Estate planning for S shareholders: maintaining qualification after death in common estate planning situations.

The S corporation qualification rules must be carefully considered when the estate for which a plan is being developed includes (or may include at a later date) an ownership interest in an S corporation. The primary purpose of this process is to prevent the inadvertent termination of the S election after the shareholder's death. Some (but not all) types of trusts may qualify as S shareholders; as such, several commonly used estate planning techniques involving trusts must be modified before they can be used in conjunction with S stock.

Certain trusts permitted

as S shareholders

Certain nonforeign trusts can qualify as S shareholders. Eligible trusts include grantor trusts, Sec. 678 or beneficiary-controlled trusts, testamentary trusts (but only for a 60-day period), voting trusts and qualified subchapter S trusts (QSSTs). Generally, trusts that permit discretionary distributions of corpus and/or income to a number of different beneficiaries do not qualify.

Grantor trusts: Trusts in which the grantor is treated as the owner of the entire trust, i.e., grantor trusts, are permitted S shareholders, provided that the grantor is a U.S. citizen or resident. The trust itself is ignored and the grantor is considered the S shareholder (Sec. 1361(c)(2)(i)).

After the grantor's death a grantor trust is allowwed to continue as an S shareholder for 60 days (Sec. 1361(c)(2)(ii)). However, if the entire principal of the grantor trust is included in the grantor's estate, the trust can continue as an S shareholder for two years (Sec. 1361(c)(2)(ii)).

Sec. 678 trusts: A person other than the grantor is treated as the grantor of a trust over which he has a substantially unrestricted power to invade the trust assets. This type of trust is commonly called a Sec. 678 or beneficiary-controlled trust. In addition, that portion of a trust over which a beneficiary has a Crummey power generally is a Sec. 678 trust, provided the grantor is not otherwise treated as the owner.

Sec. 678 trusts are treated as grantor trusts for purposes of determining the trusts' qualification as S shareholders. As a result, Sec. 678 trusts generally qualify as S shareholders provided the entire trust is treated as a grantor trust. If only a portion of the trust is treated as a grantor trust, it is uncertain whether the requirements of Sec. 1361(c)(2)(i) are met.

In Letter Rulings 8827023, 8809043, 8805032, 8613054 and 8342088, the IRS ruled that Crummey trusts qualify as S shareholders, provided no contribution is made to the trust that is not subject to the Crummey power, and the grantor is not deemed to be the owner of the trust under Sec. 675. (See also IRS Letter Ruling 90090101

After the deemed owner's death, a Sec. 678 trust is allowed to continue as an S shareholder for 60 days Sec. 1361(c)(2)(ii)). However, if the entire principal of the Sec. 678 trust is included in the grantor's estate, the trust can continue as an S shareholder for two years (Sec. 1361(c)(2)(ii)). Testamentary trusts: If S stock is transferred to a trust under the terms of a will (a so-called testamentary trust), the trust qualifies as an S shareholder, but only for the 60-day period beginning on the day on which the stock is transferred to it (Sec. 1361(c)(2)(iii)). After 60 days, the trust must divest itself of the S stock to maintain the S election.

Voting trusts: Trusts created primarily to exercise the voting power of stock transferred to it are permitted S shareholders (Sec. 1361(c)(2)(iv)). For purposes of the limitation on the number of qualifying shareholders, each beneficiary of the trust is treated as a separate shareholder.

Qualified subchapter S trusts: A QSST may be a permitted S shareholder (Sec. 1361(d)). The individual beneficiary of the trust must elect to be treated as its owner. The election is irrevocable, and it must apply from the date of the election until the trust ceases to be a QSST. A QSST is a trust that - owns stock in one or more S corporations; - distributes its income currently to one individual who is a U.S. citizen or resident; and - has terms stating that during the life of the current beneficiary, there will be only one income beneficiary; any principal distributed during the trust's term must be distributed to the current income beneficiary; the income interest of the current income beneficiary terminates on the earlier of the income beneficiary's death or the date the trust terminates; and on trust termination during the life of the income beneficiary, all principal and income must be distributed to that beneficiary.

Substantially separate and independent shares of a trust are treated as separate trusts.

Modifying common

estate planning techniques

Transfers to testamentary trusts: Normally, a testamentary trust authorizes the trustee to make discretionary distributions (often limited to an ascertainable standard) of income and/or principal to a number of different beneficiaries. This type of trust generally must dispose of its S stock within 60 days of the date of transfer or the S election will be terminated. Planning point: Revise the trust to comply with the QSST requirements, including the separate share rule, or structure it as a Sec. 678 trust.

Transfers to "living trusts": Normally; a living trust is a revocable trust established during the grantor's lifetime to facilitate the transfer of his assets at death. Living trusts usually authorize discretionary distributions to a number of different beneficiaries after the grantor's death.

During the grantor's lifetime, a living trust is characterized as a grantor trust. As a result, it qualifies as an S shareholder. After death, the living trust can continue to hold S stock for up to two years, provided the entire principal is included in the grantor's gross estate.

Planning point: Revise the trust to comply with the QSST requirements, including the separate share rule, or structure it as a Sec. 678 trust. Alternatively, the S stock can be distributed outright to the beneficiaries before the end of the two-year "grace period." Distributions of S stock to minor beneficiaries can be made to a custodian under the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act. (See IRS Letter Ruling 8343037)

Transfers to "credit shelter trusts": Normally, a credit shelter trust is a testamentary trust established to hold the amount of assets that can be transferred tax free to the next generation as a result of the unified credit (the credit "shelters" up to $600,000 of assets). Generally, the surviving spouse is given an income interest in the trust and a limited power of appointment over the principal. In addition, the trustee generally can make discretionary distributions to a variety of nonspousal beneficiaries (e.g., children of the deceased individual).

A credit shelter trust generally must dispose of the S stock within 60 days of the date of transfer or the S election will be terminated. Planning point: Revise the trust to comply with the QSST requirements, including the separate share rule. Generally, a Sec. 678 trust alternative should not be used as a credit shelter trust, since this may cause the interest deemed owned by the surviving 2spouse to be includible in his gross estate. Moreover, a Sec. 678 trust gives the beneficiaries unfettered access to principal, which may be contrary to the decedent's wishes. On the other hand, one benefit of using a Sec. 678 trust is that no QSST election is required.

The simplest solution may be to use the S stock to fund the marital trust, since it generally is easier to structure a marital trust to comply with the QSST requirements or to qualify as a Sec. 678 trust. Transfers to life estate/power of appointment marital trusts: Under the traditional marital trust arrangement, the surviving spouse is given the power, during lifetime or at death, to appoint in favor of the surviving spouse or her estate all the property owned by the trust. This power enables the surviving spouse to appoint the principal to someone other than herself. However, no one other than the surviving spouse has the power to appoint principal to anyone other than the surviving spouse. In addition, the surviving spouse is entitled for life to all the income from the trust (Sec. 2056(b)(5)).

This type of trust generally may qualify as a QSST, provided the trust terms limit distributions of principal to only the surviving spouse i.e., the surviving spouse is prohibited from appointing principal to anyone other than herself). After having received a principal distribution, the surviving spouse is free to transfer the distributed property to another person by gift.

This type of trust also may qualify as a Sec. 678 trust, provided the surviving spouse's general power of appointment is exercisable during her lifetime, and not just at death (IRS Letter Ruling 8607044). The disadvantage of structuring a life estate/power of appointment marital trust as a Sec. 678 trust is that on the surviving spouse's death the 60-day time limit generally will apply. Moreover, if the exercise of a Sec. 678 withdrawal power is subject to a condition precedent other than one solely within the beneficiary's control (such as not being exercisable until after the beneficiary has died), the beneficiary is not deemed to own the trust until the condition is satisfied. (See Hallowell, 160 F2d 536 (3d Cir. 1947); Knight, 6 TC 90 (1946).)

Another disadvantage of structuring a life estate/power of appointment marital trust as a Sec. 678 trust is that the trust may not qualify as an S shareholder if the entire trust is not treated as a grantor trust. This could occur if the beneficiary holds a power over only trust income or trust principal (Regs. Sec. 1.678(a)-1(a)). For example, if the beneficiary's access is only to income, it is doubtful that the entire trust can be characterized as a grantor trust (as required by Sec. 1361(c)(2)(A)(i)). Although a portion of the trust would be characterized as a Sec. 678 trust, it would not qualify as an S shareholder.

Another consideration is whether the transfer of S stock to a life estate/power of appointment marital trust qualifies for the marital deduction. If the principal of a trust consists substantially of property that is not likely to be income producing during the surviving spouse's life (and the spouse cannot compel the trustee to convert or otherwise make the property productive within a reasonable time), the spouse's income interest generally will not qualify as an "income interest" under Regs. Sec. 20.2056(b)-5(f)(5). As a result, the interest transferred to the surviving spouse may not qualify for the marital deduction unless the applicable rules of administration require or permit the spouse to demand that the trustee provide the spouse with the required beneficial enjoyment.

Planning point: Revise the trust to comply with the QSST requirements, including the separate share rule. in addition, the trust terms should authorize the trustee to sell the S stock back to the corporation or to the other shareholders if the stock does not produce adequate amounts of income to satisfy the tests under Regs. Sec. 20.2056(b)-5(f)(5).

Transfers to estate trust marital trusts: Am estate trust will qualify for the marital deduction when the income may be distributed or accumulated during the surviving spouse's lifetime and will be distributed to her estate on death (Rev. Rul. 68-554). This trust differs from a life estate/power of appointment marital trust in that the income of the trust does not have to be distributed to the surviving spouse annually; nor does the surviving spouse have to exercise any powers to obtain the interest. in other words, no one other than the surviving spouse has the right to receive any property from the trust; therefore, the interest passing to the surviving spouse is not a terminable interest under See. 2056(c). As a result, the interest qualifies for the marital deduction under Sec. 2056(a) without regard to Sec. 2056(b)(5) or (b)(7).

This type of trust could qualify as a QSST, provided that all the income is, in fact, distributed to the surviving spouse annually, even though such a distribution is not required by the trust instrument (Sec. 1361(d)(3)(B)). If income is not required to be distributed each year, the income must, in fact, be distributed each year to meet the income distribution rules of Sec. 1361(d)(3)(B). This means the S corporation's status may depend on whether the trustee makes the required distributions each year.

This type of trust would not qualify as a Sec. 678 trust because the surviving spouse does not have unfettered control over the trust principal. Even if the surviving spouse is the trustee (so that she has unfettered control over the income), the beneficiary's access is only to income during her lifetime. As a result, it is doubtful that the entire trust can be characterized as a grantor trust under Sec. 1361(c)(2)(A)(i).

Planning point: Do not transfer S stock to an estate trust. Transfers to QTIP marital trusts: Under the typical qualified terminable interest property (QTIP) arrangement, the surviving spouse is given the right to receive all the trust's income during her lifetime. In addition, she generally is given a limited right to invade principal for her benefit.

A QTIP trust generally qualifies as a QSST. The rules governing the operation of QTIP trusts generally are the same as those governing QSSTs. Both sets of rules prohibit the distribution of principal to anyone other than the surviving spouse during her lifetime. In addition, both sets of rules require that all income be paid to the surviving spouse (i.e., current income beneficiary).

This type of trust generally will not qualify as a Sec. 678 trust, since the surviving spouse usually does not have the unfettered right to appoint principal (IRS Letter Ruling 8607044).

One problem with transferring S stock to a QTIP trust is that income distributable from a QSST generally refers to trust accounting income under Sec. 643(b) and not taxable income. Therefore, it is possible that S income will flow through and be taxable to the surviving spouse, even though she does not receive any cash distributions. ff this occurs, the Service could argue that the trust does not qualify as a QTIP and, therefore, no marital deduction is allowed. Lifetime transfers to irrevocable life insurance trusts: Generally, an irrevocable life insurance trust is established to keep the insurance proceeds out of the insured's estate. After the insured's death, the trust may lend money to the insured's estate or it may purchase assets to provide the estate with cash. if the irrevocable life insurance trust was treated as a grantor trust with respect to the insured, it can hold S stock for 60 days after the insured's death.

Planning point: If the principal of an irrevocable life insurance trust will be used to purchase S stock, the trust should be structured as a QSST or as a Sec. 678 trust. If the trust does not qualify as a QSST or a Sec. 678 trust, it generally cannot own S stock for any length of time.