Only limited types of trusts are permitted as shareholders of corporations that have elected to be treated as S corporations. One permitted type of trust that is in common use is called the “Qualified Subchapter S Trust,” which is usually referred to as a “QSST.” A QSST can have only one income beneficiary and is generally treated as a grantor trust as to the income beneficiary. If the QSST is a part of a larger trust that is not a grantor trust, it is treated as a separate trust whose only asset is the shares of the S corporation. All items of income, gain, deduction or loss that pass through the S corporation to the QSST are in turn passed through by the QSST to its income beneficiary, due to the grantor trust nature of the QSST.
There is one exception to the pass-through rule and that is for gain or loss arising from the sale or other disposition by the QSST of the shares of the S corporation. That gain is taxable to the QSST itself. The reason for this exception is that under the trust accounting principles in force in most states, gain from the sale of shares is usually allocated to trust principal rather than to income. This means that the income beneficiary is not entitled to have the gain amount distributed. It must remain in the trust for the remainder beneficiaries. It would seem unfair if the income beneficiary had to pay tax on the gain but at the same time was not entitled to have the gain amount distributed.
In CCA 201327009 (May 1, 2013), the IRS addressed the tax treatment of interest expense incurred by a QSST to purchase the shares it holds in the S corporation. If the interest expense is treated as a deduction related to the S corporation, it should pass through to the QSST’s income beneficiary under the grantor trust rules. On the other hand, if it is treated as a general trust expense, it would be treated for income tax purposes as a part of the rest of the trust and subject to the general rules of trust income taxation.
The IRS concluded that the interest expense was directly related to the shares of the S corporation so the expense should pass through to the beneficiary. The IRS reasoned that the interest expense must be paid out of distributions of income from the S corporation that would otherwise be distributed by the QSST to the income beneficiary. Since the beneficiary’s distribution amount is reduced by the interest expense, the beneficiary should also receive the benefit of the income tax deduction for that interest expense.