Before we dive in, let’s provide some quick definitions for reference:
- S Corporation (an “S-Corp”): A corporation formed under Subchapter S of the Internal Revenue Code. (unlike a C Corporation (a “C-Corp”), which are formed under Subchapter C of the Internal Revenue Code).
- S Shareholder: Someone who owns stock in an S-Corp.
Similar to an LLC or partnership, S-Corps are “pass-through” entities, which means that the income generated by the S-Corp is not paid by the S-Corp, but rather “passes through” to the S shareholders in proportion to their ownership percentage and gets reported on their income tax returns/paid for by them individually. (The difference between this and a C-Corp is that income attributed to the C-Corp is paid by the C-Corp, and shareholders pay tax individually on dividends issued by it, which is why many people talk about the “double-tax regime” of a C-Corp.)
It is important to note that in order to create an S-Corp, you have to make an “S election” by filing IRS Form 2553, no later than 2 months + 15 days into the entity’s tax year.
Why do people even have S-Corps in the first place?
At one point in time, S-Corps were the only game in town. Prior to the enactment of widespread state LLC laws, S-Corps used to be the only choice to create a pass-through entity with corporate liability protection. Before, it was only Partnerships, C-Corps, and S-Corps. Once states started recognizing LLCs, which provide the same qualities (pass-through tax status and corporate liability protection, among other things) without all of the eligibility requirements, the popularity of S-Corps took sharply declined. In fact, most current companies today that want pass-through tax status and liability protection choose an LLC over an S-Corp. LLCs are a far better choice given the inflexible S-Corp eligibility requirements discussed below.
However, at times, you may still see newly formed S-Corps, since making an S election to convert a C-Corp into an S-Corp to achieve pass-through tax status can sometimes be a more practical option than converting the C-Corp to an LLC or partnership.
Okay, so it’s a corporation taxed like a partnership or LLC where taxable income passes through to the owners and must be reported by them on their individual income tax returns, so what’s the issue and why does it complicate estate and trust planning, and administration?
It can be complex because, in order to become and remain an S-Corp, the S-Corp itself and each S Shareholder must meet certain criteria:
- Only have one class of stock.
- 100 or fewer shareholders (note: spouses are treated as one shareholder).
- All shareholders must be individuals, estates, certain trusts, qualified retirement plans, or § 501(c)(3) organizations.
- No nonresident alien shareholders.1
Don’t Blow it!
If these qualifications are not met at nearly any point in time, the election to treat the corporation as an S-Corp and maintain pass-through status will end, it will revert to a regular C-Corp status with the “double-tax” status, which could have a financially-catastrophic effect on a small business owner - often referred to as “blowing the S election.” Note that when the double-tax regime applies, the C-Corp income is subject to a 21% federal income tax and dividends from C-Corps are subject to federal tax rates ranging from 15% to 23.8%. Additionally, once the S election is blown, it is hard to revert back to becoming an S-Corp to correct the termination of S-Corp status. An S election may not be made again for 5 years, though the IRS may grant relief from an inadvertent S election termination in certain instances (all of which require a lot of legal time/money to obtain).
Blowing the S election, where the company reverts to a C-Corp unintentionally due to a failure to administer this asset properly, is often seen as a failure to appropriately advise a client and could give rise to malpractice liability.
Though keeping the S-Corp “qualified” sounds relatively straightforward, there is frequently a lot of nuance and complexity around who qualifies as a shareholder to stay under 101 shareholders, and how to ensure trusts qualify as “certain trusts” when the S-Corp stock passes to them during an estate administration. While we could write an entire series of articles on who qualifies as a shareholder (in many scenarios, entire family units can count as one S Shareholder), we are going to focus on how to ensure a trust qualifies as an S Shareholder, since this is where there seems to be the most risk to the lawyer during the estate administration.
But can’t an estate hold the S-Corp stock and remain eligible?
The good news is that an estate itself is an eligible S Shareholder, therefore it may own the S-Corp stock throughout the period of the estate's existence, which lasts during the administration and settlement of the estate. However, the permitted time period of how long the estate may remain open and thus be in possession of the S-Corp stock as an S Shareholder is somewhat open-ended (the Internal Revenue Code does not provide specific thresholds for the maximum duration), however, the estate administration should not be unduly prolonged.
Trusts are where it gets complicated...
When someone with proper estate planning dies (particularly business owners), their estate is often distributed into trust(s) for the benefit of their loved ones, rather than held outright by those individuals. This means that when an S Shareholder dies and the S-Corp stock passes into their estate, upon distribution, if a trust ultimately is the “landing place” for the estate assets at the close of the estate administration, you now have a trust that owns S-Corp stock unless the trustee of the trust distributes that S-Corp stock out to the beneficiary. In many cases, as the S-Corp may be a valuable business interest, and thus an outright distribution to an individual or individuals might not be the best outcome.
A testamentary trust (i.e., a trust created by someone’s Will) may also be considered an eligible S Shareholder for up to 2 years from the date the shares are transferred to the testamentary trust. Note that the 2-year rule applies only if a trust is set up by a grantor who is a U.S. resident or citizen immediately before the shareholder’s death2. For both types of trusts, the shares of the S-Corp must be transferred to another eligible S-Corp shareholder at the end of the 2-year period or the S-Corp risks losing its favorable tax treatment.
Lifetime (Inter Vivos) Grantor Trusts
It is possible for a Trust to be an eligible S Shareholder if the creator (the “Grantor”) of the trust is a US citizen that transfers his/her S-Corp stock to a trust during his/her lifetime and it is characterized as a “grantor trust” that is taxable to only that individual. However, when that individual dies, it is no longer considered a grantor trust (because grantor trusts cease to be grantor trusts at the moment when the Grantor of the trust dies), and actions must be taken for the trust (or post-distribution subtrusts) to remain eligible S shareholder(s). It is important, however, that similar to estates, lifetime trusts that were previously grantor trusts also have a 2-year grace period from the date of the grantor’s death to make a proper election to remain an eligible S shareholder.
QSST or ESBT Elections
So, let’s talk about what election(s) must happen on or before the 2-year mark with respect to both testamentary trusts and lifetime trusts with a deceased grantor in order for the trust to hold S corp stock.
In order for the trust to continue to hold the S-Corp stock without blowing the S election, the Trust (or the severed portion of the trust that holds the S-Corp stock) must become either a QSST or an ESBT, and file an “election” with the IRS evidencing that decision. QSSTs and ESBTs both require the Trustee to administer the trust in very specific ways, both of which essentially enable the income from the S-Corp stock to be distributed out to an individual beneficiary.
QSST (Qualified Subchapter S Trust) rules:
- Must have only one (1) current income beneficiary.
- Current distributions of corpus must be only to current income beneficiary.
- Current income beneficiary’s income interest must extend through the beneficiary’s life or the trust term.
- Current income beneficiary must receive everything if the trust ends before beneficiary’s death.
- All income must be distributed currently.
- Income beneficiary must be an individual who is a U.S. citizen or resident.
- Must not be a foreign trust.
ESBT (Electing Small Business Trust) rules:
- All of the trust's beneficiaries must be individuals or estates, or certain charitable organizations.
- No interest in the trust may be acquired by purchase; these interests must be acquired by gift, bequest, etc.
- The trust must elect to be an ESBT.
Though an ESBT might initially sound more straightforward than a QSST, it is not. This is because the first “ESBT beneficiary” requirement is often tough to meet due to the fact that most trusts have MANY beneficiaries, even when there is only one “primary” beneficiary. The ESBT requirement encompasses all beneficiaries, either present/direct, remainder or ones who have a reversionary interest in the trust, and does not include a distributee trust. If S-Corp stock is held by an ESBT, then each potential current beneficiary is treated as a shareholder for S-Corp qualification rules.
Because of the stringent beneficiary requirement for an ESBT, most situations require the trustee to make a QSST election. Often when attorneys make their first QSST election, their concern lies with the mandatory income requirement (i.e., that there must be one income beneficiary and all income must be distributed out to that beneficiary annually). Though marital trusts also require a beneficiary spouse to receive all of the trust’s income, if the beneficiary is not a spouse, many trusts to not require all income be distributed out to a beneficiary (or beneficiaries). You may wonder, how can I make this trust fit the QSST requirements? This is where your counsel and creativity are needed and a good review of trust modification laws for the trust’s jurisdiction may be needed. In many states, there are ways to: (1) divide a trust for multiple beneficiaries such that each trust (each QSST) has one beneficiary and the trustee distributes the income to that beneficiary at least annually, (2) modify the trust’s terms so that the trustee is required to distribute the income out to the beneficiary, (3) allocate only the S-Corp stock to a QSST and sever it from the remainder of the trust funds, so that it is a trust that owns this singular asset which requires the income payout to the sole beneficiary. There are many different techniques that can be used here to ensure compliance and QSST eligibility.
If you are still in the estate planning phase, you can actually include language in your trusts that enable the trust to more easily convert to a QSST by enabling the Trustee to create trusts for purposes of qualifying under Subchapter S.
How do I make the QSST or ESBT election?
A QSST or ESBT election is made by signing and filing an election statement with the applicable Internal Revenue Service (IRS) Service Center. These elections must be made within 2.5 months of the transfer of S corporation stock to the intended QSST or ESBT. The statement itself can be very basic - no more than one page, where the Trustee “hereby elects” to treat the trust as a QSST or ESBT, and, often in bulleted points, identifies the income beneficiary and affirms that this beneficiary and the trust meets each of the eligibility requirements, and then signs the statement at the bottom in his or her capacity as Trustee.
It’s great that a trust can become an S Shareholder by making a QSST or ESBT election, but this 2 year deadline to make an election is tough! We didn’t even realize their revocable trust owned S-Corp stock until over 2 years from date of death - is there any way to fix this?
You are in luck. While we could write another article detailing the ways in which you can request relief for a late QSST or ESBT election, they are fact and circumstance specific. There are simplified ways to make the request if the omission to make the election is caught within a specific timeframe, and even ways to request and be granted relief if not.
1A U.S. citizen or resident alien shareholder and his or her nonresident alien spouse would be eligible shareholders if they made an election under § 6013(g).
2With respect to any Trust discussed in this article, 100% of the corpus of the trust must be included in the deceased shareholder’s estate in order to qualify. This is why “friends don’t let friends create joint grantor trusts” and we recommend practitioners do not draft or use a joint grantor trust unless there is a very specific and important overriding factual circumstance for doing so.