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This is the second of a two-part series discussing current issues affecting Subchapter S of the Internal Revenue Code of 1986. This second part discusses certain Subchapter S issues that
are oft-overlooked by business and estate planning counsel. Part One discussed the added flexibility given the Subchapter S corporation by Congress in 1996.
IV.THE TANGLED WEB OF TRUSTS AS S CORPORATION SHAREHOLDERS - TAX TRAPS FOR THE UNWARY
The following scenario illustrates one of the most common mistakes made by attorneys drafting wills and trusts in the United States today.
In 1990 Red, White and Blue incorporated their construction business as RWB Construction, Inc. The corporation filed an S election and passed corporate bylaws. Business was good and the
corporation earned annual income of $500,000. No shareholder's agreement was executed, however. In 1995 Red retained an attorney to prepare his estate plan, which included a revocable
trust into which Red's S corporation shares were transferred. The trust provided for discretionary distributions of income to Red's five sons, with outright distribution of 1/5 of the
trust principal when each son reaches age 25. White and Blue were unaware the shares were transferred to Red's trust. In 1996 Red died and the trust became irrevocable. Following an IRS
audit in 2000, the IRS found that the corporation's S election had terminated in 1998 because Red's trust was not a valid S corporation shareholder. Accordingly, the corporation became a
taxable C corporation in 1998, creating a tax deficiency of $510,000 for the 1998-2000 tax years. White and Blue were shocked by the huge tax bill. Both White and Blue, along with the
trustee of Red's trust, are angry at Red's estate planning lawyer, and are considering a malpractice suit.
A Subchapter S corporation may have as a shareholder an individual (except a nonresident alien), an estate, certain tax-exempt organizations, and certain trusts. Ineligible shareholders
include partnerships, LLCs, certain trusts, and IRAs. Among the challenges in planning for Subchapter S corporations is preventing the transfer of shares to ineligible shareholders, which
terminates the corporation's S election. And, termination of the S election subjects a corporation to income tax at federal rates up to 35 percent. Trusts are the most troublesome S
corporation shareholders.
Five types of trusts may be eligible S corporation shareholders: grantor trusts, section 678 deemed owner trusts, testamentary trusts (for the two-year period following the grantor's death
only), Electing Small Business Trusts ("ESBT"), and Qualified Subchapter S Trusts ("QSST"). Trusts are a ubiquitous estate planning vehicle, and it is common for such
trusts to hold S corporation shares. However, the Subchapter S requirements concerning trusts as S corporation shareholders are exacting. This area is truly a minefield, and estate
planning counsel must exercise extreme caution when drafting trusts that hold, or may hold, S corporation shares.
This discussion focuses primarily on the problematic trusts: the ESBT and QSST.
A. The Electing Small Business Trust.
The '96 Act created an entirely new kind of trust for S corporation ownership, the ESBT.1 The ESBT was created as an alternative to the
QSST, whose inflexible requirements make it unattractive for many estate plans. To qualify as an ESBT: (1) an election must be filed, (2) beneficial interests in the trust must have been
acquired in the right way, and (3) the trust must have the right beneficiaries.
First, the election to treat a trust as an ESBT is filed by the trustee, and the beneficiaries need not consent to the election. The trustee makes the ESBT election by filing with the IRS
Service Center with which the corporation files its income tax return a statement that: (a) contains the name, address, and TIN of all potential current beneficiaries, the trust, and the
corporation; (b) identifies the election as one made pursuant to section 1361(e)(3); (c) specifies the date on which the election is to be effective (not more than two months and 15 days
before the filing date); (d) specifies the date(s) on which shares of the corporation were transferred to the trust; and (e) represents that all potential current beneficiaries meet the S
corporation shareholder requirements and that the trust meets the ESBT requirements.
Second, the right way for beneficiaries to have acquired their interests in an ESBT is by gift or bequest. No interest in the trust may be acquired by purchase. In contrast, the trust may
itself acquire S corporation shares by purchase.
Finally, the right beneficiaries for an ESBT are only individuals, estates, and certain tax-exempt organizations.
The advantage of an ESBT over a QSST is that the ESBT permits the trustee to "spray" income among the trust's beneficiaries (i.e., direct more or less income to one beneficiary
at the expense of the others), and more than one person may be a current income beneficiary. Also in contrast to the QSST, the ESBT allows the trustee to accumulate rather than currently
distribute income. This flexibility comes at a price, however. The price is trust income is taxed at the trust level, prior to distribution to beneficiaries.2 Herein lies the trap for the unwary. The income tax rates for trusts are highly graduated, reaching the top tax bracket of 39.6 percent at annual taxable income of only $8,900. In contrast, individuals do not hit the top tax bracket until their taxable income reaches $297,300 (single or MFJ).
If the trust's beneficiaries are not currently taxed at the maximum tax rate, and do not expect to be so in the future, it is economically more advantageous to have the individual
beneficiaries rather than the trust pay the tax on trust income. The QSST allows such pre-tax pass-through of income to the beneficiaries. The ESBT does not.
Accordingly, upon the creation of a trust that is expected to hold S corporation shares, the trustor must be advised as to the differing tax consequences of qualifying the trust as either
a QSST or ESBT, if either is potentially applicable. The failure to so advise a client may expose estate planning counsel to malpractice liability. Moreover, it is advisable for the trust
declaration to contain explicit directives to the trustee concerning the trustor's intent to qualify as either an ESBT or a QSST. Of course, the substantive provisions of the trust
declaration control whether a trust complies with the ESBT or QSST requirements, respectively; but a statement of the intended qualification will prove extremely helpful in the event
future reformation of the trust is needed to bring the trust into compliance with either the ESBT or QSST requirements.
Recently issued proposed regulations contain attractive rules on the taxation of ESBTs. For federal tax purposes, an ESBT may consist of an S portion, a non-S portion, and in some cases a
grantor portion. Items of income, deduction, and credit attributable to a portion of an ESBT treated as owned by a person under the grantor trust rules would be taken into account on that
person's individual income tax return under the grantor trust rules. Other items may be attributed to either S portion, which includes the S corporation stock, or the non-S portion, which
includes all other trust assets. The S portion would be subject to tax under the special ESBT tax rules (i.e., taxation at the trust level), while the non-S portion is subject to the
normal trust taxation rules (i.e., possibility of taxation at the beneficiary level).3
The proposed regulations appear to offer significant flexibility in drafting trusts intended to qualify as ESBTs. Most significant is the ability to draft trusts that provide for mandatory
distributions of income where the income is not attributable to S corporation shares. Special drafting care should be exercised to give trustees specific directions as to the accumulation
and distribution of income from the S and non-S portions of an ESBT.
B. The Qualified Subchapter S Trust.
The QSST provisions have existed for many years. Nevertheless, the QSST strictures continue to befuddle many taxpayers and their counsel. A
trust's failure to meet the QSST requirements is perhaps the most common Subchapter S tax trap. The price of a trust's failure to meet the QSST requirements is termination of the
corporation's S election, making the corporation a taxable C corporation, and making shareholders grumpy. If this occurs, and counsel is at fault because the trust was not drafted in
conformity with the QSST requirements, the additional corporate-level tax (and therefore the attorney's malpractice exposure) can be substantial, depending on the corporation's level of
taxable income. Accordingly, extreme caution must be exercised when planning estates and drafting trusts intended to be QSSTs.
To qualify as a QSST, the trust instrument must require that: (a) during the life of the current income beneficiary, there be only one current income beneficiary of the trust; (b) any
corpus distributed during the life of the current income beneficiary be distributed only to such beneficiary; (c) the beneficial interest of the current income beneficiary must terminate
upon the earlier of that beneficiary's death or the trust's termination; (d) upon the trust's termination during the life of the current income beneficiary, the trust must distribute all
its assets to such beneficiary; and (e) all trust income must be distributed currently (at least annually) to only one individual who is a citizen or resident of the United States.4
The election to treat a trust as a QSST must be filed with the appropriate IRS Service Center. The current income beneficiary must consent to the election. Failure to file the election
usually results in termination of the corporation's S election. Failure to file QSST elections is not uncommon because many taxpayers and their counsel are unaware of the filing
requirement. In this situation, however, inadvertent termination relief may be granted, as described below.
The most frequent violations of the QSST rules are the scrivener's failure to provide in the trust instrument for only one current income beneficiary (which is the trap into which Red's
attorney fell in the RWB Construction, Inc. illustration above), or the trustee's actual failure to distribute all income to that beneficiary. Strict compliance with the QSST rules
prohibits sprinkling powers, discretionary distributions to anyone other than the current income beneficiary, and even use of trust income and principal to pay funeral expenses and death
taxes of the deceased trustor.
Of course, the typical trustor wants there to be more than one beneficiary of his trust. A way to circumvent the single-beneficiary rule is for the trust instrument to divide the trust
into "substantially separate and independent shares," one for each of the multiple beneficiaries, as if there were a separate trust for each beneficiary.5 This avoids the cumbersome formality of actually creating separate trusts for each beneficiary. Distributions from the separate shares must be made as if separate trusts had been created for each beneficiary. The trust instrument should strictly allocate a fixed percentage of total trust income, and a corresponding percentage of principal, to each separate share. The trust instrument should also provide that the trustee has no discretion to vary distributions from those fixed percentages.
Another way to bypass the single-beneficiary rule is to make the trust a qualified S corporation shareholder pursuant to the deemed owner rules. Section 678(a)(1) makes clear that a
beneficiary with a currently exercisable Crummey power will be treated as owner with respect to the portion of the trust over which the Crummey power is exercisable. If, collectively, all
income beneficiaries are deemed owners of the entire trust, the trust will qualify as an S corporation shareholder, even where the QSST requirements are not satisfied.
A Crummey power is the power given a beneficiary to withdraw stated amounts from the trust within a given period. Of course, the trustor hopes the beneficiary will elect not to exercise
the Crummey power, though the trustor assumes the risk the beneficiary will take the trust money and run. If the Crummey power lapses due to non-exercise, the former Crummey power holder
will continue, pursuant to section 678(a)(2), to be treated as owner of that portion of the trust over which the Crummey power applied.
For example, suppose beneficiaries A, B, and C, all individuals and U.S. citizens, are the sole beneficiaries of a testamentary trust holding 300 S corporation shares as its sole asset.
The trust allows for the accumulation of income, making the trust ineligible for the QSST election. When the trust was funded each beneficiary was given a Crummey power to withdraw 100
shares from the trust, such power to lapse after 30 days. A exercised his power and took the shares free of trust, but B and C allowed their powers to lapse. A became a qualified S
corporation shareholder in his own right, while B and C are treated as owners of the entire trust (i.e., the remaining corpus of 200 shares). Accordingly, the trust is treated as a
section 678(a)(2) deemed owner trust that is a qualified S corporation shareholder.
If successive or contingent beneficiaries are named by the trust instrument, to continue to qualify the trust as a qualified S corporation shareholder, each beneficiary must be given a
Crummey power at the time his present interests become vested.
C. Drafting Tips and Practice Recommendations
To avoid the disastrous results heaped on RWB Construction, Inc. in the illustration above, an S corporation and its counsel should
constantly monitor the corporation's shareholders to determine whether their status may terminate the corporation's S election. Moreover, minority and disgruntled shareholders can wreak
havoc by intentionally terminating the corporation's S election. For those reasons, shareholder agreements are strongly recommended. Such agreements should: (a) absolutely prohibit the
transfer of shares to a person/entity that is not a qualified shareholder pursuant to Subchapter S, (b) grant injunctive relief for violations of the former, (c) require that all
shareholders take all reasonable actions to ensure the corporation strictly complies with Subchapter S, (d) grant the corporation the right to examine trust agreements where trusts hold
shares, and (e) require that the corporation receive a copy of any QSST election, as described below.
To follow is an extract of sample language that might be appropriate for inclusion in an S corporation shareholder's agreement or buy-sell agreement.
Each Shareholder shall prepare and execute a Will or a Codicil to his existing Will, which shall contain a provision substantially as follows:
"If at the time of my death, I own an interest in shares of ABC, Inc., a Utah corporation, or any corporation which has succeeded to the assets and business of that corporation, and
such corporation has in force a valid election under Subchapter S of the Internal Revenue Code of 1986, or the corresponding provisions of future United States Internal Revenue laws, it
is my desire that such Subchapter S election continue following my death. Therefore, I direct my Personal Representative to not consent to revocation of such S election; I further direct
my Personal Representative take such other steps as may be required by the Internal Revenue Code or regulations promulgated thereunder, to continue in effect that Subchapter S
election."
So long as the Corporation's election under Subchapter S continues in effect, all succeeding wills and codicils executed by each Shareholder shall contain such a provision, or one of
substantially identical substance.
D. Inadvertent Termination Relief and Trust
Reformation
A trust's failure to meet either the QSST, ESBT or any other requirement of a qualified Subchapter S shareholder will
cause the termination of the corporation's S election.6 Such terminations make shareholders grumpy because they convert a flow-through entity into a taxable one. In certain instances, however, it is possible to put the horse back in the barn because the Service grants liberal relief from inadvertent termination of an S election.7
Inadvertent termination relief may be granted if: (1) the corporation previously made a valid S election; (2) the termination of that election was inadvertent; (3) within a reasonable time
after discovery of the termination the corporation took steps to correct the problem that lead to the termination; and (4) the corporation and shareholders agree to any adjustments the
Service may require with respect to the termination period.8
The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the event took place
without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event, tends to establish that the termination was inadvertent.
Accordingly, a corporation having a trust as a shareholder is an ideal candidate for inadvertent termination relief where the trust fails to be a qualified S corporation shareholder.
The request for inadvertent termination relief is made in the form of a request for a private letter ruling from the IRS National Office. The ruling request must contain a detailed
explanation of the event causing termination, when and how the event was discovered, and the steps taken to correct the deficiency. The ruling request must precisely follow the form and
content outlined in Revenue Procedure 2001-1 (or the first numbered Rev. Proc. of each subsequent year). The filing fee for that ruling request is currently $5,000 (a reduced user fee of
$500 is available where the trust's and corporation's annual gross income is less than $1 million). That fee, when coupled with substantial attorney fees for preparing the ruling request
make inadvertent termination relief a costly fix. That cost, however, often pales in comparison to the dual layer of taxation associated with becoming a C corporation.
The Service has discretion to grant inadvertent termination relief retroactive to all years affected by the termination, in which case the corporation is treated as if its election never
terminated. Alternatively, relief may be granted only for the period starting with the date on which the corporation again became eligible for Subchapter S treatment, in which case the
corporation is treated as a C corporation during the period for which the corporation was not eligible to be an S corporation. As to any period for which inadvertent termination relief
does not apply, remember that the statute of limitations on assessment of any corporate tax which is found to be due will run from the date the corporation files its S corporation income
tax return (Form 1120S), even though a C corporation income tax return (Form 1120) should have been filed for the termination years. This generally means only the last three years'
deficiencies may be assessed by the IRS. Tax deficiencies usually cannot be assessed against closed years.
Inadvertent terminations are not uncommon for trusts intended to be QSSTs in two instances: (a) where the trust instrument fails to prohibit distributions of income or principal to someone
other than the current income beneficiary; and (b) where a QSST election was never filed due to ignorance of the filing requirement. In the former case an irrevocable trust may generally
be reformed by Utah courts with the consent of the trustee and all current and contingent beneficiaries. Evidence of the trustor's intention that the trust be a qualified S corporation
shareholder is also helpful.
The tax regulations indicate that the terms of the trust must satisfy the QSST requirements as of the earlier of the QSST election date or the effective date of the election. A strict
reading of the regulations suggests that a reformed trust will not be a valid QSST until the date the reformation order is signed, even if the court's order of reformation indicates the
reformation is effective retroactive to either the date the trust was funded or the date the trust failed to meet the QSST requirements. In recent practice, however, the Service has
informally adopted a "go thy way and sin no more" approach and liberally granted inadvertent termination relief retroactive to all years for which the trust reformation is
effective pursuant to the court's order. In the past year, no rulings have failed to grant inadvertent termination relief.
V. CONCLUSION
In this world of the universal acceptance of the LLC and check-the-box tax classification, the Subchapter S corporation is less desirable that ever before.
Nevertheless, legislative additions to Subchapter S such as the QSub and ESBT have helped the S corporation remain a viable and popular business entity. Accordingly, business and estate
planning counsel must remain vigilant to both the opportunities and tax traps associated with Subchapter S.
Footnotes
1 The Small Business Job Protection Act of 1996, P.L. 104-188, ¤ 1302(c).
2 IRC ¤ 641(c).
3 Prop. Reg. ¤ 1.641(c)-1.
4
IRC ¤ 1361(d)(3).
5 IRC ¤ 1361(d)(3), 663(c).
6 IRC ¤ 1362(d)(2).
7 IRC ¤ 1362(f).
8 Treas. Reg. ¤ 1.1362-4(a).
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