An S corporation is a business structure that allows the passage of taxable income, losses, credits and deductions to shareholders, thereby preventing income from being exposed to the consequences of double taxation at the corporate and individual levels. Although an S corporation benefits from certain tax advantages, it also faces restrictions such as a limit on the number of shareholders – no more than 100. As part of estate planning, some individuals choose to take advantage of the availability of different kinds of trusts qualified to hold stock from S corporations. This article will focus on the different types of trusts and compliance requirements necessary for each one eligible to serve as a shareholder of the corporation.
S Corporation Requirements
Aside from the limit of shareholders in an S corporation, other requirements include incorporation in the United States, the fact that shareholders cannot be non-resident aliens and the corporation is limited to only one class of stock. In addition to individuals, trusts and certain tax-exempt organizations can be shareholders.
Eligible Shareholder Trusts
Grantor Trusts: In a grantor trust, the individual who created the trust (the grantor) remains the owner of assets and property within the trust. The grantor trust is thereby disregarded as an entity with all income, deductions and credits reported directly through the grantor’s tax return. Eligibility requires that the grantor own the entire trust, be a U.S. citizen or resident and comply with all tax laws and regulations pertaining to S corporations. Should the grantor pass away, the trust still may serve as a shareholder up to two years from the date of death.
Testamentary Trusts: A testamentary trust is written into a last will and testament and established when the individual who created the trust passes away, to manage the distribution of their estate to beneficiaries. If the individual who dies serves as a shareholder of an S corporation, the trust receives corporate stock from the estate and becomes the permissible shareholder of the corporation for up to two years. The testamentary trust must qualify as a qualified subchapter S trust (QSST) or an electing small business trust (ESBT) while the beneficiary must consent to the election of the type of trust and be an eligible S corporation shareholder.
Voting Trust: Voting trusts transfer voting right from shareholders to a trustee. This type of trust can hold S corporation stock, but beneficiaries must be eligible S corporation shareholders and the trust must be structured to maintain the S corporation’s tax status meaning the trust cannot include partnerships, corporations or nonresident aliens. Additionally, all shareholders of the S corporation must consent to creating the voting trust and having their voting rights transferred to the trustee.
Electing Small Business Trusts (ESBT): An ESBT is a trust specifically designed to hold S corporation stock as the shareholder. Most income generated by the S corporation is taxed at the trust level but certain income including qualified dividends and net capital gains can be passed down to beneficiaries to be taxed at a lower individual tax rate. Eligible beneficiaries of ESBTs include individuals, estates and certain charitable organizations.
Qualified Subchapter S Trusts (QSSTs): As its name suggests, QSSTs are designed to manage S corporation stock. A QSST must have only one income beneficiary who is entitled to all the trust’s income and must be a U.S. citizen or resident alien. Unlike an ESBT where income is taxed at the trust level, a QSST requires an annual distribution of income to the beneficiary to be taxed at the individual rate. As a result, any income generated by the trust is recognized as the income of the beneficiary who is responsible for paying the taxes. One advantage of a QSST is that, assuming it meets all eligibility requirements, it allows passage of S corporation stock to be taxed at a lower rate (i.e. the individual level).
Importance of Compliance
All of the above trusts can be excellent options to hold S corporation stocks assuming they meet eligibility requirements. Failure to comply could mean the trust loses the ability to hold stock and could additionally result in legal or financial trouble. Consulting with an experienced trusts and estate tax advisor or a financial expert can help determine the best course of action.
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Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
