The income tax is the new estate tax. With a federal estate tax exemption at over $5 million and increasing by an inflation index in future years, few clients will be subject to an estate tax. That doesn’t mean that income tax and estate planning for clients with S corporations is passé. It is just different. The 2 million plus S corporations all need succession plans. How those shares are passed on to heirs, or whether instead they should be sold, is an important planning opportunity for accountants to assist clients.
15% to 25% of clients between the ages of around 25 to 65 will experience a disability. What plans does the client have in place to deal with this risk on both a personal and corporate level? Is there a written salary continuation payment provision in the shareholders’ agreement? If the client has a personal disability income replacement policy that has a six-month waiting period before payment, perhaps the client can negotiate with the other shareholders some type of salary continuation, e.g., 100% of salary for the first 30 days of disability, and 50% of salary for the next 90 days, to bridge that gap. If no shareholder currently has any health problems all may be willing to agree to some type of provision that might benefit them as well as other shareholders. What about a buyout provision? Life insurance is often inexpensive, simple and commonly addressed in a buyout, but what about paying for disability? Too often few if any plans are made. While disability buy out insurance can and should be considered, the cost is often more than clients are willing to bear. If that is the case, then practitioners should endeavor to work out other arrangements (e.g., 10% down and the balance over 5 years in quarterly installments, based on 75% of the death buyout value to make the cash flow needs less burdensome).
If the client dies, the focus for many decades had been minimizing estate tax while passing on interests to children or other heirs. With so few clients facing a federal estate tax all succession plans should be revisited. For example, it has been common for closely held S corporation shareholders to agree on a buyout value to avoid a battle of the appraisers. This amount is often memorialized in a certificate of stated value. The shareholders agreement or buyout agreement might refer to that document. What value does it reflect and when was it last updated? Practitioners will find many of these valuations were created years ago when the client’s focus was colored by their concern over estate taxes. Those values, and that perspective, may no longer be practical.
A Better Succession Plan
Most family business succession plans focus on the senior generation gifting interests in the business to the next generation. A series of recent cases present a framework for what might be a better form of planning for many clients. Don’t have the parents gift the business, have the children start and grow a new business. This can avoid liabilities associated with the parents’ business as well as gift tax worries. The key case in this area is Bross Trucking Inc. v. Commr. TC Memo 2014-17. In Bross, the father owned and operated a trucking company but ran into regulatory issues. To avoid that issue, his three sons started their own trucking business using some of equipment used in the father’s business, and some of the same suppliers and customers. The father was not involved in the new business started by the sons. The IRS said the transaction entailed a distribution of goodwill by Bross Trucking to the father. The likely extension of this argument was the father then gave a gift of goodwill to his three sons that should have been subject to the gift tax. The Tax Court held the IRS was not correct because the goodwill involved actually belonged to the father individually, not to the corporation. Important to this conclusion was there was never an employment agreement or non-compete agreement that bound the father’s actions to the corporation. Practitioners should be alert to business transitions to younger generations. When appropriate consider a similar strategy of having the children form their own business and build their own relationships. As long as the senior generation is not involved there may be no gift transfer. This might provide a gift tax-free succession strategy. Another case that favorably held on a similar strategy was Estate of Adell v. Commr. TC memo 2014-155. For an IRS victory on this issue see Cavallaro v. Comr. TC Memo 2014-189. These cases together can give practitioners a useful roadmap in guiding clients in this planning. Might there be even a better variant of this planning? There is for many clients, yes. Have the new ventures started in an irrevocable trust so it is outside of the children’s estates and potentially more difficult to reach by an ex-spouse.
√ Family Compensation Reporting
Practitioners know to be alert for compensation arrangements that might be characterized as a second class of stock thereby disqualifying an S corporation from meeting the one class of stock requirement. There is another issue that might be relevant to consider as well in the family context. Is your client making a gift if too large a salary is paid to a child in the family business? How must practitioners disclose such a payment? While generally a gift tax return has to be filed to toll the statute of limitations for a gift, there is an exception for salaries paid to family members in the ordinary course of business. The gift tax regulations require the filing of a gift tax return to meet the adequate disclosure requirement on Form 709 or a statement attached to the return. However, if there is a transfer to a family member in the ordinary course of business it is adequately disclosed if reported for income tax return purpose, the statute of limitations will be tolled for gift tax purposes. So, for example, if a child in a family business receives a year-end bonus and it is reported on the income tax return, that will be deemed adequate disclosure for gift tax purpose (as to IRS characterizing the bonus as a gift) without the filing of a gift tax return.
√ Watch Tax Trap of Wrong Trusts Holding S Stock
There are a number of different types of trusts that can own S corporation stock. Even if the estate tax does not apply to your clients, your clients may worry about the 50% divorce rate decimating a family business. The answer, even without estate tax worries, is to have the client gift/bequeath S corporation interests into trusts for the next generations. Since only certain types of trusts can qualify to hold S corporation stock without jeopardizing the qualification for S corporation status, practitioners need to be alert that those trusts are properly structured. This will become a more common problem. With the new high estate tax exemptions more estate planning will likely be completed by general practice attorneys or business attorneys, instead of estate planning specialists. As this trend continues, accountants will have to be alert to avoid an inadvertent termination of S corporation status:
• 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 ½ 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.
• 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. 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 ½ months of becoming an S corporation shareholder. 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.
• 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 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. Occasionally this occurs inadvertently, so practitioners must be careful to review trusts to assure the appropriate status is determined, and the 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 two-year 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.
• 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).
S Corporation Income and Death of Shareholder
When an S corporation shareholder dies, the corporate income is generally prorated between the decedent and the successor shareholder (e.g. a complex trust that occurs after a grantor trust loses grantor trust status following the settlor’s death) on a daily basis before and after death. Income allocated to the period before death is included on the decedent’s final income tax return. IRC Section 1377(a)(1); Reg. Section 1.1377-1(a). Income allocated to the period after death is included on the successors’ income tax returns. Alternatively, an S corporation may elect the interim closing of the books method. This divides the corporation’s taxable year into two separate years, the first of which ends at the close of the day the shareholder died. IRC Section 1377(a)(2); Reg. Section 1377-1(b)(1).
Estates and Testamentary Trusts Generally
When a client dies owning S corporation stock the stock is usually transferred to the estate and often from the estate to various testamentary (formed on death) trusts. Practitioners should monitor all of these transfers to be certain they don’t jeopardize S corporation status:
• During the period an estate holds the S corporation stock in the estate there should generally be no issue of S status as an estate is an S corporation shareholder. IRC Sec. 1361(b)(1)(B).
• 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.
• 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 that Might Own S Corporations:
• Maritial trusts, such as a qualified terminable interest property (QTIP) will meet the requirements of either a QSST or ESBT. While QSST status has generally been elected for a high-income trust and family ESBT status might make the touchstone for material participation the trustee instead of the beneficiary thereby facilitating avoiding the 3.8% surtax.
• 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. There is another application of QSST status and bypass trusts that can present an interesting planning opportunity. Assume that a bypass trust does not own S corporation stock. It may be feasible for the trust and other family members to create an S corporation. The bypass trust, and other family members, would contribute assets to a new S corporation. The bypass trust can then make a QSST election which would make it a grantor trust as to the beneficiary. This grantor trust status might provide additional income tax and other benefits.
• 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 truest can meet either of them.
• Dynastic Trusts are often, but not always, designed to be grantor trusts. If it is not a grantor trusts then QSST and ESBT provisions will have to be reviewed to ascertain if the trust can qualify.
• 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 can be a discretionary beneficiary. These trusts are grantor trusts during the settlor’s lifetime and can hold S corporation stock.
• Beneficiary Defective Trust (BDT) 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.
• Insurance trusts generally hold few 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. Be careful, however. While many practitioners rely on the fact that the trustee can use trust income to pay life insurance premiums on insurance on the life of the grantor, other commentators have expressed some concern as to whether this assures full grantor trust status. 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.
Modifying Irrevocable Trusts to Meet S Corporation Requirements
If a trust comes to own S corporation stock, it might lack the requisite QSST or ESBT provisions, or other provisions that might prove helpful. In many cases, even if the trust has the required language, it might be desirable to effect some modification of the trust to facilitate better tax planning or even just trust administration. Practitioners can review the following and other ideas with trust counsel:
• 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.
• 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.
• The trustee could petition a court to modify a trust to make the trust meet the requirements to hold S corporation stock.
• 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 use Alaska law to decant the existing problematic trust into a newly created and better designed trust. Approximately 20 states now permit decanting.
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.