Academic journal article Journal of Accountancy

Trusts as S Corporation Shareholders: S Corporations

Academic journal article Journal of Accountancy

Trusts as S Corporation Shareholders: S Corporations

Article excerpt

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 IRC [section][section] 671-677.

TRUSTS COMMONLY USED TO HOLD S CORPORATION STOCK

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Three commonly used types of ongoing trusts qualify as S corporation shareholders: grantor trusts, qualified subchapter S trusts (QSSTs) and electing small business trusts (ESBTs).

In many circumstances, a QSST will work well; however, the trustee of a QSST must either be required by the terms of the document to pay out all the net income of the trust to the beneficiaries or must actually pay out all income. In addition, during the lifetime of that beneficiary, principal of a QSST may be paid only to that beneficiary. If the beneficiary of a QSST is a minor child, it may not be desirable to pay out all income of the trust to that minor child.

An alternative the trustee might consider is an ESBT, since trust distributions do not affect the taxation of S corporation income when the stock is held by an ESBT. In fact, if the beneficiary is in the highest marginal tax bracket, it could be advantageous for an ESBT rather than an individual to hold the S corporation stock. (However, remember that every dollar of S corporation income held by an ESBT is taxed at the highest marginal tax rate.) This is because an individual's itemized deductions are phased out at certain levels of adjusted gross income, and layering on additional S corporation income will only add to the phaseout. Because no such limitation applies to an ESBT, an overall income tax savings may result if an ESBT holds and is taxed on the S corporation stock. …

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