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Irrevocable grantor trust can provide estate tax planning opportunity for S shareholders.

The use of an irrevocable grantor trust for an S corporation can minimize estate taxes while retaining flexibility in the trust's terms.

The use of a grantor trust generally has the disadvantage of having trust earnings taxed to the grantor during his life and the trust corpus includible in the grantor's estate at death. However, if the trust arrangement is structured to allow the grantor to retain certain powers or interests in the trust property, the grantor will be deemed the owner of the trust for income tax purposes (and, therefore, the trust will be a qualified shareholder in the S corporation), but will not be treated as the owner of the trust for Federal estate and gift tax purposes. As a result, unlike a qualified subchapter S trust (QSST), the trust may provide for discretionary or sprinkle-type distributions to beneficiaries.

Sec. 1361(c)(2)(A)(i) provides that for purposes of Sec. 1361(b)(1)(B) a trust may be an S shareholder if it is treated as owned by a U.S. citizen or resident. This rule requires that the trust be treated as a grantor trust for income tax purposes but not for estate inclusion purposes. Therefore, due to the irrevocable gift in trust, the property will be removed from the shareholder's taxable estate without impairing S status. Although the initial contribution will be treated as a current gift, future appreciation is shifted away from the grantor. Further, the current economic climate may present the opportunity to place a low value on the stock, which will minimize gift tax exposure.

For example, if an S shareholder transfers stock to an irrevocable grantor trust and the grantor retains the power to reacquire the trust corpus by substituting other property of equivalent value, the trust will be treated as a grantor trust for income tax purposes by virtue of Sec. 675(4), but not for estate tax purposes.

Grantor trusts may be used as an alternative to QSSTs and may provide significant succession planning opportunities for clients by offering the following advantages: * S corporation eligibility is maintained. * The grantor's/shareholder's estate will not include future appreciation on the stock contributed to the trust (i.e., the value is frozen). * The shareholder's estate is reduced by the income tax paid by the grantor over the life of the trust. * The trust's terms may be flexible enough to allow discretionary or sprinkling cash distributions that will be received by the beneficiaries tax free (since the grantor is deemed to have received all the taxable income).

The primary risk in this transaction is not necessarily S corporation eligibility, but that the IRS may contest the transfer to trust as not representing a completed gift, with the trust corpus includible in the grantor's estate at his death. For this reason, it is essential that the trusts be structured properly.

In order to minimize future valuation problems that could arise on examination of the grantor's estate, the valuation of the gift stock should be properly documented.
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Author:Dunn, William J.
Publication:The Tax Adviser
Article Type:Brief Article
Date:Apr 1, 1993
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