Small business owners have many options when structuring their business and choosing their tax status. One option is an S corporation. The business structure you choose will affect your estate planning, so it is essential to seek the guidance of an experienced estate planning attorney and tax advisor when estate planning as a small business owner.
Due to the many ways to structure a business and estate planning goals, the advice these professionals give you may be different from the advice given to another small business owner.
What is an S Corporation?
The Internal Revenue Service (I.R.S.) describes an S corporation as “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”
This election is permitted under § 1362 of subchapter S of the Internal Revenue Code (I.R.C.), hence the name S Corporation.
An S corporation differs from a C corporation in how taxation is handled. A C corporation is first taxed on profits earned at the corporate level. Then, the profits are taxed again at the shareholder level when they are distributed.
An S corporation does not tax at the corporate level. Instead, profits are passed to the shareholders, who then report their share of the S corporation’s profits and losses on their individual tax returns.
Shareholders are assessed taxes based on their individual income tax rates.
Under the Internal Revenue Code, to be taxed as an S corporation, a business must meet the following criteria:
- It is incorporated within the United States
- It offers only one class of stock
- It does not have more than one hundred shareholders
- Shareholders are individuals, specific types of trusts or estates, or certain tax-exempt organizations
- Shareholders are not partnerships, certain corporations, or nonresident aliens
- It is not a type of corporation ineligible for S corporation taxation, including certain financial institutions, insurance companies, and domestic international sales corporations
Important considerations when owning an S corporation
Some potential considerations to plan for your S corporation when you die include:
- Will you pass the business to a spouse or loved ones as an ongoing business entity that will produce income?
- Do you need to provide employment income for your employees well after your death?
- Can you sell your ownership in the business to your co-owners, as cash is more easily distributed to your beneficiaries?
- Do you intend to shut down the business and have the assets sold when you can no longer run it?
- Have you considered whether you need to protect your beneficiaries from lawsuits, divorces, or bankruptcy once they receive their inheritance?
These and many other considerations may be part of your estate plan. As an S corporation owner, you must ensure that your estate planning carefully addresses applicable federal laws.
What kinds of trusts can own stock in an S corporation?
The three most common types of trusts that can hold S corporation stock or membership interests in an S corporation are a grantor trust, a qualified subchapter S trust (QSST), and an electing small business trust (ESBT).
Other trusts, such as a voting trust, can also own stock in an S corporation, but they are beyond the scope of this article.
In a grantor trust, the trustmaker (the grantor or person who establishes and funds the trust) retains certain powers over the trust, which causes the trust income to be taxable to the trustmaker.
A revocable living trust is one example of a grantor trust. A grantor trust is one of the preferable trusts used for owning an S corporation because it does not have some disadvantages the other two types of trusts have.
Grantor trusts (and testamentary trusts) can typically only hold S corporation stock for two years after the grantor dies.
After which, the grantor trust must either qualify as a QSST or an ESBT or distribute its stock to eligible shareholders. If this does not occur, the corporation’s S election will terminate.
Qualified subchapter S trust (QSST)
A trust must meet the following criteria to qualify as a QSST:
- The trust has only one beneficiary
- The beneficiary is a U.S. citizen or resident
- All trust income is distributed to the sole beneficiary
- The income beneficiary files an election with the I.R.S.
There are some drawbacks to a QSST, including:
- There can only be one beneficiary, so the beneficiary’s children cannot be named as a beneficiary as well
- All income must be distributed regardless of the beneficiary’s need for income, potential taxable estate, or troubling behavior
- The distributed income may be exposed to the beneficiary’s creditors, lawsuits, and divorcing spouse
Some S corporation owners overcome these drawbacks by opening multiple trusts to isolate subchapter S stock in a trust that meets these specific criteria and put other assets in other types of trusts with different terms.
Electing small business trust (ESBT)
An ESBT trust needs to meet the following criteria:
- The trustee for the trust files an election with the I.R.S. within a specific time period
- All trust beneficiaries are permissible beneficiaries under the Internal Revenue Code
Potential advantages of an ESBT:
- Not limited to one beneficiary like a QSST
- Not subject to a mandatory distribution requirement like a QSST
- Could lead to income tax savings because holding stock in an ESBT does not have certain phaseout deduction limits that individuals might
Drawbacks of an ESBT:
- ESBT’s income is taxed at the highest federal income tax rate, so overall tax may be higher than the individual tax for beneficiaries who are not already at the highest tax bracket
If trust beneficiaries are not in the highest tax bracket, an estate or tax attorney may be able to draft documents that cause beneficiaries to be treated as grantors or owners under I.R.C. § 678, which takes precedence over the regulations governing ESBT income taxation.
Owning stock in an S corporation presents some challenges in estate planning that individuals may not have.
However, careful estate planning can ensure your S corporation election does not unexpectedly terminate, resulting in disastrous tax consequences.