by John Anthony Castro, J.D., LL.M.
An S corporation election is a special election that may be made by businesses seeking corporate treatment for tax, liability, or asset protection reasons while still maintaining other benefits of being privately held. However, to achieve all these benefits simultaneously S corporations must meet a strict set of guidelines on ownership: (1) The S corporation must be a domestic corporation; (2) there may not be more than 100 shareholders; (3) there may only be 1 class of stock; (4) shareholders may only be individuals, estates, certain types of exempt organizations, and certain types of trusts. This article explores two major shareholder trusts and the process for qualifying such trusts as shareholders. An S corporation election may be jeopardized for every other shareholder if a single shareholder inadvertently transfers their interest into a trust that is not an eligible shareholder.
Under Section 1361(c)(2)(A), the trusts that may be qualified shareholders of an S corporation are: (1) trusts treated as owned by a U.S. citizen or resident individual under Secs. 671-679 (grantor trusts); (2) trusts that immediately before the death of the deemed owner were treated as owned by a U.S. citizen or resident individual under Secs. 671-679, but only for two years after the individual’s passing (provided, however, an election may be made under Sec. 645 to treat the trust as part of the estate, then the estate may hold the S corporation stock for the entire election period); (3) trusts to which stock has been transferred by a will, but only for 2 years from the date of transfer; and (4) trusts formed primarily to exercise the voting power of stock transferred to them. If the trust does not fall under the above categories it may still qualify as an S corporation shareholder by filing an election to be treated as a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT). Our focus will be the QSST and the ESBT trusts and the process for making the necessary elections.
Qualified Subchapter S Trusts (QSST)
Under Section 1361(d)(3), for a trust to qualify as a QSST, its terms must require that during the life of the current income beneficiary, the trust will have only one income beneficiary; and all of the trust’s accounting income must either be required by the terms of the trust instrument to be distributed, or actually be distributed, to the income beneficiary at least annually. The trustee must distribute trust accounting income directly to the beneficiary or to a custodial account for the benefit of a minor beneficiary. The trust’s terms must also require that corpus distributions during the current income beneficiary’s life can be made only to that beneficiary; the current income beneficiary’s income interest terminates at the earlier of the current beneficiary’s death or the termination of the trust; and, if the trust terminates during the current income beneficiary’s life, the trust’s assets are all distributed to the current income beneficiary.
Regulations further define that trusts with multiple beneficiaries can meet the QSST “single-beneficiary” requirement as well. Regulation Sec. 1.1361-1(j)(3), provides each beneficiary must have a separate and independent share of the trust, each of which is treated as a separate trust for federal income tax purposes. This will require careful drafting of the trust agreement. Also, spouses may both be listed as income beneficiaries of a QSST and they will be treated as a single beneficiary if they file a joint income tax return.
The trust’s current income beneficiary must make the QSST election. The beneficiary must file a statement that complies with Sec. 1361(d)(2) and in the manner prescribed by Regs. Sec. 1.1361-1(j)(6) and Rev. Proc. 2013-30. An alternate method available for making the QSST election, if an S corporation transfers its stock to the QSST on or before the date it makes the S corporation election, is to make the QSST election on Part III of Form 2553.
Electing Small Business Trusts (ESBT)
There are several important differences between ESBTs and QSSTs. ESBTs may have multiple beneficiaries, and trust income may be accumulated with discretion to distribute among the potential beneficiaries. The tax treatment of an ESBT is different from a QSST as well. An ESBT trust has at least two trust “portions”: and S portion, consisting of the S stock, and a non-S portion consisting of other property. Different tax rules apply to each portion of an ESBT based on the trust structure and terms. However, the S corporation portion of an ESBT is subject to the highest rate of income tax on ordinary income.
Another difference between an ESBT and QSST is the actual mechanics of the election. With an ESBT it is the responsibility of the trustee to make the ESBT election for the trust. The regulations allow in Secs. 1.1361-1(m)(2)(iii) and (j)(6)(iii) for the ESBT election to be made within two-months-and-15-day period beginning on the day the trust received the S corporation stock. The election is made by completing and filing the statement described in Reg. Sec. 1.1361-1(m)(2). The filing shall be made with the service center with which the corporation files its income tax return. In the case of a business that is not an S corporation and then elects S corporation status the ESBT election must be filed within the two-months-and-15-day period from the date of making the S corporation election.
Choice of Trust and Additional Considerations
It is important to note the differences between the QSST and the ESBT, especially the difference in who must make the election. A QSST election must be made by the beneficiary, while an ESBT election must be made by the trustee. This is an important distinction because an improperly filed election will be disregarded and the trust will not properly be treated as a QSST or ESBT as needed to maintain S corporation status. The decision between a QSST or ESBT may hinge on the structure of each particular trust. Fortunately, under Regs. Sec. 1.1361-1(m)(7), an ESBT may convert to a QSST and, conversely, under Regs. Sec. 1.1361-1(j)(12), a QSST may convert to an ESBT. However, to choose between a QSST and an ESBT, the trustee and beneficiaries must carefully consider potential tax consequences in light of potential benefits of multiple beneficiaries, accumulation of income, or split treatment of the trust depending on the circumstances.
Relief for Late Elections
The service anticipated that there may be circumstances in which an election to be treated as a QSST or ESBT may not be made within the time limits provided in the regulations as discussed above. Instead of requiring special requests for relief for each individual failure to make a timely election the service established Rev. Proc. 2013-30 to provide a standard template for how relief should be requested and the guidelines that would be applied in reviewing such requests. To request late election relief:
- The current income beneficiary or trustee must have intended to treat the trust as QSST or ESBT, respectively, as of the intended effective date;
- The beneficiary or trustee must make the request under Rev. Proc. 2013-30 within three years and 75 days after the intended effective date;
- The failure to qualify as a QSST or ESBT must have been solely because of the failure to timely file the proper election; and
- The failure was inadvertent, and the beneficiary or trustee has acted diligently to correct the mistake upon its discovery.
To obtain relief, the trustee of an ESBT or current income beneficiary of a QSST must sign and file the appropriate election form and include the following statements:
- A statement from the trustee or beneficiary that includes the information required by Regs. Sec. 1.1361-1(m)(2)(ii) (ESBT) or Regs. Sec. 1.1361(j)(6)(ii)(QSST);
- In the case of a QSST, a statement from the trustee that the trust satisfies QSST requirements of Sec. 1361(d)(3) and that the income distribution requirements have been and will continue to be met;
- In the case of an ESBT, a statement from the trustee that all potential current beneficiaries meet the shareholder requirements of Sec. 1361(b)(1) and that the trust satisfies the requirements of an ESBT under Sec. 1361(e)(1) other than the requirement to make an ESBT election; and
- Statements from all shareholders during the period between the date the S corporation election was to have become effective or was terminated and the date the completed election form is filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and for all subsequent years.
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About the Author
John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.
Bluebook Citation: John Anthony Castro, ESBT and QSST Elections: How to Qualify Trusts as S Corporation Shareholders, Int’l Tax Online Law Journal (Sept. 14, 2018) url.