Estate planning for S shareholders: maintaining qualification after death in common estate planning situations.

• Author: Taylor, Rick J.

The S corporation qualification rules must be carefully considered when the estate for which a plan is being developed includes (or may include at a later date) an ownership interest in an S corporation. The primary purpose of this process is to prevent the inadvertent termination of the S election after the shareholder's death. Some (but not all) types of trusts may qualify as S shareholders; as such, several commonly used estate planning techniques involving trusts must be modified before they can be used in conjunction with S stock.

Certain trusts permitted

as S shareholders

Certain nonforeign trusts can qualify as S shareholders. Eligible trusts include grantor trusts, Sec. 678 or beneficiary-controlled trusts, testamentary trusts (but only for a 60-day period), voting trusts and qualified subchapter S trusts (QSSTs). Generally, trusts that permit discretionary distributions of corpus and/or income to a number of different beneficiaries do not qualify.

Grantor trusts: Trusts in which the grantor is treated as the owner of the entire trust, i.e., grantor trusts, are permitted S shareholders, provided that the grantor is a U.S. citizen or resident. The trust itself is ignored and the grantor is considered the S shareholder (Sec. 1361(c)(2)(i)).

After the grantor's death a grantor trust is allowwed to continue as an S shareholder for 60 days (Sec. 1361(c)(2)(ii)). However, if the entire principal of the grantor trust is included in the grantor's estate, the trust can continue as an S shareholder for two years (Sec. 1361(c)(2)(ii)).

Sec. 678 trusts: A person other than the grantor is treated as the grantor of a trust over which he has a substantially unrestricted power to invade the trust assets. This type of trust is commonly called a Sec. 678 or beneficiary-controlled trust. In addition, that portion of a trust over which a beneficiary has a Crummey power generally is a Sec. 678 trust, provided the grantor is not otherwise treated as the owner.

Sec. 678 trusts are treated as grantor trusts for purposes of determining the trusts' qualification as S shareholders. As a result, Sec. 678 trusts generally qualify as S shareholders provided the entire trust is treated as a grantor trust. If only a portion of the trust is treated as a grantor trust, it is uncertain whether the requirements of Sec. 1361(c)(2)(i) are met.

In Letter Rulings 8827023, 8809043, 8805032, 8613054 and 8342088, the IRS ruled that Crummey trusts qualify as S shareholders, provided no contribution is made to the trust that is not subject to the Crummey power, and the grantor is not deemed to be the owner of the trust under Sec. 675. (See also IRS Letter Ruling 90090101

After the deemed owner's death, a Sec. 678 trust is allowed to continue as an S shareholder for 60 days Sec. 1361(c)(2)(ii)). However, if the entire principal of the Sec. 678 trust is included in the grantor's estate, the trust can continue as an S shareholder for two years (Sec. 1361(c)(2)(ii)). Testamentary trusts: If S stock is transferred to a trust under the terms of a will (a so-called testamentary trust), the trust qualifies as an S shareholder, but only for the 60-day period beginning on the day on which the...