If you own a small business, one of the many challenges you face is deciding what should happen to the business after your death.  

For example, upon your death,

• Do you wish to pass on your business as an ongoing operation that will produce income for your spouse or loved ones?
• Is it important that the business continue to operate after your death to provide employment for your employees?
• Would you prefer that your business partners purchase your share of the business so that the proceeds can be distributed among your beneficiaries?
• Do you intend that the business will be shut down and the assets sold?
• Is it important that your beneficiaries be protected from lawsuits, divorce, or bankruptcy once they receive their inheritances?

If the business is classified as an S corporation, additional concerns arise.

What is an S corporation?
The Internal Revenue Service (IRS) describes S corporations as “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” This election is allowed under § 1362 of subchapter S of the Internal Revenue Code, giving rise to the name “S corporation”. Unlike a C corporation, which is first taxed on profits when earned and then taxed again to the shareholders when those profits are distributed, an S corporation offers the tax advantage of being able to pass income to the shareholders without first being taxed at the corporate level. The shareholders report their share of the S corporation’s profits and losses on their individual tax returns and are assessed tax at their individual income tax rates.

Under the Internal Revenue Code, an entity must meet the following criteria to qualify for taxation as an S corporation:

• It is incorporated within the United States.
• It has only one class of stock.
• It does not have more than one hundred shareholders.
• The entity’s shareholders are individuals, specific types of trusts and estates, or certain tax-exempt organizations. Partnerships, certain corporations, and nonresident aliens cannot be shareholders of an S corporation.
• It is not one of the types of corporations that is ineligible for S corporation taxation, such as certain financial institutions, insurance companies, and domestic international sales corporations.

What types of trusts can own stock in an S corporation?
Only certain types of trusts may be shareholders of an S corporation. The most common types of trusts used to hold S corporation stock or membership interests are a grantor trust, a qualified subchapter S trust (QSST), and an electing small business trust (ESBT). (Another type of trust that could be used, a voting trust, is not discussed here.)

Grantor Trust
In general, a grantor trust is a trust in which the grantor/ trustmaker retains certain powers over the trust, causing the trust income to be taxable to the grantor. A typical revocable living trust is one type of grantor trust. Because of some of the disadvantages of QSSTs and ESBTs (discussed below), a grantor trust is often the preferred type of trust for owning an S corporation. However, grantor trusts, as well as testamentary trusts, which come into action after the death of the trustmaker, may generally hold S corporation stock for only two years after the death of the grantor. Then the trust must either qualify as a QSST or ESBT or distribute the stock to an eligible shareholder. Otherwise, the corporation’s S election will terminate.

QSST
A trust may qualify as a QSST if it meets several criteria:

• The trust has only one current beneficiary, who is a US citizen or resident.
• All trust income is distributed to that sole beneficiary.
• The income beneficiary files an election with the IRS.

A QSST may work well in many circumstances. However, its requirements can also be unfavorable in certain situations. For example, the requirement that there is only one current beneficiary means that the beneficiary’s children cannot also be beneficiaries of the trust. In addition, the requirement that all income is distributed to the beneficiary means that the income must be distributed regardless of the beneficiary’s need, potential taxable estate, or ability to manage the distributions. Further, the distributed income is exposed to the beneficiary’s creditors, lawsuits, or divorcing spouse. Some practitioners create multiple trusts to isolate subchapter S stock in a trust that meets the criteria and allow other assets to be held in a trust with different terms.

ESBT
In general, a trust may qualify as an ESBT if it meets the following criteria:

• The trustee of the trust files an election with the IRS within a certain time frame.
• The beneficiaries of the trust are all permissible beneficiaries under the Internal Revenue Code

In some circumstances, an ESBT is preferred because, unlike a QSST, it does not require a single beneficiary and mandatory distribution of all income. In addition, some income tax savings could be achieved because of certain phaseout deduction limitations that apply to individuals but that do not apply to an ESBT. However, the general rule is that all an ESBT’s income is taxed at the highest federal income tax rate. So, if not all trust beneficiaries are in the highest tax bracket themselves, the overall tax could be higher when using an ESBT to hold S corporation stock. When the trust beneficiaries are not in the highest income tax bracket, some practitioners use careful drafting to cause the beneficiaries to be treated as grantors or owners under Internal Revenue Code § 678, which takes precedence over the regulations governing ESBT income taxation.

Talk to a qualified advisor
When dealing with S corporation stock, it is essential to follow the S corporation requirements to ensure that the corporation’s S election does not terminate and result in disastrous tax consequences. If you currently own shares of stock in a business being taxed as an S corporation, call us to start forming a plan about what will happen to your business at your passing. Your loved ones and employees will thank you.