Creative ways of achieving grantor trust status.

• Author: Day, Sally E.

Sometimes a C corporation considering S corporation status has a trust as a shareholder. If the trust was not originally drafted with the intent of being an eligible S corporation shareholder but continues to hold the stock, the corporation could be prevented from making the S election. Nevertheless, it may be possible for a knowledgeable tax adviser to solve this problem if he or she knows the intricacies of the grantor trust rules of Secs. 671-677.

This item has three sections. The first presents a summary of the eight entities that qualify as eligible shareholders. The second explores the advantages and disadvantages of the three most frequently used types of trusts that qualify as S shareholders and why grantor trusts are often the preferred trust type for holding S corporation stock. The third section focuses on some less obvious ways to achieve grantor trust status, which will allow trusts that perhaps were not originally intended to hold S corporation stock to qualify as eligible shareholders.

Entities That Qualify as Eligible S Corporation Shareholders

Sec. 1361 provides that an S corporation may have the following entities as eligible shareholders:

* An individual (however, a nonresident alien cannot be a shareholder);

* An estate;

* A voting trust;

* A grantor trust, during the grantor's lifetime;

* A grantor trust, for two years following the grantor's death;

* A two-year rule trust;

* A qualified subchapter S trust (QSST); and

* An electing small business trust (ESBT). Each of the eligible trusts is described more fully below.

Voting trust: A voting trust is one that is created primarily to exercise the voting power over stock transferred to it. To qualify, there must be a written document that gives the right to vote to one or more trustees. The trust document must require that dividends on the stock be paid directly to the beneficial owners and that the title and possession of the stock be delivered to the beneficial owners when the trust terminates. Finally, the trust must terminate, by its terms or state law, on or before a specific date or event. In practice, voting trusts are seldom used.

Grantor trust: Grantor trusts, however, are very commonly used. These are often trusts for which the person who created the trust (the grantor) retains sufficient powers over the trust funds so that the trust is treated for income tax purposes as if the grantor is the direct owner of the trust assets (Sec. 671). In order to qualify as an S corporation shareholder, the trust must be treated as owned by only one person. If the trust loses its grantor trust status other than by reason of the death of the grantor, the trust is immediately disqualified as a shareholder, and the corporation's S election is immediately terminated. This could happen, for example, when a grantor amends the trust to make the formerly revocable trust...