S corporations must comply with several strict requirements or risk losing their tax-advantaged status. Among other things, they can have no more than 100 shareholders, can have no more than one class of stock, and are permitted to have only certain types of shareholders.
In an estate planning context, it’s critical that any trusts that will receive S corporation stock through operation of your estate plan be eligible shareholders.
Eligible trusts include:
Grantor Trusts. A grantor trust is eligible provided that it has one “deemed owner” who’s a U.S. citizen or resident and meets certain other requirements. Also, when the grantor dies, the trust remains an eligible shareholder for two years, after which it must distribute the stock to an eligible shareholder or qualify as a qualified subchapter S trust (QSST) or an electing small business trust (ESBT).
Testamentary Trusts. These trusts, which are established by your will, are eligible S corporation shareholders for up to two years after the transfer and then must either distribute the stock to an eligible shareholder or qualify as a QSST or ESBT.
Qualified Subchapter S Trusts (QSSTs).
A QSST requires that there be no more than one beneficiary and that all of the trust accounting income (and principal, if any) be distributed to that beneficiary, at least annually. A QSST cannot accumulate income. Other requirements include that the beneficiary be a U.S. citizen or resident and that a QSST election be filed with the IRS. The QSST election causes the trust to be treated as a grantor trust and all taxable income is picked up on the beneficiary’s tax return and paid at the beneficiary’s tax rate. A trust that has multiple beneficiaries can still meet the QSST requirements if each beneficiary has a separate and independent share of the trust, each of which is treated as separate trust for income tax purposes.
Electing Small Business Trusts (ESBTs). ESBTs may have multiple beneficiaries and an ESBT’s income can be accumulated and/or sprinkled among multiple beneficiaries. A trust qualifies as an ESBT if:
- All of its beneficiaries or “potential current beneficiaries” would be eligible shareholders if they held the stock directly;
- No interest in the trust is acquired by purchase; and
- The trust elects to be an ESBT.
For income tax purposes, an ESBT has at least two portions: an S corporation portion consisting of an S corporation’s stock, and a non-S corporation portion consisting of all other property. Unlike the QSST, the trust itself, rather than the beneficiaries, is taxed on the S corporation portion of the trust and no deductions are allowed for amounts distributed to beneficiaries. The S corporation portion is treated as a separate trust when computing income tax attributable to such stock and is taxed at the trust level at the highest tax rate.
If you have any S corporation stock that will be distributed to a trust, be sure to review its terms carefully to ensure it couldn’t inadvertently disqualify the S corporation. Contact us with further questions. I can be reached at SDitman@BerdonLLP.com or contact to your Berdon advisor.
Scott T. Ditman, a tax partner and Chair, Personal Wealth Services at Berdon LLP, advises high net worth individuals and family/owner-managed business clients on building, preserving, and transferring wealth, estate and income tax issues, and succession and financial planning.