Many small-business owners own their businesses through a business entity, like a corporation or limited liability company (LLC). And many have chosen to have their business entity taxed as an S corporation. Most likely chose this tax treatment because it offered income-tax advantages to them during their lives, without any thought to how that choice might affect their estate plan. There’s nothing wrong with that, but it is important to understand what estate-planning effects that choice can have. This post explains just that.
S Corporations: Requirements and Advantages
Contrary to a popular misconception, the term “S corporation” refers to a type of income taxation, not a type of business entity. For example, many LLCs are taxed as S corporations, even though LLCs are not technically corporations. To qualify for taxation as an S corporation, a business entity must meet certain requirements. Generally speaking, the business entity must have only one class of stock, no more than 100 owners, and those owners must be natural persons who are U.S. citizens or resident aliens.
S corporations offer three advantages to small-business owners. First, unlike entities taxed as C corporations, the income of an S corporation is not taxed at the entity level. Instead, it’s passed through to the owners, regardless of whether the entity distributes money to the owners. That means the owners recognize, and pay tax on, the entity’s income in proportion to their ownership interests in the entity. Second, also unlike C corporations, the owners of an S corporation are not taxed on distributions from the entity. That’s because they were already taxed when the entity earned the income. Finally, S corporation income is not subject to self-employment taxes, unlike income earned by entities taxed as partnerships or disregarded for tax purposes. However, to prevent abuse of this last advantage, the IRS requires that owners who work for their own S corporation receive reasonable compensation for that work. The compensation will be in the form of wages, which are subject to FICA taxes. Still, taxing a business entity as an S corporation can be an attractive choice for small-business owners because of these advantages. But how does that choice affect estate planning?
S Corporations and Estate Planning
As mentioned earlier, to qualify as an S corporation, a business entity must generally have owners who are all natural persons (i.e., individuals). However, there are some exceptions to that rule. Living trusts are an important one. Because living trusts are ignored by the IRS for income-tax purposes, a person can hold his or her S corporation stock in a living trust. After the grantor’s death, however, the trust can only continue to own the stock for a period of two years, unless it qualifies as an electing small business trust (ESBT) or a qualified subchapter S trusts (QSST). An ESBT is a trust in which the beneficiaries are all individuals, estates, and certain kinds of organizations, and no interest in which was acquired by purchase. If those requirements are met, the trustee can elect to treat the trust as an ESBT. But the advantage of holding the S corporation stock in an ESBT is offset by increased taxes due on the S corporation income “passed through” to the trust.
A QSST is a trust that has certain terms included in it. Specifically, the trust can only have one income beneficiary, and that person is the only person who can receive distributions of trust principal during his or her life. In addition, all the income of the trust must be distributed to the beneficiary at least annually. The beneficiary of a trust with those terms can elect to have the trust treated as a QSST. In that case, the S corporation income is taxed to the trust beneficiary, not the trust.
Ways That Trusts Cause Loss of S Corporation Status
The rules regarding what types of trusts can be eligible S corporation shareholders are complex. Private letter rulings frequently are issued regarding stock being transferred to a disqualified trust or a trust that is already a shareholder (and was previously eligible) somehow becoming ineligible and thus causing a termination of S corporation status. Some of the situations are logical and easily recognizable as a problem, but many involve situations that practitioners would not immediately identify as the root of any concerns. In general, estates and six types of trusts are eligible as S corporation shareholders, with the most common being grantor trusts (including a former grantor trust for two years post-death), electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), and testamentary trusts (for two years after funding). Most practitioners realize that a properly completed and timely filed election must be made for a trust to become an eligible ESBT or QSST, but there are many other problems that a practitioner may not easily recognize. The following are ways that S corporations can lose their S election status, most of them involving trusts.
• Trusts Owned by More Than One Individual: Grantor trusts (either revocable or irrevocable) are eligible but only if the trust has only one grantor (although spouses generally are treated as one shareholder). Thus, a trust that is taxable to multiple individuals under Sec. 671 would not be eligible to hold S corporation stock.
• Foreign Trusts: A foreign trust is not eligible to hold S corporation stock. However, it sometimes is difficult to determine that a trust actually is a foreign trust. In fact, a trust that originally was a U.S. trust can become a foreign trust merely because of a change in trustee. This could include situations where multiple co-trustees exist and foreign trustees obtain the ability to control the substantial decisions of the trust, even if the U.S. co-trustee accomplishes the majority of the actual activity.
• Nonresident Aliens: An S corporation cannot have a nonresident alien as a shareholder. Therefore, previously valid S corporations have become disqualified when an existing shareholder who formerly was a resident alien (an eligible shareholder) moved out of the United States (thus becoming a nonresident alien) or abandoned permanent resident status. Similarly, a corporation lost its S status when a shareholder renounced U.S. citizenship.
• Nonresident Aliens and ESBT and QSST Elections: The nonresident alien issue also can negate an otherwise valid ESBT or QSST election. In this case, a potential current trust beneficiary was a nonresident. Since all applicable beneficiaries of a QSST or an ESBT must be individuals who otherwise would be eligible to hold S corporation stock directly, the beneficiary’s nonresident alien status caused him to become an ineligible shareholder, thus causing the trust to immediately become ineligible, even though no change of ownership of the stock occurred. The same issue could arise if an ESBT document provides that any after-born children or grandchildren are automatically added as beneficiaries, and a grandchild is born who is not a U.S. citizen.
• Charitable Remainder Trusts: A charitable remainder trust (CRT) is not an eligible shareholder. Thus, in Letter Ruling 199908046, when an S corporation issued additional shares of stock to various individuals and entities, including a CRT, the S corporation status was terminated. Although Sec. 1361(c)(6)(B) provides that S corporation stock can be owned by a charitable organization (including a private foundation) that is described in Sec. 501(c)(3) and is tax-exempt per Sec. 501(a), a CRT instead is governed by Sec. 664.
• IRAs: Even though IRAs often are structured as trusts for legal purposes, Letter Rulings 200250009 and 201408018 illustrate that an IRA is not eligible as a shareholder of S corporation stock. Although Sec. 1361(c)(6)(A) permits S corporation stock to be owned by a qualified pension plan (as defined in Sec. 401(a)), an IRA instead is tax-exempt under Sec. 408. Similarly, a Roth IRA is not an eligible shareholder, since Sec. 408A governs Roth IRAs.
• Defective Trust Provisions: Sometimes, certain provisions included in a trust document may seem acceptable but can inadvertently make a trust ineligible. For example, in Letter Ruling 201451001, a grantor created an irrevocable trust solely for the benefit of one beneficiary. However, the trust was not eligible to make a QSST election because it provided that if the trust property were included in the grantor’s taxable estate upon death, the trust assets could be used to pay a portion of the grantor’s estate tax. This seemingly unrelated and unimportant provision indirectly made the grantor a potential beneficiary of the QSST, meaning that the beneficiary was not the sole beneficiary of the trust, making it ineligible to make a QSST election. Another example is a will that provided that shares were to be transferred to a trust that would have been eligible as a QSST, except that the income beneficiary was given a power to direct the trust to pay his income to someone other than himself. Therefore, the trust was not eligible to make a QSST election. Taxpayers have made this mistake several times.
• Defective Elections: Sometimes, a QSST or an ESBT election is timely filed, but the procedures for proper filing are not followed. In Letter Ruling 201144018, the trustee of a trust, rather than the beneficiary, signed a QSST election, and thus the election was not valid. Similarly, an ESBT election would be invalid (even if filed timely) if it were signed by the beneficiary rather than the trustee. Likewise, for a married couple living in a community property state, any election must be signed by both spouses (since both spouses automatically have ownership interests in stock held as community property), rather than by only the spouse who is nominally the shareholder. Finally, in Letter Ruling 201516009, the trustee of a grantor trust, rather than the grantor himself, signed the Form 2553, Election by a Small Business Corporation, making the S corporation election invalid.
• Decanting: Letter Ruling 201442047 involved an apparent “decanting.” An existing ESBT contained provisions that the grantor apparently no longer desired, so a new trust was created with the same trustee and beneficiary but with different administrative provisions. The trustee transferred the S corporation shares from the old trust to the new trust, but the trustee did not timely file a new ESBT election. Therefore, the new trust was an ineligible shareholder.
• Failure to Make Timely Elections: Failing to make timely elections is pervasive. This includes not only the S corporation election itself (on Form 2553) but also an election to make a trust an eligible shareholder as either an ESBT or a QSST within two months and 15 days after the stock is transferred into the trust. But in several unexpected situations a necessary election may be missed. For example, if a trust is a grantor trust to one individual, it is eligible as an S corporation shareholder, even though it is irrevocable (rather than revocable). However, upon termination of the grantor trust status, a separate election is necessary, even though there might not be any change in legal ownership of the stock. The deadline for making the election will depend on the situation: If the trust is irrevocable and the grantor dies, the trust is eligible to hold S corporation stock for two years (Sec. 1361(c)(2)(A)(ii)). This would apply to both intentionally defective irrevocable trusts (IDITs) as well as grantor retained annuity trusts (GRATs). Interestingly, the same rule applies to a QSST when the beneficiary of the QSST dies (see Letter Rulings 201420005 and 201516016). This is because the QSST election causes the trust to become a grantor trust to the beneficiary, even though the beneficiary did not create or fund the trust. Therefore, the rules applicable when the grantor dies apply upon the death of the QSST beneficiary. If the trust is revocable and the grantor dies, the trust probably is eligible to make a Sec. 645 election to be treated as an estate, and thus the trust is eligible to hold S corporation stock not just for two years but rather until the period of estate administration is complete.
Estate Planning with S-Corporations
With the federal state tax exemptions being so clients with family businesses held in an S-corporation are less focused on reducing estate taxes and are more focused on avoiding probate and reducing future capital gains tax through obtaining a basis step-up. To accomplish this goal, many S-corporation shareholders are placing their S-corporation shares into a grantor trust. This is an effective strategy since, at the time of the grantor’s passing, it allows the grantor’s estate to avoid probate and, if drafted correctly, may also allow the grantor to retain enough control that the shares will be included in the grantor’s estate resulting in a basis step-up. However, as with every plan, attention must be given to the potential pitfalls. S-corporations are subject to very strict rules, one of which places limitations on who or what entity can be a shareholder of an S-corporation.
Therefore, it is crucial that your plan accounts for who may own the S-corporation shares in the future. For instance, if S-corporation shares are put into a revocable grantor trust, once the grantor dies, the revocable grantor trust will change to an irrevocable trust. Under the rules applicable to S-corporations, an irrevocable trust may only hold S-corporations shares for a grace period of 2 years. After this 2-year period, the S-corporation status of the corporation will be revoked. The IRS has made exceptions to allow certain types of trusts to own S-corporation shares without endangering the S-corporation status. One of the most common options is a Qualified Subchapter S Trust (QSST). With a properly drafted trust document, at the time of the grantor’s passing, the Trustee may elect for the trust to become a QSST. However, QSST is also subject to certain requirements of its own, most notably: all of the income of the trust must be distributed, or be required to be distributed, to a single current income beneficiary who is a U.S. citizen or resident. As a result, each beneficiary would be taxed on the income that passes through the S-corporation. S-corporations and QSSTs can be an extremely useful estate and business succession planning tool. If you are an owner of a business, whether held in an S-corporation or not, we recommend that you consult with an experienced tax attorney to help you decide what choices are right for your specific situation.
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