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Can a family trust own shares in a S corp?

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April 16, 2009 2:48PM

Historically, S corporations were required to be owned by a few individuals. Over time, the concept of individuals was expanded such that some limited types of trusts were allowed to be shareholders and own stock in S corporations. The two most common types of trusts that can qualify as shareholders in S corporations are Qualified Subchapter S Trusts (QSSTs) and Electing Small Business Trusts (ESBTs). The two types of trusts are generally created by individuals who are seeking to transfer business interests to their family. Qualified Subchapter S Trusts QSSTs) The qualifying requirements for a QSST are statutorily defined under I.R.C. §1361(d)(3), and are as follows: # There is only one income beneficiary and he or she is a U.S. citizen or resident. # All income of the trust is required to be distributed currently to the one income beneficiary. # All corpus distributions must go to the one beneficiary. # The beneficiary's income interest must terminate at the earlier of the beneficiary's death or trust's termination. # An election to be treated as an eligible S corporation shareholder must be made. Additionally, in order to qualify as a QSST, the income beneficiary must make a QSST election using IRS Form 2553. The election must be filed within the 2-month and 16-day period beginning on the date the stock of the S corporation is transferred to the trust or the first day of the first taxable year for which the subchapter S election is effective, whichever is later. The income beneficiary of the QSST is required to sign his or her consent on Form 2553. Thus, it's important to note that the existence of a QSST requires the cooperation of the beneficiary. From a tax perspective, QSSTs are preferred because QSSTs are taxed as an ordinary grantor trust. In other words, the beneficiary is taxed only on the income that the beneficiary himself receives, instead of being taxed on the proportional share of income owned by the trust. This difference in amounts can be substantial. Further, because all of the trust corpus must go to the beneficiary, income cannot accumulate in the trust. For this reason and well as the desire to have multiple beneficiaries, many choose the ESBT as their trust of choice. Electing Small Business Trusts (ESBTs) Irrevocable trusts can also qualify as shareholders in an S corporation by electing to be treated as ESBTs. To become an ESBT, a trust must meet the requirements of IRC §1361(e) which are as follows: # All beneficiaries of the trust must be individuals, estates or charitable organizations described. # The S corporation stock in the trust may not be acquired by purchase # QSSTs and tax-exempt trusts cannot be ESBTs - the trust cannot be an electing QSST with regard to any stock, even stock in another S corporation; and # Each potential current beneficiary of the trust is treated as a shareholder for the purpose of the S corporation eligibility rules. In order to qualify as an ESBT, the trustee makes an election using IRS Form 2553. The ESBT election must generally be filed within the two month and 16 day period beginning on the day that the S corporation stock is transferred to the trust. From a tax perspective, an ESBT can be extremely harsh on its beneficiaries. While an ESBT can have multiple beneficiaries and can accumulate trust income, I.RC. §641(d) requires that the ESBT be taxed at the trust level on its proportionate share of taxable income of the S corporation. This tax is a flat rate equal to the highest individual marginal rate, which is currently at 35% for 2009. This is true regardless of whether the beneficiaries, themselves, receive any actual income. Finally, it is important to note that because most irrevocable trusts may elect to become (or at least partially become) one of the two types of trusts discussed above, it may be beneficial to add QSST language to future irrevocable trusts that allows the trustee to make such an election. Historically, S corporations were required to be owned by a few individuals. Over time, the concept of individuals was expanded such that some limited types of trusts were allowed to be shareholders and own stock in S corporations. The two most common types of trusts that can qualify as shareholders in S corporations are Qualified Subchapter S Trusts (QSSTs) and Electing Small Business Trusts (ESBTs). The two types of trusts are generally created by individuals who are seeking to transfer business interests to their family. Qualified Subchapter S Trusts QSSTs) The qualifying requirements for a QSST are statutorily defined under I.R.C. §1361(d)(3), and are as follows: # There is only one income beneficiary and he or she is a U.S. citizen or resident. # All income of the trust is required to be distributed currently to the one income beneficiary. # All corpus distributions must go to the one beneficiary. # The beneficiary's income interest must terminate at the earlier of the beneficiary's death or trust's termination. # An election to be treated as an eligible S corporation shareholder must be made. Additionally, in order to qualify as a QSST, the income beneficiary must make a QSST election using IRS Form 2553. The election must be filed within the 2-month and 16-day period beginning on the date the stock of the S corporation is transferred to the trust or the first day of the first taxable year for which the subchapter S election is effective, whichever is later. The income beneficiary of the QSST is required to sign his or her consent on Form 2553. Thus, it's important to note that the existence of a QSST requires the cooperation of the beneficiary. From a tax perspective, QSSTs are preferred because QSSTs are taxed as an ordinary grantor trust. In other words, the beneficiary is taxed only on the income that the beneficiary himself receives, instead of being taxed on the proportional share of income owned by the trust. This difference in amounts can be substantial. Further, because all of the trust corpus must go to the beneficiary, income cannot accumulate in the trust. For this reason and well as the desire to have multiple beneficiaries, many choose the ESBT as their trust of choice. Electing Small Business Trusts (ESBTs) Irrevocable trusts can also qualify as shareholders in an S corporation by electing to be treated as ESBTs. To become an ESBT, a trust must meet the requirements of IRC §1361(e) which are as follows: # All beneficiaries of the trust must be individuals, estates or charitable organizations described. # The S corporation stock in the trust may not be acquired by purchase # QSSTs and tax-exempt trusts cannot be ESBTs - the trust cannot be an electing QSST with regard to any stock, even stock in another S corporation; and # Each potential current beneficiary of the trust is treated as a shareholder for the purpose of the S corporation eligibility rules. In order to qualify as an ESBT, the trustee makes an election using IRS Form 2553. The ESBT election must generally be filed within the two month and 16 day period beginning on the day that the S corporation stock is transferred to the trust. From a tax perspective, an ESBT can be extremely harsh on its beneficiaries. While an ESBT can have multiple beneficiaries and can accumulate trust income, I.RC. §641(d) requires that the ESBT be taxed at the trust level on its proportionate share of taxable income of the S corporation. This tax is a flat rate equal to the highest individual marginal rate, which is currently at 35% for 2009. This is true regardless of whether the beneficiaries, themselves, receive any actual income. Finally, it is important to note that because most irrevocable trusts may elect to become (or at least partially become) one of the two types of trusts discussed above, it may be beneficial to add QSST language to future irrevocable trusts that allows the trustee to make such an election.