Thursday, August 30, 2007

NO NOL CARRYOVER TO SUBCHAPTER ‘S’ ESBT TRUST

A trust that owns stock in a Subchapter S corporation can elect to be taxed as an "electing small business trust" or "ESBT." Such an election is one method of avoiding the prohibition on trust ownership of Subchapter S corporation stock.

After making the ESBT election, the portion of the trust that owns the Subchapter S stock is taxed separately from the remaining portion of the trust. Code Section 641(c)(2)(C) limits the deductions and losses of the ESBT share to those that pass through to it as a shareholder of an 'S' corporation, losses from the disposition of the 'S' corporation stock, and a share of trust administration expenses.

What happens if the trust had a net operating loss attributable to the pass-through of 'S' corporation stock as of the time of its ESBT election? The Code is not entirely clear on whether the ESBT can deduct that NOL.

Code Section 642(h)(1) indicates that on the termination of a trust, the net operating losses of the terminating trust carry over to the beneficiaries receiving the assets of the terminating trust. Arguably, then, such losses should carry over to the ESBT trust as successor to the pre-ESBT trust. Since the losses came from the 'S' corporation, the limits under Code Section 641(c)(2)(C) on losses that are deductible by an ESBT perhaps should not apply.

In a recent Chief Counsel Advice, the IRS has indicated that the NOL cannot be carried over to the ESBT (although it can be used by the non-ESBT portion of the trust). The rationale of the Advice is that the Code Section 641(c)(2)(C) list of allowable ESBT deductions is the exclusive list of deductions, and that a Code Section 642(h)(1) NOL carryover is not included in that list (even though one could argue that it is included via Code Section 641(c)(2)(C)(i), relating to Subchapter S items described in Code Section 1366)).

Unless they feel strongly that the Advice is erroneous, practitioners should count as a "cost" to electing ESBT status the possible loss of prior NOL's attributable to the 'S' stock, unless those losses can effectively be used by the non-ESBT portion of the electing trust.

CCA 200734019 -- 08/24/2007

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