Taking Care with S Corporation Trusts
When it comes to trusts being eligible S corporation shareholders the rules concerning how a trust qualifies, what trusts qualify, and implications to the trust as a shareholder are rigid and complex. Private letter rulings are often issued in regard to trusts holding S corporation stock. Reviewing these rulings reveals a variety of mistakes that can cause a trust to be disqualified as an S corporation shareholder. Some of these situations are logical and easily recognizable, but others involve circumstances that even experienced practitioners would not immediately recognize.
Generally, estates and six types of trusts are eligible as S corporation shareholders, these include grantor trusts, electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), and testamentary trusts (for two years after funding. Most practitioners who work with trusts recognize that an election must be made for a trust to appropriately be an eligible ESBT or QSST, but the following are 10 ways that a trust can inadvertently bust an S corporation election.
1. Trusts Owned by More than One Individual
Grantor trusts (either revocable or irrevocable) are eligible under Sec. 1361(c)(2)(A)(i) but only if the trust has only one grantor (although spouses generally are treated as one shareholder). Thus, a trust that is taxable to multiple individuals under Sec. 671 would not be eligible to hold S corporation stock.
2. Foreign Trusts
A foreign trust is not eligible to hold S corporation stock. However, it sometimes is difficult to determine that a trust is actually a foreign trust. Trusts that begin as U.S. trusts can become foreign trusts if the administration provisions are not drafted tightly enough to prevent this from occurring. This could happen if the trustee becomes a foreign person, or if there are multiple trustees and a foreign trustee has or obtains the ability to control the substantial decisions of the trust.
3. Nonresident Aliens
It is also important to be aware of the general rule that an S corporation cannot have a nonresident alien as a shareholder. Thus, previously valid S corporations can become disqualified when an existing shareholder who formerly was a resident alien moves out of the United States or abandons permanent resident status. Additionally, if a shareholder renounces U.S. citizenship the S corporation can lose its status. Be sure to consult with a professional before any change in citizenship or residency status of yourself (if you are a shareholder in an S corporation) or a business partner (if the entity is an S corporation).
4. Nonresident Aliens and ESBT and QSST Elections
The nonresident alien issue can also negate an otherwise valid ESBT or QSST election. Since all applicable beneficiaries of a QSST or an ESBT must be individuals who otherwise would be eligible to hold S corporation stock directly, the beneficiary’s nonresident status could cause them to become an ineligible shareholder. This will cause the trust to become ineligible, even though no change of ownership of the stock occurred. This situation can be especially sneaky if an ESBT trust provides that “after-born” children or grandchildren are automatically added to the trust as beneficiaries and a child or grandchild is born who is not a U.S. citizen.
5. Charitable Remainder Trusts
A charitable remainder trust (CRT) is not an eligible shareholder of S corporation stock. Thus, if an S corporation issues additional shares of stock to individuals and entities, if one of those is a CRT this would terminate S corporation status. It is important to note that a charitable organization may hold S corporation shares. However, it must be the 501 organization itself that holds the shares not a CRT.
Although IRAs are typically structured as trusts for legal purposes, and IRA is not an eligible shareholder of S corporation stock. S corporation stock may be owned by a qualified pension plan, but IRAs and Roth IRAs are governed by different sections of the tax code than the qualified pension plans that are eligible to hold S corporation stock.
7. Defective Trust Provisions
Trusts are often created to achieve a multitude of goals concurrently. This means that a trusts provisions must be carefully considered to ensure that no provision specifically designed to achieve a goal inadvertently makes a trust ineligible to hold S corporation stock. For example, if a trust (intending to be a QSST) appropriately designates only one beneficiary, but also includes a provision that if the trust property is included in the Grantor’s estate upon his passing then trust assets may be used to pay any resulting estate tax. This seemingly insignificant provision indirectly made the grantor a potential beneficiary of the QSST disqualifying the trust from QSST status because there was not only one sole beneficiary.
8. Defective Elections
Occasionally, a QSST or an ESBT election is timely filed but the proper filing procedure was not followed. QSST elections require the signature of the beneficiary, while the ESBT election requires the signature of the trustee. Additionally, for married couples in community property states, any election must be signed by both spouses, rather than signed only by the spouse who is nominally the shareholder.
If an existing ESBT (or QSST) decants to change provisions that the grantor no longer desires to be in the trust. A new trust may be created with the same trustee and beneficiary but modified administrative provisions. When the S corporation shares are transferred from the old trust to the new trust, the trust must make a new ESBT (or QSST) election. If not, the trust is an ineligible shareholder and busts the S corporation election.
10. Failure to Make Timely Elections
Failure to make a timely election happens all the time. This includes not only the S corporation election itself but also an election to make a trust an eligible shareholder as either an ESBT or QSST within two months and 15 days after the stock is transferred into the trust. The timeline for making elections is further complicated in certain circumstances. For example, if a trust is a grantor trust to one individual, it is eligible as an S corporation shareholder, even though the trust may be irrevocable. However, if the grantor trust status is terminated, a separate election is necessary, even if there was no change in legal ownership of the stock.
In most circumstances, the only way to obtain a waiver of an inadvertent termination of S corporation status is to obtain a private letter ruling, which can be costly and time-consuming. Although there is a procedure available to obtain a waiver of an inadvertent termination upon failure to file a timely election, this procedure cannot be used to avoid termination of S corporation status involving a trust that is ineligible to make an election.