S corporation succession planning with trusts

S corporations are small-business corporations that elect to pass through income, losses and deductions to shareholders for federal and state tax purposes. By electing to be treated as a pass-through entity, the S corporation avoids the double taxation on traditional corporate income and dividend income distributed to shareholders. However, to retain the tax benefits of an S corporation, a company must comply with strict stock-ownership qualifications.
The S corporation may have only one type of stock issued by the company. Eligible shareholders are limited in number to no more than 100 and must not be corporations or partnerships. Individuals and estates may hold stock in the S corporation, as well as certain trusts, so long as they meet specific qualifications approved by the IRS. Trusts can be powerful tools to transition a business, but the S corporation owner must be careful to include in the succession plan only trusts that satisfy the S corporation rules in order to avoid losing the tax benefits of S corporation status.
Trusts that qualify as S corporation owners are limited to three basic types. The first is a trust treated for income tax purposes as if it is owned by an individual who retains certain powers over the trust, called a “grantor trust.”
The second type is a trust referred to as a “Qualified Subchapter S Trust” (or QSST), that has only one income beneficiary for the beneficiary’s lifetime and upon termination of the trust would be distributable to the same income beneficiary. The trustee must elect to be treated as a QSST within two months of the transfer of the S corporation stock to the trust.
The third type of qualifying trust allows multiple beneficiaries and trust income to be distributed or sprinkled among the beneficiaries and is called an “Electing Small Business Trust” (or ESBT). ESBT treatment requires an election by the trustee similar to the QSST election. These three trust types – the grantor trust, the QSST and the ESBT – give the S corporation owner options for purposes of transferring S corporation stock. The succession goals, timing of transition and circumstances surrounding the intended successor owners, such as their number, age, financial needs and abilities, may impact the owner’s choice of trust. For example, for the S corporation owner who is concerned about management of the business in the event of incapacity or death and who wishes to avoid the probate process, the owner may assign stock to a revocable trust under which the owner retains the right to all income and principal during lifetime as well as the power to revoke the trust.
This type of trust would qualify as a grantor trust so that the transfer of the stock to it would not result in a loss of S corporation status.
The owner retains control over the grantor trust during lifetime. However, in order to preserve S corporation status after the owner’s death, the trust must be structured in a way that satisfies the requirements to then serve as either a QSST or ESBT. For example, an ESBT cannot have any beneficiaries other than individuals, estates or charitable organizations. The ESBT election also cannot be made by charitable remainder trusts. With respect to a QSST, the trust can be structured so that trustees are permitted to distribute income in their discretion to an income beneficiary, but a distribution from the trust that satisfies the grantor’s obligation to support the income beneficiary would cause the trust to be ineligible for QSST treatment.
Other trust-planning techniques are available to the S corporation owner. Traditional estate tax planning for a married person often involves the use of trusts at death of a spouse to minimize estate taxes by creating a bypass trust for a surviving spouse and/or other beneficiaries to which estate tax exemptions are applied to reduce estate taxes. The remaining assets are then held solely for the surviving spouse in a separate trust, to which the unlimited marital deduction for estate tax purposes may be applied to further defer and minimize federal and/or state taxes. Such bypass and marital trusts may be drafted to qualify as either QSST or ESBT trusts.
In a different context, the S corporation owner may desire to take advantage of the estate and gift tax exemptions that allow for transfer during lifetime of up to $5.2 million in assets in 2012 (scheduled to revert to $1 million in 2013 if Congress does not act to change the law before then).
Intergenerational trusts may be used to facilitate the transfer of stock without transferring control and management of the business. Moreover, children and/or grandchildren may be beneficiaries of a trust that provides for discretionary distribution of income and principal by the trustee. These kinds of trusts may be qualified as S corporation owners if structured properly and elected by the trustee to be treated as such.
Using trusts in succession planning for S corporation owners requires special attention to the strict limitations imposed under the Internal Revenue Code. Careful drafting is necessary to ensure that any trusts designated to receive S corporation stock are crafted to meet the owner’s succession goals while preserving the S corporation tax benefits. &#8226


Kathleen A. Ryan and David C. Morganelli are partners at Partridge Snow & Hahn LLP. Ryan is a member of the firm’s probate, trust and personal-planning group. Morganelli is chairman of the firm’s tax-practice group.

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