Sole proprietorship, partnership, LLC, corporation… When starting a business, you've got options for what type of entity you want to create. In this post, we'll discuss the potential estate planning implications of creating an S Corporation.
What is an S corporation?
Many small-business owners elect to have their business entity taxed as an S corporation. In fact, according to the IRS, taxpayers file approximately five million S corporation returns a year. This is such a popular choice for small-business owners because it offers certain income-tax advantages, like “pass through” treatment of income and self-employment tax savings. Meaning, all of the business's income "passes through" the business to the owners to be reported on their individual income tax returns.
So what even is an S corporation? Big picture: an “S corporation” is not actually a type of business entity but is instead a kind of federal tax treatment. Business entities such as corporations and LLCs are formed under state law. However, the federal income tax treatment of these entities is controlled by federal tax law. For instance, many LLCs make an “S election” on IRS Form 2553 to be taxed as S corporations for federal income tax purposes, even though LLCs are not technically corporations under state law.
How does my S corporation affect my estate plan?
In particular, how does an S corporation affect my trust?
People form trusts for many reasons, such as probate avoidance, asset protection, tax planning, and charitable giving. When an S corporation is involved, it’s important to understand how to draft the trust to ensure these goals are met without messing up either the trust or the business.
Generally, to qualify as an S corporation, a business entity must have only one class of stock, no more than 100 owners, and those owners must be natural persons who are U.S. citizens or resident aliens (i.e., individuals). However, there are some exceptions to that rule, including holding stock in certain types of "grantor trusts." Since grantor trusts are disregarded by the IRS for income tax purposes, a person can hold their business interests in a grantor trust (such as a revocable living trust) without jeopardizing the election to be taxed as an S corporation.
That's easy enough while the grantor is alive. But what about when the grantor of the grantor trust dies? How does we ensure that the trust is treated like a qualified shareholder of an S corporation interest?
After the grantor’s death, the trust can only continue to own the S corporation for limited period without causing some problems, unless it qualifies as either an Electing Small Business Trust (ESBT) or a Qualified Subchapter S Trust (QSST).
An ESBT is a trust that can have multiple beneficiaries (like all of your kids) including individuals, estates, and certain kinds of organizations. With this type of trust, the trustee can elect to treat the trust as an ESBT. But all taxable income from the S corporation interest is taxed at the trust level at the highest income tax rate (adjusted for allowable deductions, like 199A and charitable giving).
A QSST is a trust that can have only one income beneficiary, and that person is the only one who can receive distributions of trust principal during his or her life. With this type of trust, the beneficiary (and not the trustee) must file the QSST election. All the income of the trust must be distributed to the beneficiary at least annually. The beneficiary of a trust with those terms can elect to have the trust treated as a QSST. In that case, the S corporation income is taxed to the trust beneficiary, not the trust. The beneficiary (and not the trustee) must file timely the QSST election. Trust terminates at the earlier of current income beneficiary’s death or trust’s termination
Can my charitable trust receive my S corporation interest?
It's also important to be aware that S corporation status can specifically affect charitable giving in an estate plan. For instance, a charitable remainder trust (CRT), which is an irrevocable trust designed to first disperse income to the beneficiaries of the trust and then donate the remainder to a designated charity, isn’t a valid S corporation shareholder. Therefore, a bequest of S corporation stock to a CRT will void the business’s S-election, causing it to convert to a C corporation (i.e., it will be subject to two layers of taxation).
On the other hand, a non-grantor charitable lead trust (CLT) is permitted to be a shareholder of an S corporation if the trust makes the ESBT election discussed above. However, this election produces highly undesirable income tax results. Since it is an ESBT, the CLT will be taxed on its pass-through income from the S corporation at the highest marginal rates for trusts, and, worse yet, the trust will be denied a charitable deduction for the S corporation income the trust distributes to charity.
S corporations provide many small business owners with income tax advantages during their lifetimes. However, if your business is held in an entity taxed as an S corporation, it is important that you consult with an experienced estate planning attorney to help you draft a trust that will achieve your giving goals while also preserving the benefits of S corporation status.
Like us. We can help with that.
Can Tallgrass Estate Planning help?
Absolutely. We ensure our trusts will be considered qualified shareholders of S corporation interests. We don't want your loved ones inheriting your hard work only for some technicality to mess things up for your trust and your business after you're gone.
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If you want to know more, we would love to talk with you. Best part, the conversation about how it could benefit you doesn't cost anything. If you're in the Tulsa area, call us at (918) 770-8940, or send an email to firstname.lastname@example.org. If you're in the Oklahoma City area, call (405) 358-3548 or send an email to email@example.com.
Disclaimer: Reading this blog post does not create an attorney-client relationship, and it is not formal legal advice. This is for information purposes only. It is always best to speak with an attorney about your questions, assets, concerns, and needs.