SBJPA expands types of trusts that qualify as subchapter S shareholders.

Prior to enactment of the Small Business Job Protection Act of 1996 (SBJPA), only five types of trusts were permissible S shareholders; of the five, only the grantor trust and the qualified subchapter S trust (QSST) provided family wealth transfer opportunities. In general, with a grantor trust, either the grantor (in the case of a grantor-controlled trust) or the beneficiary (in the case of a beneficiary-controlled trust) was treated as the entire owner of the trust for income tax purposes.

In order for a trust to be a QSST, it was required to distribute all of its income currently to one individual who was a U.S. citizen or resident. In addition, the terms of the trust had to provide that: 1. during the current income beneficiary's life there could be only one income beneficiary; 2. any corpus distributed during the current income beneficiary's life could only be distributed to such beneficiary, 3. the current income beneficiary's income interest in the trust had to terminate on the earlier of the income beneficiary's death or termination of the trust; and 4. on termination of the trust during the current income beneficiary's life-time, all of the trusts assets were to be distributed to such beneficiary.

These requirements generally restricted the family wealth transfer planning opportunities for S corporations.

New Law

Under the new law, stock in an S corporation may be held by an electing small business trust (ESBT). There are only three requirements that must be met for a trust to qualify as an ESBT: 1. all of the trusts beneficiaries must be individuals or estates eligible to be S shareholders (however, charitable organizations may hold contingent remainder interests); 2. no interest in the trust may be acquired by purchase (thus, interests in the trust must be acquired by reason of gift, bequest, etc.); and 3. the trust must elect to be treated as an ESBT.

Trusts exempt from tax and trusts with QSST elections in effect are not eligible to be ESBTs.

The portion of the trust that consists of stock in one or more S corporations is treated as a separate trust for purposes of computing the income tax attributable to the S stock held by the trust. The trust is taxed at the highest individual rate (currently 39.6% on ordinary income and 28% on net capital gain) on this portion of the trust's income. The taxable income attributable to this portion includes (1) the items of income, loss or deduction allocated to it as an S shareholder, (2) gain or loss from the sale of S stock, and (3) to the extent provided in regulations, any state or local income taxes and administrative expenses of the trust properly allocable to the S stock. No deduction is allowed for amounts distributed to the trusts beneficiaries.

Implications for Estate Planning 

The prior law requirements that a trust had to satisfy to qualify as an S shareholder often conflicted with the donor's desire to restrict the beneficiary's right to trust income or corpus. For example, for a trust to qualify as an eligible beneficiary-controlled grantor trust, the beneficiary generally was required to have an unrestricted power exercisable solely by himself to vest trust corpus and income in himself. Such an unrestricted power could conflict with the donors objective of limiting control by placing the stock in trust. Similarly, to qualify as a QSST, a trust was required to distribute all of its income currently. Thus, trust income could not be accumulated for the benefit of the beneficiary. Further, a QSST could have only one current income beneficiary and any corpus distributions made by a QSST during that income beneficiary's lifetime had to be made to that beneficiary. Thus, the trustee of a QSST could not be granted a sprinkling power (i.e., the power to distribute income and corpus among beneficiaries).

As a result of the ESBT provisions, most commonly encountered trusts will now qualify as S shareholders. Thus, estate planning flexibility is significantly enhanced, and the dispositive provisions of many taxpayers' wills (as they pertain to S stock) can be simplified. For example, trusts that accumulate income may qualify as S shareholders, as may trusts with multiple beneficiaries and trusts with "sprinkling powers." However, taxpayers need to keep in mind that the trust will be taxed at the highest individual rate.