Contributing Author: Vasili (Vas) Russis chairs the Tax & Wealth Structuring practice group at Kelleher & Buckley, LLC law firm.
Vas concentrates his practice on the representation of closely held businesses and high net worth individuals, mainly in the areas of tax structuring and planning, estate planning and administration, business structuring and planning, asset protection, IRS disputes, real estate and commercial litigation. Vas can be reached at: (P) 847-382-9130 (EM) firstname.lastname@example.org
Succession Planning to Retain S Corporation Status
Under the current tax law, S corporations are the most commonly used entity for operating businesses (other than for holding real estate). Generally, the rules for S corporation ownership allow for individuals (or their living trusts) to hold shares in an S corporation. Proper ownership of shares allows for S corporation status, which avoids the unwanted scenario of “double taxation” that is found with C corporations. Many business owners choose not to have the results associated with C corporation “double taxation”.
However, when an S corporation shareholder dies, depending on how that shareholder’s estate plan is structured, there can be a loss of S corporation status, and the corporation can be brought back into the C corporation structure, if prior planning is not properly addressed. Often a shareholder will plan to have shares in an S corporation held in a separate trust after his or her death; however, that trust needs to be properly structured in order to continue with the entity’s S corporation status.
In addition to trust planning, there are various mechanisms that can be used to preserve S corporation status upon a shareholder’s death. First, if shares are left to an individual, such a transfer will not cause a loss of S corporation status, provided other S corporation requirements continue to be met. For the most part, individuals are considered as eligible S corporation shareholders. Further, a buy-sell agreement, if properly drafted, can provide for a transfer of shares on a shareholder’s death to an individual or to such individual’s living trust. Both such parties are eligible shareholders and can continue the entity’s tax benefits found with S corporation status.
Although trust planning is generally preferable for estate planning purposes, shares left to a trust may create a situation where S corporation status could be lost. Two types of trusts – known as a Qualified Subchapter S Trust (“QSST”) and an Electing Small Business Trust (“ESBT”) – can be used to preserve an S corporation election after a shareholder’s death.
To qualify as a QSST, a trust’s terms must provide that during the life of the current income beneficiary, the trust will have only one income beneficiary and under the terms of the trust, all of the trust's accounting income must be, or is required to be, distributed to the income beneficiary at least annually. This will cause the trust’s income to be taxed at the beneficiary’s income tax rate, which may be as high as 37% (the current highest marginal rate of income tax on ordinary income). The trustee of the trust must distribute trust accounting income directly to the beneficiary or, if a minor is the beneficiary, to a custodial account for the benefit of the minor. In addition, the trust's terms must require that any distribution of assets above the trust’s income can be made only to the current income beneficiary. The QSST must provide that the current income beneficiary's interest terminates at the earlier of (a) the current beneficiary's death or (b) the termination of the trust. If the trust terminates during the current income beneficiary's life, the trust's assets must be distributed to the current income beneficiary; at death, the trust’s assets are distributed to the beneficiary’s estate.
Unlike QSSTs, ESBTs may have multiple beneficiaries. Further, trust income does not have to be distributed annually, and can be accumulated inside the trust or distributed among the multiple beneficiaries. However, with the flexibility an ESBT brings over a QSST, the tax treatment of an ESBT is not as simple as that of a QSST. An ESBT can be divided into two portions: an “S corporation portion” consisting of the S corporation stock, and a “non-S portion” consisting of all other non-S corporation stock property. One shortcoming of an ESBT is that its S corporation portion is subject to an almost “flat rate” of tax, that being the highest marginal rate of income tax on ordinary income (again, currently 37%) without the benefit of utilizing lower, marginal rates. Further, because the trust pays tax on all the S corporation income from the “S corporation portion”, no matter if income has been distributed to the beneficiaries or not, the Section 199A QBI deduction related to the “S corporation portion” of the trust will reduce the S corporation portion’s income and such deduction will stay with the trust and not be allocated to the beneficiaries.
To qualify for QSST or ESBT treatment, each trust needs to make elections. Although procedural, this step is important as making the election timely can save time, money and stress involved with making a late election if making a timely election is missed. The issues involving use of a QSST or ESBT for future planning come up when a business owner is involved in estate planning. Although more refined estate plans contain provisions to modify a trust to allow for QSST or ESBT treatment, a business owner should review whether the QSST or ESBT structure makes sense for ownership after the business owner’s death to avoid issues where added costs and potential for losing S corporation status for an entity could come forward. Tax costs, accumulation of income and continuance of S corporation status need to be weighed to make a proper decision on how business ownership may be structured for the future.