Corporations often represent a significant portion of the wealth of a small business owner. The S corporation is an artificial, and at times arbitrary, creation of the Internal Revenue Code. Regardless of whether gift or estate tax is a concern, knowledge of S corporation shareholder rules is key to avoiding revocation of S corporation status, which can produce disastrous income tax results.
Let’s review the requirements and planning trajectories of the three types of trusts most likely to hold S corporation stock—namely, grantor trusts, qualified subchapter S trusts (QSSTs) and electing small business trusts (ESBTs). We’ll offer practical drafting advice for each trust’s unique requirements, including those driven by distinctive (and often ignored) income tax treatment. We’ll also explore the advantages and limitations of each trust and place special emphasis on the critical deadlines following a death to avoid an inadvertent loss of S corporation status.
Trusts as Eligible Shareholders
The club of permitted S corporation shareholders is exclusive—not just anyone can join. An S corporation can have only 100 shareholders (although family attribution rules can increase this number),1 who may only be: (1) U.S. citizen or resident individuals, (2) estates created due to bankruptcy or death, (3) certain trusts, or (4) certain tax-exempt organizations.2 A trust is eligible only if it’s: (1) treated under IRC Sections 671-679 as a wholly owned grantor trust by an individual U.S. citizen or resident, (2) a voting trust created primarily to exercise the voting power of the S corporation stock, (3) a testamentary trust (but only for two years), (4) a QSST, (5) an ESBT, or (6) a trust that’s part of a profit-sharing or pension plan exempt from taxation under IRC Section 401(a).3 Three of the most commonly encountered and useful eligible trust shareholders are grantor trusts, QSSTs and ESBTs. (See “An Exclusive Group,” this page.)
A trust that’s wholly a grantor trust (as to both income and principal) is the first common type of trust that’s an eligible S corporation shareholder.4 This category includes revocable trusts, intentionally defective grantor trusts (IDGTs) and grantor retained annuity trusts (GRATs). For example, in lifetime planning, a person may assign S corporation stock to a revocable trust to avoid probate, sometimes referred to as a “qualified revocable trust,” or may transfer stock by gift or sale to an IDGT or a GRAT. As long as the trust remains wholly a grantor trust, no other significant requirements apply during the grantor’s lifetime for the trust to qualify as a shareholder. The income taxation of a grantor trust that holds S corporation stock is the same as any other grantor trust.
While a grantor trust is an excellent safe harbor for lifetime planning, a planner must consider what should happen when grantor trust treatment ends. A grantor trust for which such treatment ceases due to the grantor’s death continues to qualify as a shareholder for two years (not two tax years, but rather 730 days).5 When this period expires, the S corporation election will be lost, unless the shares are sold or distributed to an eligible shareholder. If grantor trust status terminates for reasons other than death, such as a voluntary termination of the grantor trust defect in an IDGT, the 2-year grace period isn’t available, and action must be taken more promptly. If the trust was drafted to qualify as a QSST or ESBT following the grantor’s death or other loss of grantor trust status, the planner must be careful to ensure that the appropriate election is timely made (discussed below).
Planning Pointer #1: Lifetime grantor trusts must provide for distribution or allocation of the stock to a qualifying shareholder no later than two years after the decedent’s death or earlier if grantor trust status terminates before death. If the shares will continue to be held in a trust, that trust should be drafted to qualify as a QSST or ESBT at that time.
Following the grantor’s death, a qualified revocable trust subject to an IRC Section 645 election to be taxed as an estate is accorded the reasonable administration period applicable to estates, but only for the period permitted by Section 645.6 If no estate tax return is required, this period is two years (the same as for a qualified revocable trust in general). If an estate tax return is required, this period ends six months after the final determination of estate tax liability.
Planning Pointer #2: When an estate tax return will be required, a Section 645 election can significantly extend the time that a revocable trust may hold S corporation stock from a period of two years to the actual time needed to finally determine estate tax.
Another popular trust for holding S corporation stock is a QSST. It qualifies as a shareholder both during the grantor’s lifetime and after death.
A QSST is subject to strict requirements.7 First, the trust terms must provide that:8
• During the current income beneficiary’s life, there’s only one income beneficiary of the trust (though a QSST can have multiple income beneficiaries if their interests qualify as separate shares under IRC Section 663(c)).
• Any corpus distributed during that beneficiary’s life may be distributed only to that beneficiary.
• The beneficiary’s income interest must terminate on the earlier of his death or termination of the trust. If the trust terminates during the beneficiary’s life, all assets must be distributed to that beneficiary.
Second, all trust accounting income must be distributed annually to the beneficiary, who must be a U.S. citizen or resident.9 Distributions made within the first 65 days after the trust’s year ends, with the appropriate election, will satisfy this requirement. Note that accounting income (cash received as dividends, for example) is different from taxable Schedule K-1 income from the corporation. Third, no distributions may be made in satisfaction of the grantor’s legal obligation to support the beneficiary.10 (See “QSST Requirements,” p. 14.)
The QSST requirements severely restrict a trust’s operation in ways that aren’t always desirable from a pure estate-planning perspective. For example:
• During the current beneficiary’s lifetime, a QSST can’t distribute income or principal to anyone other than that beneficiary. Thus, a credit shelter trust intended to sprinkle distributions among a surviving spouse and issue doesn’t qualify as a QSST. This restriction also means that a QSST can’t have Crummey withdrawal rights in multiple beneficiaries.
• A QSST can’t accumulate accounting income, making it a poor choice for generation-skipping transfer (GST) tax planning.
• The duty to distribute accounting income from a QSST prevents the trust from using income to pay premiums on a life insurance policy owned by the trust or, generally, to amortize a debt, although some private letter rulings have held that under certain circumstances, the use of S corporation dividends to amortize the debt on the purchase of S corporation stock won’t disqualify a QSST.11
• The duty to distribute accounting income also prevents spendthrift protection and special needs trust planning.
In short, to qualify as a shareholder, the QSST must sacrifice much of what makes a trust the preferred estate-planning vehicle.
While a QSST can hold both S corporation and non-S corporation assets, the QSST requirements apply to all trust assets. Thus, for example, if a trust had $10,000 of income from an S corporation and $10,000 of income from non-S corporation stocks, bonds or rents, the QSST election would result in the mandatory distribution of the entire $20,000 of trust accounting income from both S and non-S corporation sources. That is, the QSST mandatory income distribution isn’t limited to the income of the S corporation stock that made the QSST election necessary. Rather, it gathers up all trust accounting income and pushes it out of the trust.
Example: QSST required income distribution:
S corporation dividend $10,000
Non-S corporation interest,
dividends and rents $10,000
Total required QSST income distribution $20,000
Thus, it may be advisable to limit QSST assets to the S corporation stock and hold other assets in a separate trust to avoid saddling them with the QSST restrictions.
Planning Pointer #3: When a QSST would consist of S corporation stock together with significant non-S corporation income-producing assets, consider creating a QSST to hold only the S corporation stock and a separate, more flexible trust to hold the non-S corporation assets.
An often overlooked aspect of QSST planning is that the beneficiary must make the QSST election, not the trustee.12 While most beneficiaries cooperate (assuming distributions to pay income tax on S corporation K-1 income are forthcoming), an occasional beneficiary might refuse or resort to QSST election blackmail. To persuade the beneficiary, the drafter could provide that if the beneficiary doesn’t make the QSST election, then the trustee may make an ESBT election, thereby causing the trust’s income to be taxed at the highest possible rate, or impose some other penalty, such as loss of beneficiary status under other trusts.
The deadline for the QSST election, generally, is tied to the date the trust received the stock.13 For a lifetime gift of S corporation stock to a non-grantor trust, the beneficiary must make the election within 16 days and two months beginning on the date that the stock is transferred to the trust.14 For trusts that qualify for a grace period following a death, such as estate administration,15 a trust that receives S corporation stock pursuant to the terms of a will16 or a trust that ceases to be treated as a grantor trust following the grantor’s death17 (see “S Corporation Shareholder Grace Periods,” p. 15), the QSST election is due no later than 16 days and two months from the expiration of the applicable grace period.18
Planning Pointer #4: Prepare the appropriate election at the same time as the stock transfer documentation, and file the election as soon as allowable under applicable rules. When filing the election, use a method that will provide proof of timely filing, such as certified mail with return receipt requested, and retain this proof in the file.
The taxpayer may make the QSST election effective retroactively for as long as 15 days and two months before the election is filed. The election is irrevocable without the consent of the IRS.19
A trust for which a QSST election has previously been made may continue to own stock for two years after the current income beneficiary’s death.20 Within that period, the trust must distribute or sell the stock to a qualified shareholder. If, however, the QSST has a successive income beneficiary and continues to qualify as a QSST, then the successive income beneficiary is treated as consenting to the first beneficiary’s QSST election unless he affirmatively refuses to consent.21
Planning Pointer #5: If a QSST will terminate on the current income beneficiary’s death and divide into separate trusts for subsequent beneficiaries, consider drafting the QSST so that it continues as separate shares for these beneficiaries until the new trusts are funded. This technique would allow QSST treatment to continue, thereby not jeopardizing the company’s corporate S election if it takes longer than the 2-year grace period to accomplish funding of the new trusts.
The income taxation of a QSST is relatively straightforward. By making the QSST election, the beneficiary agrees to be treated as the S corporation shareholder for purposes of taxation relating to the S corporation income, distributions and adjustments to stock basis and is treated as the owner of the stock under IRC Section 678(a).22 The beneficiary, however, generally won’t be treated as the owner of the stock in the event of disposition. If the trust sells the stock, the trust recognizes the gain or loss. If the trust distributes the stock to the income beneficiary, the consequences depend on the trust’s status apart from the income beneficiary’s terminating ownership status.23 If the QSST holds non-S corporation assets, the usual Subchapter J rules govern income on those assets, unless the trust is otherwise a grantor trust24 but due to the mandatory income distribution requirement, the accounting income of the trust is taxable to the beneficiary pursuant to the customary distributable net income (DNI) rules.
The Small Business Job Protection Act of 1996 created the ESBT, so this third type of trust commonly used to hold S corporation stock is a more recent addition to the planner’s toolbox.25
While ESBTs face limitations, they’re considerably more flexible than QSSTs. ESBT requirements include:
• All beneficiaries must be individuals, estates or certain charitable organizations.26
• The individuals can be U.S. citizens or residents (similar to QSST requirements), but may also be non-resident aliens (unlike QSSTs). Non-resident aliens may not, however, be potential current beneficiaries (PCBs).27
• Charitable organizations must be as described in certain parts of IRC Section 170 (which is broader than the QSST reference to IRC Section 501(c)(3)) and may include not only religious, charitable, scientific, literary, educational and amateur sports competition organizations, but also war veterans associations, fraternal organizations (if funds are used for charitable purposes) and cemetery companies.28
For ESBT purposes, a “beneficiary” includes any person with a present, remainder or reversionary interest in the trust.29 However, the PCB is also central to the ESBT analysis with regard to the 100-shareholder and eligible shareholder tests. A PCB is any beneficiary who’s entitled to or may receive a distribution of income or principal from the trust, but not a person who holds only a future or contingent interest. PCBs include permissible appointees under a power of appointment only when the exercise becomes effective to make them currently entitled or permitted to receive distributions from the trust.30
ESBTs are also subject to other requirements. First, no interest in the trust can have been acquired by purchase.31 This restriction doesn’t mean that the trust can’t have purchased the stock, but rather that the beneficiary can’t have purchased his beneficial interest in the trust. Second, the trustee must make the ESBT election (unlike the QSST, for which the beneficiary makes the election).32 Third, the trust can’t be a QSST, exempt from tax, or a charitable remainder annuity trust or unitrust.33 (See “ESBT Requirements,” this page.)
Notably absent from the list of ESBT requirements are the QSST prohibition against multiple beneficiaries and the mandatory distribution of trust accounting income. As such, ESBT provisions more closely resemble the flexible trusts that planners typically draft. A single ESBT may have multiple beneficiaries, making a sprinkle credit shelter trust possible and allowing a trust to have multiple Crummey withdrawal right holders. The trustee can be given discretion to pay income to one, all or none of the beneficiaries as the trustee determines best. Accumulated income can be used to accomplish a variety of objectives including payment of premiums on a life insurance policy owned by the trust, amortizing a debt incurred by the trust or simply accumulating income to avoid the application of the GST tax. Income may also be accumulated if a beneficiary has special needs, is a spendthrift, has creditor problems or, as is often the case, the S corporation earnings are more than the grantor thinks the beneficiary should have on an annual basis.
The trade off for this flexibility is that, except for capital gains, the ESBT’s S corporation income (but not other income or income taxed under the grantor trust rules) is taxed to the ESBT at the highest personal income tax rate.34 Unless all beneficiaries are already in the highest income tax brackets due to other income, the ESBT income tax cost must be measured against the importance of other planning objectives. (See “Pros and Cons,” p. 17.) Any non-S corporation income is subject to the usual Subchapter J rules (unless the grantor trust rules apply).35
Planning Pointer #6: When trust beneficiaries are already in the highest income tax bracket due to other income, the ESBT provides significantly more distribution flexibility and beneficiary protection.
Planning Pointer #7: If the S corporation distributions are significant and the grantor doesn’t want the funds automatically distributed to the beneficiaries, the ESBT provides an accumulation alternative although at a potentially higher income tax.
When an ESBT holds both S corporation and non-S corporation assets, these rules result in a further twist. If the ESBT has paid the tax on the S corporation income, one might conclude that the income could be distributed to the beneficiaries tax-free. However, the ESBT and Subchapter J rules intersect to provide that if the trust has DNI attributable to non-S corporation assets, then a distribution is deemed to be first from the non-S corporation income to the extent of DNI and, accordingly, will constitute taxable income to the beneficiary. For example, consider an ESBT with $10,000 of S corporation income on which tax has been paid and $10,000 of DNI from non-S corporation sources. If the trust distributes $10,000, the beneficiary will be taxed on $10,000 of income produced by non-S corporation assets, which is considered to be swept out first by the distribution, even though the trust has already paid tax on the $10,000 of S corporation income. Thus, to get the tax-free distribution of S corporation dividends on which tax has already been paid, the beneficiary must first pay tax on any DNI attributable to non-S corporation income. Just because tax has already been paid on the ESBT income doesn’t necessarily mean that it can be distributed tax-free to the beneficiary. Rather, it depends on whether the trust has any non-S corporation DNI. (See “A Further Twist,” p. 18.)
Planning Pointer #8: To minimize taxation to the beneficiary of ESBT income when tax has been paid at the trust level, consider making the S corporation stock the ESBT’s only asset and holding any other assets in a separate trust. In addition, if any S corporation dividends remaining after taxes are likely to be retained in trust, consider providing for the distribution of such amounts to a separate trust. This approach would keep any income earned on the retained dividends in the separate trust so that there would be no DNI taxable to the beneficiaries on any future distributions from the ESBT. This way, the S corporation dividends could be distributed to the beneficiaries from the ESBT tax-free. (Income earned in the secondary trust would, however, be subject to normal fiduciary income tax rules.)
There are fewer potential traps at a beneficiary’s death than with other trusts if the ESBT will continue for the benefit of existing PCBs. If, however, new PCBs are added, the planner must consider whether they meet the applicable requirements. If they don’t, the trust has one year to dispose of the stock without losing the S election.36
Like a QSST election, an ESBT election, generally, is tied to the date the trust received the S corporation stock.37 The election must be made within 16 days and two months beginning on the date of transfer of the stock.38 With respect to trusts that qualify for a grace period following a death (see “S Corporation Shareholder Grace Periods,” p. 15), the ESBT election must be made no later than 16 days and two months from expiration of the grace period.39
Planning Pointer #9: As with a QSST election, prepare the ESBT election at the same time as the stock transfer documentation, and file the election as soon as allowable under applicable rules, using a method that will provide proof of timely filing.
The trustee may make the ESBT election effective retroactively for as long as 15 days and two months before the election is filed. It can’t be revoked without the IRS’ consent.40
Role of the Estate Planner
In dealing with transfers of S corporation stock, the estate planner will be the member of the team most likely to understand and orchestrate the disposition of stock and elections needed to qualify trusts as shareholders. In this regard, the estate planner represents an indispensable bridge over which S corporation stock passes from one generation to another.
To be successful, an estate planner must have an integral knowledge of those rules that govern trusts as permitted shareholders. Meeting deadlines is essential, so the estate planner should: (1) determine what deadlines exist, (2) identify the critical date for the election or distribution or sale of stock, and (3) enter this date in his docket control system.
Although this article has focused on opportunities and traps set by grantor trusts, QSSTs and ESBTs, an estate planner must be aware that other challenges exist for preserving S corporation status in related contexts, such as S corporation stock that passes to a shareholder’s estate or to a trust pursuant to the terms of a will. Should the estate planner miss one of the many election deadlines, he may find comfort in the limited relief offered by IRC Section 1362(f) for inadvertent termination of S corporation status under certain circumstances.41
—The authors wish to acknowledge the assistance of Steven B. Gorin, a partner at Thompson Coburn LLP in St. Louis, in writing this article.
1. Internal Revenue Code Section 1361(b)(1)(A); Treasury Regulations Section 1.1361-1(e)(3).
2. IRC Section 1361(b)(1)(B).
3. IRC Section 1361(c)(2); IRC Section 1361(d). IRC Section 1361(c)(6)(A).
4. IRC Section 1361(c)(2)(A)(i).
5. IRC Section 1361(c)(2)(A)(ii).
6. Old Virginia Brick Co. Inc. v. Commissioner, 44 T.C. 724 (1965) aff’d, 367 F.2d 276 (4th Cir. 1966); Treas. Regs. Section 1.645-1(f).
7. IRC Section 1361(d); Treas. Regs. Section 1.1361-1(j).
8. IRC Section 1361(d)(3)(A).
9. IRC Section 1361(d)(3)(B).
10. Treas. Regs. Section 1.1361-1(j)(2)(ii)(B).
11. Private Letter Rulings 200140040 (Oct. 9, 2001), 200140043 (Oct. 9, 2001) and 200140046 (Oct. 9, 2001). If the agreement relating to the debt is such that the corporation must pay to the lender directly any dividends it otherwise would have distributed to the qualified subchapter S trust (QSST), the QSST doesn’t have actual receipt of the dividends. With regard to the use of income to discharge a principal debt, see Section 502(b) of the Uniform Principal and Income Act:
If a principal asset is encumbered with an obligation that requires income from that asset to be paid directly to the creditor, the trustee shall transfer from principal to income an amount equal to the income paid to the creditor in reduction of the principal balance of the obligation.
A planner contemplating this course of action may wish to consider seeking a PLR before proceeding.
12. IRC Section 1361(d)(2).
13. In cases in which a trust already owns stock for which an S election hasn’t yet been made but will be made, the planner should consult the applicable Treasury regulations for the different deadlines that apply.
14. Treas. Regs. Section 1.1361-1(j)(6)(iii); IRC Section 1361(d)(2)(D).
15. IRC Section 1361(b)(1)(B); IRC Section 1361(c)(3).
16. IRC Section 1361(c)(2)(A)(iii).
17. IRC Section 1361(c)(2)(A)(ii).
18. See supra note 14.
19. IRC Section 1361(d)(2)(C).
20. Treas. Regs. Section 1.1361-1(j)(7)(ii).
21. Treas. Regs. Section 1.1361-1(j)(9), (10).
22. Treas. Regs. Section 1.1361-1(j)(7).
23. Treas. Regs. Section 1.1361-1(j)(8). The at-risk and passive activity loss rules differ, however.
25. Small Business Job Protection Act of 1996, Public Law 104-188, Section 1302.
26. IRC Section 1361(e)(1)(A)(i).
27. Treas. Regs. Section 1.1361-1(m)(1)(ii)(D).
28. IRC Section 1361(e)(1)(A)(i).
29. Treas. Regs. Section 1.1361-1(m)(1)(ii)(A).
30. IRC Section 1361(e)(2).
31. IRC Section 1361(e)(1)(A)(ii).
32. IRC Section 1361(e)(1)(A)(iii); IRC Section 1361(e)(3).
33. IRC Section 1361(e)(1)(B).
34. IRC Section 641(c)(2)(A); Treas. Regs. Section 1.641(c)-1(e)(1).
35. Treas. Regs. Section 1.641(c)-1(g)(i).
36. See supra note 30.
37. In cases in which a trust already owns stock for which an S corporation election hasn’t yet been made but will be made, the planner should consult the applicable Treasury regulations for the different deadlines that apply.
38. Treas. Regs. Section 1.1361-1(m)(2)(iii).
40. IRC Section 1361(e)(3).
41. Revenue Procedure 2013-30, 2013-36 I.R.B. 173.