C and S Corporations for Estate Planners: The Electing Small Business Trust (ESBT)

Breaking out, in list format, the various administrative and income tax nuances

This is the ninth installment of C and S corporations for estate planners.

For the prior article in this series, click here.

For the first article in this series and a series index, click here.

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Table of Contents

1. Intro and Recap

2. Qualifying Principles of Treas. Reg. 1.1361-1(m)

3. Income Tax Regulations under Treas. Reg. 1.641(c)-1

4. Conclusion

Intro and Recap

In the last article in this series, we covered the qualified subchapter S trust, or QSST, as a form of electing trust that could be a qualified S corporation shareholder.  The theme that has emerged over the last few articles is that, except in the case of an estate and certain nonprofit organizations, an entity can only be an S corporation shareholder if you can look through it for tax purposes to identify one or more individuals who are deemed owners of S corporation stock. 

To recap, a wholly-grantor trust can be an S corporation shareholder because the grantor trust rules treat the actual grantor, or deemed owner under IRC Section 678, as the S corporation shareholder with respect to the trust.  If the grantor or deemed owner dies (thus terminating wholly-grantor trust status), the trust has 2 years to become a new qualifying form of trust. 

For the QSST, if a valid and timely election is made, the current income beneficiary becomes the deemed S corporation shareholder.  Further, the grantor trust rules apply to the QSST to cause the current income beneficiary to be the income tax owner of the QSST’s distributive share of S corporation pass-through items of income, loss, deduction, and/or credit.  But, this grantor trust treatment does not apply to a disposition of S corporation stock that creates gain recognition – in such a case, the gain is recognized by the QSST itself instead of the current income beneficiary. 

Which brings us full circle.  A sub-theme that has emerged is the presence of some form of grantor trust rules when applied to the trust – with extremes of being all in or all-out.  Is there a way we can have a nongrantor trust, or a partial-grantor trust, that qualifies as an S corporation shareholder? 

The answer is yes with an electing small business trust, or ESBT. 

To contrast from prior articles, for ease of readability, this article is formatted for numbered points dealing with ESBTs.  There are two sets of Treasury Regulations that apply – income tax Regulations under 1.641(c)-1 (analyzing IRC Section 641(c)), and qualification/election regulations under 1.1361-1(m) (analyzing IRC Section 1361(e)).  

(And yes, after the Loper decision, I know the Treasury Regulations have reduced authority.  However, these still remain the most comprehensive sets of guidelines on ESBTs.)

For (hopefully) ease of readability, this article instead has a numbered-point format with respect to both the income tax principles and qualifying principles of an ESBT.  We will start with the qualifying principles, then move to the income tax principles.  For now, note that an ESBT is usually fully taxed as a nongrantor trust (except for any portion over which grantor trust powers are retained), with income tax being applied as a flat tax at the highest individual rate against ordinary income (but not capital gains) attributable to S corporation stock. 

Qualifying Principles of Treas. Reg. 1.1361-1(m)

1. The trust must be eligible in order to make an ESBT election.  The primary eligibility requirement is that, if any interest in the trust was acquired by purchase prior to or after the election, the trust will not qualify for the ESBT election.  Any QSST (unless converting as discussed below), or tax-exempt trust (including a charitable remainder trust but not a charitable lead trust), is not eligible for the ESBT election.  (Note that a charitable remainder trust is itself not an eligible S corporation shareholder, but other charitable organizations may be under IRC Section 1361(c)(6)).