If you’re drafting, creating, advising on, or administering a trust that will hold S corporation stock, you should consider which S corporation trust election may be required and when it must be made. The type of trust and timing of the election can affect both shareholder eligibility and tax reporting requirements.
First, you must consider what type of trust you’re creating, advising on, or administering. If the trust is a grantor trust, then it’ll be eligible as an S corporation shareholder without making an election. This is because the rules allow the trust to look through to the grantor for determining eligibility. However, upon the grantor’s passing, the trust will lose its status as a grantor trust and will need to make an election to qualify as an S corporation shareholder.
Choosing the appropriate trust election is critical when structuring nongrantor trusts that hold S corporation stock. The two allowable S corporation elections for nongrantor trusts are the qualified subchapter S trust (QSST) and the electing small business trust (ESBT). While both elections allow nongrantor trusts to qualify as eligible S corporation shareholders, they differ significantly in how income is distributed, taxed, and reported. Understanding these differences is essential for trustees, tax advisors, and beneficiaries to help ensure compliance and optimize tax outcomes.
QSST requirements
A trust qualifies as a QSST and may be treated as an eligible S corporation if it’s a domestic trust and meets all the following requirements:
- The trust has only one current income beneficiary who is a citizen or resident of the United States.
- All of the trust’s income is distributed or required to be distributed currently to the income beneficiary.
- The income beneficiary is the only person who may receive trust distributions during life.
- The income beneficiary’s interest in the trust must terminate on the earlier of his or her death or the termination of the trust.
- Upon termination of the trust during the beneficiary’s life, the trust must distribute all of its assets to the income beneficiary.
A QSST election is similar to a grantor trust arrangement because it allows the trust beneficiary, rather than the trust, to be treated as the S corporation shareholder. As a result, S corporation income generally is reported by the beneficiary instead of the trust. Depending on the beneficiary’s individual circumstances, this may result in a different tax outcome than would apply if the income were taxed at the trust level. While annual S corporation income generally is reported on the beneficiary’s return, the tax treatment of a future sale or other disposition of the S corporation stock may differ and should be evaluated based on the trust’s terms and the ownership structure in place at that time.
ESBT election
If the requirements for QSST election aren’t met, the other option is to make an ESBT election. An ESBT is more flexible than a QSST for multiple reasons, including that an ESBT may have more than one beneficiary at a time, and that current income distributions to beneficiaries aren’t required.
Below is the most common circumstance where a QSST later becomes an ESBT.
Practical wealth planning example
A common real-world progression is:
Years 1–10
- Marital trust for surviving spouse
- Sole income beneficiary
- QSST election
After spouse’s death
- Trust divides or continues for children/grandchildren
- Trustee has discretionary distribution authority
- ESBT election is made
One potential disadvantage is that S corporation income allocated to the ESBT generally is taxed at the trust level rather than the beneficiary level, often at rates higher than those applicable to individual taxpayers.
Depending on the circumstances, S corporation income within an ESBT also may be subject to the 3.8% net investment income tax at lower income thresholds than those that apply to many individual taxpayers.
As no distribution deduction is allowed to the trust for distribution of S corporation income, that income generally is taxed to the trust regardless of whether it’s distributed to trust beneficiaries.
Election timing
Regardless of which election is made, the completed election form must be filed with the Internal Revenue Service within two months and 16 days from the date the trust became a shareholder in the S corporation.
In certain post-death situations, the requirement to make an election may be delayed for up to two years. For example, special rules may apply when S corporation shares were held in a revocable living trust before death, or were held in a decedent’s estate and later transferred to a nongrantor trust created under the terms of a will.
If a QSST election is being filed, the beneficiary who’s responsible for reporting the S corporation income must sign the election, while an ESBT election can be signed by the trustee. Failure to file either election on time will make the trust an ineligible shareholder and potentially jeopardize the S corporation election for the corporation itself.
Choosing the right election
S corporation shares are one of many types of assets that can be held in nongrantor trusts. When selecting between a QSST and ESBT election, trustees and advisors should consider the trust’s distribution provisions, beneficiaries, and tax objectives. Since each election carries different reporting and tax consequences, the most appropriate choice will depend on the trust’s specific goals and circumstances.
