By Nancy C. Hughes and David T. Lewis
Once considered on the frontier of business planning, limited liability companies (LLCs) and limited partnerships (LPs) have been growing in popularity recently, with a corresponding retreat from that former favorite, the S corporation. The popularity of LLCs and LPs is due primarily to the flexibility offered by LLCs and LPs when compared to the relative rigidity of S corporations.
Additionally, the new check-the-box regulations are likely to cause lawyers and clients to favor LLCs and LPs even more and be increasingly comfortable with their use. As a result, most lawyers currently recommend that clients use LLCs and LPs for new closely held business organizations rather than S corporations. Estate planning lawyers, however, must contend with the many existing S corporations.
Congress, however, extended the frontier with the Small Business Job Protection Act of 1996, P.L. No. 104-188, 110 Stat. 1755 (Act), which made many meaningful changes that provide significant new opportunities for clients with stock in S corporations. In fact, the changes have the potential to revitalize the utility of S corporations for closely held business owners. Among the Act's most significant revisions, and the focus of this article, is the introduction of a new kid in town_the "electing small business trust" (ESBT)_as a permissible S corporation shareholder.
Before the Act, the Code limited S corporations to 35 qualified shareholders. The only types of trusts that could own stock in S corporations were grantor or "Subpart E" trusts (both during the deemed owner's lifetime and for two years following the deemed owner's death), certain testamentary trusts, voting trusts and qualified subchapter S trusts (QSSTs). Code 1361(c)(2)(A)(i)-(iv); 1361(d)(1). A grantor trust is a trust, the income of which is deemed to be owned by the trustor for income tax purposes under Code 671 - 677.
A trust from which the beneficiary has a right to withdraw the assets is also eligible to own stock in an S corporation because the beneficiary is the deemed owner of the trust under Code 678. Code 1361(c)(2)(B)(i) treats the deemed owner of the trust as the S corporation's shareholder for all purposes, including the deter-mination of the number of eligible shareholders. The grantor trust rules provide that all items of trust income, deduction or credit pass through to the trust's deemed owner for income tax purposes. Treas. Reg. 1.671-4(a). This tax treatment results in the owner reporting his or her pro rata share of S corporation income on his or her individual income tax return regardless of whether the corporation distributed the income to the trust or the trustee distributed the income to the owner. This tax treatment allows a grantor trust to accumulate or sprinkle income among numerous beneficiaries while still qualifying as an S corporation shareholder. Because a grantor trust's qualification as a permitted S corporation shareholder dies with the deemed owner, the ability to use grantor trusts as permissible shareholders was limited before the Act.
The Code also allowed certain testamentary trusts to hold S corporation stock temporarily following an individual shareholder's death. This exception provided a short transition period to permit other shareholders or the corporation to buy the trust's stock without terminating the corporation's S election. Before the Act, this transition period was 60 days after the date of the trustor's death. The Code extended the 60 day period to two years if the entire principal of the trust was included in the trustor's gross estate for federal estate tax purposes. The Act extends the application of the two year transition period to grantor and other testamentary trusts that hold S corporation stock, regardless of whether the entire trust corpus is included in the gross estate of the trustor or other deemed owner. Code 1361(c)(2)(A)(ii), (iii). This revision seemingly provides a uniform post-death transition period and allows greater flexibility after the trustor's death. The revision actually allows an extended eligibility period for testamentary trusts because the S corporation stock may be held by the estate for a reasonable administration period and then may be held as part of a testamentary trust for two years.
The voting trust exception, al-though valuable in certain business situations, provides few, if any, income tax or estate planning opportunities. The beneficiaries of a voting trust are treated as the actual shareholders of the corporation for income tax purposes and for purposes of determining the number of permitted shareholders. Code 1361(c)(2)(B)(iv).
Because of the limits Congress imposed on grantor trusts, testamentary trusts and voting trusts holding S corporation stock, lawyers historically used a QSST to hold S corporation stock over a long term. Under Code 1361(c), the income beneficiary of a trust can elect to treat the trust that owns shares of stock in an S corporation as a QSST if the following conditions are satisfied:
- during the life of the current income beneficiary, there can only be one income beneficiary of the trust;
- any corpus distributed during the life of the income beneficiary must be distributed only to that income beneficiary;
- the income beneficiary's interest in the trust must terminate on the earlier of the beneficiary's death or the termination of the trust;
- if the trust terminates during the life of the current income beneficiary, the trust must distribute all of its assets to that beneficiary; and
- all of the trust income must be distributed currently to one income beneficiary who is a U.S. citizen or resident.
For example, a QSST may not accumulate accounting income, may not permit discretionary distributions of accounting income or distributions of principal to anyone other than the income beneficiary and may not have beneficiaries other than individuals who are permitted S corporation shareholders. Although the QSST is useful in certain situations, such as a testamentary qualified terminable interest property (QTIP) trust, the potential for more diverse planning is simply not available.
Section 1302 of the Act amended Code 1361(c)(2)(A) to allow an additional type of trust, the ESBT, to hold stock in an S corporation. A trust will qualify as an ESBT if its only beneficiaries are individuals, estates or, in some circumstances, certain nonprofit organizations. Code 1361(e)(1)(A)(i). For purposes of determining the number of shareholders of the S corporation, each "potential current beneficiary" of an ESBT is counted as a shareholder. Code 1361(c)(2)(B)(v). A "potential current income beneficiary" is entitled to, or at the discretion of any person could receive, a distribution from the principal or income of the trust. Code 1361(e)(2). If there is no potential current income beneficiary, the trust itself will be treated as the shareholder. Code 1361(c)(2)(B)(v).
In addition to the restrictions on the types of beneficiaries of an ESBT, no beneficiary can have acquired an interest in the ESBT by purchase; the beneficiaries must have acquired their interests as a result of a gratuitous transfer. This restriction shows that Congress intended the ESBT primarily as an estate planning tool. Although the acquisition by purchase limitation applies to the means by which a beneficiary can acquire an interest in the ESBT, the limitation does not prohibit an ESBT from acquiring S corporation stock by purchase.
As in the case of a QSST, an election must be made to qualify the ESBT as an S corporation shareholder. Unlike a QSST for which the income beneficiary makes the election, the trustee of the ESBT makes an ESBT election. Code 1361(e)(1)(A)(iii). IRS Notice 97-12, 1997-3 I.R.B. 11 (January 2, 1997), provides interim guidance in advance of regulations regarding the ESBT election and the ESBT's consent to the S corporation election. A sample ESBT election accompanies this article.
Code 1361(e)(1)(B) provides that a trust that has a QSST election in effect and any trust exempt from income tax cannot qualify as an ESBT. The latter restriction may preclude charitable remainder trusts from qualifying as ESBTs because they are tax exempt under Code 664. Although the ESBT cannot be a tax exempt trust, for taxable years beginning after December 31, 1996, an ESBT can have a tax exempt charitable organization described in Code 170(c)(2), (3), (4) or (5) as a beneficiary, provided that the organization holds only a contingent interest and is not a potential current beneficiary. Code 1361(e)(1)(A)(i)(III).
When analyzing fully the potential planning for charitable organizations, the lawyer must consider Act 1316 in conjunction with 1302, which deals with ESBTs. Section 1316 of the Act amends Code 1361 to provide that certain exempt organizations may hold stock in S corporations. In general, for taxable years beginning after December 31, 1997, organizations exempt from tax under Code 501(c)(3) and qualified retirement plans described in Code 401(a) may own stock in an S corporation. Code 1361(c)(7). All items of income or loss of the S corporation, however, will flow through to the exempt organization shareholder as unrelated business taxable income, regardless of the source or nature of that income. Code 512(e)(1)(A). In addition, Act 1316 provides that, after December 31, 1997, a charitable beneficiary of an ESBT can be a permitted potential current ben- eficiary, eliminating the existing contingent beneficiary limitation. Code 1361(e)(1)(A)(III).
The combination of Act 1316 and 1302 provides both opportunities and pitfalls. For taxable years beginning after December 31, 1996, certain tax exempt charitable organizations may have contingent beneficial interests in an ESBT. For taxable years beginning after December 31, 1997, however, the same organizations can also be vested beneficiaries and even potential current ESBT beneficiaries. Nevertheless, the description of permitted charitable organizations in 1302 is not the same as the description of permitted shareholders in 1316.
These nuances require careful drafting of an ESBT instrument whenever a tax exempt charitable organization is a beneficiary. In most cases, the tax exempt organization that qualifies as a permitted beneficiary of an ESBT will also meet the definition of the tax exempt organization permitted to be a shareholder of an S corporation. A problem could arise for an ESBT when a tax exempt charitable organization is a qualified beneficiary of the ESBT but not a qualified shareholder of S corporation stock under 1316. The prudent lawyer in this situation should include special provisions in the trust instrument to prohibit distributions of S corporation stock to the tax exempt charitable organization.
Although the ESBT may be the best option for a client who plans a trust that will hold S corporation stock and who desires to name multiple beneficiaries or to give a trustee discretion in making distributions, or both, adverse income tax consequences for the trust will result.
For purposes of determining the taxable income attributable to the S corporation stock held by the ESBT, that portion of the ESBT principal consisting of S corporation stock will be treated as a separate trust for income tax purposes under Code 641(d)(1)(A). The income attributable to this separate trust will include any income, loss or deduction attributable to the trust's S corporation stock under Code 1366, the gain or loss from the sale of any S corporation stock and, as may be provided by the regulations, any state or local income taxes or expenses allocable to the S corporation stock. Code 641(d)(2)(c). That portion of the ESBT principal not attributable to the ownership of the S corporation stock will continue to be taxed under the normal Subchapter J rules. Code 641(d)(3).
Income attributable to this S income "separate trust" will be taxed at the highest individual rate under Code 1(e), which is currently 39.6% on ordinary income and 28% on net long- term capital gains. The result could be a higher net tax for the ESBT, as compared to the income tax when using a grantor trust or QSST, and will never be a lower tax.
The income taxation issue is complicated by the fact that the S corporation income will not be treated as distributable net income (DNI) for fiduciary income tax purposes. Code 641(d). Thus, a distribution of the S corporation income to the ESBT's beneficiaries will not generate a distribution deduction for the separate trust, making it impossible for the ESBT to shift its S corporation income to beneficiaries in lower income tax brackets. Additionally, it is unclear whether a distribution of S corporation income from the ESBT to the beneficiary will entitle the non-S corporation portion of the ESBT to a distribution deduction. Until the IRS issues guidance on this issue, an ESBT trustee may wish to segregate any cash flow from the S corporation so that the trustee does not have to trace the origin of distributed dollars to calculate the distribution deduction for the "regular" portion of the trust.
On termination of all or any portion of an ESBT, any loss carryovers or excess deductions will be taken into account by the entire trust, subject to the Subchapter J rules on trust terminations. If the ESBT terminates before the end of the S corporation's tax year, the trust must take into account its share of the S corporation tax items for the trust's final year. Planning to Use "The Good" The ability to use an ESBT in traditional unified credit/marital trust planning simplifies estate planning for clients with S corporation stock. Although a QTIP trust should always qualify as a QSST, the QSST often imposes undesirable restrictions on a credit shelter trust. The ESBT rules now allow a client to set up a trust that will hold S corporation stock and include provisions allowing discretionary distributions of income and principal to multiple beneficiaries and the accumulation of trust income. With the high income tax rate imposed on S corporation income in an ESBT and the extension of the holding period for testamentary trusts to two years, however, it may be desirable for the trustee to treat a credit shelter trust as a testamentary trust under Code 1361(c)(2)(A), rather than an ESBT, for as long as possible before making the ESBT election.
Another attractive feature of the ESBT is that if there are no potential current beneficiaries of the trust, the trust itself will be treated as a shareholder for purposes of determining the number of eligible shareholders of the S corporation. This feature makes the ESBT well suited for generation-skipping transfer tax (GSTT) planning. For instance, a client with S corporation stock could transfer the stock to a trust for the ultimate benefit of the client's grandchildren, use his or her unified credit to shelter the gift and allocate all or part of his or her GSTT exemption to the trust. The client would not retain any strings that would cause the trust to be included in the client's gross estate for federal estate tax purposes.
Several options achieve grantor trust status for income tax purposes without inclusion for estate tax purposes. One method is for the trust instrument to provide that the grantor may borrow from the trust income or principal without security. Code 675(2). A trust, however, will not be a grantor trust merely because the trustee has a general lending power. During the client's life, the client would be taxed on the trust's income, including the income attributable to the S corporation stock, even though the trust accumulates the income. After the client's death and the expiration of the two year testamentary trust holding period, the trustee could then make an ESBT election and continue to accumulate the income for the benefit of the client's grandchildren. At that point, the trust would pay tax on its S corporation income at the highest rate. This planning permits all appreciation and any income accumulated after the initial transfer to pass to the client's grandchildren or other skip persons free of transfer and income tax during the period that the client was alive.
In any of the situations discussed above, the lawyer must take special care to draft the ESBT to ensure that each beneficiary is a qualified ESBT beneficiary. If a nonqualified beneficiary of the ESBT becomes a current beneficiary, the trust will fail to qualify as an ESBT, will no longer be a permitted shareholder of the S corporation and will cause the corporation to lose its S election. As a savings measure, the Act permits the trustee to sell all of the trust's S corporation stock within 60 days after the nonqualified beneficiary becomes a current beneficiary. In this situation, that beneficiary's status as a nonqualified beneficiary will be ignored, the trust will continue to be an ESBT during the 60 day period and the corporation's S election will not terminate. Code 1361(e)(2). A lawyer should consider building in the 60 day relief provision in an ESBT if a nonqualified beneficiary becomes a potential current beneficiary of the trust.
Another difficulty in drafting and administering an ESBT is that a qualified potential current beneficiary of an ESBT does not include another trust. Many lawyers provide in trusts that, if income or principal is payable to a minor, the trustee will distribute it to a trust for the minor's benefit. The possible distribution of S stock to such a trust, which itself would be a beneficiary of the ESBT, could jeopardize the ESBT election. One solution to this problem might be for the trust instrument to give the trustee discretion to create a trust for a minor, rather than making such a trust mandatory. Until the IRS gives further guidance, however, this approach may disqualify the trust.
Another potential solution is to provide for payment to a custodian for the minor under the applicable Uniform Transfers to Minors Act or equivalent law, rather than to a separate trust. IRS representatives have unofficially indicated that the potential of a distribution to a custodian-ship should not disqualify the ESBT. Finally, the agreement could provide for separate shares, rather than new trusts, or for the old trust to continue if certain contingencies arise. With this approach, a trust will not be the beneficiary of the ESBT.
The lawyer should also check state income tax rules with respect to S qualification when an ESBT holds S corporation stock. Unless the state adopts the federal rules, the lawyer might be faced with a valid S shareholder for federal purposes and a loss of S status for state purposes.
Finally, the lawyer should check his or her standard QSST language. For example, the language may include a provision stating that, if any trust holds S stock and does not qualify as a QSST, the trustee shall segregate the stock into a separate trust that qualifies as a QSST. With that wording, the trustee would be unable to keep the stock in a sprinkling trust for which the trustee could make an ESBT election, causing a loss of flexibility.
The Act opens up new territory for lawyers wrestling with the difficulties of estate planning for clients who own S corporation stock. Al-though the ESBT is not a panacea, it does provide increased flexibility for clients with S corporation stock without many of the restrictions of a QSST. Lawyers should discuss the advantages and disadvantages of the ESBT with their clients who own S corporation stock so that the clients are aware of new estate planning options available to them. IRS officials have indicated that they hope to issue guidance very soon concerning contingent trusts as beneficiaries of ESBTs and the uncertainty associated with the accounting of S corporation income for ESBTs. Lawyers in the vanguard who explore the use of ESBTs should remain alert to new developments in this area.
Nancy C. Hughes is a shareholder with Berkowitz, Lefkovits, Isom & Kushner, P.C. in Birmingham, Alabama and is Chair of the Probate Division's (I-2) Committee on PostMortem Income Tax Planning. David T. Lewis is an associate with McGuire, Woods, Battle & Boothe, LLP in Richmond, Virginia.
Sample ESBT Election
To: Internal Revenue Service Center
[Address where corporation files its income tax return]
[Name of Trustee] (the "Trustee"), as Trustee of the [Name of Trust] (the "Trust"), hereby makes an election to treat the Trust as an "electing small business trust." In connection with such election and pursuant to Notice 97-12, 1997 - 3 IRB 11, the Trustee states as follows:
1 A. Names of All Potential Current Beneficiaries, if any
Addresses of Potential Current Beneficiaries
Taxpayer ID #'s of Potential Current Beneficiaries
B. Name of Trust Address of Trust Taxpayer ID # of Trust
C. Name of Corporation Address of Corporation Taxpayer ID# of Corporation
2. This election is made under 1361(e)(3) of the Internal Revenue Code (the"Code").
3. This election is to become effective on _______________, 199___ [not earlier than 15 days and two months before the date the election is filed].
4. The stock of [Name of Corporation] was transferred to the Trust on ___________, 199___.
5. All potential current beneficiaries meet the shareholder requirements of Code 1361(b)(1).
6. The Trust meets the definitional requirements of an ESBT under Code 1361(e).
Signed by the Trustee this the _____ day of ________________, 199___.
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