ESBTs: perhaps more advantages than disadvantages.
Trustees must exercise care when performing their fiduciary duties. One of those duties is minimizing income taxes. Nevertheless, many trustees are making electing small business trust (ESBT) elections on a trust's behalf, which subjects the ESBT portion of the trust's income to the highest marginal income tax rate (currently, 35%).
According to Sec. 1361(b)(1), only U.S. individuals, their estates and certain types of trusts, and tax-exempt organizations may be S shareholders. Three types of trusts basically qualify--grantor trusts, qualified subchapter S Subchapter S
IRS regulation that gives a corporation with 35 or fewer shareholders the option of being taxed as a partnership to escape corporate income taxes. trusts (QSSTs) and ESBTs; see Sec. 1361(c)(2)(A). Often, there may be practical, or nontax "family reasons" for shunning grantor trusts or QSSTs, leaving ESBTs as the only alternative. However, there may be some advantages to this; many trustees and beneficiaries are finding that income taxes with an ESBT are no greater than they otherwise might have been (and possibly are even lower than) for either a grantor trust or a QSST QSST Qualified Subchapter S Trust
QSST Quiet Small Supersonic Transport
QSST Quiet Supersonic Transport .
Grantor trusts: According to Secs. 671-678, a grantor trust allows the trust's creator to retain sufficient powers over the trust so that the trust is treated as if the grantor An individual who conveys or transfers ownership of property.
In real property law, an individual who sells land is known as the grantor.
grantor n. owns the assets directly, for income tax purposes. For a grantor trust to qualify as an S shareholder, it must be owned completely by only one person; see Sec. 1361 (c) (2) (A) (i). Regs. Sec. 1.1361-1(e)(2), which discusses that a trust created by a husband and wife who are both U.S. citizens or residents, falls into this category.
If the trust loses its grantor status by reason other than the grantor's death, it would be immediately disqualified dis·qual·i·fy
tr.v. dis·qual·i·fied, dis·qual·i·fy·ing, dis·qual·i·fies
a. To render unqualified or unfit.
b. To declare unqualified or ineligible.
2. , and the S election immediately terminated under Sec. 1362(d)(2)(B). This could happen if a grantor switched from a revocable rev·o·ca·ble also re·vok·a·ble
That can be revoked: a revocable order; a revocable vote.
Adj. 1. to an irrevocable trust Irrevocable Trust
A trust that, once its setup, cannot be changed at all.
This is to prevent fraudulent activities.
See also: Exemption Trust, Trust, Unit Trust
A trust that is unable to be amended, altered, or revoked. , for example.
If the grantor dies and the trust continues in existence, the S election would continue to apply for up to two years if the trust's corpus is includible in the grantor's taxable estate Taxable Estate
The total value of a deceased person's assets that are subject to taxation - minus liabilities and minus the prescribed tax-deductible portion of assets left behind by the deceased. ; see Sec. 1361(c)(2)(A)(ii) and Regs. Sec. 1.1361-1(h)(1)(ii)). If the stock is in a revocable trust Revocable Trust
A trust whereby provisions can be altered or cancelled dependent on the grantor. During the life of the trust, income earned is distributed to the grantor, and only after death does property transfer to the beneficiaries. that provides that on the grantor's death, the trust will be transferred to one or more separate trusts, the grantor trust may continue as a shareholder until the separate trust(s) are funded, as long as this occurs within two years after death. To preserve the S election, either the beneficiary of the successor trust has to make a QSST election, or the successor trust's trustee has to make an ESBT election, within two months and 15 days after the stock is transferred to the separate trusts.
QSSTs: Under Sec. 1361(d)(3) and Regs. Sec. 1.1361-1(j)(1), a QSST is a trust that contains all the following required terms:
1. During the current income beneficiary's life, the trust can have only one income beneficiary Income beneficiary
One who receives income from a trust. (a husband and wife who file jointly are treated as one beneficiary for this purpose);
2. All income is required to be distributed annually to the beneficiary (or is in fact distributed annually);
3. The income beneficiary has to be a U.S. citizen or resident;
4. Any corpus distributed during the current income beneficiary's life has to be distributed to that person;
5. The current income beneficiary's income interest terminates on the earlier of his or her death or on trust termination;
6. If the trust terminates during the current income beneficiary's life, it has to distribute all of its assets to that person.
A trust becomes a QSST only on an affirmative election by the income beneficiary or his or her legal representative; see Regs. Sec. 1.1361-1(j)(6)(ii). The trustee cannot make the QSST election; the effect of the election is to cause the income beneficiary to be treated as the owner of the portion of the trust consisting of S stock, as if the beneficiary had been the trust grantor and had retained a Sec. 671 power. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently , the trust is treated as a grantor trust to the beneficiary.
ESBTs: The ESBT is the "new kid on the block" The Small Business Job Protection Act of 1996 (SBJPA SBJPA Small Business Job Protection Act of 1996 ) amended Sec. 1361 to allow trusts not previously eligible to hold S stock as eligible S stock shareholders. Before the SBJPA, a trust was not an eligible S shareholder if the (1) trustees had the authority either to distribute or retain current income for the beneficiaries or (2) trust had multiple income beneficiaries. Thus, an ESBT's most positive features are that (1) it may have more than one beneficiary and (2) trust income may be accumulated. Both of these features are absent from QSSTs. One potential trap, however, is that each potential current trust beneficiary counts as an S shareholder for purposes of the 100-shareholder limit.
However, an ESBT has to be divided into two separate trusts to determine its income tax liability. The portion of the trust with the S stock is taxed at a flat rate equal to the highest rate imposed on trusts and estates (currently, 35% on ordinary income and 15% on net long-term capital gain Long-term capital gain
A profit on the sale of a security or mutual fund share that has been held for more than one year. ), with no deduction allowed for distributions to beneficiaries; see Sec. 641(c)(2).The S income is not included in the trust's distributable net income, nor can it be distributed or allocated to beneficiaries. The remaining portion of the trust income (non-S income) is determined in the standard way, ensuring that no items attributable to the S corporation are taken into account. Deductions for state and local income taxes and administration expenses can be allocated between the two portions in any manner "reasonable" in light of all the circumstances.
According to Sec. 1361(e)(1)(A)(i), to qualify an ESBT as an S shareholder, all trust beneficiaries must be eligible individuals or estates, or charitable organizations as described in Sec. 170(c). As mentioned above, an ESBT trustee (not the beneficiaries, as is the case with QSSTs) must make an affirmative ESBT election; see Regs. Sec. 1.1361-1(m)(2)(ii). Protective ESBT elections are not allowed. Under Sec. 1361(e)(1)(A)(ii), ESBT interests cannot be purchased; they can be established only by gift or bequest.
Why Use an ESBT?
There may be opportunities to determine whether an ESBT is advantageous.
Family trusts: In some cases, to qualify a trust as an S shareholder, a trustee's only option is to make an ESBT election. This often occurs when a family trust (also known as a "credit" or "by-pass" trust) is funded with S stock. The trust terms usually provide for more than one permissible income beneficiary. Normally, income distributions are not mandatory, but may be made at the trustee's discretion. Thus, a family trust does not typically qualify as a QSST, and the trustee must make an ESBT election (within two months and 15 days of transferring the S stock to the trust), to preserve the corporation's S election.
Tax bracket Tax Bracket
The rate at which an individual is taxed due to a particular income level.
Each income class is taxed at a different level. Generally, the more you make the more you are taxed. : When ESBT legislation was first enacted, tax advisers often did not consider using them because of the high marginal tax rate Marginal Tax Rate
The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate.
Many believe this discourages business investment because you are taking away the incentive to work harder. . However, this might not be as detrimental as it might seem at first. For example, if the stock were owned by an individual beneficiary in the highest income tax bracket Noun 1. income tax bracket - a category of taxpayers based on the amount of their income
income bracket, tax bracket
bracket - a category falling within certain defined limits , the tax would be no higher for the ESBT than for the beneficiary. In fact, if the beneficiary is in the highest individual income tax bracket, an ESBT may be even more advantageous. Individuals, but not trusts, are subject to a 3% phaseout phase·out
A gradual discontinuation. of itemized deductions. Because the phaseout is based on the individual's gross income (AGI (Artificial General Intelligence) A machine intelligence that resembles that of a human being. Considered impossible by many, most artificial intelligence (AI) research, projects and products deal with specific applications such as industrial robots, playing chess, ), increasing income by including the S earnings (in addition to other income) would only increase the amount of the phaseout, further reducing the individual's itemized deductions and increasing taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . The result would be the same for an individual's medical and miscellaneous itemized deductions, both of which are calculated on AGI. Further, credits available to individuals (e.g., college and child care credits) could also be reduced if S income reflected on an ESBT return was instead reflected on the beneficiary's individual income tax return.
Greenwich sidereal time
GST (in Australia, New Zealand, and Canada) Goods and Services Tax tax: The ESBT is a valuable tool in generation-skipping transfer (GST) tax planning Tax planning
Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. , because a grandparent can allocate the GST tax exemption against the S stock transferred to the ESBT. If the stock were instead placed in a grantor trust, the grandparent's GST tax exemption could not be used to exempt that trust from the GST tax.
Income distributions: Even if a trust were to qualify as a QSST, the trustee may choose to have it treated as an ESBT instead. As mentioned above, a QSST trustee is required to pay all income to the beneficiary. But what if the income beneficiary is a spend thrift and the trustee believes that every dollar distributed to that beneficiary would be squandered squan·der
tr.v. squan·dered, squan·der·ing, squan·ders
1. To spend wastefully or extravagantly; dissipate. See Synonyms at waste.
2. ? Would paying all income to that beneficiary be a breach of the trustee's fiduciary duties? Assuming that the trustee has the discretion to either distribute or accumulate income, one option is for the trustee to make an ESBT election, rather than for the beneficiaries to make a QSST election, because an ESBT is not required to distribute its income.
Although a tax adviser's first reaction may be to avoid an ESBT, to circumvent the high income tax rates on its income, the tax results may be no worse (and, in some situations, may actually be better) than some of the alternatives. Certainly, trustees have a duty to preserve an S election; an ESBT election may be the only way to do that, even if it means paying higher income taxes. Yet, in other situations, there may be valid nontax reasons for electing to treat a trust as an ESBT, despite the high income tax rates.
From Sally E. Day, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , South Bend, IN