An S corporation may be disqualified as an S corporation if the shareholders in the S corporation are not qualified. Only certain types of trusts qualify to be a shareholder of an S corporation stock.
These include:
- Limited voting trusts,
- Testamentary trusts and grantor trusts which are limited in duration,
- QSSTs, and
- ESBTs.
Table of contents
QSST
The qualified subchapter S trust (QSST) may be a shareholder in an S corporation. A QSST has only one income beneficiary who must be a citizen or resident of the United States. Income must be distributed currently to the income beneficiary. (It may be possible to elect annually to have the trustee retain income. PLR8836057.) Any distribution of principal during the beneficiary’s life may be made only to the income beneficiary.
If the trust terminates during the beneficiary’s life, then all of the assets must be distributed to the beneficiary [§1361(d)]. The beneficiary must elect QSST treatment for the trust. Accordingly, few Credit Shelter Trusts (which often have several family beneficiaries and continue beyond the life of a single income beneficiary) qualify as a QSST. A QSST may be structured to qualify for the gift tax and estate tax marital deduction as a QTIP (qualified terminable interest property trust) or general power of appointment marital trust.
ESBT
The electing small business trust (ESBT) is allowed as a subchapter S shareholder under the Small Business Job Protection Act of 1996 [§1361(e)].
The ESBT must meet three main requirements:
■ All trust beneficiaries must be estates or individuals who are eligible to be S Corporation shareholders. (A charity may hold a contingent remainder interest.)
■ No interest in the ESBT may be acquired by purchase. (Purchase is defined as an acquisition where the basis is determined under §1012.)
■ Finally, the ESBT must elect to be a small business trust. The portion of an ESBT, which consists of S Corporation stock pays the highest rate for trusts and estates income except capital gains [§641 (d)]. None of the income, loss, or deduction items may 90Small Business Considerations be passed through to the ESBT beneficiaries, and capital losses are allowed only to the extent of capital gains. The Credit Shelter Trust may be structured to be an ESBT. The introduction of the ESBT provides an opportunity for more flexible estate planning. With a QSST, as noted, there may be only one beneficiary.
Further, there is the requirement that there be a mandatory distribution of income. If a parent died and the property passed into a QSST for a child (particularly a young child), the income distribution to a minor for many years may be inconvenient, or the income may be more than one would want to give to a young person. With an ESBT, income may be accumulated, and trust distributions may be “sprinkled” among family members who are trust beneficiaries.
DEFERRAL OF TAX
Section 6166 covers the federal estate tax and, to a more limited extent, the generation-skipping tax. It allows for payment of federal estate tax which is attributable to a substantial interest in a closely held business, to be paid over two to ten equal annual installments. Part of the interest of the unpaid balance of the tax may be paid at the rate of 4%.
For decedents who die after 1997, the interest rate is 2% for tax attributable to the first $1 million in taxable value in qualified closely-held businesses included in the estate. This $1 million is indexed for inflation and rounded to the next $10,000 under the Taxpayer Relief Act of 1997. For decedents dying in 1999, the amount available for a 2% interest rate on its tax due has been increased to $1,010,000. (Rev. Proc. 98-61)
The interest on the remaining tax attributable to the closely held business is payable at 45% of the underpayment rate (§6601(j)). Interests in holding companies and non-readily-tradeable companies do not qualify for the 2% interest rate under the 1998 Reform Act [§6166(b)].
Section 6166 applies to corporations, partnerships, and sole proprietorships.
The benefits of §6166 are only made available to the estates of decedents who are U.S. citizens or resident aliens at the time of death. The interest in the closely held business must exceed 35% of the decedent’s adjusted gross estate for federal estate tax purposes.
Because the first installment of a §6166 deferral of payment does not need to be made until a date selected by the executor, which is not more than five years after the date prescribed in Section 6151(a) for the tax payment, the estate tax may be spread over a period as long as 14 years from the decedent’s death.
During the first five years, interest-only needs to be paid. The election for a §6166 deferral is made on the federal estate tax return or on the last date of the extension of time granted for filing the estate tax return. Some provisions allow the election to apply to the estate tax as finally determined or agreed to following any audit.
