Pass-through entities (excluding entities taxed as sole proprietorships) are the most common form of business enterprise, with S corporations being the most prolific. In 2014, nearly 1 million more S corporation income tax returns were filed than partnership income tax returns, with total S corporation return filings in excess of 4.6 million. In addition, S corporations employ a greater percentage of the private sector work force than partnerships and sole proprietorships. Given the popularity of S corporations and the pass-through income tax treatment for federal and state income tax purposes that S corporations enjoy, estate planning and business succession for many investors and business owners will inevitably involve an S corporation.
S Corporation Basics
In order to qualify as an “S corporation” and be taxed under Subchapter S of the Code, the state law business entity must be a corporation or a limited liability company that has elected to be treated as a corporation for income tax purposes. In addition, an S election must be filed with the IRS (Form 2553) within two months and 15 days of the beginning of the entity’s tax year in order for the election to relate back to the beginning of such year. Otherwise, the election is effective on the first day of the next tax year.
In addition to the legal entity and election requirements, S corporations have restrictions on the number and type of owners. First, S corporations may only have 100 shareholders. Second, those shareholders must be either individuals (who are U.S. citizens or residents), certain retirement plans (such as ESOPs or profit sharing plans), charities exempt under 501(c)(3), or certain trusts. Third, an S corporation may only have one class of stock; however, differences in voting alone (e.g., non-voting stock) will not create a second class. These rules must be considered for any estate or business succession plan involving S corporations.
Consequences of Failing S Corporation Requirements
If an S corporation fails the ownership requirements discussed above, the S corporation status terminates on the day before the terminating event. For example, if ownership of an S corporation transfers to a non-qualifying owner, the S status will terminate. At that point, the corporation will become a C corporation meaning that a double tax regime will apply (generally, C corporation income is subject to a 21% federal income tax and dividends from C corporations are subject to federal tax rates ranging from 15% to 23.8%). Moreover, upon a termination, an S election may not be made again for 5 years. In certain cases, the IRS may grant relief from an inadvertent S election termination.
Trusts and Estates
Most estate plans and wealth transfer plans incorporate one or more trusts. Trusts are of paramount importance to investors and business owners who are concerned about protecting their business interests from unnecessary liabilities, reducing wealth transfer taxes, and ensuring their business interests pass at death without unnecessary costs such as probate. Moreover, when leaving wealth to children and/or charities, a trust is an excellent vehicle to restrict access to wealth and ensure that the business owner’s ultimate objectives are fully achieved.
The first and most common type of trust that may own S corporation stock is a grantor trust. In simple terms, a grantor trust is a trust that is ignored for income tax purposes, meaning that the grantor reports all of the income earned by the grantor trust on the grantor’s personal income tax return. The “grantor” is the person who makes a gratuitous transfer to the trust. If the “grantor” or a non-adverse party (someone who does not have a substantial beneficial interest in the trust) retains certain powers or rights over the trust, then the grantor will remain the taxpayer for income tax purposes and the trust will qualify as a grantor trust. To be eligible to own S corporation stock, the grantor trust must only have one grantor (or a husband and wife) and the grantor must otherwise be eligible to own S corporation stock (e.g., a U.S. citizen individual).
Common powers possessed by the grantor that cause a trust to be a grantor trust include the power to revoke, the power to dispose of income or corpus of the trust, the ability to substitute assets in the trust for assets outside the trust that are of equivalent value, or the power to borrow from the trust without adequate interest or security. A revocable trust is a common estate planning tool to avoid probate at death and such a trust is generally a grantor trust. In addition, trusts that are used for wealth transfer planning such as grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs) may be properly structured as grantor trusts. Of course, these trusts must also be drafted with the view that once the grantor dies or certain changes occur (such as the expiration of a GRAT’s annuity), the trust must have adequate provisions to avoid disqualification as an S corporation shareholder. In addition, S corporations are frequently recapitalized into voting and non-voting interests to facilitate transfers to GRATs and IDGTs, and if done properly, the existence of non-voting interests should not risk the S status of the corporation.
Estates, Irrevocable, and Testamentary Trusts
If an owner of S corporation stock dies, there is an immediate ownership change. The tax law generally grants grace periods for S corporation ownership when a death occurs. For example, an estate may own S corporation stock during a reasonable period of administration. Testamentary trusts (those created in a will) may own S corporation interests for two (2) years from receipt of the stock from the estate. Likewise, former grantor trusts whose grantor-trust status terminated by reason of the grantor’s death may own S corporation stock for two (2) years. After the grace period, the stock must pass to another eligible S corporation owner, highlighting the need for properly drafted estate plans.
Qualified Subchapter S Trusts
A qualified subchapter S trust or “QSST” may own S corporation stock. In order to qualify, a QSST must have only one income beneficiary who is a U.S. citizen or resident. All of the trust income must be distributed to the income beneficiary each year and if principal may be distributed, it may only be distributed to the sole income beneficiary. Further, the income beneficiary’s interest must terminate on the first to occur of the income beneficiary’s death or termination of the trust. If the trust terminates during the beneficiary’s life, all of the trust assets must be distributed to the income beneficiary.
In addition to the requirements in the trust itself, the income beneficiary must make an election for the trust to be treated as a QSST. The election must be filed with the IRS service center where the S corporation files its 1120-S and must meet certain requirements such as specifying the date of election (which cannot be earlier than 2 months and 15 days before filed). The election may not be revoked without the consent of the IRS. It is important that stock not be transferred to a trust that is intended to be a QSST unless and until the election is effective.
The benefit of a QSST from a tax perspective is that the income beneficiary is treated as the deemed owner over the portion of the trust that consists of stock in the S corporation. This means that the trust’s allocable portion of the S corporation income is reported directly by the beneficiary. The trust itself must file a Form 1041 but will report the S corporation income on a separate statement that is provided to the income beneficiary and is reported on the beneficiary’s individual income tax return (Form 1040).
Due to the high income tax rate applicable to ESBTs (discussed below), the QSST is usually the better option to minimize income taxes for a non-grantor trust owning S corporation stock. Indeed, a beneficiary will not pay the highest marginal federal income tax rate until taxable income reaches $500,000 for single taxpayers and $600,000 for married taxpayers. However, because of the mandatory income distribution requirement, the QSST is less advisable for minor beneficiaries or other beneficiaries who should not have access to income.
Electing Small Business Trust
An electing small business trust or “ESBT” may also own S corporation stock. To qualify, the ESBT beneficiaries must be individuals, estates, or charitable organizations. For this purpose, a “beneficiary” means a person with a present, remainder, or reversionary interest in the trust. In addition, there are restrictions on who may be a “potential current beneficiary” or PCB. A PCB is a person to whom distributions must or can be made from the trust at the time the ESBT is to own S corporation stock and qualify as an ESBT. PCB’s may only include individuals, qualifying charities, and other qualifying trusts. Prior to the 2017 Tax Cuts and Jobs Act, only U.S. citizen or resident individuals could be PCBs. However, the new law allows non-resident aliens to be PCBs of ESBTs.
Similar to QSSTs, ESBTs require an election. The election must be made by the Trustee and be filed with the service center where the S corporation files its 1120-S. The election cannot be effective earlier than 2 months and 15 days from the date of the election.
In general, taxable income for the portion of the ESBT that owns interests in the S corporation is determined by taking into account the ESBT’s proportionate share of the income and loss from the S corporation, any gain or loss from the sale of S corporation stock, and state and local taxes and administrative expenses allocable to the S corporation. Once taxable income is determined, the highest federal income tax rate applicable to trusts applies, or 37% under current law. This rate will apply regardless of whether any distributions are made from the trust to the beneficiaries.
As noted above, a client may give S corporation stock directly to a charity that is exempt from tax under 501(c)(3) during life or at death. One issue that arises for the charity; however, is the imposition of the unrelated business income tax. Under current law, S corporation pass-through items, including passive items (such as interest and dividends), are included in a charity’s unrelated business taxable income (UBTI). For charities that are corporations, the tax rate on UBTI is 21% and for charities that are trusts, the rate ranges from 10% to 37%, but with the top rate applying at $12,500 of income. For charitable trusts, care must be taken to ensure the trust can qualify as an S corporation owner. Charitable remainder trusts, for example, may not own S corporation stock.
In addition to UBTI concerns, certain restrictions apply to private foundations, donor advised funds, and charitable lead trusts that own interests in businesses, including S corporations. These entities are subject to a 10% excise tax on “excess business holdings” which is defined as more than 20% of the voting stock of a corporation reduced by the voting stock held by certain disqualified persons (such as a substantial contributor to the charity and his or her family). The 20% threshold may be increased to 35% in certain cases where third parties have effective control over the business, and non-voting stock may be owned, in any amount, provided disqualified persons do not own more than 20% of the voting stock (or 35% if effective control resides with third parties).
Given these rules, care must be taken for business succession and estate plans that involve charitable objectives and S corporation stock.
Another consideration when planning for S corporation owners is whether the business owner’s succession plan involves a full or partial exit from the business. A full review of business exit structures is outside the scope of this article; however, a few points are worth mentioning.
If a business owner desires to sell S corporation stock to a third party, the purchaser must be a qualifying S corporation shareholder if the purchaser desires pass-through taxation to continue. For situations in which the buyer is willing to buy stock but desires a “deemed” asset purchase for tax purposes, an election under Code sections 336 or 338 will typically be made, or the S corporation may undergo a presale reorganization such as converting to a wholly-owned disregarded LLC underneath a newly formed S corporation. In these situations, the legitimacy of the S corporation’s S election and the maintenance of S status during the corporation’s existence will become a due diligence item as the buyer assesses tax risks associated with the purchase. If it appears the S election was defective or transfers have been made to non-qualifying shareholders, the buyer may not wish to proceed or may require significant indemnities and escrow deposits. As noted above, if the S election has been inadvertently terminated, the S corporation becomes a C corporation and any buyer faces exposure to C corporation income tax for open tax years.
Proper Planning Is Imperative
Given the complexity of the rules surrounding S corporation ownership, investors and business owners must carefully review their estate and business succession plans to preserve the S election and to avoid exposure to unnecessary tax liabilities or creating problems prior to a business exit.