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S Corporations and Estate Planning

November 16, 2023

Owning shares in an S Corporation can present some unique issues when it comes to your estate planning. An S-Corp is a corporation that elects special tax status under the Internal Revenue Code (IRC) Subchapter S. Often a business owner chooses S-Corp status because of the tax benefit. Profits get distributed to shareholders who pay taxes on those profits. This is why S-corps are often referred to as pass through entities–the income taxes are passed through to the individual shareholders. In contrast, with other types of corporations, the profits are taxed at the corporate level and then taxed again when they are received by shareholders. While most business owners would prefer to avoid double taxation, S-Corps are only permitted in limited cases. Additionally,  many closely-held businesses elect S-corp status when shareholders are looking to use the shares to secure their family’s future in their estate plan. However, there are pitfalls to be aware of in this scenario.

What Are the Requirements of an S-Corp

The IRC requires that you meet all of these requirements to qualify as an S-Corp:

  1. Incorporation in the U.S.
  2. Only one class of stock can be offered
  3. No more than 100 shareholders are permitted
  4. Shareholders must be individuals, specific types of trusts or estates, or certain tax-exempt organizations
  5. Shareholders cannot be partnerships, certain corporations, or non-resident aliens.

Estate Planning Considerations with S Corp Shareholders

In S-Corps that are closely held businesses, frequently, the shareholder intends for the interest in the S-Corp to provide for his or her family, so the estate plan must focus on how to best accomplish that goal. For example, what do you want to happen to your business when you die? Will your business be passed as an ongoing entity that will produce income? Is there a plan in place for selling your interest to other shareholders, such as by executing a buy-sell agreement or other option? Will the business be shut down and assets sold when you can no longer run it?

Using Trusts for Estate Planning

Depending on the needs of your family, you may want to use a trust to protect the S-Corp shares. While you are alive, you can create a grantor trust. This type of trust is considered a qualified S-Corp shareholder, which means that you can maintain S-Corp status and the tax benefits.

An estate or testamentary trust (a trust created by a will) is also a qualified shareholder but only for a limited period of time (two years). Thereafter, it must distribute the shares to a qualified shareholder, or the testamentary trust must be eligible as either a Qualified Subchapter S Trust (“QSST”) or an Electing Small Business Trust (“ESBT”)  and timely elect such status. Lifetime trusts that are treated as nongrantor trusts must also qualify and make a timely election in order to be treated as a QSST or an ESBT.

Qualified Subchapter S Trust (QSST)

The requirements for a QSST are:

  1. There can only be one present income and principal beneficiary
  2. The beneficiary must be a U.S. citizen or resident
  3. The sole beneficiary must receive all the income from the trust at least annually
  4. The income beneficiary must timely file an election for QSST status. 

A drawback of a QSST is that the trust is required to distribute the income whether the beneficiary needs the money or not. There can also only be one present income beneficiary, which might not make sense if the intent is to provide for several family members.  Note that any mandatory distribution of income under the trust provisions may subject such income distributions to creditor claims, which could undermine the asset protection features of the trust.

Electing Small Business Trust (ESBT)

In an ESBT, all trust beneficiaries must meet specific requirements set by the IRS. The trustee must also file an election for ESBT treatment within the proscribed time limit.

The downside of an ESBT is that the income is taxed at the highest federal income tax rate, so the trust may pay more tax than the beneficiary would pay if the income were taxed to them.

Other Considerations

If you do want to place your S-Corp shares in a trust, you must ensure that the trust is a qualified shareholder. If it is not a qualified shareholder, you may jeopardize the S-Corp status of the corporation for all shareholders. This means losing the tax benefits and you may also be liable under the S-Corp’s shareholder or operating agreement for damages. Many agreements have a provision that restricts shareholders from transferring their shares in a way that loses S-Corp status.

With a testamentary trust, if the trust cannot qualify for either the QSST or ESBT option, the shares must be distributed as per the terms of the trust and any corporate documents (shareholder or operating agreement). If that cannot be done, then the trust can be decanted, which involves moving assets out of the trust into a new trust that would be a qualified S-Corp shareholder.

The best way to protect and pass on your S-Corp interests is to consult with an attorney. Our lawyers can evaluate your situation and help develop a solution that meets your needs and goals. Contact us for a consultation to learn how we can assist you in creating a comprehensive estate plan.

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