Many small business owners establish S corporations because they provide the benefits of avoiding double taxation and protecting the owners against personal liability for the corporation. S corporation shareholders should be aware that establishing a family trust and funding the trust with the shares of the S corporation could cause the S Election to fail. S corporation shareholders need to use special care in drafting a trust that will hold shares in the S corporation.

A revocable grantor trust is an eligible S corporation shareholder as long as the deemed owner is alive and continues to be an eligible shareholder for two years after the death of the owner. Once the grantor passes, though, the trust must meet specific requirements to remain an eligible shareholder of the trust.

  • The trust must have only one current income beneficiary;
  • The current income beneficiary must be a U.S. citizen or resident;
  • All of the trust income must be distributed currently to the income beneficiary;
  • During the life of the income beneficiary, the income beneficiary must be the only person who can receive distributions of principal;
  • The beneficiary's income interest must terminate at the earlier of the death of the income beneficiary or the termination of the trust; and
  • If the trust terminates during the life of the income beneficiary, all of the trust assets must be distributed to the income beneficiary.
  • The income beneficiary is treated as the shareholder of the corporation during the life of the beneficiary.
  • If the trust meets these requirements, the income beneficiary must file an election to qualify as a Subchapter S Trust.

The Trust may also elect to qualify as a small business trust. Qualifying as a small business trust is simpler than qualifying as a QSST, because the only requirements are that the beneficiaries are U.S. citizens and none of the beneficiaries acquired her interest in the trust by purchase or taxable exchange. However Electing Small Business Trusts (ESBT) are taxed on the income of the S corporation, not the beneficiaries. An ESBT pays income tax at the highest rate applicable to individuals. If the beneficiaries are not in the highest income tax bracket, the ESBT can hold a significant tax disadvantage.

The information in this article is not, nor is it intended to be, legal advice. This article is for informational purposes only and may or may not apply to you. You should consult an attorney for advice regarding your particular circumstances. We invite you to contact us and welcome your calls, letters and electronic mail. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.