S corporations are small-business corporations that elect to pass through income, losses and deductions to shareholders for federal and state tax purposes. By electing to be treated as a pass-through entity, the S corporation avoids the double taxation on traditional corporate income and dividend income distributed to shareholders. However, to retain the tax benefits of an S corporation, a company must comply with strict stock-ownership qualifications.
The S corporation may have only one type of stock issued by the company. Eligible shareholders are limited in number to no more than 100 and must not be corporations or partnerships. Individuals and estates may hold stock in the S corporation, as well as certain trusts, so long as they meet specific qualifications approved by the IRS. Trusts can be powerful tools to transition a business, but the S corporation owner must be careful to include in the succession plan only trusts that satisfy the S corporation rules in order to avoid losing the tax benefits of S corporation status.
Trusts that qualify as S corporation owners are limited to three basic types. The first is a trust treated for income tax purposes as if it is owned by an individual who retains certain powers over the trust, called a “grantor trust.”
The second type is a trust referred to as a “Qualified Subchapter S Trust” (or QSST), that has only one income beneficiary for the beneficiary’s lifetime and upon termination of the trust would be distributable to the same income beneficiary. The trustee must elect to be treated as a QSST within two months of the transfer of the S corporation stock to the trust.
The third type of qualifying trust allows multiple beneficiaries and trust income to be distributed or sprinkled among the beneficiaries and is called an “Electing Small Business Trust” (or ESBT). ESBT treatment requires an election by the trustee similar to the QSST election.