Perfect balance: electing small business trusts in S corps estate tax planning.

• Author: Fukuto, Erin
• Position: Estate planning

Estate tax planners may find that, under specific circumstances, the use of Electing Small Business Trusts (ESBT) can provide the best means of achieving a desired balance between estate tax costs, income tax costs and a taxpayer's goals.

Introduction

A situation estate tax planners often encounter is one where a significant portion of family wealth is concentrated in a closely held or wholly owned business. For income tax and business reasons, the business elects to operate as an S corp. This allows the corporation to escape the payment of corporate-level income taxes, and instead, pass through its taxable income directly to the shareholders and a single level of tax is paid at the shareholder level.

Unfortunately, the requirements to maintain S corp tax treatment also limit the flexibility and available alternatives to create an effective estate tax plan that will transfer this valuable asset to the next generation.

To qualify for the tax benefits of an S election, the corporation must comply with many stock ownership requirements--one of which is that only certain trusts can be eligible shareholders. Since trusts are an important tool used in transitioning a family owned business from one generation to the next, care should be taken that only an eligible trust will be a shareholder of a closely held S corp.

Failure to monitor this can result in a revocation of the S election and cause serious income tax ramifications. This potential hazard shouldn't be overlooked when developing an estate tax plan. While there are other eligible trust shareholders, such as grantor trust and testamentary trust, which each have their uses, this article will address the benefits and disadvantages of using an ESBT versus a Qualified Subchapter S Trust (QSST).

QSST vs. ESBT as S Corp Shareholder

Often, upon the death of a shareholder of an S corp, company shares are devised to a trust. Unless the trust is an eligible shareholder and makes the proper elections, this can cause the termination of the company's S election. Conversely, corporation stock can be transferred to various trusts during the owner's lifetime as part of a succession plan, but unforeseen events may occur--the sale of the business, the death of a beneficiary, for example--that could require changes to such trusts to accommodate the taxpayer's/ grantor's needs and desires.

In these situations where trusts receive S corp shares, additional action is required to qualify the trusts as eligible S...