The rules regarding what types of trusts can be eligible S corporation shareholders are complex. Private letter rulings frequently are issued regarding (1) stock being transferred to a disqualified trust or (2) a trust that is already a shareholder (and was previously eligible) somehow becoming ineligible and thus causing a termination of S corporation status. Some of the situations are logical and easily recognizable as a problem, but many involve situations that practitioners would not immediately identify as the root of any concerns.
In general, estates and six types of trusts are eligible as S corporation shareholders, with the most common being grantor trusts (including a former grantor trust for two years post-death), electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), and testamentary trusts (for two years after funding). Most practitioners realize that a properly completed and timely filed election must be made for a trust to become an eligible ESBT or QSST, but there are many other problems that a practitioner may not easily recognize. The following are 10 ways that S corporations can lose their S election status, most of them involving trusts.
1. Trusts Owned by More Than One Individual
Grantor trusts (either revocable or irrevocable) are eligible under Sec. 1361(c)(2)(A)(i) but only if the trust has only one grantor (although spouses generally are treated as one shareholder). Thus, a trust that is taxable to multiple individuals under Sec. 671 would not be eligible to hold S corporation stock.
2. Foreign Trusts
A foreign trust (as defined in Sec. 7701(a)(31)) is not eligible to hold S corporation stock (Sec. 1361(c)(2)(A), flush language). However, it sometimes is difficult to determine that a trust actually is a foreign trust. In fact, a trust that originally was a U.S. trust can become a foreign trust merely because of a change in trustee. This could include situations where multiple co-trustees exist and foreign trustees obtain the ability to control the substantial decisions of the trust, even if the U.S. co-trustee accomplishes the majority of the actual activity.
3. Nonresident Aliens
An S corporation cannot have a nonresident alien as a shareholder (Sec. 1361(b)(1)(C)). Therefore, previously valid S corporations have become disqualified when an existing shareholder who formerly was a resident alien (an eligible shareholder) moved out of the United States (thus becoming a nonresident alien) or abandoned permanent resident status (Letter Rulings 199924018 and 201032034). Similarly, a corporation lost its S status when a shareholder renounced U.S. citizenship (Letter Ruling 200006041).
4. Nonresident Aliens and ESBT and QSST Elections
The nonresident alien issue also can negate an otherwise valid ESBT or QSST election, as illustrated by Letter Ruling 201238017. In this case, a potential current trust beneficiary was a nonresident.Since all applicable beneficiaries of a QSST or an ESBT must be individuals who otherwise would be eligible to hold S corporation stock directly, the beneficiary's nonresident alien status caused him to become an ineligible shareholder, thus causing the trust to immediately become ineligible, even though no change of ownership of the stock occurred. The same issue could arise if an ESBT document provides that any "after-born" children or grandchildren are automatically added as beneficiaries, and a grandchild is born who is not a U.S. citizen.
5. Charitable Remainder Trusts
A charitable remainder trust (CRT) is not an eligible shareholder. Thus, in Letter Ruling 199908046, when an S corporation issued additional shares of stock to various individuals and entities, including a CRT, the S corporation status was terminated. Although Sec. 1361(c)(6)(B) provides that S corporation stock can be owned by a charitable organization (including a private foundation) that is described in Sec. 501(c)(3) and is tax-exempt per Sec. 501(a), a CRT instead is governed by Sec. 664.
Even though IRAs often are structured as trusts for legal purposes, Letter Rulings 200250009 and 201408018 illustrate that an IRA is not eligible as a shareholder of S corporation stock. Although Sec. 1361(c)(6)(A) permits S corporation stock to be owned by a qualified pension plan (as defined in Sec. 401(a)), an IRA instead is tax-exempt under Sec. 408. Similarly, a Roth IRA is not an eligible shareholder, since Sec. 408A governs Roth IRAs (see Taproot Administrative Services Inc., 679 F.3d 1109 (9th Cir. 2012)).
7. Defective Trust Provisions
Sometimes, certain provisions included in a trust document may seem acceptable but can inadvertently make a trust ineligible. For example, in Letter Ruling 201451001, a grantor created an irrevocable trust solely for the benefit of one beneficiary.However, the trust was not eligible to make a QSST election because it provided that if the trust property were included in the grantor's taxable estate upon death, the trust assets could be used to pay a portion of the grantor's estate tax. This seemingly unrelated and unimportant provision indirectly made the grantor a potential beneficiary of the QSST, meaning that the beneficiary was not the sole beneficiary of the trust, making it ineligible to make a QSST election. Another example is a will that provided that shares were to be transferred to a trust that would have been eligible as a QSST, except that the income beneficiary was given a power to direct the trust to pay his income to someone other than himself. Therefore, the trust was not eligible to make a QSST election. Taxpayers have made this mistake several times (Letter Rulings 201233014, 201419009, and 201426001).
8. Defective Elections
Sometimes, a QSST or an ESBT election is timely filed, but the procedures for proper filing are not followed. In Letter Ruling 201144018, the trustee of a trust, rather than the beneficiary, signed a QSST election, and thus the election was not valid. (The same issue occurred in Letter Ruling 201516009.) Similarly, an ESBT election would be invalid (even if filed timely) if it were signed by the beneficiary rather than the trustee. Likewise, for a married couple living in a community property state, any election must be signed by both spouses (since both spouses automatically have ownership interests in stock held as community property), rather than by only the spouse who is nominally the shareholder (Letter Ruling 201240012). Finally, in Letter Ruling 201516009, the trustee of a grantor trust, rather than the grantor himself, signed the Form 2553, Election by a Small Business Corporation, making the S corporation election invalid.
Letter Ruling 201442047 involved an apparent "decanting." An existing ESBT contained provisions that the grantor apparently no longer desired, so a new trust was created with the same trustee and beneficiary but with different administrative provisions. The trustee transferred the S corporation shares from the old trust to the new trust, but the trustee did not timely file a new ESBT election. Therefore, the new trust was an ineligible shareholder.
10. Failure to Make Timely Elections
Failing to make timely elections is pervasive. This includes not only the S corporation election itself (on Form 2553) but also an election to make a trust an eligible shareholder as either an ESBT or a QSST within two months and 15 days after the stock is transferred into the trust. But in several unexpected situations a necessary election may be missed. For example, if a trust is a grantor trust to one individual, it is eligible as an S corporation shareholder, even though it is irrevocable (rather than revocable). However, upon termination of the grantor trust status, a separate election is necessary, even though there might not be any change in legal ownership of the stock. The deadline for making the election will depend on the situation:
- If the trust is irrevocable and the grantor dies, the trust is eligible to hold S corporation stock for two years (Sec. 1361(c)(2)(A)(ii)). This would apply to both intentionally defective irrevocable trusts (IDITs) as well as grantor retained annuity trusts (GRATs).
- Interestingly, the same rule applies to a QSST when the beneficiary of the QSST dies (see Letter Rulings 201420005 and 201516016). This is because the QSST election causes the trust to become a grantor trust to the beneficiary, even though the beneficiary did not create or fund the trust (Regs. Sec. 1.1361-1(j)(8)). Therefore, the rules applicable when the grantor dies apply upon the death of the QSST beneficiary.
- If the trust is revocable and the grantor dies, the trust probably is eligible to make a Sec. 645 election to be treated as an estate, and thus the trust is eligible to hold S corporation stock not just for two years but rather until the period of estate administration is complete (Regs. Secs. 1.645-1(a) and 1.1361-1(h)(1)(iv)).
- If the grantor trust ceases to be treated as a grantor trust (e.g., the grantor "toggles off" an IDIT), then either an ESBT or a QSST election must be made within two months and 15 days after the termination of grantor trust status (Letter Rulings 201516001, 201516002, 201445001, 201445003, and 201423013). The two-year eligibility period of Sec. 1361(c)(2)(A)(ii) applies only upon the death of the grantor.
- The same is true upon termination of grantor trust status for a GRAT at the end of the payment period (Letter Ruling 201425003).
In most of the situations discussed here, the only way to obtain a waiver of an inadvertent termination of S corporation status is to obtain a private letter ruling, which can be very costly and time-consuming (see Rev. Proc. 2016-1). Although Rev. Proc. 2013-30 provides methods to obtain a waiver of an inadvertent termination upon failure to timely file an election (items 9 and 10 above), taxpayers cannot use this revenue procedure to avoid termination of S corporation status involving a trust that simply is ineligible to make an election.
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.