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%).

Overview

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 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.

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 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, and the S election immediately terminated under Sec. 1362(d)(2)(B). This could happen if a grantor switched from a revocable to an irrevocable trust, 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; see Sec. 1361(c)(2)(A)(ii) and Regs. Sec. 1.1361-1(h)(1)(ii)). If the stock is in a revocable trust 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 (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, 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) 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), 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: When ESBT legislation was first enacted, tax advisers often did not consider using them because of the high marginal tax rate. 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, 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 of itemized deductions. Because the phaseout is based on the individual's gross income (AGI), 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. 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.

GST tax: The ESBT is a valuable tool in generation-skipping transfer (GST) tax planning, 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? 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.

Conclusion

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, South Bend, IN