(Use of trusts in S corporation succession planning.)(Small Business Tax Solutions)

Q. Many of my clients operate their businesses as S corporations. I know qualified subchapter S trusts (QSSTs) cm be S corporation shareholders. Can other types of trusts be used in S corporation succession planning?

A. In addition to individuals and estates, under current law only four types of trusts are permissible S corporation shareholders: QSSTs, grantor trusts, Internal Revenue Code section 678 trusts and voting trusts.

Grantor Trusts

IRC section 1361 (c) (2) (A) (i) says a trust treated as owned by a US. citizen or resident may hold S corporation stock. Any trust in which the grantor retains powers or rights described in IRC sections 671 to 677 is deemed to be owned by the grantor. Thus, a qualifying grantor trust may own S corporation stock.

Succession planning. Revocable (or living) trusts have become popular as effective will substitutes because of their privacy and probate-avoidance features. They can own S corporation stock because they are deemed to be grantor trusts under section 676.

Since IRC section 2702 was enacted, grantor-retained annuity trusts (GRATs) and grantor-retained unitrusts (GRUTs) have become popular succession-planning tools. When a grantor retains a specified income interest for a certain period, the value of the gift of the remainder interest can be significantly discounted, effectively leveraging the grantor's unified credit. The flowthrough nature of S corporation income makes it an ideal way to fund a GRAT.

Section 678 Trusts

If someone other than the grantor has sole power over a trust's income or corpus, he or she is deemed the owner of the trust under section 678. Such trusts can own S corporation stock in a way similar to grantor trusts.

Succession planning. A general power of appointment trust is an alternative to a qualified terminable interest property (QTIP) trust for obtaining the estate tax marital deduction. The surviving spouse has a general power of appointment over the entire trust and is thus deemed to be its owner. This means such trusts can be structured as section 678 trusts and can own S corporation stock--even if there is more than one permissible beneficiary.

A section 678 trust also may be used for the unified credit shelter bequest to children or for QTIP property following the surviving spouse's death. The trust may have more than one beneficiary as long as one has the sole power to vest trust income and corpus in him- or herself. The Internal Revenue Service held in several private letter rulings that a noncumulative Crummey withdrawal power qualifies a trust as a section 678 trust as long as no transfer to the trust exceeds the beneficiary's withdrawal power.

Voting Trusts

A trust created primarily to exercise the voting power of stock transferred to it is an eligible S corporation shareholder. To qualify as a voting trust, the proposed regulations require a written agreement that

* Delegates to one or more trustees the right to vote.

* Requires all distributions with respect to the stock be paid to, or on behalf of, the stock's beneficial owners.

* Requires tide and possession of the stock to be delivered to the beneficiaries on trust termination.

* The trust terminate, by its terms or by state law, on or before a specific date or event (proposed regulations section 1.1361-1A(h)(3)).

Succession planning. A voting trust is used when a business's founder has died and no successor has been named.

Q. Can a "sprinkling" trust, providing for discretionary income or principal distributions among children or grandchildren, be funded with S corporation stock? Under current law, such a multiple beneficiary trust

A. cannot own S corporation stock because it does not meet the above eligibility requirements.

However, an "electing small business trust" was proposed in the S Corporation Reform Act of 1995 (see JofA, Aug.95, page 31) and the Tax Technical Corrections Bill of 1995. Income or principal would be distributed or accumulated for the benefit of one or more beneficiaries provided each was eligible to own stock in an S corporation and no interest in the trust was acquired by purchase. The trust would be taxed at the highest marginal income tax rate for trusts, with no deduction for distributions.

STEVEN J. CROWELL, CPA, JD, Phd, is visiting professor of accountancy at Wake Forest University and an associate in the law firm Blanco, Tackabery, Combs & Matamoros in Winston-Salem, North Carolina. He is an author in the AICPA tax CEA series.