Opinion ID: 2595160
Heading Depth: 1
Heading Rank: 5

Heading: The Third Change: Modification of Trust to Meet Requirements of S Corporation Shareholder

Text: The trustees seek to qualify the Trust for Subchapter S corporation treatment under the IRC, a substantial tax benefit to the Trust as well as the beneficiaries. Petitioners again rely on a mistake by the scrivener in failing to include a provision granting the Trustees the flexibility to divide the Trust into shares which would have enabled the Trust to qualify as a qualified subchapter S trust (QSST) without the reformation of the court. According to the petition, the Trust is not permitted under the IRC to be a shareholder in a Subchapter S corporation because the Trust has more than one income beneficiary. However, the trustees contend that substantially separate and independent shares of one trust are treated as separate trusts under the IRC and qualify as a QSST pursuant to 26 U.S.C. § 1361(d) (2000). Thus, the trustees sought authorization from the district court to create three separate and independent shares within the existing Trust which would enable the trust to qualify as a QSST. The respective shares of each beneficiary would remain unchanged with granddaughter Kathy Sue (Harris) Beshears retaining a one-fourth interest, granddaughter Carole Lynn (Harris) Fitzgerald retaining a one-fourth interest, and son John G. Harris retaining a one-half interest. The trustees requested authority to divide the Trust into three separate shares for each Trust beneficiary in order to qualify for Subchapter S treatment under the IRC. The trustees based their request for reformation on a mistake, claiming that the scrivener failed to include a provision granting the trustees the flexibility to divide the Trust into shares which would have enabled the Trust to qualify as a QSST. In support of their claim, the trustees rely upon Harris' intent to minimize estate tax liability combined with the seemingly technical nature of this modification of the Trust. We note that the scrivener's affidavit does not mention the proposed change or a failure to provide the flexibility in the Trust for such division. The trustees provided a clear rationale for the necessity of their proposed change. The IRC governs the type of trusts which qualify as shareholders in S corporations. According to the trustees, a shareholder in a S corporation must be an individual. 26 U.S.C. § 1361(b)(1)(B). However, there is an exception for trusts defined at 26 U.S.C. § 1361(c)(2), which are expressly permitted to be shareholders in S corporations. The QSST is expressly included in the group of trusts permitted to be shareholders in S corporations at 26 U.S.C. § 1361(c)(2). 26 U.S.C. § 1361(d)(1)(A). However, the following specific requirements for a QSST prevent the Harris' trust from qualifying: (3) For purposes of this subsection, the term `qualified subchapter S trust' means a trust (A) the terms of which require that (i) during the life of the current income beneficiary, there shall be only 1 income beneficiary to the trust, (ii) any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary, (iii) the income interest of the current income beneficiary in the trust shall terminate on the earlier of such beneficiary's death or the termination of the trust, and (iv) upon the termination of the trust during the life of the current income beneficiary, the trust shall distribute all of its assets to such beneficiary, and (B) all of the income (within the meaning of section 643(b)) of which is distributed (or required to be distributed) currently to 1 individual who is a citizen or resident of the United States. 26 U.S.C. § 1361(d)(3). The trustees argue that the Trust in its present form, will not qualify as a QSST because there is presently more than one individual beneficiary receiving distributions from the Trust. They further point out that the IRS will generally recognize the prospective effect of a state court modification of a trust to qualify as a QSST. See Rev. Rul. 93-79, 1993-2. In order meet the requirements of a QSST, the district court ordered the following modifications: B. The Trustees are authorized to create within the Trust three separate and independent shares, one-fourth (¼) for the benefit of Kathy Sue (Harris) Beshears, one-fourth (¼) for the benefit of Carole Lynn (Harris) Fitzgerald, and one-half (½) for the benefit of John G. Harris, to enable the Trust to qualify as a QSST. The Trustees shall be authorized to segregate assets in kind so that the fair market value of the assets in each share on the date of the division is equal to the above fractional amounts. C. The Trustees are directed to segregate and administer each share in accordance with the existing terms and provisions of the Trust as follows: (a) each beneficiary would continue to receive all income generated by his or her respective share; (b) discretionary distributions of principal to any such beneficiary shall be made from such beneficiary's respective share only; and (c) any such discretionary distributions of principal are limited to an ascertainable standard as provided by the reformed provision referred to in Paragraph A above. The record does not provide clear and convincing evidence to support reformation of the Trust to include powers to divide it into three separate trusts. However, the following provisions of K.S.A. 2002 Supp. 58a-417 of the KUTC provide specific authority for affirming the third change ordered by the district court: (a) After notice to the qualified beneficiaries, a trustee may combine two or more trusts into a single trust or divide a trust into two or more separate trusts, if the result does not impair rights of any beneficiary or adversely affect achievement of the purposes of the trust. The trustee may make a division under this section by: (1) Giving written notice of the division, not later than the 30th day before the date of a division under this subsection, to each qualified beneficiary; and (2) executing a written instrument, acknowledged before a notary public or other person authorized to take acknowledgments of conveyances of real estate stating that the trust has been divided pursuant to this section and that the notice requirements of this subsection have been satisfied. (b) A trustee, in the written instrument dividing a trust, shall allocate trust property among the separate trusts on a fractional basis by identifying the assets and liabilities passing to each separate trust, or on any other reasonable basis. The trustee shall allocate undesignated trust property received after the trustee has divided the trust into separate trusts in the manner provided by the written instrument dividing the trust, or, in the absence of a provision in the written instrument, in a manner determined by the trustee. The modification reached by the district court in authorizing division of the Trust into three separate shares does not impair the rights of any beneficiary or adversely affect achievement of the purposes of the Trust. All parties of interest support and encourage the proposed change. Finally, the change authorized by the district court is in accord with the provisions of K.S.A. 2002 Supp. 58a-417 in all respects. Moreover, K.S.A. 2002 Supp. 58a-416 supports such modification because it achieves Harris' tax objectives and is consistent with Harris' probable intention. We, therefore, affirm the district court order authorizing the trustees to divide the Trust into three separate shares for each Trust beneficiary in order to qualify for Subchapter S tax treatment under the IRC. Affirmed. ABBOTT, J., not participating. DAVID S. KNUDSON, J., assigned.