Top 10 easy ways that trusts cause loss of S corporation status.

• Author: Hills, Marvin D.

The rules regarding what types of trusts can be eligible S corporation shareholders are complex. Private letter rulings frequently are issued regarding (1) stock being transferred to a disqualified trust or (2) a trust that is already a shareholder (and was previously eligible) somehow becoming ineligible and thus causing a termination of S corporation status. Some of the situations are logical and easily recognizable as a problem, but many involve situations that practitioners would not immediately identify as the root of any concerns.

In general, estates and six types of trusts are eligible as S corporation shareholders, with the most common being grantor trusts (including a former grantor trust for two years post-death), electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), and testamentary trusts (for two years after funding). Most practitioners realize that a properly completed and timely filed election must be made for a trust to become an eligible ESBT or QSST, but there are many other problems that a practitioner may not easily recognize. The following are 10 ways that S corporations can lose their S election status, most of them involving trusts.

1. Trusts Owned by More Than One Individual

   Grantor trusts (either revocable or irrevocable) are eligible under Sec. 1361(c) (2)(A)(i) but only if the trust has only one grantor (although spouses generally are treated as one shareholder). Thus, a trust that is taxable to multiple individuals under Sec. 671 would not be eligible to hold S corporation stock.

2. Foreign Trusts

   A foreign trust (as defined in Sec. 7701(a)(31)) is not eligible to hold S corporation stock (Sec. 1361(c)(2)(A), flush language). However, it sometimes is difficult to determine that a trust actually is a foreign trust. In fact, a trust that originally was a U.S. trust can become a foreign trust merely because of a change in trustee. This could include situations where multiple co-trustees exist and foreign trustees obtain the ability to control the substantial decisions of the trust, even if the U.S. cotrustee accomplishes the majority of the actual activity.

3. Nonresident Aliens

   An S corporation cannot have a nonresident alien as a shareholder (Sec. 1361(b)(1)(C)). Therefore, previously valid S corporations have become disqualified when an existing shareholder who formerly was a resident alien (an eligible shareholder) moved out of the United States (thus becoming a nonresident alien) or...