Electing Small Business Trusts: A New Planning Technique

Changes that make S corporations more appealing in estate planning were brought about by the Small Business Jobs Protection Act of 1996. Previously, a trust that held S corporation stock had to be either a grantor trust or a qualified subchapter S trust (QSST). Now the Act has created the electing small business trust (ESBT), a more flexible trust for holding S corporation stock.

In the past, estate planners often used grantor trusts to hold S corporation stock. But under prior law, on the grantor’s death, the trust often violated S corporation rules, jeopardizing the S election. And QSSTs were restrictive because they allowed only one beneficiary and required all income to be paid out during the beneficiary’s lifetime.

Recognizing that these arcane rules often inhibited business owners from using S corporations or created traps for the unwary, Congress amended the rules to allow more types of trusts to hold S corporation stock.

ESBT Election
While all ESBT beneficiaries must be individuals or estates eligible to be S corporation shareholders, ESBTs can have multiple beneficiaries and accumulate income. Each beneficiary is counted as a shareholder in applying the S corporation 75-shareholder limit. All S corporation income earned by an ESBT is taxed at the highest marginal tax rate for trusts, currently 39.6%. This income is not reduced by expenses of the trust. Distributions are tax-free to the beneficiaries. If the trust makes a distribution of S earnings to the beneficiary, the distribution:

• Is not taken from other income of the trust,
• Is not an accumulation distribution of previously taxed income of the trust,
• Does not produce a distribution of distributable net income of the trust to the beneficiary, and
• Is not further taxed. The beneficiary will receive the distributions net of the income tax without double taxation.

Charities cannot be current beneficiaries, but they can be contingent remainder beneficiaries. In addition, beneficiaries may not acquire their interest in a trust by purchase.

ESBT elections must be made in a timely fashion by the trustee, and failure to do so could terminate the S election. The Internal Revenue Service has, however, been ordered to be more lenient in allowing late S elections and curing those inadvertently terminated.

In addition, the ESBT may not be a QSST. This means that the trust may not have made a QSST election with respect to stock held in the trust.

If a trust qualifies as an ESBT, the portion of the trust holding S corporation stock is treated as a separate trust.

No Disadvantages for the Rich
There are no income tax disadvantages for families whose income is already taxed in the highest marginal tax bracket. Of course, state laws may affect state taxation differently. The new law does, however, open up alternative types of estate planning opportunities and eliminates a significant trap that the old law created. Most newly created trusts for estate planning purposes will qualify to be S corporation shareholders.