Trusts for holding S corporation interests: QSSTs vs. ESBTs

Only certain types of trusts are permitted to hold an interest in an S corporation. Two of these are an electing small business trust, or ESBT, and a qualified Subchapter S trust, or QSST. An ESBT is allowed as a shareholder under Sec. 1361(e), which was added by the Small Business Job Protection Act of 1996.¹ The provision was initially praised by advisers and their business owner clients because it did not include the two major restrictions of the QSST, which was created by legislation Congress passed in 1982.² Those two primary restrictions of the QSST were that the trust could only have one beneficiary and that all the ordinary income of the trust needed to be distributed currently to the sole beneficiary. This article compares the relative advantages and disadvantages of a QSST versus an ESBT in estate planning.

Tax treatment of QSSTs and ESBTs

The permissible shareholders of an S corporation include a “trust all of which is treated … as owned by an individual who is a citizen of the United States” (Sec. 1361(c)(2)(A)(i)). A QSST with respect to which a beneficiary makes an election is treated as a trust described in Sec. 1361(c)(2)(A)(i).³ For purposes of Sec. 678(a), the beneficiary of such a trust is treated as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the beneficiary makes the election.⁴ As the deemed owner of the trust’s S corporation’s shares, the QSST beneficiary is taxed on the entirety of the trust’s share of the S corporation’s income, regardless of whether the income is distributed to the trust.

An ESBT is handled differently under the Code. With an ESBT, whether and to what extent the beneficiaries of the trust are treated as owners of the trust’s share of the corporation’s stock for purposes of Sec. 678(a) is up to the drafter of the trust. The Code provides merely that an ESBT is a permissible shareholder of an S corporation.⁵ The ESBT and its beneficiaries are then taxed under Sec. 641(c). The relevant regulations clarify that, although in general the ESBT’s portion of the S corporation’s income will be taxed at the highest federal income tax rate, taxation of the trust’s beneficiaries at their own income tax rates under Sec. 678(a) takes precedence over this general rule.⁶

Advantages of an ESBT over a QSST

Compared to ESBTs, QSSTs generally have significant disadvantages.⁷ These include:

• There can be only one lifetime beneficiary of a QSST, meaning that the beneficiary’s children cannot also be beneficiaries of the trust, which is not the case for an ESBT.
• Unlike an ESBT, all the ordinary income of a QSST must be distributed to the beneficiary currently, regardless of need, thus causing potentially unnecessary:
  • Buildup of the QSST beneficiary’s taxable estate by the compounded value of the QSST’s share of the S corporation’s distributed income;
  • Exposure of the compounded value of the QSST’s share of the S corporation’s distributed income to potential lawsuits against the QSST’s beneficiary;
  • Exposure of the compounded value of the QSST’s share of the S corporation’s distributed income to potential marital rights of the QSST beneficiary’s former spouse; and
  • Full access to the S corporation’s distributed income to an underaged, spendthrift, or special-needs QSST beneficiary.
• Because the clients will most likely not want the income generated by all their other assets, including IRA and 401(k) plan benefits, to be automatically distributed to the trust beneficiary, two separate trusts (or at least two separate shares of one trust) will normally need to be established for each beneficiary.

Given the above-described limitations of a QSST, the option of using an ESBT for holding S corporation interests in trust may need to be explored more than it has been in the past. Judicious use of Sec. 678 in the drafting of an ESBT, for example, can largely eliminate the relevance of the maximum federal trust income tax rate on the trust’s share of the S corporation’s income. Under Sec. 678, a person other than the grantor is treated as the owner of any portion of a trust over which the person:

• Has a power (exercisable solely by himself or herself) to vest the corpus or the income from the trust in himself or herself; or
• Has previously partially released or otherwise modified such a power and subsequently retains control of the trust that under the grantor trust rules would cause the grantor to be treated as the trust’s owner.

Under Sec. 678, if the beneficiaries of an ESBT are granted the sole power to withdraw the S corporation income that is distributed to the trust annually, they are taxed on this trust income at their own tax rates regardless of whether they withdraw it. An ESBT itself is not taxed on the income of the trust attributable to the S corporation to the extent the beneficiaries are taxed under Sec. 678.

If the beneficiaries of an ESBT are given withdrawal rights, each beneficiary’s rights should be designed to fully or partially lapse at the end of each year, but only to the extent of 5% of the value of the trust each year, in order to avoid annual taxable gifts by the beneficiaries under Sec. 2514(e). In most states, the beneficiaries’ annual withdrawal powers will not be protected from lawsuits against the beneficiaries, but the lapsed portions of the withdrawal rights will be so protected.⁸

It is doubtful that the income the ESBT beneficiaries do not elect to withdraw from the trust will be considered divisible marital property, not just because it can be argued that it is property received by way of inheritance or gift, but primarily because the property is not actually owned by the beneficiaries, once the power to withdraw the same has lapsed. Instead, and at best, it would seem the following provision from the Uniform Marital Property Act should apply: “The right to manage and control marital property transferred to a trust is determined by the trust.”⁹

Advantages of a QSST over an ESBT

On the other hand, despite their desirable features, ESBTs have some potential disadvantages compared to QSSTs. Under Sec. 678, it may be impossible in certain situations to cause all the taxable income allocable to an ESBT’s interest in the S corporation to be taxed to the trust’s beneficiaries. It is, of course, impossible for income (including taxable income) not actually distributed by the S corporation to the trust (i.e., in the way of dividends) to be withdrawable by the trust’s beneficiaries. Thus, only the ordinary income of the S corporation portion of an ESBT is withdrawable.

If a portion of the taxable income of the S corporation is not distributed to the ESBT (i.e., as a result of working capital or other needs), and in effect is therefore allocable to trust corpus, this retained taxable income of the S corporation will be taxed to the ESBT at the highest federal income tax rate. If the client’s family controls the S corporation, one possible workaround to this situation would be for the S corporation to first distribute this portion of the income to the ESBT and then have the trustee of the ESBT voluntarily invest the same back into the corporation.

But if the client’s situation is such that this workaround is unavailable because there will be significant annual retained income of the S corporation that cannot be distributed to the ESBT and recontributed to the corporation, then a QSST may be the preferred estate planning choice over an ESBT, provided the client’s family is able to control distributions of the corporation’s income to the trust.¹⁰ The reason for this is that only the income that the corporation actually distributes to the trust needs to be distributed to the trust beneficiary under the QSST rules and Sec. 1361(d)(3)(B). The balance can remain in the corporation (and therefore in the protected trust), yet still be taxed to the beneficiary as the Sec. 678 deemed owner of that portion of the trust which consists of the trust’s interest in the corporation.

The potential problem with using a QSST in this situation is that in many families there will be family members who are actively involved in the business (and who can therefore benefit from salaries and bonuses) and family members who are not so involved. All or some of the latter family members may want the corporation to distribute as much income as possible to their trust(s) in the way of dividends. Since these dividend distributions must be made proportionately to all of the corporation’s shareholders, the QSST may then have the effect of “overfunding” the shares of the family member beneficiaries who are actively involved in the business, as well as the shares of other family member beneficiaries who do not need more current income, with income that must then be distributed to them outright.

Modification of existing QSSTs and ESBTs

If a trustee thinks that an existing irrevocable QSST would be better structured as an ESBT with Sec. 678 income withdrawal powers in the beneficiary, or that an existing ESBT lacking Sec. 678 withdrawal rights should be modified to include the same, it may be appropriate to utilize a state decanting statute or other form of nonjudicial or judicial modification of the trust, or perhaps even a power granted to the trustee in the trust document itself.

Note, however, that under a questionable reading of the Code and regulations, some state decanting statutes (including those based on the Uniform Trust Decanting Act) may at first blush appear to prohibit an existing QSST from being decanted to an ESBT. These decanting statutes should be reviewed carefully, however, because although the apparent intent of these statutes may have been to prohibit a QSST from decanting to an ESBT, in many cases the decanting will actually be permitted.¹¹

In drafting decanting or other trust modification documents, an adviser should bear in mind the potential federal estate and gift tax issues involved. If the modification documents are carefully drafted, however, so that the only change relates to substitution of the right to withdraw income distributed from the S corporation to the trust (i.e., trust accounting income, within the meaning of Secs. 643(b) and 1361(d)(3)(B)), it would seem that the income beneficiary has given up nothing on a current basis because the beneficiary has retained the right to withdraw the same trust accounting income distributed by the S corporation to the trust. Note, however, that there are also potential generation-skipping transfer tax issues involved if the trust was irrevocable before 1986, because the new trust may have the effect of pushing more assets down to succeeding generations.

These are some issues to consider when seeking to modify an existing QSST or ESBT. For further discussion of these types of trusts, see Hartman and Walter, “Trusts as S Corporation Shareholders,” also in this issue.

Footnotes

¹ Small Business Job Protection Act of 1996, P.L. 104-188.

² Subchapter S Revision Act of 1982, P.L. 97-354, §2.

³ Sec. 1361(d)(1)(A).

⁴ Sec. 1361(d)(1)(B).

⁵ Sec. 1361(c)(2)(A)(v).

⁶ Regs. Sec. 1.641(c)-1.

⁷ One notable exception is where a QSST is being used in conjunction with a qualified terminable interest property (QTIP) trust, where only the surviving spouse can be a lifetime beneficiary and all the trust’s ordinary income must be distributed to the surviving spouse currently.

⁸ For more information on the technical aspects of utilizing Sec. 678, including sample forms, see Blase, 6–7–8: Estate Planning With Section 678 of the Internal Revenue Code (2022).

⁹ Uniform Marital Property Act, §5(c).

¹⁰ Note that the tax issues here would be compounded if provisions found in the proposed Build Back Better Act, which would impose 5% and 8% surtaxes at levels of trust income of as low as $200,000, are passed.

¹¹ For more on the topic of decanting from a QSST to an ESBT, see Blase, “Decanting a QSST to a ESBT,” Estate Planning (May 2022) (forthcoming).