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Can Trusts Take Advantage of the Tax Benefits of S Corporations?

When it comes to tax planning, business owners should learn the difference between a C and an S corp trust.

The letters refer to the subchapter of the federal tax code relating to the income taxation of corporate structures. For businesses, S corporations can provide a way to avoid the kind of double taxation that C corporations incur.

What is the difference between an S Corp and a C Corp?

By way of background, C corporations must pay taxes on earnings at the corporate level, and their shareholders are separately taxed on amounts distributed to them as dividends as well. Therefore, each dollar earned by the C corporation is taxed twice before it reaches the hands of the corporation’s shareholders. In an S corporation, tax income is taxed only once, with the tax being paid by the corporation’s shareholders. In essence, this leaves more money for the shareholder and less for the taxing authorities.

While the tax benefits of S corporation status can be substantial, restrictions apply: the corporation must have 100 or fewer shareholders (companies like Amazon or EBay need not apply) and the shareholders must generally be individuals or estates.

Tax Benefits of S Corp Trust Status for Business Owners

Business owners should be aware that, with proper planning, trusts can also own S corporation shares and take advantage of the associated tax benefits. S corporation shares may end up being held in trust in a variety of different ways. For estate planning or asset protection purposes, a shareholder may elect to leave their interest in a business to a trust instead of passing the shares directly to an heir (for example, if a minor child is the beneficiary). Individual shareholders can also leave S corporation shares to a trust through their estate plans.

Alternately, the trustees of a Trust which owns C corporation stock may wish to convert the corporation into an S corporation.

Trusts, however, face complications when they own S corporation stock. If not handled properly, trust ownership of S corporation stock may force the corporation to be treated as a C corporation, subjecting it to the heavier tax burden discussed above. Trusts are not permitted to be shareholders of an S corporation unless they qualify for an automatic exemption or file a timely election to be treated as a qualifying trust. Most trusts which receive S corporation stock through a stockowner’s estate plan do not qualify for the automatic exemption, so they must make an election to be treated as a qualifying trust within two years, two months, and 16 days of the stockowner’s death.

There are two types of qualifying trusts:

  • A Qualified Subchapter S Trust (QSST): This type of trust can have no more than one income beneficiary, and all income from the corporation must be distributed annually. In cases where there are multiple beneficiaries, each beneficiary must be treated as if they have their own, separate trust. The trustee of a trust with multiple beneficiaries can create sub-trusts that allow for easier management, but in order to be a QSST, all income received by each sub-trust must be distributed to the beneficiary of that specific sub-trust.
  • An Electing Small Business Trust (ESBT): This type of trust is less restrictive but more complicated than a Qualified Subchapter S Trust. The ESBT retains the qualities of a traditional trust. Income does not need to be distributed in the same year it was earned. However, taxation is far more complex. The ESBT has to treat S corporation assets separately for IRS purposes, which can be complicated. and is a situation that requires experienced counsel to help wade through.

Shareholders looking to place their S corporation stock in trust should consider the potential estate and gift-planning issues which may arise. Often, the entire purpose of placing stock in a trust is to protect the assets for children or others who are too young, or otherwise unqualified to manage money. In the case of a QSST, the trust holds and controls the shares, and the child gets the income. To prevent the child from prematurely having access to trust income, a QSST may provide for the income to be distributed to a Uniform Transfer to Minors Act (UTMA) account, which will be managed for the child’s benefit until the child turns 18 or 21. If a UTMA is not utilized, an Electing Small Business Trust might be the better option, because the trustee maintains control over both the stock and the income.

The Importance of Seeking Professional Counsel for Business and Estate Planning

It’s critical to ensure that a trust is qualified under IRS rules to handle S corporation stock. If the trust doesn’t qualify, it has two years to resolve its S corporation stock ownership, failing which the corporation and all of its shareholders (not only the trust) may lose the tax benefits of an S corporation. Because of the restrictions imposed on rules S corporation ownership, families forming a business might consider the possibility of forming an LLC (a limited liability company) instead. LLCs are more flexible and trusts of any kind can own a membership interest in an LLC.

Whether business owners are forming a C corporation, an S corporation, S corp trust, or an LLC, the smart move is to consult with counsel — once when forming their business and again when they are planning their estate.

This post does not constitute legal advice or establish an attorney-client relationship.

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