Trusts as S Corporation Shareholders

Sometimes a C corporation considering S corporation status has a trust as a shareholder. If the trust was not originally drafted with the intent of being an eligible S corporation shareholder but continues to hold the stock, the corporation could be prevented from making the S election. Nevertheless, it may be possible for a knowledgeable tax adviser to solve this problem if he or she knows the intricacies of the grantor trust rules of IRC §§ 671–677.

TRUSTS COMMONLY USED TO HOLD S CORPORATION STOCK

Three commonly used types of ongoing trusts qualify as S corporation shareholders: grantor trusts, qualified subchapter S trusts (QSSTs) and electing small business trusts (ESBTs).

In many circumstances, a QSST will work well; however, the trustee of a QSST must either be required by the terms of the document to pay out all the net income of the trust to the beneficiaries or must actually pay out all income. In addition, during the lifetime of that beneficiary, principal of a QSST may be paid only to that beneficiary. If the beneficiary of a QSST is a minor child, it may not be desirable to pay out all income of the trust to that minor child.

An alternative the trustee might consider is an ESBT, since trust distributions do not affect the taxation of S corporation income when the stock is held by an ESBT. In fact, if the beneficiary is in the highest marginal tax bracket, it could be advantageous for an ESBT rather than an individual to hold the S corporation stock. (However, remember that every dollar of S corporation income held by an ESBT is taxed at the highest marginal tax rate.) This is because an individual’s itemized deductions are phased out at certain levels of adjusted gross income, and layering on additional S corporation income will only add to the phaseout. Because no such limitation applies to an ESBT, an overall income tax savings may result if an ESBT holds and is taxed on the S corporation stock. However, if not all trust beneficiaries are in the highest marginal bracket themselves, the overall tax could be higher if the stock is owned by an ESBT, because of the 35% flat tax rate that applies to the S corporation portion of an ESBT.

GRANTOR TRUST TREATMENT OFTEN PREFERABLE

Because of these disadvantages of QSSTs and ESBTs, grantor trust treatment often becomes the preferred way to qualify a trust as an eligible S corporation shareholder. To qualify as an S corporation shareholder, the trust must be treated as owned by only one person. If the grantor dies and the trust continues in existence, the S corporation election continues to apply for up to two years from the grantor’s death. However, if the trust loses its grantor trust status other than by reason of the death of the grantor, the trust is immediately disqualified as a shareholder and the corporation’s S election is immediately terminated.

For a detailed discussion of the issues in this area, see “Creative Ways of Achieving Grantor Trust Status,” by Sally E. Day, CPA, in the September 2009 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief

The Tax Adviser Also look for articles on the following subjects in the September 2009 issue of The Tax Adviser:

• Results of our tax software survey.
• Significant developments in estate planning.
• Proposed rules for posttransaction accounting methods.

FROM THE TAX ADVISER

The Tax Adviser is the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or e-mail taxsection@aicpa.org for a subscription to the magazine or to become a member of the Tax Section.