If a qualified subchapter S trust (QSST) owns both S corporation stock and other assets, determining whether the income from the other assets must be distributed to the beneficiary depends on the terms of the trust document. It is possible to draft a QSST for which the income from other assets can be accumulated inside the trust.
A QSST is one of several types of trusts that are eligible to hold stock in an S corporation. Its two primary requirements are (1) there can be only one beneficiary of the trust and (2) all income must be distributed at least annually (Sec. 1361(d)(3)(B)).
In this context, "income" means fiduciary accounting income (also called trust accounting income, or TAI) of the trust, rather than taxable income. For example, if an S corporation's Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., shows $100,000 of taxable income, but the S corporation makes a distribution of only $45,000, the TAI required to be paid from the trust to the beneficiary is only $45,000. From an income tax perspective, the full $100,000 will be taxable to the beneficiary because the QSST election causes the portion of the trust consisting of the S corporation stock to be treated as a grantor trust to the beneficiary (Sec. 1361(d)(1)(B)). The income from any assets (other than from the S corporation) is taxed based on normal trust income tax rules.
However, one of the requirements to qualify for QSST status is that the trust must distribute (or be required by its terms to distribute) all the income of the trust currently to the sole income beneficiary. Therefore, a common assumption is that the non-S corporation portion of the trust must be a simple trust (which is required to distribute all income to the beneficiary) rather than a complex trust (which is allowed to accumulate income). With proper planning, however, the non-S corporation income can be accumulated.
Many times, a trust is created before it owns S corporation stock, and therefore it might have multiple beneficiaries or does not require all income to be distributed annually. Typically, the only way for these types of trusts to subsequently become the owner of S corporation stock is to elect to become an electing small business trust (ESBT). However, it frequently is preferable to become a QSST rather than an ESBT because of the tax rate savings. Additionally, QSSTs may provide opportunities to minimize the 3.8% tax on net investment income. To facilitate qualification as a QSST, the trust document should contain language that will trigger a change in the provisions of the trust consistent with QSST requirements if S corporation stock is acquired. This can occur in two ways.
The first way to structure a change in the trust is to maintain the status as a single trust but mandate that TAI be distributed instead of accumulated. If there are multiple beneficiaries, adding S corporation stock also will necessitate creating a separate share for each beneficiary. For example, if a nonqualifying trust with three beneficiaries is revised to be three separate shares, each of which requires that all income be paid to one beneficiary, each separate share is eligible to make a QSST election. This is permissible based on the flush language of Sec. 1361(d)(3), which states that a "substantially separate and independent share of a trust within the meaning of section 663(c) shall be treated as a separate trust for purposes of this subsection and subsection (c)." Regs. Sec. 1.1361-1(j)(3) reiterates the flush language by cross-referencing the separate-share rules found in Sec. 663(c) and explaining that each separate and independent share must meet the QSST requirements.
However, since QSSTs must distribute all of their income annually, if a separate share owns other assets and interests in addition to S corporation stock, the income on those other assets would constitute TAI that must be distributed to the beneficiary (Regs. Sec. 1.1361-1(j)(1)(i)). Therefore, if the original trust was a complex trust that wants to become a QSST, this change would force the trust to distribute all TAI to the income beneficiary.
Overall, using the flush language of Sec. 1361, Sec. 663(c), and Regs. Sec. 1.1361-1(j)(3) would allow a trust to resolve the issue of having multiple beneficiaries (by creating a separate share for each beneficiary, so long as each separate share had only one beneficiary), but it would not resolve the issue of being required to distribute income from the other assets.
To be able to accumulate the income earned on non-S corporation assets, the S corporation stock must be transferred into a subtrust separate from the other assets and interests in the trust. In this way, the TAI related to the S corporation stock can be distributed while allowing the income from the other interests and assets to continue to be accumulated inside a trust. Under this scenario, the subtrust would elect QSST status, while the original trust could continue to be a complex trust.
If the original trust has multiple beneficiaries, then a separate S corporation subtrust would need to be created for each beneficiary. The original trust, however, can continue to hold the other assets as a complex trust with multiple beneficiaries. Each subtrust can have identical provisions to the original trust regarding disposition of the assets upon the death of the beneficiary, although if the trust closes during the lifetime of the beneficiary, all the assets must be paid only to that beneficiary (see Secs. 1361(d)(3)(A)(ii) and (iv)). Each separate trust (or subtrust) would need to have a separate employer identification number and file a separate income tax return (Regs. Sec. 1.671-4(b)(6)(iii)). Therefore, one additional tax return may be required if subtrusts are used. For example, if there are four beneficiaries of a single complex trust and four subtrusts are created to hold the S corporation stock, the original trust would remain to hold the other assets, which means five returns are needed. If the original trust simply separated into four separate QSSTs (each holding both S corporation stock and other assets), only four returns would be required.
Even if a trust is not currently the owner of S corporation stock, the trust instrument nevertheless should include language that would be triggered when the trust becomes the owner of S corporation stock, that modifies the trust provisions to make it eligible to make an election to be a QSST. Although one method to accomplish this is to require that all income of the existing trust be distributed, a preferable method would be to transfer the S corporation stock to one or more separate subtrusts that each are eligible to make a QSST election. In this way, any income generated by the other assets or investments can be accumulated or paid at the discretion of the trustee, even though any income generated by the S corporation stock will be required to be distributed to the income beneficiary.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.