Earlier this year, the IRS issued Rev. Proc. 2013-30 to provide relief to corporations that have ceased to qualify as S corporations where the terminating event was not reasonably within the control of the corporation. In particular, the Rev. Proc. addresses late QSST and ESBT elections.

 The issuance of the Rev. Proc., which consolidates various relief provisions previously adopted by the IRS, points to the continuing difficulty that some taxpayers have in determining whether trusts to which shares of S corporation stock are transferred are permitted S corporation shareholders. This state of affairs may lead to some serious tax and economic consequences to taxpayers who are engaged in gift and estate planning with respect to their shares of S corporation stock.

 The Internal Revenue Code limits the permitted shareholders of an S corporation to domestic individuals, estates, certain trusts, and certain exempt organizations.  What follows is a brief description of the basic rules applicable to the ownership of S corporation stock by trusts.

 Trusts that May Hold S Corp. Stock

 Grantor Trusts

 A grantor trust is a trust, all of which is treated, for tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.

Upon the death of the deemed owner of the grantor trust, if the trust was a grantor trust immediately before the death, and it continues in existence after the death, the trust may continue to hold S corporation stock, but only for the 2-year period beginning on the day of the deemed owner’s death. In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.

Testamentary Trusts

A trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will, may hold S corporation stock, but only for the 2-year period beginning on the day the stock is transferred to the trust.

 QSSTs

A QSST is a permitted S corporation shareholder if the beneficiary of the QSST makes an election under the Code. A QSST is defined as a trust that

  1. distributes or is required to distribute  all of its income to a citizen or resident of the United States,
  2. has certain trust terms, including the requirement that there be only one income beneficiary,
  3. does not distribute any portion of the trust corpus to anyone other than the current income beneficiary during the income beneficiary’s lifetime, including the time at which the trust terminates, and
  4. the income interest of the current income beneficiary ceases on the earlier of such beneficiary’s death or the termination of the trust.

In the case of a QSST with respect to which a beneficiary makes an election, the beneficiary of the trust is treated, for purposes of the grantor trust rules, as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the election is made.

A QSST election is made by signing and filing an election statement with the applicable IRS Service Center. The QSST election must be made within the 16-day-and-2-month period beginning on the day that the S corporation stock is transferred to the trust.

ESBTs

An ESBT is a permitted S corporation shareholder. It is defined as any trust where:

  1. the trust does not have as a beneficiary any person other than an individual, an estate, or certain charitable organizations;
  2. no interest in the trust was acquired by purchase; and
  3. an election has been made with respect to the trust.

 To qualify as an ESBT, the trustee of the trust must make an ESBT election by signing and filing an election statement with the applicable IRS Service Center. The ESBT election must be filed within the same time requirements prescribed for filing a QSST election.

 Who is Treated as the Shareholder for Various Tax Purposes

 For purposes of

  1. qualification as a small business (“S”) corporation and, in general, for purposes of
  2. (i) the pass-through of items of S corporation income, loss, deduction, or credit, (ii) the adjustments to basis of shareholder’s stock, and (iii) the treatment of distributions by an S corporation, the shareholder of S corporation stock held by a trust that is a permitted shareholder, is determined as follows:

 (A) If stock is held by a grantor trust, the deemed owner of the trust is treated as the shareholder.

(B) If stock is held by a trust that was a grantor trust immediately before the death of the deemed owner, and the trust continues in existence after the death of the deemed owner, the estate of the deemed owner is generally treated as the shareholder as of the day of the deemed owner’s death.

 The estate ordinarily will cease to be treated as the shareholder upon the earlier of the transfer of the stock by the trust or the expiration of the 2-year period beginning on the day of the deemed owner’s death.

 If the trust qualifies and becomes an electing QSST, the beneficiary and not the estate is treated as the shareholder as of the effective date of the QSST election. If the trust qualifies and becomes an ESBT, the shareholders are determined under paragraph (E), below, as of the effective date of the ESBT election.

 However, solely for purposes of applying the pass-through, basis and distribution rules, the trust is treated as the shareholder of S corporation stock held by the former grantor trust. If the trust continues to own the stock after the expiration of the 2-year period, the corporation’s S election will terminate unless the trust is otherwise a permitted shareholder.

(C) If stock is held by an electing QSST, the income beneficiary who makes the QSST election, and is treated (for purposes of the grantor trust rules) as the owner of that portion of the trust that consists of the S corporation stock, is treated as the shareholder for purposes of the qualification, pass-through, basis and distribution rules; however, the beneficiary will not be treated as the owner of the S corporation stock in determining and attributing the income tax consequences of a disposition of the stock by the QSST.
If, upon the death of an income beneficiary, the trust continues in existence, continues to hold S corporation stock but no longer satisfies the QSST requirements, is not a grantor trust, and does not qualify as an ESBT, then, solely for purposes of the qualification rule, as of the date of the income beneficiary’s death, the estate of that income beneficiary is treated as the shareholder of the S corporation with respect to which the income beneficiary made the QSST election.

 The estate ordinarily will cease to be treated as the shareholder for purposes of the S corporation qualification rule upon the earlier of the transfer of that stock by the trust or the expiration of the 2-year period beginning on the day of the income beneficiary’s death.

 During the period that the estate is treated as the shareholder for purposes of the qualification rule, the trust is nevertheless treated as the shareholder for purposes of the pass-through, basis and distribution rules.

 If, after the 2-year period, the trust continues to hold S corporation stock and does not otherwise qualify as a permitted shareholder, the corporation’s S election terminates.

(D) If stock is transferred or deemed distributed to a testamentary, the estate of the testator is treated as the shareholder until the earlier of the transfer of that stock by the trust or the expiration of the 2-year period beginning on the day that the stock is transferred or deemed distributed to the trust.

 However, solely for purposes of applying the pass-through, basis and distribution rules, in the case of a testamentary trust, the trust is treated as the shareholder of the S corporation stock held by the trust. If the trust continues to own the stock after the expiration of the 2-year period, the corporation’s S election will terminate unless the trust otherwise qualifies as a permitted shareholder.

 If the trust qualifies and becomes an electing QSST, the beneficiary and not the estate is treated as the shareholder as of the effective date of the QSST election. If the trust qualifies and becomes an ESBT, the shareholders are determined under paragraph (E), below, as of the effective date of the ESBT election.

(E) If S corporation stock is held by an ESBT, each potential current beneficiary is treated as a shareholder.  The trust itself, however, is treated as a separate taxpayer for purposes of the pass-through rules – the income does not flow-through to the beneficiaries; in addition, any gain from the disposition of the S corporation stock is taxable to the trust; the ESBT is not entitled to a deduction for distributions to its beneficiaries.

 A trust cannot make a conditional ESBT election that would be effective only in the event the trust fails to meet the requirements for an otherwise eligible. If a trust attempts to make such a conditional ESBT election and it fails to otherwise qualify as an eligible S corporation shareholder, the S corporation election will terminate because the corporation will have an ineligible shareholder.

Estate – Or Is It A Trust?

An estate is an eligible S corporation shareholder. Upon the death of an S corporation shareholder, if the decedent’s stock in the corporation is held by the executor of his estate for purposes of administration, the estate will become a shareholder as of the date of the decedent’s death. This is true notwithstanding the fact that state law may provide that the legal title to the stock passes directly to the decedent’s legatees or heirs.

However, an estate cannot remain in existence indefinitely. Indeed, under IRS regulations, an estate will be considered terminated if the period of administration is unduly prolonged. The period of administration of an estate is the period actually required by the executor to perform the ordinary duties of administration, such as the collection of assets and the payment of debts, taxes, legacies, and bequests.

The IRS may contend that a corporation has ceased to qualify as an S corporation where one of its shareholders is, in effect, a testamentary trust, rather than an estate, where the executors have long since completed their duties as executors yet have continued to hold the stock (i.e., the estate has converted into a trust).

 Conclusion

The forgoing discussion highlights the complexity of the rules governing the ownership and taxation of trusts that hold shares of stock in an S corporation. In light thereof, it is easy to appreciate how an S corporation may inadvertently lose its status by virtue of a trust’s ceasing to qualify as a permitted shareholder. Thankfully, the IRS has provided some relief from such terminations, as in the form of Rev. Proc. 2013-30.

However, it also underlines the importance of having a well-drafted shareholders agreement, one that restricts the transfer of stock so as to preserve the corporation’s S election and that ensures the cooperation of all the shareholders in preserving or reinstating the election.