Business Succession Planning: Pros and Cons of Passing S Corp Shares in Trust

Business succession planning and estate planning are often linked together, particularly in the case of closely held family businesses. In the case of a shareholder who wishes to pass along their shares of an S corporation as defined in IRC § 1361(a) (an “S Corp”), a popular option is to transfer these shares into a grantor trust while the owner is alive, with the trust or a subtrust set to hold these shares for the benefit of others upon the grantor’s death. This structure can assist in keeping a business within a family or other close group by restricting alienation of shares and assist in passing a business to the next generation without the need to go through the formal process of updating corporate documents, amending bylaws or articles of incorporation or entering into separate shareholder agreements.

However, this comes with some complications. For instance, S-Corps can only be owned by 100 or fewer shareholders, though attribution rules do allow certain related shareholders to collectively count as one shareholder.[1] Also, S-Corps can only be owned by individual human beings, estates, certain types of organizations, and certain types of trusts, none of whom can be nonresident aliens.[2] Although grantor trusts such as revocable inter vivos trusts, which are a common estate planning tool, may hold such shares during the grantor shareholder’s lifetime, the options for holding shares after the shares are transferred out of the grantor’s control are more limited.[3] These include both Electing Small Business Trusts as defined in IRC § 1361(e)(1) (“ESBTs”) and Qualified Subchapter S Trusts, as defined in IRC § 1361(d)(3) (“QSSTs”), which are commonly used options for holding S Corp shares and are the subject of the remainder of this article.

Background on Electing Small Business Trusts

An ESBT is a trust:

• whose beneficiaries are all either individuals, estates, or certain organizations which can receive charitable gifts under IRC § 170(c),
• the interest in which was not obtained by purchase, and
• for which an election statement is submitted to the IRS by the trustee.[4]

Note that certain trust types are barred from making the election.[5] The election must be made within 2 months and 15 days of the desired effective date,[6] must be filed to the IRS service center where the S-Corp files its tax return, and must disclose, among other things, the potential current beneficiaries and the S Corps in which the ESBT holds stock.[7]

The advantages of an ESBT include flexibility to have multiple beneficiaries,[8] to hold shares of multiple S Corps,[9] and to either accumulate or distribute the income of the trust.[10] Each potential current beneficiary is treated as a separate shareholder of the underlying S Corps, so care should be taken to avoid exceeding the 100 shareholder limit.[11] To the extent that one portion of an ESBT is deemed to be owned by a grantor, the grantor trust rules apply, with some exceptions.[12] If the ESBT holds S Corp shares and other assets at the same time, the ESBT will be treated as two separate trusts for tax purposes: one ESBT  holding the stock in S Corps (the “S Portion”); and the other ESBT holding non-S Corp assets.[13] Even if an ESBT holds stock in multiple S Corps and is so divided, it will be treated as a single trust administratively, will have a single EIN, and will file a single tax return.[14] Furthermore, unlike an S Corp, an ESBT may have a nonresident alien as a current beneficiary.[15] However, a downside is that aside from capital gains, the taxable income of the S Portion will be taxed at the highest marginal trust rate for federal income tax purposes if it is taxed as a non-grantor trust.[16]

Background on Qualified Subchapter S Trusts

A QSST is a trust whose terms require that:

• during the lifetime of the current income beneficiary, there shall be only 1 income beneficiary of the trust,
• any principal distributions made from the trust during the current income beneficiary’s lifetime may only be made to that beneficiary,
• the income interest of the current income beneficiary terminates on their death or the trust’s dissolution, and
• if the trust does terminate during the current income beneficiary’s lifetime, all the assets of the trust must be distributed to that beneficiary.[17]

The income beneficiary must be a citizen or resident of the U.S.[18] The beneficiary must elect for QSST treatment for each S Corp it owns, in part or in whole. Such election is made by submitting to the IRS service center that processes the S Corp’s tax return a statement (i) containing the name, address, and taxpayer identification number of the income beneficiary, trust, and S Corp, (ii) identifying the filing as an IRC § 1361(d)(2) filing, (iii) specifying an effective date that is not earlier than 2 months and 15 days before the date of the filing, (iv) specifying the date when the S Corp shares were transferred to the trust, and (v) providing information and representations necessary to show that (a) the trust has a single current income beneficiary, (b) the trust is required to distribute all of its income currently or that the trustee will distribute all of its income currently if not required by the trust’s terms, and (c) no distribution of income or corpus by the trust will be made to satisfy any legal obligation of the grantor to support or maintain the income beneficiary.[19] Once the election is made, it is irrevocable except with IRS consent.[20] Additionally, the election must be filed within 2 months and 16 days of certain triggering events:

• The election must be made within 2 months and 16 days after the date of transfer, if S Corp stock is transferred to a trust. The same period applies if the transfer consists of stock in a C Corporation for which an S-election has been made but is not yet in effect.[21]
• In the case of a C corporation whose stock is already held by the trust, but which makes an S election, the effective date of the S election determines the filing deadline of the QSST election. If the S election dates back to the beginning of the current tax year (the year in which such election is made), the QSST election is due within 2 months and 16 days after the effective date the S election. If the S election becomes effective at the beginning of the next tax year (immediately following the year in which such election is made), the QSST election is due within 2 months and 16 days after the date the S election was made.[22]
• If a trust ceased to be a grantor trust (or other qualified subpart E trust), the filing is due within 2 months and 16 days after the date on which the trust ceased to be a qualified subpart E trust. If the estate of the trust’s deemed owner is the shareholder, then the filing is due within 2 months and 16 days after the date on which the estate of the deemed owner ceased to be treated as a shareholder.[23]
• If a testamentary trust is the shareholder, then the filing is due within 2 years, 2 months and 16 days following the transfer in trust, pursuant to a Will or certain electing trusts, as further detailed in Reg §1.1361-1(h)(1)(iv).[24]

The beneficiary is treated as the owner of the S Corp stock held by the trust, similar to a grantor in the case of a grantor trust,[25] though special rules are provided for in the regulations.[26]

Conclusion

Understanding the structural and tax implications of using ESBTs and QSSTs is essential for business owners and estate planners seeking to preserve S corporation status while facilitating smooth business succession. These trusts offer powerful tools to balance family and business interests, but they also come with strict requirements and potential tax drawbacks that must be carefully navigated. By working with experienced legal and tax advisors, business owners can design trust arrangements that support long-term goals, minimize risk, and help ensure a seamless transition of ownership across generations.

In our next article in the series, we will discuss some of the potential practical disadvantages to using trusts to hold S Corp shares in a family-run or other closely held business.

[1] IRC §§ 1361(b)(1)(A), (c)(1).

[2] IRC §§ 1361(b)(1)(B) (limiting shareholders of S Corps to individuals, estates, trusts described in (c)(2) and organizations described in (c)(6)), 1361(b)(1)(C).

[3] The trusts described in IRC § 1361(c)(2) are (i) Grantor trusts and other trusts treated as owners of the underlying trust property as described in IRC subpart E of part I of subchapter J, (ii) Grantor trusts and other trusts described in (i), the grantor of which has died within the last two years, (iii) a testamentary trust created to hold stock, but only for a period of two years, (iv) voting trusts, (v) an electing small business trust described under IRC § 1361(e)(1), and (vi) certain kinds of retirement accounts holding stock in banks or other depository institutions under particular circumstances. Note that other restrictions specified in IRC § 1361(b)(1) also still apply.

[4] IRC § 1361(e)(1)(A).

[5] See IRC § 1361(e)(1)(B).

[6] See Reg § 1.1361-1(m)(2)(iii). But note that there is an exception for certain trusts including grantor trusts and for testamentary trusts, during a two year period following the death of the owner or transfer into the testamentary trust, respectively. Reg §1.1361-1(m)(2)(iv) (“A trust that is a qualified S corporation shareholder under section 1361(c)(2)(A)(ii) or (iii) may elect ESBT treatment at any time during the 2-year period described in those sections or the 16-day-and-2-month period beginning on the date after the end of the 2-year period. If the trust makes an ineffective ESBT election, the trust will continue nevertheless to qualify as an eligible S corporation shareholder for the remainder of the period described in section 1361(c)(2)(A)(ii) or (iii).”).

[7] See Reg § 1.1361-1(m)(2).

[8] See Reg. § 1.1361-1(m)(2)(ii)(A).

[9] See Reg. § 1.641(c)-1(d)(2)(iii); Reg. § 1.1361-1(m)(2)(ii)(A).

[10] See Reg § 1.641(c)-1(a).

[11] Reg §1.1361-1(m)(4)(vii).

[12] See Reg § 1.641(c)-1(a). Compare Reg § 1.641(c)-1(b)(1) and Reg § 1.641(c)-1(c) with Reg § 1.641(c)-1(b)(2) and Reg § 1.641(c)-1(d).

[13] See Reg §§ 1.641(c)-1(a), (d).

[14] See Reg § 1.641(c)-1(a).

[15] Reg. § 1.1361-1(m)(1)(ii)(D). See also Reg §1.641(c)-1(b)(1)(ii) and (b)(2)(ii).

[16] Reg §1.641(c)-1(e). See also Reg §1.641(c)-1(d) regarding the determination of the taxable income of the S Portion.

[17] IRC § 1361(d)(3)(A).

[18] IRC § 1361(d)(3)(B).

[19] See IRC § 1361(d)(2)(B)(i); Reg §1.1361-1(j)(6)(ii).

[20] Reg § 1.1361-1(j)(11).

[21] See Reg § 1.1361-1(j)(6)(iii)(A).

[22] See Reg § 1.1361-1(j)(6)(iii)(B).

[23] See Reg § 1.1361-1(j)(6)(iii)(C).

[24] See Reg § 1.1361-1(j)(6)(iii)(D). “If a corporation’s S election terminates because of a late QSST election, the corporation may request inadvertent termination relief under section 1362(f).” Reg §1.1361-1(j)(6)(iii)(E).

[25] See IRC § 1361(d)(1)(B) (“for purposes of section 678(a), the beneficiary of such trust shall be treated as the owner of that portion of the trust which consists of stock in an S corporation with respect to which the election under paragraph (2) is made”); IRC § 678(a) (detailing the general rule as to when an individual other than the grantor shall be treated as the owner of any portion of a trust).

[26] See, e.g., Reg §§ 1.1361-1(j)(7)-(8).

——————————————————————–

This DarrowEverett Insight should not be construed as legal advice or a legal opinion. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. Please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.

This Insight does not constitute written tax advice as described in 31 C.F.R. §10, et seq. and is not intended or written by us to be used and/or relied on as written tax advice for any purpose including, without limitation, the marketing of any transaction addressed herein. Any U.S. federal tax advice rendered by DarrowEverett LLP shall be conspicuously labeled as such, shall include a discussion of all relevant facts and circumstances, as well as of any representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) upon which we rely, applicable to transactions discussed therein in compliance with 31 C.F.R. §10.37, shall relate the applicable law and authorities to the facts, and shall set forth any applicable limits on the use of such advice.