Information Release

IT 2000-01 - Grantor Trust Provisions Take Precedence Over ESBT Provisions - January 19, 2000

Effective for individual and estate taxable years beginning after December 31, 1999, the Income Tax Audit Division will require certain individuals and estates to include in their federal adjusted gross income ("FAGI") and Ohio taxable income all relevant pass-through items of income, gain or loss from S corporations when such items have been treated as reportable for federal income tax purposes on a trust's fiduciary income tax return (Form 1041) because the trust has elected to be taxed as an Electing Small Busi-ness Trust ("ESBT") under Internal Revenue Code ("IRC") section 1361(e)(3). Specifically, if an individual or estate would be treated as the owner of all or a portion of a trust pursuant to IRC section 671 et seq., then such individual or estate shall include in his, her or its FAGI or Ohio taxable income all relevant S corporation pass-through items as if the individual or estate were itself the actual owner of the S corporation stock owned by the trust.¹

Furthermore, because the Income Tax Audit Division will treat such trusts as grantor trusts rather than as ESBT's, the trust cannot qualify as an electing small business trust excluded, under Ohio Revised Code ("ORC") section 5733.40(I)(1), from the definition of a "qualifying investor." As such, for taxable years beginning after December 31, 1999, an S corporation must pay the 5% pass-through entity withholding tax and related estimated tax (ORC sections 5747.41 and 5747.43) with respect to "adjusted qualifying amounts" (ORC section 5733.40(A)(1)(a)) which pass through to such trusts.

For taxable years beginning after December 31, 1999, assessments for unpaid tax and all related failure-to-timely-pay and failure-to-timely-file charges will apply (i) to such individuals and estates who do not adjust their FAGI and Ohio taxable income (and timely pay tax and related estimated tax thereon) in accordance with this information release and (ii) to S corporations which do not timely pay the 5% withholding tax and the related es-timated tax with respect to such S corporation distributive shares.

Discussion

The Internal Revenue Code does not contain any provisions which expressly state that an ESBT which also qualifies as and/or is described as a grantor trust is exempt from the grantor trust provisions. Neither does the "Blue Book" provide or address any such exemption.²  In fact, the principal advocate of the ESBT legislation has cautioned that the provisions of an ESBT's governing instruments ". . . should be limited so that no power would result in the inclusion of trust assets or revenue in the trustee's own estate or income."³   Thus, even the principal advocate of the ESBT legislation implicitly recognizes that an ESBT which also qualifies as and/or is described as a grantor trust is, in fact, subject to the grantor trust provisions for taxation rather than qualifying for the special rules for taxation of ESBT's under IRC section 641(c).

The Income Tax Audit Division recognizes that various tax practitioners have differing interpretations of how the ESBT provisions interplay with the grantor trust provisions of the Internal Revenue Code. Some have advocated that the ESBT provisions should take precedence over the grantor trust provisions, while others believe that a grantor trust can-not make the ESBT election.⁴  In light of the fact that neither the U.S. Treasury Department nor the Internal Revenue Service has issued any guidance in this area, and barring any change in the federal tax law or issuance of new U.S. Treasury regulations to the contrary, the Income Tax Audit Division's position is that a grantor trust cannot make the ESBT election.

If you have questions regarding this information release, please contact the Income Tax Audit Division at 614-433-7610 (TTY: 1-800-750-0750).

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¹Of course, individuals and estates will not have to make these adjustments to the extent these individuals and estates have already done so on their federal income tax returns.

 

²Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 104th Congress.

 

³See the last sentence of Frederick G. Corneel's article, "The Electing Small Business Trust: Subchapter S's User-Friendly Estate Planning Tool" beginning on page 215 of the April, 1997 issue of the Journal of Taxation. The "Editor's Note" appearing in that article states as follows:

 

"Mr. Corneel was the principal advocate on Capitol Hill for ESBTs, and he worked with the staffs of both the Joint Committee and Treasury in drafting the legislation.
. . . Moreover, until there is Treasury guidance or further legislation, his analysis of the law stands as uniquely important to any potential users of this new estate planning tool."

⁴See item number 4 in the American Institute of Certified Public Accountants December 21, 1999 corre-spondence to IRS Assistant Chief Counsel Paul F. Kugler. That letter is reproduced in the December 29, 1999 edition of BNA, Inc.'s TaxCore. But see Apple, "Ohio Income Tax Treatment of The Newest "S" Corporation Shareholder: The Electing Small Business Trust," The Ohio CPA Journal, April - June, 1998 on page 29, 4th line down: "Grantor trusts cannot elect to be treated as an ESBT."