[4830-01-U]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 18 and 602

[TD 8600]

RIN  1545-AE86

Definition of an S corporation   

AGENCY:  Internal Revenue Service (IRS), Treasury.

ACTION:  Final regulations.

SUMMARY:  This document contains final regulations relating to the definition
of an S corporation under section 1361 of the Internal Revenue Code of 1986. 
Changes to the applicable tax law were made by the Subchapter S Revision Act
of 1982, the Tax Reform Act of 1984, the Tax Reform Act of 1986, the Technical
and Miscellaneous Revenue Act of 1988, and the Omnibus Budget Reconciliation
Act of 1989.  The final regulations provide guidance on the requirements to be
an S corporation.
EFFECTIVE DATE:  These regulations are effective July 21, 1995.
FOR FURTHER INFORMATION CONTACT:  Laura Howell, telephone 202-622-3060 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
     The collection of information contained in these final regulations has
been reviewed and approved by the Office of Management and Budget in
accordance with the requirements of the Paperwork Reduction Act (44 U.S.C.
3504(h)) under control number 1545-0731.  The estimated annual burden per
respondent varies from 30 minutes to 60 minutes, depending on individual
circumstances, with an estimated average of 45 minutes.
     Comments concerning the accuracy of this burden estimate and suggestions
for reducing this burden should be sent to the Internal Revenue Service, Attn: 
IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office
of Management and Budget, Attn:  Desk Officer for the Department of the
Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.
Background
     On October 7, 1986, the IRS published in the Federal Register a notice
of proposed rulemaking containing proposed amendments to the Income Tax
Regulations (26 CFR Part 1) under section 1361 of the Internal Revenue Code
(Code).  These amendments were proposed to conform the regulations to sections
2 and 6 of the Subchapter S Revision Act of 1982 and to section 721(c) and (f)
of the Tax Reform Act of 1984.  After consideration of all comments received
by Treasury and the IRS regarding the proposed amendments, those amendments
are adopted as revised by this Treasury decision.  The final regulations also
reflect the amendments made to section 1361 by sections 901(d)(4)(G) and
1879(m) of the Tax Reform Act of 1986, section 1018(q)(2) of the Technical and
Miscellaneous Revenue Act of 1988, and section 7811(c)(6) of the Omnibus
Budget Reconciliation Act of 1989.
     On January 26, 1983, the IRS published temporary regulation 18.1361-1
under section 1361(d)(2) of the Internal Revenue Code of 1954 (TD 7872) in the
Federal Register 
to provide guidance as to the election to treat a qualified subchapter S trust
as a wholly-owned grantor trust.  The temporary regulations are adopted as
revised by this Treasury decision, and 18.1361-1 of the temporary regulations
is removed.
Explanation of Provisions
     The proposed regulations define a domestic corporation as a corporation
as defined in section 7701(a)(2) created or organized in the United States or
under the law of the United States or any state or territory.  Commentators
recommended that this definition be clarified to provide that an association,
unincorporated but taxable as a corporation, may elect to be treated as an S
corporation.  The final regulations revise the definition of a domestic
corporation for purposes of the S corporation provisions by providing that an
entity that is classified as an association taxable as a corporation under
301.7701-2 of the Procedure and Administration Regulations may elect to be
treated as an S corporation provided it meets the other requirements of a
small business corporation.  
     Section 1361(b)(2)(C) provides that an insurance company subject to tax
under subchapter L may not elect to be treated as an S corporation.  However,
the Subchapter S Revision Act of 1982 (the Act) provided a grandfather rule
for a qualified casualty insurance electing small business corporation.  The
proposed regulations provide the grandfather rules for a qualified casualty
insurance electing small business corporation.  Additionally, the Act provided
a grandfather rule with regard to the affiliation rule under section
1361(b)(2)(A) for a corporation that is affiliated with a foreign corporation
or DISC.  The final regulations remove the grandfather rules for a qualified
casualty insurance electing small business corporation since they are no
longer generally applicable.  However, corporations that fit within those
grandfather rules and certain corporations having oil and gas production
should refer to section 6(c) of Pub. L. 97-354 for appropriate guidance.
     The proposed regulations provide a special rule for a corporation having
a shareholder who has a legal life estate or usufruct interest in the stock. 
The proposed regulations provide requirements for such shareholder to qualify
as an eligible shareholder.  Upon further consideration by the IRS and
Treasury, the final regulations remove this special rule from the proposed
regulations.  The issue will be addressed in other published guidance.  
     The proposed regulations provide that persons for whom stock of a
corporation is held by a nominee, guardian, custodian, or agent are generally
considered to be shareholders of the corporation, but if stock is owned by a
partnership, the partnership (and not its partners) is considered to be the
shareholder and the corporation does not qualify as a small business
corporation.  Commentators questioned why stock which is held by a partnership
as nominee for an individual should not be considered to be owned by the
individual rather than the partnership for purposes of determining whether a
corporation qualifies as an S corporation.  Commentators suggested that this
point be clarified.  The final regulations adopt this suggestion by providing
that a partnership may hold S corporation stock as a nominee for a person who
will be treated as the shareholder.
     The proposed regulations contain a rule that prohibits a nonresident
alien from being an eligible S corporation shareholder.  Commentators
recommended an additional rule that would warn that a U.S. citizen married to
a nonresident alien who, under applicable local law, has an interest in the
U.S. citizen's stock could not be a shareholder of an S corporation.  The
final regulations provide that, if a U.S. shareholder's nonresident alien
spouse has a current ownership interest in the shareholder's stock under
applicable local law, the S corporation has an ineligible shareholder and
therefore does not qualify as a small business corporation.  For example, the
laws of a nonresident alien spouse's country may give the nonresident alien
spouse a community property interest in the U.S. spouse's property.  In that
case, the corporation would not constitute a small business corporation as of
the date the nonresident spouse acquired an interest in the stock of the
corporation, and the corporation's S election would terminate.  See Ward v.
United States, 661 F.2d 226 (Ct. Cl. 1981).  If the termination is
inadvertent, relief may be available under section 1362(f) of the Code.
     The final regulations add and reserve 1.1361-1(g)(2) addressing the
status of dual residents.  When the proposed regulations under 301.7701(b)-
7(a)(4) (published in the Federal Register (26 CFR 518) on April 27, 1992) are
finalized, this section will contain a cross reference to those final
regulations.
     For purposes of section 1361(c)(2)(A)(i), the proposed regulations
define a subpart E trust as a trust all of which (income and corpus) is
treated (under subpart E, part I, subchapter J, chapter 1 of the Code) as
owned by one individual (whether or not the grantor) who is a citizen or
resident of the United States.  Commentators expressed concern regarding the
definition of a subpart E trust and suggested that for purposes of determining
whether a trust meets the subpart E requirements under section
1361(c)(2)(A)(i), the relevant period for making that determination is the
period during which the trust holds S corporation stock.  The final
regulations adopt the commentators' suggestion.  Therefore, whether the trust
is a wholly-owned trust during any period in which the trust does not hold S
corporation stock is not relevant.  In addition, the final regulations define
a subpart E trust as a trust all of which is treated as owned by an
individual.  This definition tracks the language of section 1361(c)(2)(A)(i). 
Therefore, the trust is a permitted shareholder if the grantor or another
person includes in computing taxable income and credits all of the trust's
items of income, deductions, and credits against tax under the rules in
1.671-3.
     The final regulations clarify that a voting trust is a permitted
shareholder only if it is a subpart E trust.  Further, the final regulations
add rules concerning who is treated as the shareholder for purposes of
sections 1366, 1367, and 1368 when certain permitted trusts hold stock of an S
corporation.  For example, when stock of an S corporation is held by a trust
that ceases to be a subpart E trust upon the death of the deemed owner, and
the trust is a permitted shareholder for a 60-day period (or a 2-year period
if applicable) under section 1361(c)(2)(A)(ii), the trust (and not the estate
of the deemed owner) is treated as the shareholder for purposes of sections
1366, 1367, and 1368, even though the estate is treated as the shareholder for
purposes of section 1361(b)(1).
     The final regulations provide that if a husband and wife file a joint
return, are both U.S. citizens or residents, and are both designated
beneficiaries of a trust, they are treated as one beneficiary for purposes of
meeting the requirements of a qualified subchapter S trust (QSST).  In
addition, the final regulations add a rule that if any distribution from the
trust satisfies the grantor's legal obligation to support the income
beneficiary, the trust ceases to be a QSST as of the date of the distribution
because under section 677(b) the grantor would be treated either as the owner
of the ordinary income portion of the trust or as a beneficiary of the trust
under section 662 and 1.662(a)-4.
     The proposed regulations provide the general rule that would deny a
trust qualification as a QSST if the terms of the trust do not preclude the
possibility that in the future the trust may not meet the requirements of
section 1361(d)(3)(A).  Commentators suggested that the general rule be
deleted because it should be sufficient if a trust currently complies with
those requirements.  For example, it was suggested that if the income
beneficiary has a lifetime special power to appoint the income and corpus of
the trust to another person, the trust would qualify as a QSST until the power
is exercised.  The final regulations do not adopt this suggestion because the
statute clearly requires that the terms of the trust instrument provide that,
during the life of the current income beneficiary, there be only one income
beneficiary, and that any corpus distributed may be distributed only to such
beneficiary.  The statute generally precludes the possibility of future
non-compliance.  However, because of the concern expressed that a trust
instrument could not feasibly preclude the addition to a trust of a
beneficiary that is mandated by a court of law, the final regulations provide
for this exception to the general rule.
     Commentators requested guidance as to whether a qualified terminable
interest property (QTIP) trust qualifies as a permitted shareholder of an S
corporation.  The final regulations provide that a trust treated as a QTIP
trust under section 2056(b)(7) will qualify as a QSST, and a trust treated as
a QTIP trust under section 2523(f) may qualify as a subpart E trust if wholly-
owned by the grantor.  In the latter case, the trust does not satisfy all of
the QSST requirements because the grantor is treated as the owner of the
income portion of the trust under sections 672(e) and 677.
     Commentators also requested guidance as to whether an income beneficiary
of a trust that meets the QSST requirements, and who is treated as the owner
of all of the trust, or the portion of the trust that consists of S
corporation stock under subpart E (and thus is a permitted shareholder under
section 1361(c)(2)(A)(i)), may nevertheless make a protective QSST election. 
The final regulations add provisions for a protective QSST election for income
beneficiaries of certain grantor trusts.
     The final regulations also change the result in Rev. Rul. 92-84, 1992-2
C.B. 216.  Rev. Rul. 92-84 holds that if a QSST sells its S corporation stock,
the current income beneficiary and not the trust must recognize any gain or
loss.  After the publication of Rev. Rul. 92-84, practitioners expressed
concern with respect to the sale of the stock by a QSST in an installment
sale.  Practitioners questioned whether the trust could effectively use the
installment method under section 453 to report gain realized on the sale of
the stock and expressed concern about how the IRS would treat an installment
sale of S stock by a QSST.  Practitioners suggested that since the income
beneficiary was treated as the owner of the stock sold, the income beneficiary
would be treated as the owner of the installment obligation received in
exchange for the sale of the stock.  However, concern was expressed that
because the QSST ceases to be a QSST as to the S corporation stock that was
sold, the income beneficiary would no longer be treated as the owner of the
installment obligation held by the trust and there may have occurred a
disposition of the installment obligation under section 453B(a).  
     On further consideration, the IRS and Treasury have determined that the
income beneficiary of a QSST who is a section 678 deemed owner of the S
corporation stock solely by reason of section 1361(d)(1) should not be treated
as the owner of the consideration received by a QSST upon its disposition of S
corporation stock.  Under the final regulations, the consideration is treated
as received by the trust in its status as a separate taxpayer under section
641.  Thus, for example, any gain recognized on a sale of the S corporation
stock is the gross income of the trust.  Similarly, the trust may report any
gain realized upon the sale under section 453 if the sale otherwise qualifies
as an installment sale.  This provision of the final regulations reflects an
interpretation of section 1361(d)(1) and has no bearing upon the operation or
effect of the principles of sections 671 through 679 beyond the context of a
QSST.
     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 under the statutes for both the
QSST and the income beneficiary but before the effective date of these final
regulations, the QSST and the income beneficiary may treat the transaction
under Rev. Rul. 92-84 or under these final regulations.  However, the QSST and
the income beneficiary must take consistent reporting positions.  The final
regulations require that the QSST and the income beneficiary must state on
their respective returns that they are taking consistent reporting positions. 
Effect on other documents
     Rev. Rul. 92-84, 1992-2 C.B. 216 is obsolete as of July 21. 1995.
     Special Analyses
     It has been determined that this Treasury decision is not a significant
regulatory action as defined in EO 12866.  Therefore, a regulatory assessment
is not required.  It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory
Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations and,
therefore, a Regulatory Flexibility Analysis is not required.
Drafting Information
     The principal author of these final regulations is Laura Howell, Office
of Chief Counsel (Passthroughs and Special Industries).  However, other
personnel from the IRS and Treasury Department participated in their
development.
List of Subjects 
26 CFR Parts 1 and 18
     Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
     Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
     Accordingly, 26 CFR parts 1, 18 and 602 are amended as follows:
PART 1--INCOME TAXES
     Paragraph 1.  The authority citation for part 1 is amended by adding an
entry in numerical order to read as follows:
     Authority:  26 U.S.C. 7805.  * * * 
Sections 1.1361-1(j)(6), (10) and (11) also issued under 26 U.S.C.
1361(d)(2)(B)(iii). * * *
     Par. 2.  Section 1.1361-0 is revised to read as follows:
1.1361-0 Table of contents.
     This section lists captions contained in 1.1361-1.
1.1361-1 S Corporation defined.
(a)  In general.
(b)  Small business corporation defined.
(1)  In general.
(2)  Estate in bankruptcy.
(3)  Treatment of restricted stock.
(4)  Treatment of deferred compensation plans.
(5)  Treatment of straight debt.
(6)  Effective date provisions.
(c)  Domestic corporation.
(d)  Ineligible corporation.
(1)  General rule.
(2)  Exceptions.
(3)  Inactive corporation exception.
(e)  Number of shareholders.
(1)  General rule.
(2)  Special rules relating to stock owned by husband and wife.
(f)  Shareholder must be an individual or estate.
(g)  No nonresident alien shareholder.
(1)  General rule.
(2)  Special rule for dual residents.
(h)  Special rules relating to trusts.
(1)  General rule.
(2)  Foreign trust.
(3)  Determination of shareholders
(i)  [Reserved]
(j)  Qualified subchapter S trust.
(1)  Definition.
(2)  Special rules.
(3)  Separate and independent shares of a trust.
(4)  Qualified terminable interest property trust.
(5)  Ceasing to meet the QSST requirements.
(6)  Qualified subchapter S trust election.
(7)  Treatment as shareholder.
(8)  Coordination with grantor trust rules.
(9)  Successive income beneficiary.
(10) Affirmative refusal to consent. 
(11) Revocation of QSST election.
(k)(1)  Examples.
(2)  Effective date.
(l)  Classes of stock.
(1)  General rule.
(2)  Determination of whether stock confers identical rights to distribution
and liquidation proceeds.
(3)  Stock taken into account.
(4)  Other instruments, obligations, or arrangements treated as a second
class of stock.
(5)  Straight debt safe harbor.
(6)  Inadvertent terminations.
(7)  Effective date.

     Par. 3.  Section 1.1361-1 is amended by adding paragraphs (a), and (c)
through (k) to read as follows:
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.
*****
     (c) Domestic corporation.  For purposes of paragraph (b) of this
section, the term domestic corporation means a domestic corporation as defined
in 301.7701-5 of this chapter, and the term corporation includes an entity
that is classified as an association taxable as a corporation under 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) A member of an affiliated group (determined under section 1504
without regard to any exception contained in section 1504(b)), whether or not
that affiliated group has ever filed a consolidated return;
     (ii) A financial institution to which section 585 applies (or would
apply but for section 585(c)) or to which section 593 applies;
     (iii) An insurance company subject to tax under subchapter L;
     (iv) A corporation to which an election under section 936 applies; or 
     (v) A DISC or former DISC.
     (2) Exceptions.  See the special rules and exceptions provided in
sections 6(c)(2), (3) and (4) of Pub. L. 97-354 that are applicable for
certain casualty insurance companies and qualified oil corporations.
     (3) Inactive corporation exception.  (i) For purposes of paragraph
(d)(1)(i) of this section, a corporation (parent corporation) will not be
treated as a member of an affiliated group during any period within a taxable
year by reason of the ownership of stock in another corporation (subsidiary
corporation) if the subsidiary corporation--
     (A) Has not begun business at any time on or before the close of that
period; and
     (B) Does not have gross income for that period.
     (ii) The determination under paragraph (d)(3)(i) of this section of the
date on which a subsidiary corporation begins business is made by taking into
account all the facts and circumstances of the particular case.  A corporation
has not begun business, however, merely because it is in existence. 
Ordinarily, a corporation begins business when it starts the business
operations for which it was organized.  Mere organizational activities, such
as the obtaining of the corporate charter, are not alone sufficient to
constitute the beginning of business.  An example of a corporation that has
not begun business is a corporation incorporated for the sole purpose of
reserving a corporate name in a state or states in which the parent
corporation is not doing business.  If the activities of a corporation have
advanced to the extent necessary to establish the nature of its business
operations, however, the corporation is deemed to have begun business.  For
example, a corporation that acquires operating assets necessary for the type
of business contemplated may be deemed to have begun business.
     (iii) If a subsidiary corporation ceases to be an inactive corporation
as defined in paragraph (d)(3)(i) of this section, then the parent
corporation's election under section 1362(a) will terminate on the earlier of
the first day that the subsidiary corporation begins business, or the first
day, determined under the subsidiary corporation's method of accounting, that
the subsidiary corporation realizes gross income.
     (iv) The application of paragraph (d)(3) of this section is illustrated
by the following examples:
     Example 1.  In 1996, Corporation P, a C corporation, owns all of the
stock of Corporation Q.  P and Q both use the calendar year as their taxable
year.  For purposes of paragraph (d)(1)(i) of this section, P would not be
considered at any time during 1996 to be a member of an affiliated group
solely by reason of its ownership of Q's stock if Q has not begun business at
any time on or before January 1, 1997, and has no gross income for calendar
year 1996 or any prior calendar year.  Thus, P could qualify as a small
business corporation during 1996 if it meets the other requirements provided
in section 1361(b).  Assuming that P's ownership of Q stock remains unchanged,
P would cease to be a small business corporation on the day that Q either
begins business or realizes gross income (determined under Q's method of
accounting), whichever day occurs earlier.

     Example 2.  Assume the same facts as in Example 1, except that
Corporation Q had begun business prior to 1995, but became inactive in 1995. 
For purposes of paragraph (d)(1)(i) of this section, P is considered to be a
member of an affiliated group because Q had begun business prior to becoming
inactive in 1995.  Therefore, even though Q was inactive in 1996, P is not
eligible to make the S election until P liquidates Q.
     (e) Number of shareholders--(1) General rule.  A corporation does not
qualify as a small business corporation if it has more than 35 shareholders. 
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 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) (relating to nominees and paragraph (h) (relating
to certain trusts) of this section, 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 which was a qualified subpart E trust
immediately before the death of the deemed owner and which continues in
existence after the death of the deemed owner, but only for the 60-day period
beginning on the day of the deemed owner's death.  However, if a trust is
described in the preceding sentence and the entire corpus of the trust is
includible in the gross estate of the deemed owner, the trust is a permitted
shareholder 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 of the S corporation during the period of administration of
the decedent's estate or if, after the period of administration, the trust
continues to hold the stock pursuant to the terms of the will or the trust
agreement.  See 1.641(b)-3 for rules concerning the termination of estates
and trusts for federal income tax purposes.  If the trust consists of
community property, and the decedent's community property interest in the
trust is includible in the decedent's gross estate under chapter 11 (section
2001 and following, relating to estate tax), then the entire corpus of the
trust will be deemed includible in the decedent's gross estate.  Further, for
the purpose of determining whether the entire corpus of the trust is
includible in the gross estate of the deemed owner, if the decedent's spouse
was treated as an owner of a portion of the trust under subpart E immediately
before the decedent's death, the surviving spouse's portion is disregarded.
     (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 or an electing QSST) to which S corporation stock is transferred
pursuant to the terms of a will, but only for the 60-day period beginning on
the day the stock is transferred to the trust.
     (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.
     (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 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 60-
day period (or, if applicable, 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.           
     (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 to a testamentary trust (other than a
qualified subpart E trust or an electing QSST), 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 60-day period beginning on the day that the
stock is transferred to the trust.
     (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.
     (ii) Exceptions.  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) that does not qualify as a QSST, the trust is treated as the
shareholder.  If the trust continues to own the stock after the expiration of
the 60-day period (or, if applicable, the 2-year period), the corporation's S
election will terminate unless the trust is otherwise a permitted shareholder. 
If the trust is a QSST described in section 1361(d) and the income beneficiary
of the trust makes a timely QSST election, the beneficiary and not the trust
is treated as the shareholder from the effective date of the QSST election;
and 
     (B) If stock is transferred to a testamentary trust described in
paragraph (h)(1)(iii) of this section (other than a qualified subpart E trust
or a trust that has a QSST election in effect), the trust is treated as the
shareholder.  If the trust continues to own the stock after the expiration of
the 60-day 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 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 1.651(a)-2(a) and 
1.663(b)-1(a) for rules 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 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 1.677(b)-1 for rules on the
treatment of trusts for support and 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 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
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 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 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.
     (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 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 but also
satisfies the requirements of 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)(ii) 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
corporation's S election terminates because of a late QSST election, the
corporation may request inadvertent termination relief under section 1362(f). 
See 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.  
     (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, and is not a qualified subpart E trust, 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 60-day period beginning on the day
of the income beneficiary's death.  However, if the entire corpus of the trust
is includible in the gross estate of that income beneficiary, the estate 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.  For
the purpose of determining whether the entire trust corpus is includible in
the gross estate of the income beneficiary, any community property interest in
the trust held by the income beneficiary's spouse which arises by reason of
applicable U.S. state law is disregarded.  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 60-day period, or the 2-year period, if applicable, the trust
continues to hold S corporation stock, 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 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.
     (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 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 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 27, 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).  Because the entire corpus of
the trust is includible in A's gross estate under section 2038, 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 election if the trust
qualifies as a QSST.  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.  After the 2-year period, if no QSST election
is made, 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.  60-day 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, 1996.  The trust continues in existence after
F's death but is no longer a qualified subpart E trust.  The entire corpus of
the trust is not includible in F's gross estate.  On August 1, 1996, 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 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 F's
estate could be treated as a permitted shareholder of Corporation P is
September 29, 1996 (that is, the last day of the 60-day 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 F's estate could
be treated as a permitted shareholder of Corporation O is August 29, 1996
(that is, the last day of the 60-day period that begins on the date of F's
death).

     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 H dies on November 1, 1996.  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, 1996, because corpus distributions
may be made to someone other than L, the current (successive) income
beneficiary.  Under section 1361(c)(2)(A)(ii), H's estate (and not the trust)
is considered to be the shareholder for purposes of section 1361(b)(1) for the
60-day period beginning on November 1, 1996.  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 60-day period. 
After the 60-day 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 before December 30, 1996, (the last day of the 60-day
period) assuming that neither L nor J becomes the 36th 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
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 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 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), and paragraphs (c)
through (k) of this section 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), and paragraphs (c) through (k) do not apply, see
18.1361-1 of this chapter (as contained in the 26 CFR edition revised April
1, 1995).
     (ii) Exception.  If a QSST has sold or otherwise disposedof 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
beneficiarymay 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.
PART 18--TEMPORARY INCOME TAX REGULATIONS UNDER THE SUBCHAPTER S REVISION ACT
OF 1982
     Par. 4.  The authority citation for part 18 is revised to read as
follows:
     Authority:  26 U.S.C. 7805.
     Par. 5.  Section 18.0 is revised to read as follows:
18.0 Effective date of temporary regulations under the Subchapter S Revision
Act of 1982.
     The temporary regulations provided under 18.1377-1, 18.1379-1, and
18.1379-2 are effective with respect to taxable years beginning after 1982,
and the temporary regulations provided under 18.1378-1 are effective with
respect to elections made after October 19, 1982.
18.1361-1 and 18.1366-5  [Removed]
     Par. 6.  Sections 18.1361-1 and 18.1366-5 are removed.
18.1378-1  [Amended]
     Par. 7.  Section 18.1378-1 is amended as follows:
     1.  The fourth sentence of paragraph (b)(2)(i) is amended by removing
the language "18.1362-1(b)" and adding the language "1.1362-6(b)(2)(ii) of
this chapter" in its place.
     2.  The fifth sentence of paragraph (b)(2)(i) is removed.
     3.  The second sentence of paragraph (b)(2)(ii) is amended by removing
the language "18.1362-1(a)" and adding the language "1.1362-6(b)(2)(i) of
this chapter" in its place.
     4.  Paragraph (b)(3) is removed.
     5.  Paragraph (c) is removed and reserved.
     6.  Paragraph (e) is removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT       Par.
8.  The authority citation for part 602 continues to read as follows:
     Authority:  26 U.S.C. 7805.
602.101 [Amended]
     Par. 9.  Section 602.101, paragraph (c) is amended by removing the entry
for 18.1361-1 from the table and adding the entry "1.1361-1...1545-0731" in
numerical order to the table.
     

                            Margaret Milner Richardson
                         Commissioner of Internal Revenue

Approved:  May 9, 1995
               Leslie Samuels
     Assistant Secretary of the Treasury