Using qualified Subchapter S trusts (QSSTs).

• Author: Ellentuck, Albert B.

The Internal Revenue Code specifies broad categories of trusts that qualify as S shareholders. One of these, the qualified Subchapter S trust (QSST), is modeled after the grantor trust. It is eligible to hold stock in an S corporation, and, under the S corporation rules, it is treated as a Subpart E trust (Sec. 1361(d); Regs. Sec. 1.1361-1(j)).

The QSST may be useful for estate planning purposes. It may also be useful for holding S stock for the benefit of a minor or incompetent.

Net investment income tax of a QSST

Individuals, estates, and certain trusts are subject to a net investment income tax, which is an additional tax of 3.8%. The net investment income tax applies to estates and trusts if there is undistributed net investment income and the adjusted gross income (AGI) exceeds the highest fiduciary income tax bracket for the year ($12,500 in 2017) (Sec. 1411(a)(2)). The tax also applies to QSSTs to the extent the net investment income is retained in the trust. Although the S corporation income of a QSST is taxed to the individual income beneficiary, capital gain on the sale of the S corporation stock is taxed at the trust level. If the QSST's AGI exceeds the threshold amount, the QSST would owe the net investment income tax on the capital gain.

With the higher income tax rates at lower threshold amounts and the 3.8% net investment income tax on undistributed net investment income at such a low threshold for estates and trusts, fiduciaries should consider opportunities to minimize the tax liability by making additional distributions of income to beneficiaries (if permitted and optimal, based on all the facts and circumstances).

Designing a QSST

The beneficiary must elect QSST status, and the QSST must meet the following requirements (Regs. Sec. 1.1361-1(j)(1)):

* The trust must have only one income beneficiary during the life of the current income beneficiary, and that beneficiary must be a U.S. citizen or resident;

* All of the income of the trust must be (or must be required to be) distributed currently to the one income beneficiary;

* Any corpus distributions that might occur during the life of the current income beneficiary must also go to that one beneficiary;

* The income interest of the beneficiary must terminate on the earlier of the beneficiary's death or the trust's termination;

* An election to be treated as an eligible S corporation shareholder must be made separately for the stock of each S corporation held by the trust...