ESBT Election Form: Trusts and S-Corps - Corporate Direct, Inc.

Given the restrictions on the ownership of S-Corporation stock, it may be difficult for grantors to store such stock into a trust. However, upon proper election, the IRS regulations allow for two types of trusts to remedy this issue. Electing Small Business Trusts (ESBTs) and Qualified Subchapter S Trusts (QSSTs) are the two main trust types eligible to be S corporation shareholders under the Internal Revenue Code.

Qualified Subchapter S Trust (§ 1361(d))

The first such trust is the Qualified Subchapter S Trust (QSST). A QSST is a trust that requires only one beneficiary who must be a United States resident. The beneficiary is required to make the QSST election within 2.5 months of the trust receiving stock. The election statement must be filed with the IRS, and the current income beneficiary must meet specific shareholder requirements for federal income tax purposes. A Sample QSST election form is included below.

Electing Small Business Trust (§ 1361(e))

The second type of trust is the Electing Small Business Trust (ESBT). An ESBT is a trust that allows for multiple beneficiaries, and the beneficiary can be an individual, estate or a charitable organization. Only the trustee is required to make the ESBT election, and the election statement must be filed within 2.5 months of the trust's receipt of S corporation stock. ESBTs are subject to special tax treatment under the Internal Revenue Code, including the highest income tax rate on the S corporation's income allocated to the trust, and ordinary income, capital gains, and charitable contributions are taxed according to specific rules. The grantor portion of an ESBT is taxed separately from the S portion, and the trust's taxable income is calculated under the normal rules applicable to trusts unless otherwise specified. The beneficial interest and contingent interest of current beneficiaries must be considered when determining eligibility, and ineligible shareholders, such as nonresident aliens or foreign trusts, can jeopardize the S corporation election. The IRS may require records relating to the ESBT election, and the estimated average burden for compliance is regulated under the Paperwork Reduction Act. Excess deductions, such as charitable deductions, may not be carried forward by ESBTs, and the normal rules for charitable contribution deductibility may be modified by recent legislative changes. A private letter ruling may be requested from the IRS if relief is needed for a late or defective ESBT election. The corporation files the S corporation election and related documents, including the valid control number, with the appropriate IRS service center.

Why the ESBT is better than the QSST

ESBTs are preferred over QSSTs for the simple reason that ESBTs are the more flexible option. QSSTs can only have one beneficiary that must be an individual. In addition, the children of the QSSTs beneficiary are barred from becoming beneficiaries. On the other hand, an ESBTs can have multiple beneficiaries including individuals, estates, and charitable organizations, and children of ESBT beneficiaries can become beneficiaries in the future. ESBTs allow for multiple current beneficiaries, including estates and charitable organizations, and the current income beneficiary's life is a key factor in QSST eligibility. A decedent's estate can also be an eligible S corporation shareholder for a limited period. The deemed owner rules and separate trust requirements may apply to certain trust structures under the Internal Revenue Code. The tax attributable to S corporation income held by an ESBT is calculated at the trust level, and the trust must file income tax returns reporting this income. Corporation shareholders must comply with all applicable internal revenue law and maintain proper records relating to their S corporation status. The normal rules for S corporations and corporation elections apply unless specifically modified by IRS regulations or legislative amendments. The process for making and revoking ESBT elections is governed by IRS procedures, and timely and accurate filing is essential to maintain S corporation eligibility.

It is worth noting that one must be careful when making such an election. Failure to make these elections in a timely manner may result in the corporation losing its Subchapter S status, which could impose the double tax under Subchapter C. The loss of S corporation status can occur if the trust fails to meet eligible shareholder requirements or if the trust's receipt of S corporation stock is not properly documented. Angering other shareholders this way is not a position that you want to be in.

SAMPLEQSSTELECTION

Internal Revenue Service Center

RE: QUALIFIED SUBCHAPTER S TRUST ELECTION

The current income beneficiary of the         Trust hereby elects under IRC § 1361(d)(2) to treat the trust as a qualified Subchapter S trust pursuant to IRC § 1361(c)(2)(A)(i). The following information is provided:

Current Income Beneficiary:

Name

Address

Taxpayer identification number

Trust:

Name

Address

Taxpayer Identification Number

S Corporation:

Name

Address

Taxpayer Identification Number

This election is made under IRC § 1361(d)(2) to be effective as of [date]             . On

[date] the stock of ** was transferred to the ___ Trust, which meets all the requirements of Reg. § 1.1361 – 1(j)(6)(ii)( E)(1), (2), and (3) as follows:

1. All trust income will be or is required to be distributed currently to one individual beneficiary who is a citizen or resident of the U.S.
2. During the life of the current income beneficiary, there is only one income beneficiary of the trust.
3. Any corpus distributed during the life of the current income beneficiary may be distributed only to that income beneficiary.
4. The current income beneficiary’s income interest in the trust terminates on the earlier of that beneficiary’s death or the termination of the trust.
5. If the trust terminates during the life of the current income beneficiary, the trust will distribute all of its assets to that income beneficiary.
6. No distribution by the trust (income or corpus) will be in satisfaction of the grantor’s legal obligation to support the income beneficiary.

********_          ____            _**** Signature of beneficiary          Name of beneficiary   Date

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