Making a Trust an Eligible S Corp. Shareholder: QSST and ESBT Elections

Editor: Mark G. Cook, CPA, MBA

S Corporations

Eligibility requirements for an S corporation include that it must be a domestic corporation; have no more than 100 shareholders (under Sec. 1361(c)(1) all members of a family and their spouses and estates are treated as one shareholder); have only one class of stock; and have no nonresident alien shareholders. Shareholders may be only individuals, estates, certain types of exempt organizations, and certain types of trusts. This item describes eligible shareholder trusts and the elections they must make. An S corporation election may be jeopardized when a shareholder dies and his or her interest is transferred to a trust that is not eligible to be a shareholder or has not made the proper election.

Under Sec. 1361(c)(2)(A), the trusts that may be qualified shareholders of an S corporation are: (1) trusts treated as owned by a U.S. citizen or resident individual under Secs. 671—679 (grantor trusts); (2) trusts that immediately before the death of the deemed owner were treated as owned by a U.S. citizen or resident individual under Secs. 671—679, but only for a period of two years, beginning on the day of the deemed owner’s death (provided, however, that if an election is made under Sec. 645 to treat the trust as part of the estate, then the estate may hold the S corporation stock for the entire election period); (3) trusts to which stock has been transferred by a will, but only for two years; and (4) trusts formed primarily to exercise the voting power of stock transferred to them. If the trust does not fall under the above categories, it may still qualify as an S corporation shareholder by filing an election to be treated as a qualified subchapter S trust (QSST) or an electing small business trust (ESBT).

Qualified Subchapter S Trusts

Under Sec. 1361(d)(3), for a trust to qualify as a QSST, its terms must require that during the life of the current income beneficiary, the trust will have only one income beneficiary; and all of the trust’s accounting income must either be required by the terms of the trust instrument to be distributed, or actually be distributed, to the income beneficiary at least annually. The trustee must distribute trust accounting income directly to the beneficiary or to a custodial account for the benefit of a minor beneficiary. In addition, the trust’s terms must require that corpus distributions during the current income beneficiary’s life can be made only to that beneficiary; the current income beneficiary’s income interest terminates at the earlier of the current beneficiary’s death or the termination of the trust; and, if the trust terminates during the current income beneficiary’s life, the trust’s assets are all distributed to the current income beneficiary.

Under Regs. Sec. 1.1361-1(j)(3), a trust that has multiple beneficiaries can meet the QSST single-beneficiary requirement if each beneficiary has a separate and independent share of the trust, each of which is treated as a separate trust for federal income tax purposes. Spouses who are both income beneficiaries of a QSST will be treated as a single beneficiary if they are U.S. citizens or residents and they file a joint income tax return.

The trust’s current income beneficiary must make the QSST election under Sec. 1361(d)(2), by filing a statement with the information and in the manner prescribed by Regs. Sec. 1.1361-1(j)(6) and Rev. Proc. 2013-30. If the S corporation transfers its stock to the QSST on or before the date the corporation makes its S election, the QSST election may be made on Part III of Form 2553, Election by a Small Business Corporation.

Electing Small Business Trusts

Unlike QSSTs, ESBTs may have multiple beneficiaries, and trust income can be accumulated and/or sprinkled among the multiple beneficiaries. The tax treatment of an ESBT is different from, and more complicated than, that of a QSST. An ESBT has at least two portions: an S portion consisting of the S stock, and a non-S portion consisting of all other property. An ESBT may also have a grantor portion. Different tax rules apply to each portion of an ESBT. One shortcoming of an ESBT is that its S corporation portion is subject to the highest rate of income tax on ordinary income (currently, 39.6%).

The trustee must make the election to treat a trust as an ESBT within the two-month-and-16-day period beginning on the date of the trust’s receipt of the S corporation stock (see Regs. Secs. 1.1361-1(m)(2)(iii) and (j)(6)(iii)). The trustee makes the election by completing and filing the election statement described in Regs. Sec. 1.1361-1(m)(2). Where a corporation whose stock the trust holds makes an S election, the trustee must make the ESBT election within the two-month-and-16-day period beginning on the day the S election is effective.

Choice of Trust

The decision to elect to be a QSST or ESBT may hinge on the structure of each particular trust. Under Regs. Sec. 1.1361-1(m)(7), an ESBT may convert to a QSST and, under Regs. Sec. 1.1361-1(j)(12), a QSST may convert to an ESBT; but when making the choice between a QSST and an ESBT, the trustee must weigh tax costs of an ESBT against the benefit of its ability to accumulate income to the trust.

Late Election Relief

Relief is available for late QSST and ESBT elections under Rev. Proc. 2013-30. A trust must meet the following requirements when requesting relief for a late election:

• The current income beneficiary or trustee must have intended to treat the trust as a QSST or ESBT, respectively, as of the intended effective date;
• The beneficiary or trustee must make the request under Rev. Proc. 2013-30 within three years and 75 days after the intended effective date;
• The failure to qualify as a QSST or ESBT must have been solely because of the failure to timely file the proper election; and
• The failure was inadvertent, and the beneficiary or trustee has acted diligently to correct the mistake upon its discovery.

To obtain relief, the trustee of an ESBT or the current income beneficiary of a QSST must sign and file the appropriate election form, which must include the following statements:

1. A statement from the trustee of the ESBT or the current income beneficiary of the QSST that includes the information required by Regs. Sec. 1.1361-1(m)(2)(ii) (in the case of ESBT elections) or Regs. Sec. 1.1361-1(j)(6)(ii) (in the case of QSST elections);
2. In the case of a QSST, a statement from the trustee that the trust satisfies the QSST requirements of Sec. 1361(d)(3) and that the income distribution requirements have been and will continue to be met;
3. In the case of an ESBT, a statement from the trustee that all potential current beneficiaries meet the shareholder requirements of Sec. 1361(b)(1) and that the trust satisfies the requirements of an ESBT under Sec. 1361(e)(1) other than the requirement to make an ESBT election; and
4. Statements from all shareholders during the period between the date the S corporation election was to have become effective or was terminated and the date the completed election form is filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and for all subsequent years.

Additional procedural requirements for requesting relief are found in Rev. Proc. 2013-30.

EditorNotes

Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-422-7244 or mcook@singerlewak.com.

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