Do you currently own or will potentially own stock in an S Corporation? Trust and estate law provides two different avenues to fund a trust with S Corporation Stock: An Electing Small Business Trust (ESBT) and a Qualified Subchapter S Trust (QSST). A trust can elect to be either, but not both. This article will take a closer look at each trust’s requirements and tax implications.
Electing Small Business Trust (ESBT) – With an ESBT, typically a portion of the trust’s assets are invested in S-Corporation stock. To be treated as this type of trust for tax purposes, a specific election must be made by the trustee under Section 1361 of the Internal Revenue Code (IRC) within 2 1/2 months of the trust receiving the stock. As such, all of the trust’s beneficiaries must be individuals or estates eligible to be S-Corp shareholders. However, each beneficiary counts as a separate shareholder for the purposes of meeting the 100 or fewer shareholder requirement for S-Corporations. The trust is then treated as two separate trusts: 1) The portion of the trust related to the investment in S-Corp stock is taxed at the individual rate based on all activity related to the S-Corp, such as income, deductions, taxes paid by the S-Corp, etc. 2) The remaining portion of the trust not related to an S-Corp investment is taxed in the same manner as a normal trust.
Qualified Subchapter S Trust (QSST) – A Qualified Subchapter S Trust (QSST) is similar to an ESBT, but with three main differences. First, the beneficiary makes the QSST election rather than the trustee. Second, while an ESBT allows for multiple beneficiaries so long as the S-Corp meets its other requirements, only one (1) beneficiary, who is a U.S. citizen or resident, is allowed in a QSST. Third, the entirety of the income portion of the trust related to S-Corp investments is passed directly to the beneficiary and is thus taxed at the individual level. However, like ESBTs, the portion of the trust not related to an S-Corp investment is taxed in the same manner as a normal trust. There are several requirements to be met under Sec. 1361 (d) (3) of the Internal Revenue Code (IRC), including that the the trust only have one (1) income beneficiary.
It is possible to convert an ESBT to a QSST and vice versa. To do so, the trust must meet the requirements of the trust it wishes to convert to (i.e. an EBST may convert to a QSST provided the requirements of the QSST are met), and a election to convert must not have been made in the last 36 months.
With both types of trusts, making one mistake can be costly. For example, failing to make the proper elections can jeopardize the S-Corporation’s existence as an S Corporation and creates the potential to be subject to double taxation on both the corporation and its shareholders. If you would like to know more about these trusts or need assistance in setting up an ESBT or QSST, please contact us at 858-558-9200.