New questions spring from the application of ESBT provisions.

• Author: Kolk, Michael
• Position: Electing small business trust

Beginning this year, there are several new law changes affecting S corporations. One of the more intriguing opportunities, especially in the area of estate planning, relates to the ability of an S corporation to be owned by an electing small business trust (ESBT). Previously, S stock held in trust was limited to two very narrowly defined types of trusts: grantor trusts and qualified subchapter S trusts (QSSTs). These options did not give planners much flexibility in structuring an income or estate tax plan. An ESBT affords a taxpayer the ability to keep the income generated by the S corporation in the trust and to allow family spray provisions in the trust. ESBTs are also very useful when a taxpayer is interested in maximizing income accumulation not subject to the generation-skipping transfer tax. Additionally, charities can be named as contingent beneficiaries, which presents other estate planning options. An interesting by-product of this arrangement is to remove income from the taxpayer's adjusted gross income (AGI), thereby affecting many of the phase-out items that are linked to AGI (such as the itemized deduction phase-out, miscellaneous itemized deduction floor and residential rental real estate $25,000 allowance). However, due to the newness of ESBTs, there are still a number of potential issues that have not yet been fully explored.

One area clearly affected by changes in Federal income tax is state tax provisions. In many states, Federal law dictates the tax status of an entity for state tax purposes. Certain states, such as Idaho and North Carolina, have specifically stated that they will permit the new changes in Federal S corporation law too apply directly in their states. However, other states are not as accommodating and, in fact, may have already required a separate state-level S election in order to obtain state S status. For example, California has already announced that it does not currently conform to the new Federal S corporation legislation.

The California tax statutes rely on the Federal S corporation law that existed as of Jan. 1, 1993. Therefore, if a taxpayer decides to transfer stock to an ESBT for Federal tax purposes in 1997, California law does not recognize an ESBT as a valid S shareholder. Therefore, S status would be revoked for state tax purposes on the date of the stock transfer and California would require the corporation to file as a regular corporation for the balance of the year and thereafter...