New questions spring from the application of ESBT provisions.

Beginning this year, there are several new law changes affecting S corporations. One of the more intriguing opportunities, especially in the area of estate planning, relates to the ability of an S corporation to be owned by an electing small business trust (ESBT). Previously, S stock held in trust was limited to two very narrowly defined types of trusts: grantor trusts and qualified subchapter S trusts (QSSTs). These options did not give planners much flexibility in structuring an income or estate tax plan. An ESBT affords a taxpayer the ability to keep the income generated by the S corporation in the trust and to allow family spray provisions in the trust. ESBTs are also very useful when a taxpayer is interested in maximizing income accumulation not subject to the generation-skipping transfer tax. Additionally, charities can be named as contingent beneficiaries, which presents other estate planning options. An interesting by-product of this arrangement is to remove income from the taxpayer's adjusted gross income (AGI), thereby affecting many of the phase-out items that are linked to AGI (such as the itemized deduction phase-out, miscellaneous itemized deduction floor and residential rental real estate $25,000 allowance). However, due to the newness of ESBTs, there are still a number of potential issues that have not yet been fully explored.

One area clearly affected by changes in Federal income tax is state tax provisions. In many states, Federal law dictates the tax status of an entity for state tax purposes. Certain states, such as Idaho and North Carolina, have specifically stated that they will permit the new changes in Federal S corporation law too apply directly in their states. However, other states are not as accommodating and, in fact, may have already required a separate state-level S election in order to obtain state S status. For example, California has already announced that it does not currently conform to the new Federal S corporation legislation.

The California tax statutes rely on the Federal S corporation law that existed as of Jan. 1, 1993. Therefore, if a taxpayer decides to transfer stock to an ESBT for Federal tax purposes in 1997, California law does not recognize an ESBT as a valid S shareholder. Therefore, S status would be revoked for state tax purposes on the date of the stock transfer and California would require the corporation to file as a regular corporation for the balance of the year and thereafter. Presumably, it would also mean that state-level S status could not be reestablished for a period of five years after revocation of the state-level S election.

The same is also true in Pennsylvania; however, its statute is somewhat more outdated, as it allows only corporations that qualify under the Federal statute that existed on Jan. 1, 1983. Thus, state tax rates applied to corporations in Pennsylvania are higher than they are on individuals. Accordingly, there can be a significant state tax savings to making a Pennsylvania S election. Therefore, while an ESBT may make significant sense in transferring wealth -- but not control -- in estate planning situations, significant state tax issues must also be addressed.

Another unclear area is the interplay of the ESBT provisions with the subpart E grantor trust provisions. Theoretically, an ESBT election could be made in a grantor trust. If that occurs, it is unclear which rules would apply. Policy considerations suggest that the subpart E rules should override other provisions and, therefore, an ESBT election may not be available to a grantor trust. In addition, the IRS has indicated that the ESBT election will be subject to rules similar to those governing QSSTs. If this is true, an ESBT election would take effect only after the trust is no longer a grantor trust (usually on the grantor's death). If, however, the ESBT election takes precedence, a significant potential loophole exists in certain states. In Ohio, for example, trusts do not pay tax at the trust level; income accumulated in complex trusts is not taxed for state purposes until an accumulation distribution is made and distributable net income (DNI) is distributed out to beneficiaries in later years. The ESBT rules, however, explicitly state that income received from the S corporation over which an election is made does not create DNI and, therefore, a distribution does not alter the fact that the tax is paid at trust level and does not create a second beneficiary level of tax.

Therefore, if the ESBT rules were to prevail in states that do not tax trusts, a grantor trust could be established to hold the stock of an S corporation. The Federal tax would be paid totally at the trust level and (conceivably) no state income tax would be owed. As noted, this has the further benefit of reducing the grantor's AGI and relieving pressure on certain phase-outs. Since S income in an ESBT is taxed for Federal tax purposes at the highest individual marginal tax rate, unless a taxpayer is already a high earner, there could be serious rate inflation created at the Federal level. If, however, the taxpayer is a high earner and is already paying 39.6% in Federal taxes, the transfer of S stock to an ESBT clearly has little downside.

A final potential issue relating to ESBTs is the treatment of distributions in trusts when the trust holds not only S stock, but also other assets that may be generating income during the current year. The ESBT rules provide that in these situations, taxpayers should view the trust as two separate trusts within one trust -- one taxed under the ESBT rules and the second one taxed under the traditional trust tax rules. The dilemma arises when distributions are made from the trust and the allocation of that distribution needs to be identified as coming from either the S portion or the general trust portion. If amounts distributed are deemed to come from the general trust portion, taxable income is shifted from the trust and creates taxable income to the beneficiary receiving it. However, if the distribution comes from the S portion, all the tax on the trust's income has already been paid and nothing is reallocated out to any beneficiary. No clear guidance is given in terms of which layer of income is first used, or if there is to be a distribution with some apportioning methodology used to determine the character of each amount.

Clearly, ESBTs, along with many of the other new S provisions, offer planners and taxpayers a significant number of new items in their arsenal in planning for income and/or estate taxes. However, it is important to address the more intricate issues that arise in the practical application of these provisions. Over time, many of these issues will be addressed by the IRS or state legislators; in the meantime, be aware of the true costs of ESBT planning.