Creative Ways of Achieving Grantor Trust Status

Editor: Frank J. O’Connell Jr., CPA, Esq.

Sometimes a C corporation considering S corporation status has a trust as a shareholder. If the trust was not originally drafted with the intent of being an eligible S corporation shareholder but continues to hold the stock, the corporation could be prevented from making the S election. Nevertheless, it may be possible for a knowledgeable tax adviser to solve this problem if he or she knows the intricacies of the grantor trust rules of Secs. 671–677.

This item has three sections. The first presents a summary of the eight entities that qualify as eligible shareholders. The second explores the advantages and disadvantages of the three most frequently used types of trusts that qualify as S shareholders and why grantor trusts are often the preferred trust type for holding S corporation stock. The third section focuses on some less obvious ways to achieve grantor trust status, which will allow trusts that perhaps were not originally intended to hold S corporation stock to qualify as eligible shareholders.

Entities That Qualify as Eligible

S Corporation Shareholders Sec. 1361 provides that an S corporation may have the following entities as eligible shareholders:

• An individual (however, a nonresident alien cannot be a shareholder);
• An estate;
• A voting trust;
• A grantor trust, during the grantor’s lifetime;
• A grantor trust, for two years following the grantor’s death;
• A two-year rule trust;
• A qualified subchapter S trust (QSST); and
• An electing small business trust (ESBT).

Each of the eligible trusts is described more fully below.

Voting trust: A voting trust is one that is created primarily to exercise the voting power over stock transferred to it. To qualify, there must be a written document that gives the right to vote to one or more trustees. The trust document must require that dividends on the stock be paid directly to the beneficial owners and that the title and possession of the stock be delivered to the beneficial owners when the trust terminates. Finally, the trust must terminate, by its terms or state law, on or before a specific date or event. In practice, voting trusts are seldom used.

Grantor trust: Grantor trusts, however, are very commonly used. These are often trusts for which the person who created the trust (the grantor) retains sufficient powers over the trust funds so that the trust is treated for income tax purposes as if the grantor is the direct owner of the trust assets (Sec. 671). In order to qualify as an S corporation shareholder, the trust must be treated as owned by only one person. If the trust loses its grantor trust status other than by reason of the death of the grantor, the trust is immediately disqualified as a shareholder, and the corporation’s S election is immediately terminated. This could happen, for example, when a grantor amends the trust to make the formerly revocable trust irrevocable or when the grantor terminates or waives a power that he or she previously held (that caused the grantor trust status).

Grantor trust, following grantor’s death: If the grantor dies and the trust continues in existence, the S corporation election continues to apply for up to two years from the grantor’s death.

Two-year rule trust: Two-year rule trusts are testamentary trusts or living trusts that receive distributions from the grantor’s estate after December 31, 1996, under pour-over wills and can hold S corporation stock for up to two years, even if they are not otherwise eligible shareholders. The two-year period begins on the date the stock is actually transferred to the trust. This provides some time for a buyout or distribution of the stock to a qualified shareholder.

QSST: A QSST is a trust that under Sec. 1361(d)(3) contains all the following required terms:

• During the life of the current income beneficiary, there can be only one beneficiary;
• All income either is required to be distributed annually or is in fact actually distributed annually;
• Any corpus distributed during the life of the current income beneficiary must be distributed to that person;
• The current income beneficiary’s income interest terminates on the earlier of his or her death or termination of the trust;
• If termination of the trust occurs during the life of the current income beneficiary, the trust must distribute all its assets to that person; and
• The beneficiaries must file an election to be treated as a qualifying trust.

ESBT: The Small Business Job Protection Act of 1996, P.L. 104-188, broadened the type of trusts that are eligible S corporation shareholders. Starting with tax years beginning after December 31, 1996, ESBTs can be eligible shareholders. To be an ESBT, Sec. 1361(e) states that the following conditions must be met:

• All beneficiaries of the trust must be individuals or estates eligible to be S corporation shareholders (except charitable organizations may hold contingent remainder interests);
• No interest in the trust may be acquired by purchase—generally, interests must be acquired by gift or bequest; and
• The trustee must file an election to be treated as a qualifying trust.

The portion of an ESBT that consists of S corporation stock is treated as a separate trust for purposes of computing the income taxation of the trust. The S corporation income of this portion of the trust is taxed at the highest trust income tax rate (currently 35%). In computing the trust’s income tax on this portion of the trust, no deduction is allowed for amounts distributed to the beneficiaries. The taxable income of the S corporation portion of the trust includes items allocated to the trust on the Schedule K-1 received from the S corporation, less any state or local taxes and administrative expenses properly allocable to the S corporation portion of the trust. Gain or loss on the sale of S stock by the trust is also taxed to the S portion of the trust. To the extent there are other assets owned by the trust in addition to the S corporation stock, the income tax on those assets is computed separately under the normal income tax rules applicable to trusts.

Advantages/Disadvantages of Most Frequently Used Trusts to Hold S Corporation Stock

There are three commonly used types of ongoing trusts that qualify as S corporation shareholders: grantor trusts, QSSTs, and ESBTs (as described above). Of those trust choices, a QSST or an ESBT may not be the most desirable for various reasons, so the grantor trust becomes the solution of choice.

There are circumstances in which a QSST will work well. However, the trustee of a QSST must either be required by the terms of the document to pay out all the net income of the trust to the beneficiaries or must actually pay out all income. In addition, during the lifetime of that beneficiary, principal of a QSST may be paid only to that beneficiary. If the beneficiary of a QSST is a minor child, it may not be desirable to pay out all income of the trust to that minor child.

An alternative the trustee might consider is an ESBT since trust distributions do not affect the taxation of S corporation stock income held by an ESBT. In fact, if the beneficiary is in the highest marginal tax rate him- or herself, it could be advantageous for an ESBT to hold the S corporation stock rather than an individual (remember that every dollar of income of an S corporation held by an ESBT is taxed at the highest marginal tax rate). This is because an individual’s itemized deductions are phased out at certain levels of adjusted gross income, and layering on additional S corporation income will only add to the phaseout. Because no such limitation applies to an ESBT, an overall income tax savings will result if an ESBT holds and is taxed on the S corporation stock. However, if not all trust beneficiaries are in the highest marginal bracket themselves, the overall tax could be higher if the stock is owned by an ESBT because of the 35% flat tax rate that applies to the S corporation portion of an ESBT.

In many situations, grantor trust treatment often becomes the preferred way to qualify a trust as an eligible S corporation shareholder.

Less Obvious Ways to Achieve Grantor Trust Status

Any analysis of the proper classification of a trust type begins with a thorough review of the language contained in the applicable trust document. Sometimes the provisions of the trust document are straightforward, and it is obvious from a simple analysis that a trust qualifies as a grantor trust. Other documents may not be as clear, especially in situations in which the documents were drafted many years ago, making the analysis of the proper trust type more challenging.

Once the trust document has been thoroughly analyzed, the next step involves the application of the proper Code sections in making the determination of trust type for income tax purposes. Again, this may be a fairly simple analysis because there are some straightforward Code sections that cause the entire trust to be classified as a grantor trust. But sometimes the tax adviser must use multiple Code sections to get the entire trust to be treated as a grantor trust.

Some Code sections may apply grantor trust status to the income portion of the trust, while other Code sections may apply it only to the principal portion of the trust. Because the entire trust needs to be taxed to the same grantor in order to result in an eligible S corporation shareholder, the tax adviser must review the Code provisions very closely in these situations.

For example, under Sec. 677(a), the grantor shall be treated as the owner of any portion of a trust whose income (note that this is referring to the income portion of a trust) without the approval or consent of any adverse party is (or in the discretion of the grantor or a nonadverse party or both may be):

• Distributed to the grantor or the grantor’s spouse;
• Held or accumulated for future distribution to the grantor or the grantor’s spouse; or
• Applied for the payment of life insurance premiums on the life of the grantor or grantor’s spouse.

If the trustee is an adverse party (for example, a child who is also remainder beneficiary of the trust), the trust document must require the income to be paid. But if the trustee is a nonadverse party, the test as to whether the income portion of the trust qualifies as a grantor trust is relaxed—it is sufficient that the income may be (rather than must be) paid.

Once the adviser determines that the income portion of the trust qualifies as a grantor trust, the analysis shifts to the principal portion of the trust. If the grantor can control who will receive the beneficial interest of the trust, the principal portion will also qualify as a grantor trust under Sec. 674 and the regulations thereunder. Sec. 674 states that the grantor shall be treated as the owner of any portion of a trust for which the beneficial enjoyment of the corpus (or the income therefrom) is subject to a power of disposition exercisable by the grantor or a nonadverse party, or both, without the approval of any adverse party.

Following are some examples of these concepts:

Example 1: The trust document indicates that the trustee, T1, shall pay to the grantor, G1, or expend for her benefit such part or all of the trust’s net income and principal as T1 determines is desirable for the grantor’s health, education, maintenance, and support and for the health, education, maintenance, and support of any person dependent on G1. T1 is a nonadverse party.

Because the trust’s income and principal may be paid to G1 and because T1 is a nonadverse party, the income portion of the trust qualifies as a grantor trust under Sec. 677, and the principal portion of the trust qualifies as a grantor trust under Sec. 674. Therefore, because both portions of the trust qualify as grantor trusts, this trust qualifies as an eligible S corporation shareholder.

Example 2: G2 is the grantor of a trust. Per the provisions of her trust document, the trustee, T2, is required to pay G2 the trust’s entire net income during her lifetime. G2 has a testamentary power of appointment over the remainder of the trust to appoint to her surviving spouse if he is alive at her death, but if he has predeceased her, the trust estate will be distributed to the heirs of G2’s mother. Under the trust instrument and the law of G2’s state, capital gains are added to the corpus of the trust.

The result is that the trust is a grantor trust with respect to the income portion per Sec. 677 because G2 receives all the trust’s net income. Because G2, as the donor, has testamentary power of appointment over the remainder of the trust, it meets the requirements of Regs. Sec. 1.674(b)-1(b)(3), resulting in grantor trust treatment over the principal portion of the trust as well. This is a grantor trust that qualifies as an eligible S corporation shareholder.

Conclusion

As in the examples above, trusts that may not appear to qualify as S corporation shareholders could actually be grantor trusts eligible to own S corporation stock. By carefully considering the intricacies of the grantor trust rules in Secs. 671–677, one may discover that a trust not originally drafted with the intent of holding S corporation stock may be an eligible shareholder after all.

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EditorNotes

Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com