Protecting Tax Benefits for Estates Holding S Corporation Stock


By: John A. Grey

Today, S corporations represent the most common type of corporate tax filing. Planning for an estate, which includes closely held business interests held through an S corporation requires careful planning so as to ensure that the flow-through tax benefits are not jeopardized. An S corporation affords significant income tax benefits as the owners are only subject to one level of taxation as compared to two layers imposed upon a traditional C corporation. Qualification for S corporation treatment requires certain elements such as having no more than 100 shareholders and one class of stock. If this criterion is not satisfied, the corporation will no longer be taxed as an S corporation to the tax detriment of the shareholders. In estate and succession planning for closely held businesses, high net worth clients often establish an Intentionally Defective Grantor Trust (hereinafter “IDGT”) to hold S corporation stock. Thereafter, the S corporation stock can either gifted or sold to the IDGT during the grantor’s lifetime as consistent with their long-term succession goals. The transfer of S corporation stock to the IDGT has significant tax benefits. Death of the Grantor One of the primary issues practitioners must address is planning after the death of the grantor. At the death of the grantor of an IDGT, the IDGT ceases to have such status. However, the IDGT will generally continue to be treated as a qualified S corporation shareholder for two years; thereafter, the trust will cease to be an eligible S shareholder unless it otherwise qualifies as another type of trust permitted to be an S shareholder and an election is timely filed. The potential loss of tax saving S corporation status can undermine years of successful planning thus defeating the very purpose of a large estate plan. However, this unfortunate result can be prevented through proper planning. QSST Election Option One option is to elect to be treated as a QSST which can be a permitted S corporation shareholder providing the beneficiary makes the election. A QSST is a trust which: (1) distributes or is required to distribute all income to a citizen or resident of the United States; (2) has certain trust terms including the requirements of only one beneficiary; (3) does not distribute any portion of the trust corpus to anyone other than the current income beneficiary during their lifetime; and finally, (4) the income interest of the current income beneficiary ceases on the beneficiary’s death or the termination of the trust. Providing the QSST satisfies this criterion, the QSST may qualify as an S corporation shareholder; consequently, the shareholders will only be subject to one level of taxation. ESBT Option The ESBT is an equally attractive option for holding S stock and is less restrictive than a QSST. Specifically, an ESBT is any trust which: (1) does not have as a beneficiary any person other than an individual, estate, or organization defined in Section 170(c)(2) through (5); (2) no interest in the trust was acquired by purchase; and (3) an election has been made with respect to the trust. To qualify as an ESBT, the trustee of the trust must make the election by signing and filing an election statement with the IRS Service Center. An ESBT is treated as two separate share trusts for tax purposes, an S portion that consists of all of the S corporation stock and a non-S part, which encompasses of all of the other trust assets. Advantages and Disadvantages of the ESBT The ESBT allows for multiple income beneficiaries among whom the trustee can distribute income and principal at their discretion. This allows the client to make transfers to several beneficiaries through a sprinkle trust, affording control over the timing and the amount of the distributions. Nevertheless, the ESBT can produce a potentially higher tax cost. Conclusion In summary, estate and succession planning for clients who own closely held businesses requires careful attention to S corporation stock. Only certain kinds of trusts under an estate plan may hold S corporation stock; accordingly, estate practitioners must carefully evaluate whether a particular trust qualifies for this tax friendly status following the grantor’s death. For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Director of the Trusts & Estates Practice Group, at 973-230-2080 or or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or

Tags: Asset ProtectionIncome Tax PlanningS corporationtax benefitstrusts and estatesjudson steinjohn greygenova burnsshareholderclosely held businesssuccession planningcorporate tax filingincome tax