Estate Planning for S Corporations: Small Business Trusts
Dec. 13, 2022
One of the greatest challenges of owning a small business is handling taxes. When an individual owns a business entity that's classified either entirely or partially as an S corporation, things can get complicated. If you own an S Corp, it's important to seek the guidance of an experienced estate planning attorney and tax advisor. These professionals can craft a plan tailored to your unique needs.
They may ask you the following questions to learn more about your situation.
Upon your death,
Do you intend to pass on your business to produce income for your loved ones?
Do you want your business to continue operating for years, and continue to employ your staff?
Would you prefer to sell the company to the other owners in exchange for cash, and distribute that amongst your beneficiaries?
Or, do you intend to shut down the business and have the assets sold?
Is it important that your beneficiaries be protected from lawsuits, divorce, or bankruptcy once they receive their inheritances?
As a business owner, there are many scenarios you need to consider. What do you want to happen to your business when you pass away? Because of certain federal laws, your estate planning must carefully address your S corporation.
What is 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.” This election is allowed under § 1362 of subchapter S of the Internal Revenue Code (I.R.C.), which is where S corporations get their name. A C corporation is first taxed on profits when earned and then again to the shareholders when those profits are distributed. An S corporation, on the other hand, offers the tax advantage of being able to pass income to the shareholders without first being taxed at the corporate level. The shareholders report their share of the profits (or losses) on their individual tax returns. The tax is then assessed at their individual income tax rate.
Under the Internal Revenue Code, an entity must meet the following criteria to qualify as an S corporation:
It is incorporated within the United States.
It has only one class of stock.
It has less than 100 shareholders.
Its shareholders are individuals, specific types of trusts and estates, or certain tax-exempt organizations. Partnerships, certain corporations, and nonresident aliens cannot be shareholders of an S corporation.
It is not one of the types of corporations ineligible for S corporation taxation. For example, certain financial institutions, insurance companies, and domestic international sales corporations.
What Types of Trusts Can Own Stock in 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).
In general, a grantor trust is a document in which the grantor (i.e., the trust maker) retains certain powers over the trust. This causes the trust income to be taxable to the grantor. A revocable living trust is one well-known type of grantor trust. 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 can generally only hold S corporation stock for two years after the death of the grantor. At that point, the trust must either qualify as a QSST or ESBT, or distribute the stock to an eligible shareholder. Otherwise, the business will cease to qualify as an S corporation.
A trust may qualify as a QSST if it meets the following criteria:
The trust has only one current beneficiary who is a US citizen or resident.
All trust income is distributed to that sole beneficiary.
The income beneficiary files an election with the IRS.
A QSST may work well in some situations but not others. For example, the requirement that there is only one current beneficiary means that the beneficiary’s children will be excluded. In addition, the trust income must be distributed to that beneficiary regardless of their need or behavior, or tax consequences. Further, that distributed income would be exposed to the beneficiary’s creditors, lawsuits, and/or divorcing spouse.
Some business owners create multiple trusts to fix these issues. They can isolate subchapter S stock in a trust that meets the criteria and hold other assets in a trust with different terms.
In general, a trust may qualify as an ESBT if it meets the following criteria:
● The trustee of the trust files an election with the IRS within a certain time frame.
● The beneficiaries of the trust are all permissible under the Internal Revenue Code.
ESBT trusts are not subject to the single beneficiary and mandatory distribution requirements of a QSST. Also, because of changing tax laws, holding S corporation stock in an ESBT could result in income tax savings. But, the general rule is that all an ESBT’s income is taxed at the highest federal income tax rate. 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.
The good news is, estate planning attorneys have developed a way to get around this issue. If the trust beneficiaries are not in the highest income tax bracket, they can be treated as grantors or owners under I.R.C. § 678. This law takes precedence over the regulations governing ESBT income taxation.
Hire an Estate Planning Attorney That Specializes in S Corporations
When dealing with S corporation stock, it is essential to follow the tax law. You don't want the corporation's S election to terminate after you're gone, as that would result in disastrous tax consequences. If you currently own shares or stock in an S corporation, call us at 614-389-9711 to start forming a plan about what will happen to your business at your passing. Your loved ones and employees will thank you.