ESBTs: perhaps more advantages than disadvantages.

• Author: Day, Sally E.
• Position: Electing small business trust

Trustees must exercise care when performing their fiduciary duties. One of those duties is minimizing income taxes. Nevertheless, many trustees are making electing small business trust (ESBT) elections on a trust's behalf, which subjects the ESBT portion of the trust's income to the highest marginal income tax rate (currently, 35%).

Overview

According to Sec. 1361(b)(1), only U.S. individuals, their estates and certain types of trusts, and tax-exempt organizations may be S shareholders. Three types of trusts basically qualify--grantor trusts, qualified subchapter S trusts (QSSTs) and ESBTs; see Sec. 1361(c)(2)(A). Often, there may be practical, or nontax "family reasons" for shunning grantor trusts or QSSTs, leaving ESBTs as the only alternative. However, there may be some advantages to this; many trustees and beneficiaries are finding that income taxes with an ESBT are no greater than they otherwise might have been (and possibly are even lower than) for either a grantor trust or a QSST.

Grantor trusts: According to Secs. 671-678, a grantor trust allows the trust's creator to retain sufficient powers over the trust so that the trust is treated as if the grantor owns the assets directly, for income tax purposes. For a grantor trust to qualify as an S shareholder, it must be owned completely by only one person; see Sec. 1361 (c) (2) (A) (i). Regs. Sec. 1.1361-1(e)(2), which discusses that a trust created by a husband and wife who are both U.S. citizens or residents, falls into this category.

If the trust loses its grantor status by reason other than the grantor's death, it would be immediately disqualified, and the S election immediately terminated under Sec. 1362(d)(2)(B). This could happen if a grantor switched from a revocable to an irrevocable trust, for example.

If the grantor dies and the trust continues in existence, the S election would continue to apply for up to two years if the trust's corpus is includible in the grantor's taxable estate; see Sec. 1361(c)(2)(A)(ii) and Regs. Sec. 1.1361-1(h)(1)(ii)). If the stock is in a revocable trust that provides that on the grantor's death, the trust will be transferred to one or more separate trusts, the grantor trust may continue as a shareholder until the separate trust(s) are funded, as long as this occurs within two years after death. To preserve the S election, either the beneficiary of the successor trust has to make a QSST election, or the successor trust's trustee has to make an ESBT...