One of the many challenges of owning a small business is determining the appropriate tax classification of the company. When an individual owns a business entity classified either entirely or partially as an S corporation, it is essential to seek the guidance of an experienced estate planning attorney and tax advisor when planning for death. If you have an interest in an S corporation, you might consider a trust. Depending on your estate planning goals, the advice these professionals provide may be very different from the advice they would give to another business owner.
For example, upon your death,
As you can see, a business owner should consider various scenarios regarding estate planning with a viable business. And because of specific federal laws, your estate planning must carefully address a company taxed as an S corporation.
The Internal Revenue Service (IRS) describes S corporations as “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” The IRS allows this deduction under § 1362 of subchapter S of the Internal Revenue Code (IRC), where S corporations get their name. With a C corporation, Congress first taxes on profits when earned and then taxes again to the shareholders when those profits distribute. In contrast, an S corporation offers the tax advantage of passing income to the shareholders without facing tax at first the corporate level. The shareholders report their share of the S corporation’s profits and losses on their individual tax returns and pay tax at their individual income tax rates.
Under the Internal Revenue Code, an entity must meet the following criteria to qualify for taxation as an S corporation:
As stated above, only specific types of trusts may be shareholders of an S corporation. The three most common types of trusts used to hold S corporation stock or membership interests are a grantor trust, a qualified subchapter S trust (QSST), and an electing small business trust (ESBT). (You could also use a voting trust, which is beyond this article’s scope.)
The commonly used revocable living trust is one type of grantor trust. In general, a grantor trust is a trust in which the grantor (also called the trustmaker) retains certain powers over the trust, which causes the trust income to be taxable to the grantor. Because of some of the disadvantages of QSSTs and ESBTs (discussed below), a grantor trust is often the preferred type of trust for owning an S corporation. However, grantor trusts (testamentary trusts) may hold S corporation stock for only two years after the grantor’s death. At this point, the trust must either qualify as a QSST or ESBT or distribute the stock to an eligible shareholder. Otherwise, the corporation’s S election will terminate.
A trust may qualify as a QSST if it meets several criteria:
A QSST may work well in many circumstances; however, its requirements can also be unfavorable in certain situations. For example, the requirement that only one current beneficiary means that the beneficiary’s children cannot also be beneficiaries of the trust. In addition, the requirement that all income distributes to the beneficiary means that the income must distribute regardless of the beneficiary’s need, potential taxable estate, or troubling behavior. Further, distributing income in this manner exposes it to the beneficiary’s creditors, lawsuits, and divorcing spouse. Some practitioners create multiple trusts to isolate subchapter S corporation stock in a trust that meets the criteria and allows other assets to be held in a trust with different terms.
In general, a trust may qualify as an ESBT if it meets the following criteria:
The advantages of an ESBT are that they are not subject to the single beneficiary and mandatory distribution requirements of a QSST. In addition, because of certain phaseout deduction limitations that apply to individuals but do not apply to an ESBT, holding S corporation stock in an ESBT could result in income tax savings. However, the general rule is that the IRS taxes ESBT’s income at the highest federal income tax rate. Suppose the trust beneficiaries are not in the highest income tax bracket. So if not all trust beneficiaries are in the highest tax bracket themselves, the overall tax could be higher when using an ESBT to hold S corporation stock. In that case, some practitioners use careful drafting to cause the beneficiaries to be treated as grantors or owners under IRC § 678, which precedes the regulations governing ESBT income taxation.
When dealing with S corporation stock, it is essential to follow the S corporation requirements to ensure that the corporation’s S election does not terminate and result in disastrous tax consequences. If you currently own shares of stock in a business taxed as an S corporation, contact us to start forming a plan about what will happen to your business at your passing. Your loved ones and employees will thank you.
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