Options for Safeguarding Your S Corporation Ownership — Beyond Your Death– May 22, 2018 by Stephenie Truong

S Corporations must follow explicit rules to be eligible and remain in good standing as an electing S Corporation. One such rule is that the S Corporation can only have shareholders who are U.S. citizen- or resident-individuals, estates, certain trusts and certain tax-exempt organizations. While during your lifetime you as an individual fulfill the requirement of an eligible shareholder, without proactive planning, upon death that ownership could change — jeopardizing your status and the corporation itself.  If at any time there are ineligible shareholders, the S Corporation no longer qualifies for pass-through treatment, potentially subjecting clients to double taxation at the corporate and shareholder level. Taking action steps now can effectively safeguard your S Corporation later. 

Estates as S Corporation Shareholders

The Internal Revenue Code allows an estate of a deceased shareholder to be an S Corporation shareholder. The eligibility of an estate shareholder is valid throughout the estate’s existence, which continues during the period of administration and settlement. The duration of this period is not explicitly defined in the code, but it is clear that the duration cannot be unduly prolonged. The “right” amount of time reasonable for the estate to fulfill its responsibilities and subsequently terminate will be highly dependent on facts and circumstances.  

Trusts as S Corporation Shareholders

Certain trusts are permitted S Corporation shareholders, such as Subpart E or grantor trusts, testamentary trusts, qualified Subchapter S trusts (QSST) and electing small business trusts (ESBT). Therefore it would be ideal to either own the S Corporation through a qualifying trust or have formal plans to transfer ownership into one upon death.
The qualifying Subpart E trust must be a wholly owned grantor trust with only one deemed owner. Upon the death of the grantor, the trust will cease to be a grantor trust, but will continue as a qualified S Corporation shareholder for two years after the date of the grantor’s death.
The qualified grantor trust may make a Section 645 election to be treated as part of the estate for a maximum of two years. This election allows the filing of one tax return and gives the trust certain tax advantages that it otherwise would not have. At the end of the Section 645 election period, the S Corporation stock is transferred to a subsequent or testamentary trust, thereby becoming a permitted S Corporation shareholder for another two years from the date of transfer. At the end of these two years, the testamentary trust will cease to be a qualified S Corporation shareholder unless it makes timely elections to be treated as another type of permitted trust. 

Qualified Subchapter S Trusts

Becoming a qualified Subchapter S trust (QSST) is another option to extend your S Corporation ownership after death. There are four requirements: 

  1. There can be only one income beneficiary during the lifetime of the current income beneficiary and all income must be distributed at least annually,
  2. Distributions of principal can only be made to the income beneficiary during the lifetime of the current income beneficiary,
  3. Income interest of the current income beneficiary must terminate on the earlier of the beneficiary’s death or the termination of the trust, and
  4. All trust assets must be distributed to the current income beneficiary if the trust terminates during the lifetime of the current income beneficiary. 

The current income beneficiary must make an election with the IRS to be treated as a QSST. The election must be made timely to be effective — within two months and 15 days from the date of transferring S Corporation stock into the trust, the date that the grantor trust ceases to be a grantor trust, or the end of the two-year period for a testamentary trust. The election will be effective for the existence of the trust, including all successive income beneficiaries, or until the S Corporation stock is disposed of and revoked only with the consent of the S Corporation secretary. A separate election must be made for each respective corporation. 

Electing Small Business Trust

An electing small business trust (ESBT) is also an option; it has three general requirements: 

  1. The trust cannot have beneficiaries other than individuals, estates and certain charitable organizations,
  2. Beneficiaries cannot acquire a trust interest by purchase, and
  3. An election must be made for the trust. 

Note that unlike a grantor trust, testamentary trust, and QSST, an ESBT is not restricted to having only one current income beneficiary. As a result, be cautious of any potential current beneficiary that is entitled to a distribution from the principal or income of the trust. Each potential current beneficiary is treated as one eligible shareholder for the S Corporation eligibility rules, which has a 100 shareholder limit.
For the ESBT, it is the trustee that must make the election with the IRS, not the beneficiary. An election must be made within the same time constraint as a QSST election, within two months and 15 days of its effective date. The election is effective for the taxable year and all subsequent years of the trust, unless revoked with the consent of the secretary. Only one election needs to be made even if the trust holds stock in more than one S Corporation. 

Making the Right Moves

Presume that you are an individual shareholder of an S Corporation and unexpectedly pass away. If your ownership is passed into the hands of an ineligible shareholder, the S Corp status is immediately terminated. If your ownership is passed on to several beneficiaries resulting in more than 100 shareholders, the S Corp status is immediately terminated. Upon termination, the business will be subject to double taxation as a C Corporation – once on the corporate level and again on the shareholder level. When an S Corp status is terminated, it is barred from making a new S Corp election for five years.
Due to the stringent rules surrounding S Corporation eligibility and the limited trust options that qualify as S Corporation shareholders, it is important to proactively take steps during your lifetime to ensure your ownership is sustained by your beneficiaries and to prevent disastrous tax consequences to the S Corporation and remaining shareholders.

Please contact a member of your service team, or contact Stephenie Truong at struong@cohencpa.com or Alane Boffa at aboffa@cohencpa.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.