Holding S Corporation stock in a trust
Mark Sellner, CPA, JD, LLM (taxation) | February/March 2023 Footnote
Editor's note: Updated January 31, 2023
Holding S Corporation stock in a trust might be part of a shareholder’s estate, gift and personal financial planning strategy to transfer ownership to heirs, family members or other beneficiaries.
However, there are strict rules for holding S Corporation stock in a trust to avoid violating the eligible shareholder rules. A two-year limit following death may apply as well. And an inadvertent mistake may require an expensive IRS private letter ruling to correct if automatic procedures are not available.
Eligible shareholder rules
An S Corporation may not have:
- More than 100 shareholders.
- A person who is not an individual as a shareholder, (other than an estate, certain types of trusts or certain exempt organizations).
- A nonresident alien as a shareholder.
- More than one class of stock.1
A corporation in which any shareholder is another corporation, a partnership (including a multi-member LLC), or a trust other than a permitted trust, does not qualify as a small business corporation eligible to elect S Corporation status.
2
Permitted trusts
Several types of trusts are permitted S Corporation shareholders.3 Foreign trusts are not permitted.4
Grantor (Subpart E) trusts
A shareholder may choose to hold shares in a living trust to authorize a trustee to manage assets in the event of the grantor’s incapacity or otherwise, and to avoid probate at death.
A trust, all of which is treated as owned by an individual who is a citizen or resident of the United States, is an eligible shareholder.
A trust that was a qualified grantor (Subpart E) trust immediately before the death of the deemed owner and that continues in existence after the death of the deemed owner is an eligible shareholder, but only for the two-year period beginning on the day of the deemed owner’s death. During that period, the estate of the deemed owner is treated as the shareholder.
Pitfall: Upon retention of stock in a trust after death, an ineligible shareholder issue will arise if the stock is retained in trust beyond the two-year period.
Solution: The shareholder list should be reviewed each year that Form 1120-S US Income Tax Return for an S Corporation is prepared.
Testamentary trusts
A trust with respect to stock transferred to it pursuant to the terms of a will is an eligible shareholder, but only for the two-year period beginning on the day on which such stock is transferred to it. After that, the stock often would be distributed to designated beneficiaries, who must be eligible shareholders themselves to protect the S Corporation status.
Pitfall: Upon transfer of stock to a testamentary trust at death, an ineligible shareholder issue will arise if the stock is retained in trust beyond the two-year period.
Solution: The shareholder list should be reviewed each year that Form 1120-S US Income Tax Return for an S Corporation is prepared.
Qualified Subchapter S trusts
One use of a qualified Subchapter S trust (QSST) might be to transfer S Corporation stock for the benefit of a grandchild.
A qualified Subchapter S trust, whether created during a grantor’s lifetime or upon death, is an eligible shareholder if the following requirements are satisfied:
- All of the income is distributed currently to one individual who is a citizen or resident of the United States, namely, an eligible shareholder.
- The terms of the trust must require that:
- There is only one income beneficiary of the trust.
- Any corpus distributed is only to that income beneficiary.
- The income interest in the trust will terminate on the earlier of the income beneficiary’s death or the termination of the trust.
- Upon termination of the trust, the trust will distribute all of its assets to the income beneficiary.
- If the terms of the trust do not preclude the possibility that any of the requirements will not be met, the trust will not qualify as a QSST.
If, under local law, a distribution to the income beneficiary is in satisfaction of the grantor’s legal obligation of support to that income beneficiary, the trust will not qualify as a QSST as of the date of distribution.
A QSST is not taxed on its share of S Corporation income, since the beneficiary is, but the trust itself is taxed at trust tax rates that are much more progressive than individual tax rates on any gain on the disposition of shares.5 This point should not be overlooked when advising on the sale of an S Corporation.
Pitfall: Often overlooked, the current income beneficiary of the trust must make a QSST election generally within 75 days of transfer of the stock.6
Solution: A copy of the QSST election should be retained in the S Corporation permanent file. Late election relief is provided in Rev. Proc. 2013-30.
Electing small business trusts
One use of an electing small business trust (ESBT) might be to transfer S Corporation stock for the benefit of one or more grandchildren, while accumulating income for a period of time rather than distributing it currently.
An electing small business trust is a trust that meets the following requirements:
- The trust does not have as a beneficiary any person other than an individual, an estate or certain charitable organizations.
- No interest in the trust has been acquired by purchase.
- The trustee makes a timely ESBT election.
An ESBT is taxed — at trust tax rates that are much more progressive than individual tax rates — on its share of S Corporation income and any gain on the disposition of shares.
Unlike other permitted trust beneficiaries, a nonresident alien is an eligible beneficiary of an ESBT and an eligible potential current beneficiary, because the trust itself rather than the beneficiary is subject to income tax.
Pitfall: The trustee must make the ESBT election by signing and filing, with the IRS Service Center where the S Corporation files its income tax return, a statement that meets the requirements of the tax regulations.
Solution: A copy of the ESBT election should be retained in the S Corporation permanent file. Late election relief is provided in Rev. Proc. 2013-30.
Voting trusts
A voting trust might be used as a corporate governance tool, like a proxy statement. It is created primarily to exercise the voting power of S Corporation stock transferred to it.
To qualify as a voting trust for S Corporation purposes, the beneficial owners must be treated as the owners of their respective portions of the trust and the trust must have been created pursuant to a written trust agreement entered into by the shareholders.
Transitioned IRA trust holding bank stock
An IRA or Roth IRA trust holding S Corporation bank stock as of Oct. 22, 2004, is an eligible shareholder. Individual retirement accounts and Roth IRAs are not otherwise eligible S Corporation shareholders.
Correcting an eligible shareholder violation
An IRS private letter ruling is expensive in both time and money, even at a reduced filing fee of $3,000 for a taxpayer with gross income under $250,000.
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Before a private letter ruling would be requested related to an S Corporation issue, the automatic procedures in Revenue Procedure 2013-30 and Revenue Procedure 2022-19 should be reviewed.
Rev. Proc. 2013-30 provides automatic permission to make late elections, including qualified Subchapter S trust elections and electing small business trust elections. Because the procedures are in lieu of the letter ruling process, user fees do not apply. If Rev. Proc. 2013-30 does not apply to a particular S Corporation issue, a private letter ruling may be requested.
The IRS recently issued Rev. Proc. 2022-19 providing taxpayer assistance procedures to allow S Corporations and their shareholders to resolve frequently encountered issues with certainty and without requesting a private letter ruling. Much of the guidance addresses second class of stock issues, rather than eligible shareholder violations.
An inadvertent failure to timely elect QSST or ESBT status is covered by Rev. Proc. 2013-30, but the outright inclusion of an ineligible shareholder or the misclassification of a permitted trust must be addressed directly with the IRS.
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Mark Sellner consults with other CPAs and their clients on business and executive tax matters, including S Corporation and partnership taxation and the tax consequences of buying and selling a business. He is a member of the Minnesota Society of CPAs, where he has received the R. Glen Berryman Excellence in Teaching Award and the Distinguished Service Award. You may reach him at Sellner-Tax-Consulting-LLC@outlook.com or 612-508-4107.
1 IRC Section 1361(b)(1)
2 Reg. Sec. 1.1361-1(f)
3 Reg. Sec. 1.1361-1(h)(1)
4 Reg. Sec. 1.1361-1(h)(2)
5 Reg. Sec. 1.1361-1(j)(8)
6 Reg. Sec. 1.1361-1(j)(6)(ii)
7 Rev. Proc. 2023-1
8 See, for example, LTR 202242001, July 27, 2022
