There are over two million S corporations. In 2012 there has been a tremendous shift of wealth to trusts as taxpayers endeavor to take advantage of what might be a final window of wealth transfer opportunity before 2013. The result is the transfer of significant assets, including S corporations into trusts. What types of issues should practitioners be alert for?
Specific S Corporation Trusts
1 Qualified Subchapter S Trust (QSST) is perhaps the most well known of all trusts that hold stock in an S corporation. To qualify as a QSST all trust accounting income of the trust must be distributed currently to a single individual shareholder. During the current income beneficiary’s lifetime distributions of principal of the trust can only be made to that current beneficiary. The beneficiary must make the QSST election by filing a signed election statement with the IRS within 2 1/2 months of becoming a shareholder. IRC Sec. 1361(d)(2)(D). If assets other than S corporation stock are held in the same trust they are not subject to the QSST rules and can be treated separately.
2 Electing Small Business Trust (ESBT) can provide a more flexible option for a trust to be an S corporation shareholder. A sprinkle or spray trust with multiple beneficiaries, like many bypass trusts, may retain S corporation stock as an ESBT.
3 All of the “potential beneficiaries” must, however, be individuals, estates or qualified charitable organizations. None of the interests of the trust in the S corporation stock could have been acquired by purchase. The trust itself must make the ESBT election by filing a statement with the IRS within 2 1/2 months of becoming an S corporation shareholder.
4 The trust must pay income tax on the S portion of any income at the highest applicable income tax rate. There is no offsetting deduction for income distributed to beneficiaries. Thus, the new 3.8% Medicaid tax on passive investment income may be incurred on top of the highest marginal tax rate with no opportunity to distribute to beneficiaries to mitigate it. As with the QSST above, if the trust owns other assets, non-S corporation income is not subject to the harsh ESBT rules.
5 Grantor trusts have become common vehicles for holding S corporation stock, especially with the substantial transfers following the 2010 tax act. A grantor trust is a trust that is treated as wholly owned by an individual under the provisions of Code Section 678. While generally this individual is the settlor or trustor establishing the trust, this is not always the case. Some trust drafting techniques will intentionally result in a person other than the settlor being taxed as the grantor for income tax purposes.
6 Occasionally this occurs inadvertently, so practitioners must be careful to review trusts to assure the appropriate status is determined, and that correct grantor is identified. Following death of the grantor the status of the trust as a grantor trust will end. The trust may continue for the twoyear period noted above for estates to hold S corporation stock. That period may be extended if the formerly grantor trust was a revocable living trust that can make the election under Code Section 645 to be taxed as part of the estate. Following these periods, whichever apply, the trust must meet other criteria to continue to hold S corporation stock.
7 Voting trust can be used to control the vote of stock in a closely held S corporation while the beneficial owners of the stock, each of whom qualifies as an S corporation shareholder, continue to benefit as owners from their economic interests in the stock. IRC Sec. 1361(c)(2)(A)(iv).
Estates and Testamentary Trusts Generally
8 During the period an estate holds the S corporation stock, there should generally be no issue of S status as an estate is an S corporation shareholder. IRC Sec. 1361(b)(1)(B).
9 If the administration of the estate is extended unreasonably, the IRS can argue that the estate has been terminated and S status could be in jeopardy.
10 Testamentary trusts, funded on a client’s death, will have to qualify to hold S corporation stock for two years without meeting any other special S corporation requirements. IRC Sec 1361(c)(2)(A)(iii). After the second anniversary of the date the S corporation stock is transferred to a testamentary trust, the trust will have to meet general S corporation trust requirements, e.g., QSST or ESBT.
Common Estate Planning Trusts
11 Martial trusts, such as a qualified terminable interest property (QTIP) will meet the requirements to hold stock in an S corporation. The common testamentary (formed on death under a will or revocable living trust) QTIP trust should qualify to meet the requirements of a Qualified Subchapter S Trust (“QSST”) IRC Sec. 2056(b)(7). A lifetime (inter vivos) QTIP trust may be treated as a grantor trust and thereby qualify to hold S corporation stock. IRC Sec. 1361(c)(2)(A)(i).
12 Credit Shelter Trusts, also known as “bypass trusts” or “applicable exclusion trusts” can be structured in many different ways so no conclusion should be drawn as to whether or not it will qualify as any particular type of S corporation trust without first reviewing the terms of the trust. Some bypass trusts are designed so that one beneficiary must receive current income and hence qualify as a QSST. Many, perhaps most, bypass trusts have multiple current beneficiaries and will have to elect to be taxed as an ESBT to qualify to hold S corporation stock.
13 Grantor Retained Annuity Trusts (GRATs) are grantor trusts during the annuity term and can therefore hold S corporation stock during that period. Following the termination of the annuity term some GRATs distribute assets to children outright. In such cases, if the children qualify as S corporation shareholders, S corporation status will not be jeopardized. However, many perhaps most GRATs name trusts to hold the remainder interests. Some of these trusts are designed to continue to be grantor trusts as to the settlor of the GRAT. Those will continue to qualify to hold S corporation stock. If the remainder trust is not a grantor trust then the QSST and ESBT provisions have to be reviewed to ascertain if the trust can meet either of them.
14 Dynastic Trusts are often, but not always, designed to be grantor trusts. If it is not a grantor trust then QSST and ESBT provisions will have to be reviewed to ascertain if the trust can qualify.
15 Self Settled or Domestic Asset Protection Trusts are trusts formed in a state, typically Alaska, Delaware, Nevada or South Dakota, which permit the person establishing the trust to be a discretionary beneficiary. These trusts are grantor trusts during the settlor’s lifetime and can hold S corporation stock.
16 Beneficiary Defective Irrevocable Trust (BDIT) is intentionally designed to qualify as a grantor trust as to the beneficiary, not the settlor. As such, BDITs can hold S corporation stock and the beneficiary will report his or her share of S corporation income.
17 Insurance trusts generally hold fe assets other than a bank account and an insurance policy while the settlor/insured is alive. However, many insurance trusts are grantor trusts during this time period. Following the death of the settlor/insured the insurance trust may purchase S corporation stock from the settlor’s estate. But following death the trust cannot be a grantor trust (except perhaps as to the beneficiaries as a result of the Crummey powers) so that the trust may have to qualify at that point as a QSST or ESBT.
Common Trust Transactions
18 Modification of a trust by fiduciaries, such as a trustee or trust protector, exercising powers granted under the trust agreement might be feasible. These may suffice to change the trust to one that qualifies as a grantor trust or QSST.
19 Many trust agreements permit the trustee to subdivide the trust into separate trusts. This might be used to isolate the S corporation stock in one trust that can meet S corporation requirements. Non- S corporation stock can be held in other sub-trusts. This approach might enhance the results of the trust overall.
20 The trustee could petition a court to modify a trust to make the trust meet the requirements to hold S corporation stock.
21 Decanting is a process by which one trust is poured over into another trust. If the existing trust cannot hold S corporation stock that was transferred to it, the trustee might move the trust to a state like Alaska; and then use Alaska law to decant the existing problematic trust into a newly created and better designed trust.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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