Electing small business trusts.

The end of the Summer brought a flurry of legislative activity, with the president signing into law four bills from July to October. One was the Small Business Job Protection Act of 1996 (SBJPA), which included many provisions affecting small businesses. (See JofA, Nov. 96, pages 25-26.)

Under the SBJPA, the law governing subchapter S corporations underwent numerous changes, one area of which will open up new estate planning opportunities for CPAs concerning the types of trusts allowed to hold S corporation stock.

PRIOR LAW

Previously, only individuals, estates and certain limited types of trusts were eligible to be S shareholders. For estate planning purposes, this meant that many estate planning strategies available to regular corporations and to partnerships (especially those involving multiple beneficiaries) could not be used in an S corporation setting.

NEW LAW

Under the SBJPA, stock in an S corporation may be held by an "electing small business trust" (ESBT), by which the beneficiaries are, in effect, the shareholders of the S corporation.

To qualify as an ESBT, a trust must meet only three requirements:

1. All of the trust's beneficiaries must be individuals or estates eligible to be S shareholders. Note that, for 1997, certain charitable organizations may hold only contingent remainder interests and cannot be beneficiaries.

A beneficiary is any person to whom a distribution of income or principal may be made during the tax year. Therefore, any person who could receive a distribution of income or principal will be counted as a shareholder for purposes of the 75-shareholder limit (which was 35 before the SBJPA).

2. No interest in the trust may be acquired by purchase; these interests must be acquired by gift, bequest, etc.

3. The trust must elect to be an ESBT. Trusts exempt from tax and those with elections in effect under prior law are not eligible to be ESBTs.

Taxation of ESBTs. In return for added flexibility, the ESBT is taxed in a different manner from normal trusts. The S stock portion of the trust, which is treated as a separate trust when computing the income tax attributable to such stock, is taxed at the highest individual rate (currently, 39.6% on ordinary income and 28% on net capital gains). The taxable income attributable to the S portion includes only the items of income, loss or deduction attributable to the trust as a shareholder under the normal S corporation rules; gain or loss from its disposition of S Stock; and any state or local income taxes and trust administrative expenses properly attributable to the S stock (to the extent provided in future regulations). Capital losses are allowed only to the extent of capital gains.

The trust itself, rather than the beneficiaries, is taxed on the S portion of the ESBT. Thus, in computing the trust's income tax on its S stock, no deduction is allowed for amounts distributed to beneficiaries, and no deduction or credit is allowed for any items other than those listed in the paragraph above.

The tax for the non-S-stock portion of the ESBT is determined under the usual rules applicable to trusts.

PLANNING IMPLICATIONS

Previously, the following requirements for trusts to qualify as S shareholders conflicted with normal estate planning objectives: (1) The beneficiary had to have an unrestricted power; this could conflict with the donor's goal of limiting control by placing the stock in trust. (2) The trust was required to distribute all of its income currently; thus, trust income could not accumulate for the beneficiary's benefit. (3) A qualified trust could have only one current income beneficiary and any distributions of corpus had to be made to that beneficiary; thus, a trustee could not have the power to distribute income and trust corpus among beneficiaries.

These kinds of conflicts can now be avoided. All these objectives may be achieved (as they pertain to S stock), and estate plans may be made simpler and more flexible.

For a discussion of this new law and other current developments, see the Tax Clinic, edited by Richard Bobrow, in the January 1997 issue of The Tax Adviser.

--Nicholas Fiore, editor The Tax Adviser

Editor's Note 

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.