SMALL-BUSINESS TRUST CANNOT DEDUCT NET OPERATING LOSS FROM S CORPORATION PORTION.

UILC: 642.04-00

LEGEND:

The NOL carryover remained unused upon the termination of A's estate on Date 2, the same date that Trust was funded. As a residuary testamentary beneficiary of A's estate, Trust succeeded to the NOL carryover that was unused by A's estate at the time of its termination under § 642(h)(1).

Trust qualified as a permissible S corporation shareholder under § 1361(c)(2)(A)(iii) during the 2-year period beginning on Date 2, the date the X stock was transferred to it pursuant to A's will. In order to remain an eligible trust following the 2-year period, the trustee made an election for Trust to be an ESBT under § 1361(c)(3), effective Date 3.

Section 1.642(h)-3(a) of the Income Tax Regulations provides that the phrase "beneficiaries succeeding to the property of the estate or trust" means those beneficiaries upon termination of the estate or trust who bear the burden of any loss for which a carryover is allowed, or of any excess of deductions over gross income for which a deduction is allowed, under § 642(h).

Section 1.642(h)-3(c) provides that in the case of a testate estate, the phrase normally means the residuary beneficiaries (including a residuary trust), and not specific legatees or devisees, pecuniary legatees, or other nonresiduary beneficiaries.

Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

Section 1361(b)(1)(B) provides that the term small business corporation is a domestic corporation which is not an ineligible corporation and which does not have as a shareholder a person (other than an estate and other than a trust described in § 1361(c)(2) or an organization described in § 1361(c)(6)) who is not an individual.

Section 1361(c)(2)(A)(i) provides that a trust all of which is treated (under subpart E of part 1 of subchapter J of chapter 1) as owned by an individual who is a resident of the United States is an eligible shareholder. Section 1361(c)(2)(A)(iii) provides that for purposes of § 1361(b)(1)(B), a trust with respect to stock transferred to it pursuant to the terms of a will may be a shareholder, but only for the 2-year period beginning on the day on which such stock is transferred to it. Section 1361(c)(2)(A)(v) provides that an ESBT is an eligible shareholder.

Section 1361(e) defines an ESBT. Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), an ESBT means any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in § 170(c)(2), (3), (4), or (5), or (IV) an organization described in § 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary, (ii) no interest in such trust was acquired by purchase, and (iii) an election under § 1361(e) applies to such trust. Section 1361(e)(3) provides that an election under § 1361(e) shall be made by the trustee. Any such election shall apply to the taxable year of the trust for which made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

Section 1.641(c)-1(a) provides that an ESBT is treated as two separate trusts for purposes of determining income tax. The portion of an ESBT that consists of stock in one or more S corporations ("the S portion") is treated as one trust. The portion of an ESBT that consists of all the other assets in the trust is treated as a separate trust ("the non-S portion").

Section 641(c)(2)(C) provides that the taxable income of the S portion is determined by taking into account only items of income, loss, deduction, or credit that are (i) the items required to be taken into account under § 1366, (ii) any gain or loss from the disposition of stock in an S corporation, and (iii) to the extent provided in regulations, State or local income taxes or administrative expenses to the extent allocable to items described in § 641(c)(2)(C)(i) or § 641(c)(2)(C)(ii). No deduction or credit shall be allowed for any amount not described in § 641(c)(2)(C), and no item described in § 641(c)(2)(C) shall be apportioned to any beneficiary.

We conclude that § 641(c)(2)(C) provides a complete list of the items of income, loss, deduction, or credit that the S portion of an ESBT may take into account. Section 642(c)(2)(C), flush language, provides that "no deduction or credit shall be allowed for any amount not described in this paragraph." The NOLs that Trust succeeded to under § 642(h)(1) are not described in § 641(c)(2)(C); therefore, the S portion of Trust is precluded from taking deductions attributable to those NOLs. However, the NOLs should be available as a deduction to the non-S portion Trust following Trust's ESBT election.

The taxpayer does not agree that the NOLs should not be available to the S portion of Trust. The taxpayer argues that the NOL should be allocated to the S portion of Trust because the NOL is attributable to losses sustained by X, an S corporation whose stock is held within the S portion of the Trust. We disagree with this interpretation. We conclude that the plain language of § 641(c)(2)(C) excludes the NOL from being available to the S portion of Trust.

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