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S CORPORATION TRUST NOL TRAP

August 27, 2007

A newly-released IRS legal memorandum (ILM 200734019) points out a potential trap for testamentary trusts that become electing small business trusts (ESBTs). The memorandum says that any net operating losses incurred by the trust from S corporation passthrough losses before the ESBT election takes effect do not carry over to the ESBT.

The tax law allows any trust that acquires S corporation stock at death to hold the stock for two years without terminating the S corporation status. Many such trusts find that an ESBT election is the only way to retain S corporation status. An ESBT is taxed like it is two trusts; it pays tax on its S corporation income at the highest individual tax rate under a special tax regime; it reports its other income on a conventional trust tax return.

Trusts often go for a period of months before they make their ESBT election. If the S corporation has a loss for this period, the resulting pre-ESBT NOL can only offset non-S corporation income after the ESBT election takes effect.

The Moral? Trusts that acquire S corporation stock need to evaluate whether to make an ESBT election immediately. They can retroactively elect ESBT status within 2 1/2 months of when they acquire the stock; otherwise they must wait until the start of the next tax year.

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