Converting from a QSST to an ESBT, or vice versa

In some planning situations, it may be advisable to change a trust from one type of eligible trust — either a qualified Subchapter S trust (QSST) or an electing small business trust (ESBT) — to the other. For example, the more flexible requirements that apply to ESBTs may make it desirable to convert a QSST (with its stricter requirements) to an ESBT. Alternatively, converting an ESBT to a QSST will avoid the ESBT requirement that the trust must pay tax at the highest individual tax rates.

Converting a QSST to an ESBT

The QSST can be converted to an ESBT if the following requirements are met (Regs. Sec. 1.1361-1(j)(12)):

• The trust is eligible to be an ESBT (see Sec. 1361(e)), except for the requirement under Sec. 1361(e) (1)(B)(i) that the trust not have a QSST election in place under Sec. 1361(d)(2);
• The trustee and the current income beneficiary of the trust make the ESBT election explained below for stock of each S corporation held by the trust;
• The trust has not converted from an ESBT to a QSST within the 36-month period before the effective date of the new ESBT election; and
• The ESBT election is to be effective not more than 15 days and two months prior to the date on which the election is filed and not more than 12 months after the date on which the election is filed.

If an election specifies an effective date more than 15 days and two months prior to the date on which the election is filed, it will be effective 15 days and two months prior to the date on which it is filed. If an election specifies an effective date more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it was filed.

Example 1. Converting a QSST to an ESBT: A few years ago, N established a QSST for her daughter and transferred S corporation shares into it. N now has another child and wants to include that child as a trust beneficiary. She also wants the trust income to accumulate for the children rather than distributing it annually. N would pay tax at the maximum rate even if the stock were not transferred to the trust.

An ESBT would accomplish N’s goals. ESBTs are generally more flexible than QSSTs, since the trustee can accumulate income and distribute income and principal to a group of beneficiaries. However, all potential current ESBT beneficiaries are counted as S corporation shareholders for purposes of the Sec. 1361(b)(1)(A) 100-shareholder limit. Also, ESBTs usually have a higher tax cost because all income is taxed at the highest individual tax rate in effect. The tax planner determines that the QSST meets the requirements of Regs. Sec. 1.1361-1(j)(12) and can be converted to an ESBT. N’s daughter and the trustee of the trust must make the ESBT election as described below. The conversion can be effective up to 15 days and two months before, or up to 12 months after, the election is filed.

Tax planning considerations

Before converting a QSST to an ESBT, the planner should consider the impact of the election on the corporation’s S election and the potential additional tax at the trust level. As mentioned, all potential current ESBT beneficiaries are counted as S corporation shareholders for the 100-shareholder limit. Also, ESBTs usually have a higher tax cost because all income of the portion of an ESBT that consists of S corporation stock is taxed at the highest individual tax rate in effect.

Making the ESBT election

The current income beneficiary and the trustee of the trust must sign an ESBT election and file it with the IRS Service Center where the S corporation files its income tax return. This ESBT election must state at the top of the document: “ATTENTION ENTITY CONTROL — CONVERSION OF A QSST TO AN ESBT PURSUANT TO SECTION 1.1361-1(j)” and include all information otherwise required for an ESBT election. A separate election must be made for the stock of each S corporation held by the trust.

Once a QSST election is made, it is revocable only with the consent of the IRS (Sec. 1361(d)(2)(C)). Nevertheless, IRS consent to revoke a QSST election as of the effective date of the ESBT election is automatically granted to any QSST that satisfies the requirements of Regs. Sec. 1.1361-1(j). Thus, separate IRS permission to revoke the QSST election is not required when converting a QSST to an ESBT under Regs. Sec. 1.1361-1(j).

Effect of the election on passthrough income

For purposes of allocating passthrough income, the QSST will be treated as terminating its interest in the S corporation, and the ESBT will be treated as a new shareholder. The last day the QSST will be a shareholder is the day before the effective date of the ESBT election, and the new ESBT will be a shareholder beginning on the effective date of the ESBT election.

Conversion of a QSST to an ESBT generally does not result in the trust’s terminating its entire interest in the S corporation. Thus, the corporation generally cannot make an election to use specific accounting when a shareholder’s entire interest is disposed of. However, if the trust was (1) a testamentary trust that received S stock pursuant to the terms of a will, or (2) a trust existing before death that was treated as a grantor trust, the shareholders of the S corporation are considered to change from the deemed owner or testator to the potential current beneficiaries. In either situation, the corporation can make an election to use specific accounting because a shareholder’s entire interest was disposed of (see the preamble to the ESBT regulations (T.D. 8994)).

Converting an ESBT to a QSST

An ESBT can be converted to a QSST if the following requirements are met (Regs. Sec. 1.1361-1(m)(7)):

• The trust is eligible to be a QSST (see Sec. 1361(d));
• The trustee and the current income beneficiary of the trust make the QSST election explained below for the stock of each S corporation held by the trust;
• The trust has not converted from a QSST to an ESBT within the 36-month period before the effective date of the new QSST election; and
• The QSST election is to be effective not more than 15 days and two months prior to the date on which the election is filed and not more than 12 months after the date on which the election is filed.

If an election specifies an effective date more than 15 days and two months prior to the date on which the election is filed, it will be effective 15 days and two months prior to the date on which it is filed. If an election specifies an effective date more than 12 months after the date on which the election is filed, it will be effective 12 months after the date it was filed.

Example 2. Converting an ESBT to a QSST: Assume the same facts as in Example 1. However, instead of a QSST, N had set up an ESBT that held her S corporation stock, with her daughter as the beneficiary. N now prefers to avoid the trust taxation at the maximum rate and wants to convert the trust to a QSST. The trust meets all the QSST requirements and can convert to QSST status.

The IRS has privately ruled that each income beneficiary’s share of an ESBT may constitute a separate and independent share of the trust under Sec. 663(c) and also separately qualify as a QSST, provided that the trust’s income is distributed currently. Accordingly, if the applicable requirements are met, each income beneficiary can file a QSST election to revoke the ESBT election for his or her separate share without terminating the ESBT election for the other income beneficiary’s share of the trust (IRS Letter Ruling 201122003).

Tax planning considerations

Although the requirements for a QSST are more restrictive (e.g., a QSST trustee can only distribute income to a single beneficiary), an ESBT that would meet the QSST requirements and for which the resulting restrictions are not an overriding concern should consider converting to a QSST, since the tax costs are usually lower.

Making the QSST election

The current income beneficiary and the trustee of the trust must sign a QSST election and file it with the IRS Service Center where the S corporation files its income tax return. This QSST election must state at the top of the document: “ATTENTION ENTITY CONTROL — CONVERSION OF AN ESBT TO A QSST PURSUANT TO SECTION 1.1361-1(m)” and include all information otherwise required for a QSST election under Regs. Sec. 1.1361-1(j)(6). A separate election must be made for the stock of each S corporation held by the trust.

Once an ESBT election has been made, it is revocable only with the consent of the IRS (Sec. 1361(e) (3)). Nevertheless, IRS consent to revoke an ESBT election as of the effective date of the QSST election is automatically granted to any ESBT that satisfies the requirements of Regs. Sec. 1.1361-1(m)(7). Thus, separate IRS permission to revoke the ESBT election is not required when converting an ESBT to a QSST under Regs. Sec. 1.1361-1(m)(7).

Effect of the election on passthrough income

For purposes of allocating passthrough income, the ESBT will be treated as terminating its interest in the S corporation, and the QSST will be treated as a new shareholder. The last day the ESBT will be a shareholder is the day before the effective date of the QSST election, and the new QSST will be a shareholder beginning on the effective date of the QSST election.

Conversion of an ESBT to a QSST generally does not result in the trust’s terminating its entire interest in the S corporation. Thus, the corporation generally cannot make an election to use specific accounting when a shareholder’s entire interest is disposed of. However, if the trust was (1) a testamentary trust that received S stock pursuant to the terms of a will, or (2) a trust existing before death that was treated as a grantor trust, the shareholders of the S corporation are considered to change from the deemed owner or testator to the current income beneficiary. In either situation, the corporation can make an election to use specific accounting because a shareholder’s entire interest was disposed of. See the preamble to the ESBT regulations (T.D. 8994).

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.