Placing S stock in trust.
The first three trusts allow for only one income beneficiary; the last two, while they allow for more than one income beneficiary, have a limited life. At the end of the limited life of the testamentary rust and the successor trust, a trustee must convey the trust stock to an individual or another eligible trust.
Most estate planners prefer to set up inter vivos and revocable trust arrangements, which become irrevocable only on the grantor's death. Property placed in an inter vivos trust can escape delay, court interference and expensive probate. As long as the grantor retains the income and control over a revocable inter vivos trust, he is treated as the trust owner and the grantor trust has no tax liability.
In the same way, grantors are deemed to own S stock in grantor trust outright (Sec. 677). While the grantor trust rules tax the deemed owners on income from any part of the grantor trust corpus they control, Sec. 136(c)(2)(A)(i) states that the grantor trust is an eligible S shareholder only if its deemed owner controls the income from all its corpus.
A grantor retained income trust (GRIT) gives the income beneficiary a right to all the income that the trust corpus earns and is therefore deemed the owner of the trust income. Deemed ownership changes the GRIT into an eligible S shareholder (Sec. 674(a)). By using a GRIT, a grantor may reduce the taxable value of a gift of the remainder interest by the present value of its retained income interest. If a grantor survives the term of the GRIT, the remainderman will own the S stock outright and the stock will be outside the grantor's estate.
Unfortunately, GRITs have major drawbacks, especially in the context of holding S stock. If the grantor dies before the GRIT term expires, the property comes back into the grantor's estate at death. Additionally, in a family context, the GRIT must pay the grantor/beneficiary an annuity interest under the new Sec. 2702(a) "anti-freeze rules" in order to discount the gift by the present value of the income interest. To be safe, a GRIT holding S stock should pass out all S income distributions currently. Sometimes it is difficult for a grantor to guarantee that the S stock will pay a fixed rate of return for the life of the GRIT. Since, if an S corporation distributes S income to any shareholder, it must distribute the same payment to all shareholders, it is unsafe for a shareholder agreement to contractually bind an S corporation to make a fixed payment. Also, the S corporation must earn enough and have sufficient equity to support such payments for the GRIT's term.
Sec. 678 trust
Sec. 678 trusts are often used when parents want to make periodic payments to their children during their lifetimes. Sec. 678(a) makes it possible for a trust to pay income to a person other than the grantor without losing its eligibility as an S shareholder. The grantor is deemed the owner of the trust that deserves to that grantor the right to receive all the corpus and income from the trust. Sec. 678 provides that when a nongrantor trust gives beneficiaries the right to vest income in themselves, they then become the deemed owners of the income for income tax purposes. Sec. 678 shifts the grantor's deemed ownership of the trust income interest to another and the taxes such beneficiaries on the trust income. The trust still has no tax liability and it remains purely a passthrough entity; hence, any trust whose beneficiary may effectively invade its income or corpus is an eligible S shareholder.
Sec. 678 eligibility proves especially handy in the context of a marital trust. A properly drawn marital trust will have only one income beneficiary (usually the surviving spouse). The general power of appointment martial trust qualifies for the marital deduction and grants the surviving spouse the power to invade or, in general, appoint the trust principal and income. As such, the general power of appointment marital trust is a Sec. 678 trust and, therefore, eligible to be an S shareholder.
Qualified subchapter S trust
The grantor trust or a Sec. 678 trust may qualify to hold S stock because the beneficiaries may freely invade it. A QSST allows the grantor to complete a gift of S stock to a child and still tie up the stock until the child reaches a certain age. There are four key requirements under Sec. 1361(d)(3) to qualify as a QSST. 1. Only one current income beneficiary is allowed. 2. The QSST may make corpus distributions only to that income beneficiary as long as he lives. If the QSST term ends while its current income beneficiary is still living, it must distribute all corpus to that beneficiary. 3. The interest of the QSST beneficiary must terminate on the earlier of the beneficiary's death or the termination of the QSST period. 4. The income beneficiary (or the beneficiary's legal representative) must make a timely election of QSST status.
The QSST may have only one current income beneficiary at a time; however, there may be one or more successive lifetime income beneficiaries. The QSST may have a life estate followed by one or more remainder interests in the form of a successor trust. Keep in mind that, in this context, "income" is accounting income rather than taxable income. Since S corporations often retain their taxable income for operating funds, trustees cannot distribute what they do not receive; therefore, a carefully constructed trust instrument should define income to be actual S distributions.
Regardless of how the governing instrument defines income, the trust K-1 must pass to the beneficiary his pro rata portion of S income. Since S corporations often accumulate income at the corporate level, the beneficiary may have insufficient funds to meet a tax liability; therefore, a grantor should consider funding a QSST with other income-producing assets, in addition to S stock, in order to satisfy a tax liability. (Often tax-free municipals are well-suited). It is important to draft a QSST to require distribution of income at least annually. In this way the trust will remain qualified even if a trustee fails to make annual payments.
The QSST beneficiary must affirmatively elect QSST status within two months and 16 days after the S stock is transferred to a trust. If no election is made, the S election will terminate. Grantors will often use nonvoting S stock in conjunction with a QSST to maintain control over the corporation. By issuing both voting and nonvoting S stock to the parents, the parents can then transfer the nonvoting portion to the QSST.
Another planning point of note is that the trust terms that satisfy the QSST requirements usually satisfy those for the qualified terminable interest property (QTIP) election. Both the QSST and the QTIP trusts --require the payment of all trust income to one beneficiary; --require the trust to pay corpus to no one other than the income beneficiary during that beneficiary's lifetime; and --permit remainder interests.
Again, the QTIP marital trust must make the QSST election for the first time on the death of the grantor. Since the deadline is two months and 16 days after the transfer of the S stock into the QSST, careful planning is required to make sure the deadline is not missed during the estate administration process.
A will may pour over S stock into a trust as a probate asset. A trust receiving S stock bequests must be very carefully planned, since the trust may have more than 35 shared income beneficiaries or may have an ineligible beneficiary (such as a non-U.S. citizen). A testamentary trust has 60 days to transfer stock into the hands of an eligible S shareholder (Sec. 1361(c)(2)(A)(iii)). As a planning point, an S shareholder should never devise S stock to a testamentary trust that pays income to more than one beneficiary or to an ineligible beneficiary. If this situation were to arise, an executor would want to hold the S stock in the estate. Instead of being allowed 60 days to transfer stock as in a testamentary trust, a probate estate may hold the S stock as long as there is a reason to keep the estate open. This allows an executor sufficient time to transfer the S stock to an eligible shareholder. This will often give the estate time to sell the S stock to an eligible shareholder (possibly the children active in the business) and then distribute cash to a testamentary trust.
Again, careful planning is required to ensure that, on the death of a grantor who set up a qualified trust to hold S stock, or on the death of an income beneficiary, the successor trust should be planned so that it is eligible to hold S stock. If a successor trust has more than 35 beneficiaries or a nonresident alien beneficiary, the successor trust has a certain period of time to remedy the situation.
If all the trust assets of a successor trust holding S stock are includible in the gross estate of the deemed owner (the person with the lifetime right to control the principal and income), the trust has two years to place the S stock in the hands of an eligible shareholder. If the trust assets are not includible in the deemed owner's gross estate, the trust has only 60 days to place the S stock in the hands of an eligible shareholder. In most cases the trust assets of an eligible successor trust are includible in the owner's gross estate. In the case of the grantor trust or a GRIT (assuming the grantor dies before the GRIT term expires), the trust will usually have the full two-year time period for transfer. A carefully drawn trust instrument usually directs the trustee to place separately numbered S stock certificates in individual trust shares. This separate trust share treatment divides a successor trust into a cluster of eligible shareholders.
As previously mentioned, an understanding of the trust eligibility rules can make to possible to rely on certain trusts as wealth transfer vehicles for S stock. With properly written terms, S stock can fit neatly into a standard marital deduction trust.
The trust will ensure the well-being of the surviving spouse and on the second death the S stock certificates may pass to a nonmarital trust with distinct trust shares to hold them separately for children. The QSST is the most often used recipient of a lifetime gift of S stock. An annual gift of S stock to a QSST can achieve the desired estate planning objectives of a lifetime gift, including reduced income taxes through income splitting between the S shareholder and the QSST beneficiary, reduction or elimination of estate taxes on the transferred S stock, and protective trust management and control of the stock.
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|Title Annotation:||subchapter S corporations|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1992|
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