§318 Employee Trust Attribution | Foreign Trust US Tax Law Firm

In a previous article, I explained special §318 rules concerning grantor trusts as an exception to the general §318 trust attribution rules. Today, I will discuss the special §318 employee trust attribution rules as another exception to the general §318 trust attribution rules.

§318 Employee Trust Attribution: Focus on Tax-Exempt Employee Trusts

First of all, it is important to define the type of employee trust which is the subject of today’s article. The focus is on employee trusts described in §401(a) and which are tax-exempt under §501(a), collectively “tax-exempt employee trusts”. In other words, we are discussing mostly trusts which were created under qualified pension, profit-sharing and stock bonus plans.

§318 Employee Trust Attribution: Main Rule – No Attribution to Tax-Exempt Employee Trusts

Under §§318(a)(2)(B)(i) and 318(a)(3)(B)(i), there is no downstream and upstream (respectively) attribution of stock between a tax-exempt employee trust and its beneficiaries. In other words, there is no §318 attribution of corporate stocks from a tax-exempt employee trust to its beneficiaries and there is no §318 attribution of corporate stocks from the beneficiaries to the trust.

Under §501(b), the non-attribution rule applies even in situations where a tax-exempt employee trust is subject to tax on its unrelated business income.

§318 Employee Trust Attribution: Certain Exceptions to Non-Attribution

The non-attribution rule with respect to tax-exempt employee trusts is reasonable and just. There are, however, certain exceptions to this rule.

A major exception concerns ESOP trusts. Under Petersen v. Commissioner, 924 F.3d 1111 (10th Cir. 2019), the non-attribution of stock ownership from tax-exempt trust to employee beneficiaries does not apply to certain ESOP trusts.

Moreover, certain tax-avoidance transactions will render the non-attribution rule inapplicable. For example, under §409(p)(3)(B), an individual is deemed to own stocks held by an ESOP trust for the purposes of determining whether there has been a prohibited allocation of S-corporation stock to a disqualified person.

§318 Employee Trust Attribution: Special Case of “Loss Corporations”

A “loss corporation” presents an interesting set of issues with respect to §318 employee trust attribution rules.

Let’s first define the loss corporation. The IRC §382(k)(1) provides the following definition of a loss corporation: “a corporation that is entitled to use a net operating loss carryover or having a net operating loss for the taxable year in which the ownership change occurs. Such term shall include any corporation entitled to use a carryforward of disallowed interest described in section 381(c)(20). Except to the extent provided in regulations, such term includes any corporation with a net unrealized built-in loss.”

The IRC §382(g) defines “ownership change” as a two-step process. First, there must be an “owner shift”, which means with respect to a 5% shareholder, that there is a change in the respective ownership of stock of a corporation, and such change “affects the percentage of stock of such corporation owned by any person who is a 5-percent shareholder before or after such change.” Second, the ownership change occurs if, immediately after any owner shift, “the percentage of the stock of the loss corporation owned by 1 or more 5-percent shareholders has increased by more than 50 percentage points” over “the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by such shareholders at any time during the testing period.” Id. The testing period is three years. §382(i).

Now that we know what a loss corporation is, we can analyze its interaction with the §318 employee trust attribution rules. Generally, under §318(a)(2)(B)(i), the participants in a qualified plan under which a tax-exempt employee trust is established are not treated as owners of any shares of a “loss corporation” owned by the trust.

This general rule, however, contains an important exception where the IRS will treat beneficiaries of the tax-exempt employee trust as owners of the loss corporation for certain §382 purposes. See 114 Reg. §1.382-10, T.D. 9269, 71 Fed. Reg. 36,676 (June 28, 2006), applicable to all distributions after June 23, 2006 (for distributions on or before June 23, 2006, see former Reg. §1.382-10T).

Why do we have this exception? The problem is that, by blocking the operation of general §318 trust attribution rules, a distribution of stocks in a loss corporation by the tax-exempt employee trust to the plan beneficiaries may cause an “ownership change” since the beneficiaries are not treated as owners of any interest in a loss corporation. Once the ownership change occurs, §382 may limit the amount of taxable income that can be offset by certain loss carryovers and recognized built-in losses of the loss corporation. Hence, the IRS enacted this exception to §318(a)(2)(B)(i) for certain §382 purposes. This is one of many examples of “an exception to an exception” that saturate the Internal Revenue Code.

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