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The S Corporation & Estate Planning

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When an estate plan includes an S corporation, a shareholder seeking to protect the Subchapter S election under the Internal Revenue Code (IRC) must be aware how the stock can be passed to others without jeopardizing this status. Restrictions limit the ways that the stock can be transferred, but – within these restrictions – one can find opportunities in the estate-planning context to protect the S corporation election while achieving objectives for the estate plan. Various possibilities will be introduced after a look at why a business owner would make this election in the first place and why its continued existence would be a focus of an estate plan.

WHY PROTECTING THE CORPORATE TAX STATUS MATTERS

In Subchapter S of Chapter 1 in the Internal Revenue Code, the statutes explaining the S corporation election, the purposes for deciding on this status, and limitations and restrictions that must be followed in protect this status are set forth. Small businesses may choose to incorporate, typically becoming C corporations. A hallmark of such entities is “double taxation.” This means that the average corporation is taxed on its profits (if any); then, after the corporate income tax is assessed, the profits that remain can be distributed as dividends, for example, to the entity’s stockholders. They must account for their shares of the corporate profits when they pay their personal income taxes. Since the corporate profits are taxed at these two levels, this is labeled as double taxation.

On the other hand, when a C corporation makes a successful election to become an S corporation, the problem of double taxation no longer exists because S corporations are taxed as if they were partnerships, which are treated as pass-through entities under the IRS’s income-tax laws. In partnerships, the individual partners receive their shares of the profits, and these are taxed only once – i.e., as shares of each partner individually.

While partnerships are not taxed at two levels, there are other problems, including the possibility of partners being personally liable for a portion of the partnership’s liabilities and debts. A major benefit of incorporation is the basic rule that individual shareholders are not legally responsible for the corporation’s debts and damages beyond their investment in the corporation. This look at partnerships and C corporations leads to the reason that the S corporation appeals to many business owners.

Meanwhile, another potential consideration regarding estate planning with an S corporation that has more than one owner of its stock is that a shareholder agreement often will exist. Due to the closely-held nature of the company, this agreement may contain restrictions on transfers of stock because these transfers can disrupt the continued operation of the business. It may require consent from any other shareholders, who want new members who are likely to act in the best interests of the corporation and the current shareholders. Any plan for the future must fit into the parameters of the shareholder agreement, in addition to the legal considerations.

Despite the various limitations and restrictions that S corporations face which result in making estate planning a precarious undertaking for a layperson, an S corporation is an entity that also has distinct advantage over the C corporation and over the partnership that lead many business owners accept these limitations and restrictions to achieve a tax advantageous position. The IRS treats S corporations as pass-through entities, despite their corporate status. This provides the benefit experienced by partnerships – there is no double taxation, and any profits only are taxed at the shareholder level. A shareholder of S corporation stock also does not pay self-employment tax.

Furthermore, as a corporation, this entity’s owners have the same protections that stockholders in any C corporation have regarding personal responsibility for corporate debts and damages. Of course, there is a price to be paid for receiving this favorable treatment. As noted earlier, estate planning with an S corporation presents difficulties that must be navigated in order to protect the corporate designation permitted by the Internal Revenue Code. Methods that can allow the transfer of S corporate shares while not causing the revocation of the S election exist and must be considered when an estate plan is being constructed.

LEGAL LIMITATIONS AND RESTRICTIONS TO WORK AROUND

The fact that business owners who successfully elect to benefit from the advantages of being an S corporation also must accept certain limitations and restrictions that are tied to this election has been noted. As these elements are a major concern when an individual prepares an estate plan, an introduction to the limitations and restrictions that exist is necessary. One needs to understand why the transfer of S corporation shares is not straightforward in the way that it is with an ordinary C corporation and then have some knowledge of what options are available as a result.

The Internal Revenue Code places restrictions on the number and types of shareholders that S corporations can have. For example, an S corporation faces a limitation on the maximum number of stockholders who can own its stock. Currently, this number is one hundred – exceeding 100 owners violates the law and results in a forfeiture of the S election. While a family-owned business might not be large enough for this to prove troublesome, any plans for succession and stock transfers must be set up in order to avoid allowing ownership to expand beyond this total.

In terms of the shares themselves, an S corporation can have only one class of stock according to IRC Section 1361(b)(1)(D). However, within this class, shares may be classified as voting or nonvoting. The use of nonvoting shares allows transfers of significant value to be made without also transferring control.

The estate plan also must be drafted with a clear idea of the types of individuals and entities that are permitted to own S corporation stock; without such careful consideration, an estate plan can undermine the objective of protecting the S election. Non-resident aliens cannot have an ownership interest; the owner’s estate should be set up so that all shares will pass to U.S. citizens, resident aliens, certain tax-exempt organizations, and certain types of trusts.

The restrictions on ownership ensure that profits, which pass through the S corporation to its shareholders, will not escape annual taxation by the IRS. The limited group of potential owners eliminates most corporations, partnerships, and LLCs, for example, from owning any stock in an S corporation if it is to retain its tax status under the Internal Revenue Code.

INCLUDE QUALIFIED OWNERS TO PERPETUATE THE BUSINESS

When developing an estate plan, a current owner of stock must focus on choosing “qualified” owners – these are individuals and entities who meet the requirements to own shares in an S corporation, which are set out in the Internal Revenue Code. Otherwise, the business could lose this status, meaning that any current shareholders are likely to suffer financially. While a large number of entities and individuals are eliminated from consideration by tax laws, there are specific categories of entities and individuals qualified under the tax code to be owners. When estate planning, an owner needs to understand this so that she or he can determine the choice that is appropriate based on the owner’s vision of the corporation’s future and the best course of action to turn the vision into reality.

Of course, for a business to survive as an ongoing concern, an individual owning shares in an S corporation not only must choose a new owner who falls within the group of qualified owners but also must choose a successor who can perpetuate the business. Beyond looking at individuals, the person could name a trust or a tax-exempt organization to receive the available shares from the estate. This becomes a difficult decision that involves considering multiple options.

 THE CATEGORIES OF POTENTIAL SHAREHOLDERS UNDER THE IRC

While looking at these options, an individual must be sure that the any succession plan accounts for two major decisions that are vital to preserving S corporation status. First, the plan must avoid transferring any shares of the corporate stock to ineligible shareholders, the categories of which already have been reviewed. Second, the individual must detail necessary elections (e.g., the Qualified Subchapter S Trust or Electing Small Business Trust election) that protects against termination of the S corporate status when the grantor dies as well as post-mortem elections that may be required to prevent termination.

With these concerns in mind, the planner generally can look at only a limited number of possibilities. The choices for the transfer of stock ownership include the following: family members, “key persons” who are involved with the S corporation, the decedent’s estate (for a limited period of time), various types of trusts, and certain tax-exempt organizations.

TRANSFERS TO HEIRS OR BENEFICIARIES

With a family business that involves an S corporation, a number of options for ownership transfer can be available. If not specified in the estate plan, a decedent’s shares would pass to the individual’s heirs. This probably is not the optimal choice. For example, the heirs who receive shares based on laws of intestacy may not have the skills or interest to be involved in running a business. A will could be set up to transfer shares to beneficiaries chosen by the testator who had the will drafted to distribute her or his stock.

AN ESTATE CAN BE A QUALIFIED OWNER … FOR A LIMITED TIME

If stock is passed according to a decedent’s will or via a state’s intestacy laws, the ownership of the shares does not transfer to beneficiaries or heirs immediately. In addition, stock does not pass to a trust or a tax-exempt organization, both of which will be reviewed in more detail later, at the time of death. When going through the estate planning process, the shareholder needs to understand that her or his estate can own stock of an S corporation.

However, the length of time that this situation can exist is not open ended. Eventually, these shares will be owned by individuals (as noted above) or entities (as will be noted below). The estate’s personal representative can maintain ownership in the estate for a “reasonable” time. This is not defined in terms of days but is defined by the diligence of the personal representative, who cannot permit an unreasonable delay in transferring ownership from the estate to the new owner as chosen by the decedent or, if the decedent as not set up a comprehensive estate plan, by the defaults established under the law.

If the time frame is determined to be unreasonably long, then the S election may be terminated. What is “unreasonable” is not defined with precision. Instead, it depends on the facts of the case because, the more complicated the estate, the longer the period in which it can reasonably be the owner of the S corporation stock. In the end, though, no estate can last forever so, at some point, the stock must move out of the estate and go to a qualified owner pursuant to the Internal Revenue Code.

GIFTING SHARES COULD BE A USEFUL ESTATE-PLANNING OPTION

Of course, not every estate or succession plan calls for transfers to be made after death. There are ways that the current owner can look to transfer shares prior to death. One possibility is the use of gift giving during one’s lifetime. Often, a parent wants to pass interests in a business to the parent’s issue when they might be considered appropriate successors to the parent. These transfers could be made to individuals or, if distribution is to occur to those individuals in the future, to a trust for this purpose.

Using gifts to make the transition necessitates looking at gift-tax implications. The plan may avoid gift taxation by making gifts each year to each individual that are valued at no more than the annual exclusion for gifts, which is $16,000 per individual for 2022. Other possibilities exist, but the ones mentioned are used commonly to pass business interests from one generation of a family to the next.

BUY-SELL AGREEMENT: CURRENT OWNERS MAY PURCHASE STOCK

There may be reasons why a plan to bring new family members into the business might not be feasible. A shareholder may plan for the S corporation to have an agreement in place that permits a “key person” within the business to purchase a decedent’s shares. In conjunction with the buy-sell agreement, the current shareholder could facilitate this transition by arranging for a life-insurance policy to fund the purchase.

When setting up such a plan, the shareholder should have a qualified appraiser determine the fair market value of the stock since the shares are not publicly traded – valuation always is a concern when an S corporation is involved. Also, this plan only works when there are at least two shareholders in the corporation since the person buying the shares must be an owner at the time.

ESTATE PLANNING AND ELIGIBLE ENTITIES AS SUCCESSOR OWNERS

The current owner may determine that passing shares to individuals does not fulfill the intent behind the estate plan. As long as the shareholder is not bound by an agreement to offer the stock to particular individuals, she or he is in a position to consider specific entities as the new owner of S corporation stock via the estate plan. Some of these options exist prior to death while the others occur post mortem.

Trusts Are the Most Common Entities to Consider

Commonly, an owner in this situation will look at the various types of trust are allowed to own S corporation shares. This requires a thorough understanding of the different purposes that trusts can serve so that an informed decision regarding which is best suited to carry out the intent of the estate plan can be implemented. A brief review of the various possibilities follows.

There are numerous variations among the universe of trusts. However, while purposes may differ, they share common elements. For example, a trust is a legally distinct entity in which assets are managed for the benefit of a select group of beneficiaries. It is created when the grantor (sometimes known as of the settlor) provides trust property that generally should grow in value; this corpus (or principal) is intended to increase in value so that the beneficiaries, under specified conditions, will share in thus benefit. Finally, the trust property is under the control of a trustee – the legal owner of this property – who must manage and invest the trust’s principal on behalf of the beneficiaries.

There are a variety of reasons for using a trust, as opposed to an outright gift to beneficiaries, which is why different types of trusts exist – they have their own characteristics that establish their character and their usefulness in certain situations. The estate planner must be aware of this and select the type of trust(s) that fits with the grantor’s intent in setting up the trust.

Only a Few Trust Types Can Own Subchapter S Stock

Meanwhile, with an S corporation, only a handful of trust types can be used. The grantor has to understand the purpose of creating a trust as well as creating the type of trust that not only fulfills this purpose but also fits into one of the permissible categories.

In estate planning, an individual is limited in the types of trusts that can be established, and various options will depend on elections made after the individual’s death. The Internal Revenue Code includes the following among the trusts that can be eligible S corporation shareholders: grantor trusts; trusts established by the shareholder who also is the deemed owner of the trust at death can continue for two years after the date of death; testamentary trusts created within two years of receipt; Qualified Subchapter S Trusts (QSSTs); Electing Small Business Trusts (ESBTs); and voting trusts. The Internal Revenue Code spells out these choices within Section 1361, in which the IRS also defines what an S corporation is. Considerations regarding each of these are set forth below.

Grantor Trusts

The grantor trust can be relatively easy to establish, but there are certain requirements if it is to hold S corporation stock without jeopardizing the S election. The grantor who sets up the trust must be a U.S. citizen or resident. Additionally, the stock and other assets of the trust must be treated as owned by the grantor. This means that person who puts the assets into this type of trust maintains control over the trust, including the ability to determine distributions from the trust. As a result, the grantor is responsible for any income taxes incurred due to the operation of the trust, as opposed to the trust having any obligation for their payment.

As long as the trust meets these requirements when the grantor dies, it does not have to terminate at that time. Instead, the IRC permits the trust to continue its existence for up to two years after the death of the deemed owner. During this period, it remains eligible to hold S corporation stock, with the estate of the deemed owner becoming the new shareholder.

A grantor also can create a trust that is irrevocable, with control over the assets placed in the trust being surrendered by the grantor. By surrendering this control, the grantor generally is not responsible for paying taxes on the trust’s income. This would eliminate the use of this type of trust for the transfer of S corporation stock.

Intentionally Defective Grantor Trusts: A Twist on the Grantor Trust

However, trusts and the laws and regulations that pertain to them can be quite complex. There are trusts in which the grantor surrenders control over assets placed in the trust – which usually would lead to taxation of the trust for income that is generated and prevent it from holding S corporation stock – receiving some treatment by the IRS as a revocable trust. This is known as the “intentionally defective grantor trust” (IDGT).

This is one of the more complicated trusts among those that can be used with S corporation stock – it must be drafted very precisely to succeed here. An IDGT relies on specific rules in which the IRS permits an irrevocable trust to employ certain conditions that will allow an irrevocable trust to be treated as a revocable trust to a sufficient extent when a S corporation in involved. Usually, this starts with a grantor trust that is drafted with an intentional flaw that will require the individual to remain responsible for paying taxes on income produced by the trust.

The assets in the IDGT will not be part of the estate of the former S corporation shareholder – this is in contrast to a revocable trust in which the grantor remains the actual owner of the property held in the trust. These assets are transferred to an IDGT by either gift or sale. The typical beneficiaries will be the grantor’s children or grandchildren, who benefit by eventually receiving the trust’s assets without a reduction in value due to income taxation because the grantor already paid these. The intentionally defective grantor trust can be a useful tool when an S corporation is involved but only when enough care has been taken to structure it so that it does not run afoul of the applicable rules.

Time-Limited Usefulness of a Testamentary Trust

While an intentionally defective grantor trust can be rather complicated to include in an estate plan, a testamentary trust is simpler to establish. After the shareholder’s death, the estate’s personal representative must work to establish a functional trust. The trust must be funded, with steps taken to permit it to hold the S corporation stock without jeopardizing the corporation’s election. The problem with this option is that it is time limited by definition.

A testamentary trust can retain the stock for no more than two years after the shares are received. If this trust is intended to be an irrevocable trust, the language establishing it must be examined and modified, if necessary, so that the testamentary trust ceases to hold the S corporation stock beyond the time limitation.

Before this period has expired, the trust must qualify as a type of trust that the Internal Revenue Code permits to own S corporation stock. If the terms will not allow the steps required to turn this into an eligible trust to be taken, then the stock should not be placed in the trust in order to protect the S election.

Two Statutory Elections that Can Replace a Testamentary Trust

Assuming that an eligible trust can be created, there are numerous variations of trusts that meet the requirements set out in IRC Section 1361. Since grantor trusts are eligible, an estate planner could use the previously described intentionally defective grantor trust. There are two trusts set forth within Section 1361 that a testamentary trust could become with a timely election.  These are the Qualified Subchapter S Trust (QSST) and the Electing Small Business Trusts (ESBT). A brief review of each follows.

A Qualified Subchapter S Trust Election and Its Effect on the Estate Plan

Section 1361(d) of the Internal Revenue Code introduces the Qualified Subchapter S Trust as a trust that can own stock of an S corporation. However, a trust that elects to have this subsection apply to it has to meet specific criteria. One of the requirements is that the trust can have only one current income beneficiary who can receive benefits from the S corporation stock.

Additionally, any distributions of the QSST’s assets can be made only to that beneficiary, who must be a U.S. citizen or resident. The current beneficiary’s interest ends with this individual’s death. However, if the trust terminates prior to this beneficiary’s death, then the beneficiary will receive all of the trust assets

The timing of a QSST election is important. For example, a testamentary trust that becomes the owner of S corporation stock must elect to be treated under this subsection within two months and 15 days after it becomes a shareholder. If this deadline is missed, then the opportunity to make this election is lost unless late-election relief under Revenue Procedure 2013-30 is obtained.

Electing Small Business Trust and the Impact of its Election

A second option that can be considered before the period that a testamentary trust can hold S corporation stock expires is found in Section 1361(e) of the IRC. Like the QSST, the Electing Small Business Trust (ESBT) must be a domestic trust; this means that a U.S. court exercises primary supervision over its administration and at least one U.S. person controls all of its substantial decisions (26 CFR Section 301.7701-7). It also has a period of two months, 15 days after the trust becomes an S corporation shareholder or the business becomes an S corporation to elect to be an ESBT.

QSST v. ESBT: Advantages and Disadvantages under the IRC

An area in which the Electing Small Business Trust differs from the Qualified Subchapter S Trust involves beneficiaries. A QSST is limited to one income beneficiary while the ESBT is more flexible, allowing there to be more than one “potential current beneficiary” (as defined in Section 1361(e)(2)).

The EBST also permits the multiple beneficiaries to receive income from the trust, but each is required to be eligible to be owners of S corporation stock. The list of possibilities includes U.S. citizens and residents, estates and qualifying tax-exempt organizations (see below).

While the ability to have more current beneficiaries than a QSST can have may be advantageous in terms of the estate plan, the income distributions to the trust’s beneficiaries are likely to face higher tax rates since the ESBT is taxed on this income and generally will pay at a higher marginal tax rate than individual beneficiaries. Meanwhile, the QSST’s income is taxed as income to its current beneficiary. The respective limitations of these two trusts have to be considered before choosing one in the context of an estate plan.

What are Potential Purposes of a Voting Trust?

There is another trust that can hold S corporation stock which is mentioned in Section 1361 that can hold S corporation to be considered here: the voting trust. It is not really an estate planning option because it involves owners of stock creating a trust via a written agreement that delegates their voting rights to one or more trustees. The individual owners of the shares are taxed on any income generated, and the trust is subject to termination on a specific date or upon the occurrence of a specific event. Such trusts can be important when an S corporation is facing a hostile takeover, loss of control, and potential conflicts of interest. The voting trust is mentioned in the interest of completeness since its purpose of pooling voting rights of shareholders would arise after the estate plan’s purpose of transferring ownership to the shareholders is fulfilled.

Viewing Tax-Exempt Organizations Alone or Within a Trust

Another estate-planning option for an S corporation shareholder centers on certain tax-exempt organizations (see Section 1361(c)(6)) that are permitted to be shareholders under the Internal Revenue Code. These include Section 401(a) organizations (pension, profit-sharing and stock-bonus plans) as well as Section 501(c)(3) charitable organizations that are tax exempt under Section 501(a) of the IRC.

Some Section 501(c)(3) organizations merit further scrutiny because they are private foundations instead of public charities. Private foundations usually receive most of their contributions from a primary donor and are controlled by a small group of individuals. As a result, they lack public accountability, and this has led to them facing additional restrictions and excise taxes that can reduce the impact of contributions. This is worth considering if you would look at a private foundation to become an S corporation shareholder in an estate plan.

SOME CONCLUDING CONSIDERATIONS

When there is no shareholder agreement that specifies to whom or what an owner’s shares can be transferred, then an S corporation shareholder’s options fall into the above categories. The person looking at estate planning must work within the limited structure provided by the Internal Revenue Code. Gifting of shares those eligible under the Internal Revenue Code, passing ownership via will to eligible individuals and entities, and placing stock into certain types of trusts are the basic choices available for the estate planner here. Of course, there is no perfect solution, but one must start with well-defined objectives regarding an estate plan to be developed. Then, each of the possibilities can be reviewed to find the best way to meet the objectives. Often, the assistance of experienced professionals is crucial in order to navigate this complicated process to lead to the development of the desired estate plan.

The Need for an Estate Plan

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Everyone needs an estate plan. Due to the range of decisions and situations that such a plan can cover, you shouldn’t let a lack of property or wealth keep you from addressing this. An estate plan generally includes a number of documents, and only some of these focus on transferring wealth when you die.

 

Of course, one of the essential pieces is a Last Will and Testament. This is important for certain transfers of property but also can deal with other topics, such as burial arrangements. The second essential part of your estate plan is a Durable Power of Attorney, although it basically is effective only while you are living. You could choose someone to make financial decisions or, at least, handle your financial affairs, such as paying bills, when you are unable to do these things. A Medical Power of Attorney can provide authority over some medical decisions when your medical condition prevents you from speaking for yourself.

 

A final essential element in every estate plan is commonly known as a Living Will (or Advance Directive). It permits you to make decisions regarding the medical treatment and care that you would want when you can no longer communicate your wishes and are not likely to recover in the opinion of doctors who have examined you while you have been in this condition. You could name a surrogate decision maker, but – if a decision is covered in the Living Will – you can require that your surrogate follows your wishes.

 

The need for a Power of Attorney and a Living Will may be more understandable than the need for a Will if a person has does not own much. However, your Last Will and Testament can provide valuable information, regardless of the size of your estate. You may have items that have sentimental value to family members or even a small amount of cash that you want a particular person to have after your death. A Will can be used to make your intent clear. It also can provide other information; for example, you can name the person you want to handle the necessary activities that follow a person’s death, including handling taxes and your final expenses. You also must remember that, while your Will can make your wishes clear, the necessary person has to have access to it in order for it to be effective.

 

While a Will is important in transferring ownership of property to others, an estate plan can use other methods to do this. Each possibility has positive and negative points that are best reviewed with a professional. One method is to set up a joint account with the right of survivorship, which avoids the probate process but not necessarily the so-called death taxes (such as Pennsylvania’s inheritance tax). Other assets, including a life-insurance policy, can name beneficiaries so probate again can be avoided. Another possibility with life insurance is to use it to fund a trust as part of your estate plan.

 

Trusts of various types can be used for a variety of purposes. There are trusts that are intended to reduce the tax bill for your estate and for others – this is a complicated area that’s beyond the scope of this post, but it may be a realistic consideration depending on your circumstances. An example is a “credit-shelter” trust that a wealthy spouse might want to shield a surviving spouse’s estate from a large federal estate tax bill later on.

However, trusts are not just a tool of the rich and can be created for purposes that don’t focus on protecting wealth. For example, you may have a child who receives Medicaid (or, as it is known in Pennsylvania, Medical Assistance), which limits income and resources that your child can have while retaining eligibility. You could decide to disinherit your child to avoid the loss of these benefits, but you might consider a “supplemental needs” trust in your estate plan. Basically, this does not permit payments that would replace government benefits but can pay for other things to supplement what your child receives from public sources. A carefully drafted trust would make this possible.

 

Estate planning can even take place through gifts while you are alive and through post-mortem planning, such as a disclaimer by a beneficiary or an heir of something that she would receive so that it goes to someone else. Disclaimers often are used based on tax implications. With the numerous potential aspects of an estate plan, a person often benefits from consulting with a professional about the available options. Even the seemingly simplest estate can benefit from a review of an individual’s objectives and the consideration of ways that you might be met.

 

For the moment, there is one final thought to keep in mind. You never should view an estate plan as a final product. With time, changes occur in a life. The purpose of the plan may change if you get married or divorced, for example. Laws also change, and your plan may no longer meet your tax-planning goals when new tax laws are passed. An estate plan should be reviewed every few years, at least, so that it remains relevant to your current circumstances. No matter how simple or complex an estate plan may be, you need to make sure that it is one that you can live with as time goes by.