Using qualified Subchapter S trusts (QSSTs)

The Internal Revenue Code specifies broad categories of trusts that qualify as S shareholders. One of these, the qualified Subchapter S trust (QSST), is modeled after the grantor trust. It is eligible to hold stock in an S corporation, and, under the S corporation rules, it is treated as a Subpart E trust (Sec. 1361(d); Regs. Sec. 1.1361-1(j)).

The QSST may be useful for estate planning purposes. It may also be useful for holding S stock for the benefit of a minor or incompetent.

Net investment income tax of a QSST

Individuals, estates, and certain trusts are subject to a net investment income tax, which is an additional tax of 3.8%. The net investment income tax applies to estates and trusts if there is undistributed net investment income and the adjusted gross income (AGI) exceeds the highest fiduciary income tax bracket for the year ($12,500 in 2017) (Sec. 1411(a)(2)). The tax also applies to QSSTs to the extent the net investment income is retained in the trust. Although the S corporation income of a QSST is taxed to the individual income beneficiary, capital gain on the sale of the S corporation stock is taxed at the trust level. If the QSST’s AGI exceeds the threshold amount, the QSST would owe the net investment income tax on the capital gain.

With the higher income tax rates at lower threshold amounts and the 3.8% net investment income tax on undistributed net investment income at such a low threshold for estates and trusts, fiduciaries should consider opportunities to minimize the tax liability by making additional distributions of income to beneficiaries (if permitted and optimal, based on all the facts and circumstances).

Designing a QSST

The beneficiary must elect QSST status, and the QSST must meet the following requirements (Regs. Sec. 1.1361-1(j)(1)):

• The trust must have only one income beneficiary during the life of the current income beneficiary, and that beneficiary must be a U.S. citizen or resident;
• All of the income of the trust must be (or must be required to be) distributed currently to the one income beneficiary;
• Any corpus distributions that might occur during the life of the current income beneficiary must also go to that one beneficiary;
• The income interest of the beneficiary must terminate on the earlier of the beneficiary’s death or the trust’s termination;
• An election to be treated as an eligible S corporation shareholder must be made separately for the stock of each S corporation held by the trust (Regs. Sec. 1.1361-1(j)(6)); and
• A new (successor) income beneficiary does not have to file an election to continue QSST status (however, the new beneficiary may affirmatively refuse to consent to the QSST election, which would invalidate the QSST election and revoke the S election (Regs. Sec. 1.1361-1(j)(9))).

Example 1. Designing a QSST: A is the CEO and one of 15 shareholders in G Corp., a successful manufacturing firm that has been an electing S corporation for several years. The corporation has a history of profitability and regularly distributes its net income to the shareholders. A’s mother, H, is an elderly widow who requires expensive, long-term nursing care. H’s financial resources are limited, and A has been providing an increasing amount of support for her mother. A is paying individual income tax at the top rates, while her mother has minimal taxable income. A would like to gift about 20% of her stock in G to her mother, as this would provide sufficient cash flow to supportH.

Because H’s health causes her to be less than fully rational on some days, A is concerned about making an outright gift of her G stock to H. Instead, she wants to use some form of trust providing income to H. At H’s eventual death, A wants to specify her minor child, B, as a successor income beneficiary, with the trust to terminate by distributing the stock to the child when she reaches the age of majority. Since this is a split-interest plan, the trust will not qualify as a grantor trust in which all income and corpus is treated as owned by a U.S. citizen or resident. However, a split-interest trust may qualify as a QSST. To create a QSST for H, the trust must comply with the six provisions listed above.

After reviewing these criteria with A, the planner concludes that a QSST would be consistent with her objectives. The trust instrument would direct all income to H during her lifetime, with termination of the trust delayed until after her death. The income of the trust includes distributions from the S corporation but does not include the trust’s pro rata share of the S corporation’s items of income, loss, deduction, or credit (i.e., passthrough items) (Sec. 1361(d)(3); Regs. Sec. 1.1361-1(j)).

Distributions from the S corporation to the trust and income from sources within the QSST (other than S corporation passthrough items) are subject to the annual distribution requirement. For example, if the S corporation allocated $20,000 of income to the trust and made a distribution of $15,000 to the trust, the trust would be required to distribute $15,000 to H. The $20,000 of passthrough income is not under the annual distribution requirement. H includes the $20,000 in gross income on her Form 1040, U.S. Individual Income Tax Return, however. Upon H’s death, the trust agreement can authorize the trustee, in accordance with state law, to distribute income for the period from the last distribution date to the date of her death either to her estate or to A’s child as the successor beneficiary (Rev. Rul. 92-64).

As a final point, the practitioner would ensure that A properly complies with any required gift tax filings. Under the trust terms, A is creating a split-interest trust, consisting of a life estate transferred to her mother and a remainder interest to her child. (See Notice 89-24, regarding the valuation formula for split-interest gifts.) In addition, there will be no step-up in basis in the stock at H’s eventual death, as would have occurred if the stock had been given outright toH.

As Example 1 shows, a QSST may be a split-interest trust for the benefit of the current income beneficiary with a remainder interest for the benefit of another person. When it is desirable to divide the remainder interest among two or more beneficiaries, additional QSSTs can be used to preserve the corporation’s S election.

Example 2. Recognizing when more than one QSST is needed: Assume the same facts as in Example 1, except A has two minor children, B and C. A plan to use a single trust for the benefit of both A’s mother and, later, her two children would have a significant drawback because the plan would call for her two children to become the income beneficiaries of the trust upon H’s death. When this occurs, the trust would cease to be a QSST because it would have more than one current income beneficiary. This would lead to loss of S status for the corporation because a trust with two income beneficiaries is not an eligible shareholder. This loss of S status would not occur immediately upon H’s death because her estate temporarily would be deemed the S shareholder (Regs. Secs. 1.1361-1(k), Example (4)(iii), and -1(j)(7)(ii)).

To avoid this drawback, the practitioner advises A to establish two trusts for H, with a different child named as remainderman of each trust. A QSST can have one or more successive income beneficiaries. However, naming one or more successive income beneficiaries risks the company’s S status because each successive income beneficiary is permitted to affirmatively refuse to consent to the original QSST election (Regs. Sec. 1.1361-1(j)(9)). Such a refusal would terminate the S status because the trust would be considered an ineligible S shareholder.

‘After-born’ clause

Any corpus transfers from a QSST during the life of the income beneficiary must be directly to that beneficiary. An “after-born” clause would violate QSST eligibility (Rev. Rul. 89-45).

Example 3: Assume the same facts as in Example 2, except A establishes a separate QSST for each of her two children, with each child as sole income and corpus beneficiary of the trust. However, in the event additional children are born, A would like to add an “after-born” provision, under which a new trust would be formed for each additional child, via a transfer of shares from each existing QSST (so that after the transfer, each QSST would hold an equal number of shares for each child). This “after-born” clause would violate QSST eligibility. Under A’s proposal to include an “after-born” provision, corpus could be distributed to a newborn sibling’s trust, leading to termination of S status because of the violation of QSST eligibility rules.

Separate and independent subtrusts can qualify as QSSTs

For S shareholder eligibility purposes, substantially separate and independent shares of a single trust are treated as separate trusts under the QSST rules (Secs. 1361(d)(3) and 663(c); IRS Letter Ruling 200942020). Thus, separate and independent subtrusts can qualify for QSST status. However, from a drafting standpoint, it is normally preferable to create separate QSSTs.

When a QSST’s assets were divided into two shares following the death of the current income beneficiary, with the income from each share payable to a different beneficiary, the IRS ruled that the two QSST shares were substantially separate and independent shares within the meaning of Sec. 663(c). Therefore, each share could be considered a separate trust for QSST eligibility purposes. Furthermore, the trust’s QSST election would continue and the income beneficiary of each share would not be required to file a QSST election for his or her separate share for the trust. Accordingly, the corporation’s S election would remain in effect (IRS Letter Ruling 201119005).

The IRS has ruled that a separate and independent share of a trust cannot qualify as a QSST if there is even a remote possibility that the trust assets will be distributed during the lifetime of the current income beneficiary to someone other than the beneficiary (Rev. Rul. 93-31). (In this ruling, the trustee had the power to distribute all or part of the trust assets to a beneficiary of another subtrust if necessary for that beneficiary’s health, education, support, or maintenance.)

Example 4: Assume the same facts as in Example 3. A could create a single trust for H’s benefit that comprises two separate subtrusts. H would be the sole income beneficiary of each subtrust, and, upon her death, A’s children would be the successive income beneficiary of each subtrust. However, upon H’s death, it is important to ensure that the trust does not authorize the distribution of trust assets from one subtrust to the child who is not the income beneficiary of that subtrust.

Formalities of the trust instrument

A QSST instrument is required, and the tax planner can assist in conveying the requirements for the trust document to the client’s attorney. IRS regulations hold that a trust instrument that does not specifically prohibit a disqualifying event could fail as a QSST (Regs. Secs. 1.1361-1(j)(1)(ii) and (iii)). The provisions of the trust instrument and applicable local law both need to be considered. For example, if the terms of a trust are silent on corpus distributions, and distributions of corpus to persons other than the current income beneficiary are permitted under local law, then the trust would not meet the criteria for QSST status (Regs. Secs. 1.1361-1(j)(1)(ii) and (iii)). Accordingly, the trust document should specifically state within its terms each of the QSST qualifying criteria.

This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 31st edition (March 2017), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).