Electing Small-business Trusts

An Effective Way to Plan for Succession in a Closely Held Business

Planning for an estate that includes an interest in a closely-held business always requires special attention. Not only will the business likely be the culmination of a lifetime of work, it is usually a large part of the owner’s estate. If the business interest is in the form of S-corporation stock, even greater care must be taken to ensure that the benefits of S-corporation treatment are not lost.
An S corporation enjoys substantial income-tax benefits because its shareholders are subject to only one layer of taxation, instead of the two layers imposed upon a C corporation. In order for a corporation to qualify for S treatment, a number of requirements must be met as follows:
• The corporation can have no more than 100 shareholders;
• No shareholder can be a non-resident alien individual;
• The corporation can have only one class of stock; and
• No shareholder can be an entity other than estates, certain charities, and certain types of trusts.
The primary operating document in an estate plan is often a revocable trust, so care must be taken to ensure that the trust complies with the S-corporation rules and that the beneficiaries of the trust are qualified shareholders. If either of these conditions is not met, the disastrous result will be that the corporation will lose its S status and its favorable tax treatment for all its shareholders.
One type of trust that always qualifies as a shareholder of an S corporation is the statutorily created Electing Small Business Trust (ESBT). The ESBT was created by Congress in 1996 as a means of authorizing a discretionary trust to be a qualified shareholder. Prior to the creation of the ESBT, the only type of trust that was authorized to hold S corporation stock after the death of the grantor was the Qualified Subchapter S Trust (QSST).
The QSST has the drawback, however, of allowing only a single-income beneficiary, to whom all of the income of the trust must be distributed currently. The income beneficiary is also the only beneficiary of the trust principal while he or she is alive. These restrictions on the trust diminish its usefulness as an estate-planning tool. The ESBT, on the other hand, allows for multiple-income beneficiaries, among whom the trustee can distribute income and principal at the trustee’s discretion, as well as allow income to be accumulated within the trust.
There are only two requirements for a trust to qualify as an ESBT:
• All of the beneficiaries must be either individuals who are U.S. citizens or resident aliens, estates, or certain types of charitable organizations; and
• None of the beneficiaries can have acquired his or her interest in the trust by purchase or taxable exchange.
For purposes of determining whether an S corporation has fewer than 100 shareholders, all the potential current beneficiaries of the trust are counted. A potential current beneficiary is any beneficiary to whom the trustee is required or has the discretion to make current distributions of income or principal. A beneficiary who has only a future interest in the trust is not counted as a shareholder of the ESBT. On the other hand, for purposes of determining whether all the individual beneficiaries are U.S. citizens or resident aliens, all the beneficiaries of the trust, including those holding a remainder or reversionary interest, are taken into account.
To elect ESBT treatment, the trustee must sign and file a specified statement with the IRS. The statement must include:
 • The name, address, and taxpayer-identification number of the trust;
• The potential current beneficiaries, and the S corporations in which the trust currently holds stock;
• An identification of the election as an ESBT election made under the relevant Internal Revenue Code section;
• The first date on which the trust owned stock in each S corporation;
• The date on which the election is to become effective (not earlier than 15 days and two months before the date on which the election is filed); and
• Representations signed by the trustee stating that the trust and all the potential current beneficiaries meet the definitional requirements of the relevant code section.
The ESBT has the advantage of greater flexibility for estate-planning purposes, but it carries a higher tax cost than most other trusts. For the portion of an ESBT that holds S-corporation stock, the trust is taxed at the highest individual income-tax rate, regardless of whether it distributes the income from the S-corporation stock to the beneficiaries. If the beneficiaries of the trust are not in the highest income tax bracket, the ESBT can carry a significant tax cost. For example, in 2010, the highest marginal income-tax rate was 35%.
All the income of the ESBT would be taxed at that rate, even if was distributed to beneficiaries who were all in the 15% bracket. For a $10,000 distribution, that is the difference between paying taxes of $3,500 versus $1,500. Furthermore, the trust cannot take many of the deductions or offsetting losses that would be available to an individual beneficiary.
The trustee must weigh the options and determine whether the greater flexibility is worth the higher tax cost of the ESBT. Although the election to be treated as an ESBT is irrevocable, the ESBT can be converted to a QSST under certain circumstances to take advantage of pass-through taxation.
The ESBT can be a very useful tool in planning for an estate that will hold S-corporation stock. It provides greater flexibility, albeit at a higher tax cost, than other subchapter S-qualified trusts. Such trusts must be carefully drafted, however, because their many technical requirements can prove to be a trap for the unwary.
 
Julie R. Lackner is an estate-planning attorney with the Springfield-based regional law firm Bacon Wilson, P.C. She is a member of the Estate Planning Council of Hampden County and the National Academy of Elder Law Attorneys; (413) 781-0560; baconwilson.com; bwlaw.blogs