-1 
distributes some S corporation stock to Trust-2. A, as the current 
income beneficiary of Trust-2, makes a timely and effective election to 
treat Trust-2 as a QSST. Because Trust-2 is a valid S corporation 
shareholder, the distribution to Trust-2 does not terminate the ESBT 
election of Trust-1. Trust-2 itself will not be counted toward the 75-
shareholder limit of section 1361(b)(1)(A). Additionally, because A is 
already counted as an S corporation shareholder because of A's status as 
a potential current income beneficiary of Trust-1, A is not counted 
again by reason of A's status as the deemed owner of Trust-2.
    Example 6. Potential current beneficiaries and distributee trust not 
holding S corporation stock. (i) Distributee trust that would itself 
qualify as an ESBT. Trust-1 holds stock in X, an S corporation, and has 
a valid ESBT election in effect. Under the terms of Trust-1, the trustee 
has discretion to make distributions to A, B, and Trust-2, a trust for 
the benefit of C, D, and E. Trust-2 would qualify to be an ESBT, but it 
owns no S corporation stock and has made no ESBT election. Under 
paragraph (m)(4)(iv) of this section, Trust-2's potential current 
beneficiaries are treated as the potential current beneficiaries of 
Trust-1 and are counted as shareholders for purposes of section 
1361(b)(1). Thus, A, B, C, D, and E are potential current beneficiaries 
of Trust-1 and are counted as shareholders for purposes of section 
1361(b)(1). Trust-2 itself will not be counted as a shareholder of 
Trust-1 for purposes of section 1361(b)(1).
    (ii) Distributee trust that would not qualify as an ESBT or a QSST. 
Assume the same facts as in paragraph (i) of this Example 6 except that 
D is a nonresident alien. Trust-2 would not be eligible to make an ESBT 
or QSST election if it owned S corporation stock and therefore Trust-2 
is a potential current beneficiary of Trust-1. Since Trust-2 is not an 
eligible shareholder, X's S corporation election terminates.
    (iii) Distributee trust that is a section 1361(c)(2)(A)(ii) trust. 
Assume the same facts as in paragraph (i) of this Example 6 except that 
Trust-2 is a trust treated as owned by A under section 676 because A has 
the power to revoke Trust-2 at any time prior to A's death. On January 
1, 2003, A dies. Because Trust-2 is a trust described in section 
1361(c)(2)(A)(ii) during the 2-year period beginning on the day of A's 
death, under paragraph (m)(4)(iv)(C) of this section, Trust-2's only 
potential current beneficiary is the person listed in section 
1361(c)(2)(B)(ii), A's estate. Thus, B and A's estate are potential 
current beneficiaries of Trust-1 and are counted as shareholders for 
purposes of section 1361(b)(1).
    Example 7. Potential current beneficiaries and powers of 
appointment. M creates Trust for the benefit of A. A also has a 
currently exercisable power to appoint income or principal to anyone 
except A, A's creditors, A's estate, and the creditors of A's estate. 
The potential current beneficiaries of Trust will be A and all other 
persons except for A's creditors, A's estate, and the creditors of A's 
estate. This number will exceed the 75-shareholder limit of section 
1361(b)(1)(A). If Trust holds S corporation stock, the corporation's S 
election will terminate.

    (9) Effective date. This paragraph (m) is applicable for taxable 
years of ESBTs beginning on and after May 14, 2002.

[T.D. 8419, 57 FR 22649, May 29, 1992; 57 FR 28613, June 26, 1992, as 
amended by T.D. 8600, 60 FR 37581, July 21, 1995; 60 FR 49976, Sept. 27, 
1995; 60 FR 58234, Nov. 27, 1995; 61 FR 2869, Jan. 29, 1996; T.D. 8869, 
65 FR 3849, Jan. 25, 2000; T.D. 8940, 66 FR 9929, 9957, Feb. 13, 2001; 
T.D. 8994, 67 FR 34397, May 14, 2002; T.D. 9078, 68 FR 42252, July 17, 
2003]