A common estate planning technique for many small business owners is to transfer ownership of their business interests to their revocable living trusts, either during lifetime or with a “transfer on death” (TOD) designation. While this technique has several advantages, the most important being the avoidance of probate of the business interest at death, the terms of the trust need to be considered to ensure it is – and will continue to be after death – an eligible shareholder of an S corporation.
As an initial matter, as long as the business owner is living, his or her revocable trust is treated as a “grantor trust” for income tax purposes, and as such, is an eligible S corporation shareholder. After death, the trust will remain an eligible shareholder for a period of two years during the administration process. Once the two years has passed, the trust must either distribute the stock outright to an eligible shareholder, or, if the stock is to remain in trust, must qualify as either a qualified subchapter S trust (QSST) or an electing small business trust (ESBT).
To qualify as a QSST, the trust must require that all of the net income be distributed to a single beneficiary. While principal of the QSST may also be distributed to the beneficiary in the discretion of the Trustee, the QSST cannot provide for multiple beneficiaries. The income from a QSST is taxed at the individual beneficiary’s income tax rate.
To qualify as an ESBT, the Trustee may have discretion to accumulate income, and there may be multiple beneficiaries. However, the tradeoff for this flexibility is that the ESBT is taxed at the trust income tax rate, which is usually higher than individual rates.
For both a QSST and ESBT, elections must be filed with the IRS within a certain period of time, so it is imperative for a Trustee to consult with legal counsel regarding these options. If a trust fails to qualify as an eligible shareholder, the corporation’s election to be treated as an S corporation would be revoked. For small business owners of an S corporation, it is important to consider how the S corporation stock fits into the business owner’s overall estate plan, particularly if there is a possibility for the stock to be held in a trust after death.