February 2, 2026
Revocable Trusts as Shareholders and 2-Year Rule
Frequently, for probate avoidance purposes, S corporation stock is either owned in a shareholder’s revocable trust during life or allocated to the shareholder’s revocable trust effective upon their death. During a shareholder’s life, their revocable trust is generally a permitted S corporation shareholder as a grantor trust. Upon death, a revocable trust which ceases to be a grantor trust as a result of the grantor’s death remains a permissible shareholder for a 2-year period following the death.
After the 2-year eligibility period expires, whether the corporation’s election continues depends on whether the trust is an eligible shareholder at that time, or if the stock is distributed to an eligible shareholder. Eligible trust shareholders are discussed further below.
Estates and 645 Elections
Additionally, a deceased shareholder’s stock may pass to their estate. Estates are permitted shareholders provided the estate administration is not “unduly prolonged.” Whether an administration is unduly prolonged is a subjective test which depends on the specific circumstances of the estate, including the complexity of the administration and distribution of complex assets. Two years is generally reasonable, although longer periods may be appropriate if there is legitimate administrative complexity.
If a Section 645 election is in place, S corporation stock held in the electing trust is treated as part of the decedent’s estate (if there is an executor), or as an estate (if there is no executor), solely during the period of the Section 645 election. After the Section 645 election ends, the stock held in the trust is deemed transferred to a new trust, and continued eligibility must be evaluated based on the trust’s status and surrounding facts.
Irrevocable Trusts as S Corporation Shareholders
As noted above, permissible trust shareholders include revocable trusts, both during the life of the settlor and for two years after the settlor’s death, and trusts to which stock is transferred either by a Section 645 electing trust or pursuant to a will, also for a 2-year period. Pursuant to Section 1361(c)(2), the following trusts are additionally permitted to own S corporation stock: (a) a voting trust; (b) an electing small business trust (an “ESBT”); or (c) a trust that constitutes an IRA, in certain circumstances. Additionally, pursuant to Section 1361(d), a “qualified subchapter S trust” (a “QSST”) is additionally permitted to own S
corporation stock provided it qualifies and makes a timely election.
Thus, after the expiration of the 2-year eligibility period for a decedent shareholder’s revocable trust to hold their S corporation stock, the trust must either itself qualify as one of the foregoing trusts or transfer the stock to another permissible shareholder (i.e., an individual, qualifying trust, or other qualifying entity). Similarly with a decedent’s estate, if there is no revocable trust involved, the beneficiary receiving the stock must qualify as a permissible S corporation shareholder.
ESBT and QSST Elections
Electing small business trusts (ESBTs) and qualified subchapter S trusts (QSSTs) are commonly used in estate planning to retain S corporation interests in trust for future generations. Precise drafting is essential to ensure that a trust is eligible to make either election after a decedent’s passing.
Both ESBTs and QSSTs have specific requirements for qualification as S corporation shareholders, as well as different tax considerations. An ESBT is generally more flexible, as it may have multiple beneficiaries, and the trust terms can determine how each beneficiary is treated for tax purposes with respect to the S corporation interest. The ESBT itself pays income tax on its share of S corporation income, which is taxed at the highest individual income tax rate in effect for the year.
QSST rules are more stringent, as they can only name one lifetime beneficiary and all trust accounting income must be distributed to that beneficiary each year. A QSST election is made by the beneficiary, and the beneficiary – not the trust – is treated as the owner of the S corporation shares. As a result, the beneficiary is taxed on the trust’s entire share of S corporation income. This structure ensures pass-through tax-treatment at individual rates.
Qualifying trusts must file an election to be treated as either an ESBT or QSST with the IRS. These elections are irrevocable and may be effective up to 15 days and 2 months before the date of the election.
S Election Termination
If an S corporation violates any of the Section 1361(b) eligibility requirements, including ownership by an ineligible shareholder, it ceases to be treated as a small business corporation effective as of the date of the violation. For example, if a decedent shareholder’s S corporation stock is held by their revocable trust beyond the 2-year period and fails to qualify as an eligible shareholder beyond this eligibility period (for example, by making a QSST or ESBT election), the corporation’s S election will terminate as of the first day of such ineligibility.
After a corporation’s S election is terminated, if no relief is otherwise provided as discussed below, a corporation will not be eligible to make another S election until the fifth taxable year after the first taxable year for which the termination is effective, unless the IRS consents to the re-election.
Relief for Late Elections
Fortunately, the IRS provides relief for late elections in these types of scenarios. Revenue Procedure 2013-30 provides procedures for automatic relief for certain late elections, including late ESBT and QSST elections, within 3 years and 75 days after the election’s intended effective date. Additionally, because it is not uncommon for these errors to go unnoticed for years at a time, S corporations may pay a significant user fee and request a private letter ruling from the IRS for relief. Both avenues for correction require coordination with legal counsel and expense for the corporation – even if the late election is ultimately resolved. Thus, ensuring these elections are made properly and on time is critical to preserving the corporation’s S status and avoiding costly remedial measures.
While the IRS offers mechanisms to correct mistakes after they occur, the best strategy is to implement careful planning and regularly review ownership and governance documents to avoid unintended consequences in the first place.
Proper Systems to Avoid S Corporation Termination
The most effective way to prevent an inadvertent termination of S corporation status upon a shareholder’s death is through thoughtful advanced planning and implementing systems for succession upon a shareholder’s death. One available mechanism is a buy-sell agreement, a binding agreement between the S
corporation and its shareholders that governs how ownership interests will transfer upon certain triggering events, such as death, disability, or retirement. A well-drafted buy-sell agreement provides certainty regarding who may acquire the deceased shareholder’s stock and under what terms. By ensuring that shares will only pass to eligible S corporation shareholders, it helps preserve the company’s S election and prevent inadvertent disqualification.
Life insurance is a common funding mechanism for these buy-sell arrangements. The death benefit proceeds provide immediate liquidity to facilitate the purchase of a deceased shareholder’s stock, sparing both the corporation and surviving shareholders from financial strain. These policies may be owned either by the corporation or by the individual shareholders, depending on the structure of the agreement. However, these arrangements should be evaluated carefully in light of the recent U.S. Supreme Court decision in Connelly v. United States, which treats corporate-owned life insurance proceeds as a corporate asset for estate tax valuation purposes.
Regular review of buy-sell agreements, life insurance ownership, and shareholder eligibility provisions should form part of every S corporation’s governance protocol. Periodic coordination with counsel can help ensure compliance and smooth sailing through generational transitions.
Conclusion
The death of a shareholder can present both emotional and financial challenges for a closely held business. For S corporations, advanced planning can cushion the impact from a tax and business planning perspective. Establishing and maintaining properly structured buy-sell agreements, coordinating life insurance ownership, proper estate plan drafting, and closely monitoring shareholder eligibility upon a shareholder’s passing can protect the corporation’s S election and minimize the risk of costly and disruptive tax consequences.
In short, proactive planning today can spare the business and its owners from significant headaches tomorrow — preserving both the company’s continuity and the legacy it represents.
Death of a Shareholder: Avoiding S Corp Tragedy
When a business partner passes away, the loss is felt on both a personal and professional level. The death of a founding partner or cherished colleague can deeply impact a business and its operations, both internally and for its clients. In the wake of a passing, many owners fail to realize – or realize too late – the additional tax implications that may arise on both an entity and shareholder level.
When the business is an S corporation, succession to the deceased shareholder’s stock presents unique risks. The remaining shareholders and the successors to the decedent shareholder’s stock must pay careful attention to ensure that at all times the company’s stock is owned by a permitted shareholder and timely elections are made, if applicable, to maintain the company’s S election. In many cases, the company may have little or no insight into the decedent shareholder’s estate planning, who will ultimately receive the shares, or whether parties are making timely elections. Given the risk that inadvertent S election termination may result in loss of pass-through treatment and thus, significant tax consequences, it is crucial to thoroughly understand the applicable rules and timelines, and to implement protective protocols to guide the way upon a shareholder’s death.
Qualification as an S Corporation
An S corporation is a “small business corporation” for which an election, made under Section 1362(a), is in effect. To qualify for the election, the corporation may not: (a) have more than 100 shareholders; (b) have any non-individual shareholders (other than certain trusts and tax-exempt entities); (c) have a nonresident alien as a shareholder (other than as a potential current beneficiary of an ESBT); or (d) more than one class of stock. Permitted shareholders generally include individuals (provided they are U.S. citizens or residents), estates, certain trusts, and certain tax-exempt organizations.
An S corporation is a “small business corporation” for which an election, made under Section 1362(a), is in effect. To qualify for the election, the corporation may not: (a) have more than 100 shareholders; (b) have any non-individual shareholders (other than certain trusts and tax-exempt entities); (c) have a nonresident alien as a shareholder (other than as a potential current beneficiary of an ESBT); or (d) more than one class of stock. Permitted shareholders generally include individuals (provided they are U.S. citizens or residents), estates, certain trusts, and certain tax-exempt organizations.
Revocable Trusts as Shareholders and 2-Year Rule
Frequently, for probate avoidance purposes, S corporation stock is either owned in a shareholder’s revocable trust during life or allocated to the shareholder’s revocable trust effective upon their death. During a shareholder’s life, their revocable trust is generally a permitted S corporation shareholder as a grantor trust. Upon death, a revocable trust which ceases to be a grantor trust as a result of the grantor’s death remains a permissible shareholder for a 2-year period following the death.
After the 2-year eligibility period expires, whether the corporation’s election continues depends on whether the trust is an eligible shareholder at that time, or if the stock is distributed to an eligible shareholder. Eligible trust shareholders are discussed further below.
Estates and 645 Elections
Additionally, a deceased shareholder’s stock may pass to their estate. Estates are permitted shareholders provided the estate administration is not “unduly prolonged.” Whether an administration is unduly prolonged is a subjective test which depends on the specific circumstances of the estate, including the complexity of the administration and distribution of complex assets. Two years is generally reasonable, although longer periods may be appropriate if there is legitimate administrative complexity.
If a Section 645 election is in place, S corporation stock held in the electing trust is treated as part of the decedent’s estate (if there is an executor), or as an estate (if there is no executor), solely during the period of the Section 645 election. After the Section 645 election ends, the stock held in the trust is deemed transferred to a new trust, and continued eligibility must be evaluated based on the trust’s status and surrounding facts.
Irrevocable Trusts as S Corporation Shareholders
As noted above, permissible trust shareholders include revocable trusts, both during the life of the settlor and for two years after the settlor’s death, and trusts to which stock is transferred either by a Section 645 electing trust or pursuant to a will, also for a 2-year period. Pursuant to Section 1361(c)(2), the following trusts are additionally permitted to own S corporation stock: (a) a voting trust; (b) an electing small business trust (an “ESBT”); or (c) a trust that constitutes an IRA, in certain circumstances. Additionally, pursuant to Section 1361(d), a “qualified subchapter S trust” (a “QSST”) is additionally permitted to own S
corporation stock provided it qualifies and makes a timely election.
Thus, after the expiration of the 2-year eligibility period for a decedent shareholder’s revocable trust to hold their S corporation stock, the trust must either itself qualify as one of the foregoing trusts or transfer the stock to another permissible shareholder (i.e., an individual, qualifying trust, or other qualifying entity). Similarly with a decedent’s estate, if there is no revocable trust involved, the beneficiary receiving the stock must qualify as a permissible S corporation shareholder.
ESBT and QSST Elections
Electing small business trusts (ESBTs) and qualified subchapter S trusts (QSSTs) are commonly used in estate planning to retain S corporation interests in trust for future generations. Precise drafting is essential to ensure that a trust is eligible to make either election after a decedent’s passing.
Both ESBTs and QSSTs have specific requirements for qualification as S corporation shareholders, as well as different tax considerations. An ESBT is generally more flexible, as it may have multiple beneficiaries, and the trust terms can determine how each beneficiary is treated for tax purposes with respect to the S corporation interest. The ESBT itself pays income tax on its share of S corporation income, which is taxed at the highest individual income tax rate in effect for the year.
QSST rules are more stringent, as they can only name one lifetime beneficiary and all trust accounting income must be distributed to that beneficiary each year. A QSST election is made by the beneficiary, and the beneficiary – not the trust – is treated as the owner of the S corporation shares. As a result, the beneficiary is taxed on the trust’s entire share of S corporation income. This structure ensures pass-through tax-treatment at individual rates.
Qualifying trusts must file an election to be treated as either an ESBT or QSST with the IRS. These elections are irrevocable and may be effective up to 15 days and 2 months before the date of the election.
S Election Termination
If an S corporation violates any of the Section 1361(b) eligibility requirements, including ownership by an ineligible shareholder, it ceases to be treated as a small business corporation effective as of the date of the violation. For example, if a decedent shareholder’s S corporation stock is held by their revocable trust beyond the 2-year period and fails to qualify as an eligible shareholder beyond this eligibility period (for example, by making a QSST or ESBT election), the corporation’s S election will terminate as of the first day of such ineligibility.
After a corporation’s S election is terminated, if no relief is otherwise provided as discussed below, a corporation will not be eligible to make another S election until the fifth taxable year after the first taxable year for which the termination is effective, unless the IRS consents to the re-election.
Relief for Late Elections
Fortunately, the IRS provides relief for late elections in these types of scenarios. Revenue Procedure 2013-30 provides procedures for automatic relief for certain late elections, including late ESBT and QSST elections, within 3 years and 75 days after the election’s intended effective date. Additionally, because it is not uncommon for these errors to go unnoticed for years at a time, S corporations may pay a significant user fee and request a private letter ruling from the IRS for relief. Both avenues for correction require coordination with legal counsel and expense for the corporation – even if the late election is ultimately resolved. Thus, ensuring these elections are made properly and on time is critical to preserving the corporation’s S status and avoiding costly remedial measures.
While the IRS offers mechanisms to correct mistakes after they occur, the best strategy is to implement careful planning and regularly review ownership and governance documents to avoid unintended consequences in the first place.
Proper Systems to Avoid S Corporation Termination
The most effective way to prevent an inadvertent termination of S corporation status upon a shareholder’s death is through thoughtful advanced planning and implementing systems for succession upon a shareholder’s death. One available mechanism is a buy-sell agreement, a binding agreement between the S
corporation and its shareholders that governs how ownership interests will transfer upon certain triggering events, such as death, disability, or retirement. A well-drafted buy-sell agreement provides certainty regarding who may acquire the deceased shareholder’s stock and under what terms. By ensuring that shares will only pass to eligible S corporation shareholders, it helps preserve the company’s S election and prevent inadvertent disqualification.
Life insurance is a common funding mechanism for these buy-sell arrangements. The death benefit proceeds provide immediate liquidity to facilitate the purchase of a deceased shareholder’s stock, sparing both the corporation and surviving shareholders from financial strain. These policies may be owned either by the corporation or by the individual shareholders, depending on the structure of the agreement. However, these arrangements should be evaluated carefully in light of the recent U.S. Supreme Court decision in Connelly v. United States, which treats corporate-owned life insurance proceeds as a corporate asset for estate tax valuation purposes.
Regular review of buy-sell agreements, life insurance ownership, and shareholder eligibility provisions should form part of every S corporation’s governance protocol. Periodic coordination with counsel can help ensure compliance and smooth sailing through generational transitions.
Conclusion
The death of a shareholder can present both emotional and financial challenges for a closely held business. For S corporations, advanced planning can cushion the impact from a tax and business planning perspective. Establishing and maintaining properly structured buy-sell agreements, coordinating life insurance ownership, proper estate plan drafting, and closely monitoring shareholder eligibility upon a shareholder’s passing can protect the corporation’s S election and minimize the risk of costly and disruptive tax consequences.
In short, proactive planning today can spare the business and its owners from significant headaches tomorrow — preserving both the company’s continuity and the legacy it represents.
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