Trusts for holding S corporation interests: QSSTs vs. ESBTs.

• Date: 01 May 2022
• Author: Blase, James G.

Only certain types of trusts are permitted to hold an interest in an S corporation. Two of these are an electing small business trust, or ESBT, and a qualified Subchapter S trust, or QSST. An ESBT is allowed as a shareholder under Sec. 1361(e), which was added by the Small Business Job Protection Act of 1996. (1) The provision was initially praised by advisers and their business owner clients because it did not include the two major restrictions of the QSST, which was created by legislation Congress passed in 1982. (2) Those two primary restrictions of the QSST were that the trust could only have one beneficiary and that all the ordinary income of the trust needed to be distributed currently to the sole beneficiary. This article compares the relative advantages and disadvantages of a QSST versus an ESBT in estate planning.

Tax treatment of QSSTs and ESBTs

The permissible shareholders of an S corporation include a "trust all of which is treated... as owned by an individual who is a citizen of the United States" (Sec. 1361(c)(2)(A)(i)). A QSST with respect to which a beneficiary makes an election is treated as a trust described in Sec. 1361(c)(2)(A)(i). (3) For purposes of Sec. 678(a), the beneficiary of such a trust is treated as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the beneficiary makes the election. (4) As the deemed owner of the trust's S corporation's shares, the QSST beneficiary is taxed on the entirety of the trust's share of the S corporation's income, regardless of whether the income is distributed to the trust.

An ESBT is handled differently under the Code. With an ESBT, whether and to what extent the beneficiaries of the trust are treated as owners of the trust's share of the corporation's stock for purposes of Sec. 678(a) is up to the drafter of the trust. The Code provides merely that an ESBT is a permissible shareholder of an S corporation. (5) The ESBT and its beneficiaries are then taxed under Sec. 641(c). The relevant regulations clarify that, although in general the ESBT's portion of the S corporation's income will be taxed at the highest federal income tax rate, taxation of the trust's beneficiaries at their own income tax rates under Sec. 678(a) takes precedence over this general rule. (6)

Advantages of an ESBT over a QSST

Compared to ESBTs, QSSTs generally have significant disadvantages. (7) These include:

* There can be only one lifetime beneficiary of a QSST, meaning that the beneficiary's children cannot also be beneficiaries of the trust, which is not the case for an ESBT.

* Unlike an ESBT, all the ordinary income of a QSST must be distributed to the beneficiary currently, regardless of need, thus causing potentially unnecessary:

* Buildup of the QSST beneficiary's taxable estate by the compounded value of the QSST's share of the S corporation's distributed income;

* Exposure of the compounded value of the QSST's share of the S corporation's distributed income to potential lawsuits against...