Converting Trust Elections for S Corporation Stock

When an individual who dies owns S corporation stock that will be held in trust for certain beneficiaries as a means of creditor or spendthrift protection or tax planning, the trustee will have to decide whether to make a qualifying subchapter S trust (QSST) election or an electing small business trust (ESBT) election. No matter the initial decision, future reviews may be warranted to account for changes in circumstances. A conversion from a QSST to an ESBT may make the most sense after review.

QSSTs and ESBTs

A trust may be a shareholder of an S corporation if owned by a U.S. citizen, and a QSST can be treated as such by making an election under Internal Revenue Code (IRC) Section 1361(c)(2)(A)(i). The trust beneficiary is treated as the owner of the portion of the trust that holds the S corporation stock. Under IRC Section 678(a), the QSST beneficiary is taxed on the entirety of the trust’s share of the S corporation’s income.

The ESBT is treated as a permissible shareholder of the S corporation, and the ESBT and its beneficiaries are taxed under IRC Section 641(c). However, the trust’s beneficiaries will be taxed at their own income tax rates for distributions made to them from the trust. The designated beneficiaries of an ESBT, along with the income and tax implications, depend on the trust instrument provisions.

The QSST Option

For QSSTs, there may be only one lifetime trust beneficiary, and all ordinary income of a QSST must be distributed to the beneficiary, regardless of need or any trustee discretion. The mandatory income distribution requirement may result in an increase in the beneficiary’s taxable estate, loss of some creditor or divorce protection, potential spendthrift issues, and disqualification for state or federal benefits for those with special needs. If, however, the income of the S corporation cannot be distributed to the trust or the trust’s beneficiary, then the trustee may have no choice but to make a QSST election for the trust, regardless of the financial risks of the income being deemed or actually distributed to the trust beneficiary.

The ESBT Option

An ESBT election is appropriate for certain trusts where the beneficiaries are granted the sole power to withdraw the S corporation income distributed to the trust. This allows such income to be taxed at the beneficiaries’ tax rates, regardless of whether they withdraw such income. To the extent that taxable income of the S corporation is not distributed to the ESBT and instead is allocable to the trust corpus, the retained taxable income will be taxed to the ESBT at the trust’s highest federal income tax rate. Certain workarounds may be possible, so intentional planning is needed to align with family members’ goals. ESBTs are generally more flexible than QSSTs, but each of the potential current beneficiaries is counted as an S corporation shareholder for purposes of the 100-shareholder limit under IRC Section 1361(b)(1)(A). Therefore, careful planning may be needed by the trust and the S corporation.

Conversion

Due to changes in circumstances for the trust, its beneficiaries, or the S corporation, the trustee of a QSST may want to convert to an ESBT or modify a trust to grant withdrawal rights prior to such conversion. Treasury Regulations Section 1.1361-1(j)(12) provides the following for a QSST to ESBT conversion:

• The trust is eligible to be an ESBT under IRC Section 1631(e).
• The trustee and the current income beneficiary of the trust make the ESBT election for stock of each S corporation held by the trust.
• The trust has not converted from an ESBT to a QSST within 36 months of the effective date of the new ESBT election.
• The ESBT election is to be effective not more than 15 days and two months prior to the date on which the election is filed (and not more than 12 months after the date on which the election is filed).

Both the trustee and the current trust beneficiary must sign the ESBT election and file it with the IRS, stating at the top of the document: “Attention Entity Control – Conversion of a QSST to an ESBT pursuant to Section 1.1361-1(j).” The QSST is treated as terminating its interest in the S corporation, effective as of the day before the effective date of the ESBT election, and the ESBT is treated as a new shareholder effective as of the effective date of such election.

Conclusion

The decision to convert a QSST to an ESBT may accommodate certain changes in circumstances for a trust beneficiary and the S corporation. Prior to making this conversion, a trustee should review the trust instrument to determine the tax effects. The trustee may also consider whether a trust modification, or decanting, might help better administer the ESBT. It is important for trustees to collaborate with the S corporation and the trust beneficiaries to determine the appropriate election as well as the tax and income implications of the current and any modified trust provisions. 

Brian M. Balduzzi, JD, LLM (Taxation), CFP, is an attorney with Faegre Drinker Biddle & Reath LLP in Philadelphia and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at brian.balduzzi@faegredrinker.com.