S Corp Issues for Trusts and Estates: Qualified …media.straffordpub.com/products/s-corp-issues-for-trusts...2020/07/01 · S Corporation Issues for Trusts and Estates: Qualified

S Corp Issues for Trusts and Estates: Qualified

Shareholders, Key Tax Rules, Multiple Trusts,

QSST, ESBT

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Stefania L. Bartlett, Counsel, Cummings & Lockwood, Stamford, CT

Cara Howe Santoro, Attorney, Cummings & Lockwood, Stamford, CT

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© Cummings & Lockwood LLC 2020

Presented by

S Corporation Issues for Trusts and Estates:

Qualified Shareholders, Key Tax Rules, Multiple Trusts, QSST, and ESBT

Cara Howe Santoro, Esq. Stefania L. Bartlett, Esq.Cummings & Lockwood LLC Cummings & Lockwood LLCSix Landmark Square Six Landmark SquareStamford, CT 06901 Stamford, CT 06901

(203) 351-4195 (203) [email protected] [email protected]

5


What is an S Corporation?

▪ A corporation that elects to pass corporate income, losses, deductions, and credits through to shareholders for federal income tax purposes

▪ Must meet several stringent requirements found in IRC § 1361

▪ Penalties for failing to comply can be severe

6


How to Form an S Corporation

▪ Organize as a C corporation under state law

▪ Elect S corporation status on Form 2553 - Election by a Small Business Corporation

– Must file within 2.5 months of beginning of tax year to be effective for that year; otherwise anytime during tax year preceding the tax year election is to take effect

▪ Other organizations (such as LLCs) may elect to be taxed as an S corporation pursuant to the entity classification, or “check the box,” regulations found under IRC § 7701

7


Eligibility requirements for an S Corporation IRC § 1361

▪ domestic corporation

▪ only one class of stock

– as long as the economics of the stock are the same (i.e., the right to distributions), there may be different classes of stock (i.e., voting and non-voting)

▪ no more than 100 shareholders

▪ all shareholders are:

– individuals

– estates

– certain kinds of trusts

– certain charities

– S corporation may be owned 100% by another S corporation (“QSub”)8


One Class of Stock

▪ stock is considered part of the same class if dividend and liquidation preferences are the same

▪ there may be different voting rights that apply to different “classes” of stock while still maintaining the one class rule, pursuant to IRC § 1361(c)(4)

– rights usually defined in a stockholder’s agreement or entity’s charter

▪ Disproportionate distributions may create another class

▪ Disguised equity may create another class

– May be found in buy-sell or redemption agreements

– Definition of one class and exceptions in Treas. Reg. § 1.1361-1(l)

9


Straight Debt Safe Harbor Treas. Reg. § 1.1361-1(l)(5)

▪ “A written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand, or on a specified date”

– Helpful for redemptions of S corporation stock paid over time using a promissory note

▪ Additional requirements:

– loan must not have interest rates or payment dates contingent on profit

– loan must not be convertible into equity

– loan must be held by an individual (not a nonresident alien), an estate or trust described in IRC § 1361(c)(2)

10


100 Shareholders -IRC § 1361(b)(1)(A)

▪ Members of a family treated as 1 shareholder for 100 shareholder requirement

– “members of a family” means a common ancestor, lineal descendant of such common ancestor, and any spouse or former spouse (IRC § 1361(c)(1))

– includes adopted children (IRC § 1361(c)(1)(C))

– Not an ancestor if more than 6 generations removed from the youngest generation of shareholders

11


Qualified S Corporation Shareholders Individuals

▪ Must be a U.S. Citizen or Resident

▪ Proceed with caution if spouse is a nonresident alien, particularly in community property jurisdictions where spouse may be entitled to an undivided one-half interest

▪ In those situations, shareholder spouse may need to disclaim interest or have a marital agreement whereby nonresident alien spouse agrees he/she is not entitled to any interest in S corporation stock

▪ Ownership governed by state/local law

12


Qualified S Corporation Shareholders Nonprofits

▪ Organizations described in IRC § 401(a) (retirement plans) and IRC § 501(c)(3) (public charities/private foundations) that are exempt from tax under IRC § 501(a) are eligible

– Charitable remainder trusts are not qualified shareholders

– Charitable lead trusts are qualified shareholders if the trust is a grantor trust or it makes a qualifying election

– IRAs and Roth IRAs generally are not eligible shareholders

▪ Treas. Reg. § 1.1361-1(h)(vii) provides a bank/depository institution exception

– Adverse tax consequences to tax-exempt shareholder:

▪ All income from S corporation is unrelated business taxable income pursuant to IRC § 512

▪ All gain from sale of S corporation stock is unrelated business taxable income pursuant to IRC § 512

13


Qualified Subchapter S Subsidiaries -IRC § 1361(b)(3)

▪ Wholly owned domestic subsidiary of an S corporation

▪ Election made on Form 8869

▪ Effective at any time during a taxable year

▪ If qualifies as a QSub, generally not treated as a separate corporation except for:

1. tax liabilities incurred in years when it was a separate entity

2. employment taxes

3. certain excise taxes, federal refunds or tax credits

4. certain information returns

14


Qualified S Corporation ShareholdersEstates

▪ an estate is an eligible shareholder for a reasonable period of time required to administer the estate (IRC § 1361(b)(1)(B); Old Virginia Brick Co. v. Commissioner, 367 F.2d 276 (4th Cir. 1966))

▪ there is no statutory length of time an estate may be open

▪ Rev. Rul. 76-23: estate will continue to be an eligible shareholder for the period during which the estate complies with the provisions of IRC § 6166

▪ there are no other automatic rules that allow estates to remain open

15


Qualified S Corporation ShareholdersTrusts

▪ Under IRC § 1361(c)(2), certain trusts are permitted to be S corporation shareholders

▪ only domestic trusts are permitted to be S corporation shareholders

▪ a trust is considered to be a domestic trust if it meets a two-part test (IRC §§ 7701(a)(30) and 7701(a)(31))

– court test

– control test

16



Under IRC § 1361(c)(2)(A), the following types of trusts are allowed to be S corporation holders without making any special elections:

▪ qualified subpart E trusts

– includes trusts under IRC §§ 673 - 677 and 679 where the grantor is treated as the owner, along with trusts under IRC § 678 where a person other than the grantor is treated as the owner

– upon death of deemed owner: trust qualifies as an S corporation shareholder and may continue to hold S corporation stock for up to 2 years (IRC § 1361(c)(2)(A)(ii))

– exception for IRC § 645 election (Treas. Reg. § 1.1361-1(h)(1)(iv)(B))

17



– accounting during this time period can be more difficult if IRC § 645 election is not made

▪ the trust is treated as the shareholder for purposes of

– IRC § 1366 (pass through items of income, loss, deduction, and credit);

– IRC § 1367 (adjustments to shareholder’s basis in stock); and

– IRC § 1368 (distributions)

▪ for all other tax purposes, estate of testator is treated as the shareholder (IRC § 1361(c)(2)(B)(iii))

18



▪ testamentary trusts

– qualifies as a shareholder and may continue to hold S corporation stock for up to 2 years beginning on the date the stock is transferred to the trust (IRC § 1361(c)(2)(A)(iii))

▪ voting trusts

– there are specific requirements for a voting trust to qualify (Treas. Reg. § 1.1361-1(h)(1)(v)), including:

▪ in writing

▪ delegates the right to vote to one or more Trustees

▪ requires distributions from the S corporation be paid to the beneficiaries or on behalf of the beneficiaries

▪ requires that the stock be transferred to the beneficial owners when the trust terminates, and

▪ sets a date or event in which the trust terminates 19



If a trust does not fall into one of those categories, it may still qualify as an S corporation shareholder if an election is made to be treated as:

▪ qualified subchapter S trust (QSST) under IRC § 1361(d)

▪ electing small business trust (ESBT) under IRC § 1361(e)

20


QSSTIn order to qualify as a QSST, a trust must meet requirements under IRC § 1361(d)(3):

▪ all of the trust income is distributed, or is required to be distributed, currently to one beneficiary who is a citizen or resident of the U.S. (IRC § 1361(d)(3)(B))

▪ the terms of the trust must (IRC § 1361(d)(3)(A)):

– permit only one income beneficiary at a time during the current income beneficiary’s lifetime

– allow principal distributions only to the income beneficiary

– provide that the income beneficiary’s interest terminates upon the earlier of (i) the income beneficiary’s death or (ii) termination of the trust

– provide that if the trust terminates during the income beneficiary’s lifetime, all assets must be distributed to the income beneficiary

21


QSST

▪ special rule for spouses under Treas. Reg. § 1.1361-1(j)(2)(i)

– spouses will be treated as one beneficiary for the QSST requirements if they (i) are income beneficiaries of the same trust, (ii) file a joint income tax return, and (iii) are both U.S. citizen or U.S. residents

▪ legal obligation to support under Treas. Reg. § 1.1361-1(j)(2)(ii)(b)

– if a distribution is made to the income beneficiary in satisfaction of a grantor’s legal obligation to support that beneficiary, then the trust will not qualify as a QSST as of the date of distribution

▪ special needs trust exception (PLR 9444059)

– IRS has ruled that the income distribution requirement is met where the income from a QSST is distributed to a special needs trust even when the special needs trust only makes limited distributions to the beneficiary

22


QSST

▪ separate share rule under Treas. Reg. § 1.1361-1(j)(3)

– substantially separate and independent shares of a single trust may be treated as separate trusts for purposes of qualifying the trust as a QSST if the shares are treated as separate trusts under IRC § 663(c)

▪ ceasing to meet QSST requirements

– if a trust ceases to meet the income distribution requirement, but still meets the terms of the trust requirements, then the trust ceases to be a QSST on the first day of the next taxable year (Treas. Reg. §1.1361-1(j)(5))

– if a trust ceases to meet the terms of the trust requirements, then the trust ceases to be a QSST as of the date it fails to meet the requirement (Treas. Reg. § 1.1361-1(j)(5))

23


ESBT

In order to qualify as a ESBT, a trust must meet requirements under IRC § 1361(e):

▪ the trust only has individuals, estates of individuals and/or certain charities as beneficiaries (IRC § 1361(e)(1)(A)(i))

▪ no beneficiary’s interest in the trust was acquired by purchase (IRC § 1361(e)(1)(A)(ii))

▪ the Trustee must make a timely election to treat the trust as an ESBT (IRC § 1361(e)(1)(A)(iii))

24


ESBT▪ beneficiary

– a beneficiary is any person who has a present, remainder or reversionary interest (Treas. Reg. § 1.1361-1(m)(1)(ii)(A))

▪ potential current beneficiary

– potential current beneficiary is any person who may receive a distribution of income or principal from the trust ((IRC § 1361(e)(2) and Treas. Reg. § 1.1361-1(m)(4))

– each potential current beneficiary is considered a shareholder for the purposes of the shareholder requirements

– if the trust disposes of all of the S corporation stock, then any potential current beneficiary will not be treated as a potential current beneficiary as of the 1 year period ending on the date of the disposition (IRC § 1361(e)(2))

– Nonresident aliens who are potential current beneficiaries of an ESBT are no longer treated as ineligible shareholders of an S Corporation

25


Making the Election

Requirements QSST ESBTWho makes the election? Income beneficiary

(Treas. Reg. § 1.1361-1(j)(6)(ii))

Trustee

(Treas. Reg. § 1.1361-1(m)(2)(i))

What is the due date of

the election?

Within 2-month and 16-day

period beginning on date stock is

transferred to the trust, with

exceptions

(Treas. Reg. § 1.1361-1(j)(6)(iii))

Within 2-month and 16-day

period beginning on date stock is

transferred to the trust, with

exceptions

(Treas. Reg. § 1.1361-

1(m)(2)(iii))

How is the election made? Filing Form 2553; statement filed

with IRS

(Treas. Reg. § 1.1361-1(j)(6)(ii))

Statement filed with IRS

(Treas. Reg. § 1.1361-1(m)(2)(ii))

26


Requirements QSST ESBTHow many elections must

be made?

Separate QSST elections must be

filed for each S corporation in

which the trust holds an interest

(IRC § 1361(d)(2)(B)(i) and Treas.

Reg. § 1.1361-1(j)(6)(i))

One ESBT election is required,

even if trust owns stock in

multiple S corporations (unless

different IRS service centers

are involved)

(Treas. Reg. § 1.1361-

1(m)(2)(ii))

How long is election in

effect?

In effect for successor

beneficiaries unless beneficiary

affirmatively refuses to consent

(IRC § 1361(d)(2)(B)(ii) and

Treas. Reg. § 1.1361-1(j)(9) and

(10)); until trust fails to meet the

requirements or disposes of S

corporation stock (Treas. Reg. §

1.1361-1(j)(5))

Until trust fails to meet the

requirements or disposes of S

corporation stock

(Treas. Reg. § 1.1361-1(m))

Making the Election

27


Requirements QSST ESBTMay the election be

revoked?

Yes, but only with the

consent of the

Commissioner

(IRC § 1361(d)(2)(C) and

Treas. Reg. § 1.1361-

1(j)(11))

Yes, but only with the

consent of the

Commissioner

(Treas. Reg. § 1.1361-1(m))

Is relief available for late

elections?

Yes, see Rev. Proc. 2013-30

for simplified method of

relief; if requirements are not

met, must submit a request

for a private letter ruling

Yes, see Rev. Proc. 2013-30

for simplified method of

relief; if requirements are not

met, must submit a request

for a private letter ruling

Making the Election

28


Conversion from ESBT to QSST

▪ Consent of Commissioner required to revoke ESBT election pursuant to IRC § 1361(e)(3)

▪ Treas. Reg § 1.1361-1(m)(7), an ESBT may automatically convert to a QSST if certain conditions are met:

– Trust meets requirements to be a QSST under IRC § 1361(d)

– Trustee and current income beneficiary sign the election

– Includes required information under Treas. Reg. § 1.1361-1(j)(6)

– No prior conversion within last 36 months

29


Conversion from ESBT to QSST

– Election effective not more than 15 days and 2 months prior to filing or 12 months after filing

– Election made with respect to stock of each S corporation held by the trust

– Election states: “ATTENTION EQUITY CONTROL -CONVERSION OF AN ESBT TO A QSST PURSUANT TO SECTION 1.1361-1(m)”

– Rev. Proc. 98-23 provides guidance on conversions in both directions

30


Conversion from QSST to ESBT

▪ Consent of Commissioner required to revoke QSST election pursuant to IRC § 1361(d)(2)(C)

▪ Treas. Reg. § 1.1361-1(j)(12), a QSST may automatically convert to an ESBT if certain conditions are met:

– Trust meets requirements of an ESBT under IRC § 1361(m) (except requirement that trust does not have a QSST election in effect)

– Trustee and current income beneficiary sign the ESBT election

– No prior conversion within last 36 months

31


Conversion from QSST to ESBT

– Election effective not more than 15 days and 2 months prior to filing or 12 months after filing

– Election made with respect to stock of each S corporation held by the trust

– Election states: “ATTENTION EQUITY CONTROL -CONVERSION OF A QSST TO AN ESBT PURSUANT TO SECTION 1.1361-1(j)”

– Rev. Proc. 98-23 outlines the requirements for conversion

32


Taxation of S Corporations

▪ Pass through entity with one level of taxation at shareholder level

▪ Shareholders are taxed on their profit distributions and wage income (if employees/active owners)

▪ IRC § 1368 dictates how S corporation distributions are taxed in the hands of shareholders:

– tax-free reduction of shareholder’s basis

– taxable dividend (only if accumulated E&P)

– gain from sale of stock

33



▪ Pursuant to IRC § 1367, an S corporation shareholder annually adjusts his/her basis in the corporation’s stock to reflect items of gain, loss, deduction, and distribution

– basis is increased for capital contributions, income, and excess of deductions for depletion over basis of property subject to depletion

– basis is decreased for distributions (other than those taxed as dividends pursuant to IRC § 1368), nondeductible expenses not properly chargeable to a capital account

– basis cannot be reduced below zero

34



▪ If S corporation has accumulated E&P (if previously a C corporation or acquired the assets of a C corporation in a IRC § 381 transaction), must preserve second level of tax

– Accumulated E&P taxed as dividend to shareholder, subject to shareholder’s Accumulated Adjustment Account (“AAA”) pursuant to IRC § 1368(c)

– This way, S corporation can distribute its income before being treated as making a distribution from E&P

– AAA may be reduced below zero only by losses (not by distributions)

35


Application of IRC § 199A

▪ Allows deduction of income from qualified trade or business

▪ Deduction ultimately taken at individual or trust shareholder level

▪ 2 components to the deduction:

– 1) deduction equals 20 percent of qualified business income (QBI) from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate

– 2) deduction equals 20 percent of the combined qualified REIT dividends (including REIT dividends earned through a regulated investment company (RIC)) and qualified PTP income

▪ Deduction limited to lesser of the QBI component plus the REIT/PTP component or 20 percent of taxpayer's taxable income minus net capital gain

36


Application of Section 199A

▪ Consider “reasonable compensation” and relationship with 199A deduction

– QBI does not include reasonable compensation payments to a taxpayer for services rendered

– Reasonable compensation increases W-2 wages when applying the W-2 wage limitation

37


Taxation of S Corporations State Level

CAUTION: Don’t forget to check state law!

▪ Not all states recognize S corporations– Those that do not, generally tax S corporations as C

corporations

▪ Certain states require a separate state S election in addition to the federal election

▪ Some states allow composite returns (S corporation files on behalf of all shareholders)

▪ Some states require estimated tax payments38


Built in Gains Tax IRC § 1374

▪ S corporation may be subject to a built in gains tax when a C corporation converts to an S corporation or an S corporation acquires assets in a tax free (IRC § 381) transaction

– If so, S corporation must track these assets for the next 5 years, pursuant to IRC § 1374(d)(7)(A)

– Any disposition taxed at highest corporate tax rate (currently 35%)

– Purpose is to prevent avoidance of taxable liquidation

39


Passive Income Limitation IRC § 1375

▪ “sting tax” on excess net passive investment income

– Passive investment income includes interest, dividends, royalties, and certain rents

– Excess net passive income (amount that exceeds 25% of gross receipts) taxed at the highest corporate tax rate under IRC §11(b), which is currently 35%

– IRS may waive tax if corporation mistakenly determined that it had no E&P and distributes E&P within certain time period

▪ S corporation must have accumulated E&P for tax to apply

40


Passive Income Limitation IRC § 1375

▪ If: S corporation has accumulated E&P at the close of each of 3 consecutive tax years and has gross receipts for each of those tax years more than 25% of which are passive investment income (IRC § 1362(d)(3) and Treas. Reg. §1.1362-2(c))

▪ Then: S corporation status automatically terminates in year 4, pursuant to IRC § 1362(d)(3)

– Relief for inadvertent termination under IRC § 1362(f)

– Requires a private letter ruling

41


Taxation of QSST

▪ Current income beneficiary pays tax on income (IRC § 678(a))

– Portion of trust holding S corporation ignored for income tax purposes

▪ Therefore, allocable portion of income not subject to current distribution requirement

– If harsh result, UPIA allows fiduciary to adjust between principal and income to offset shifting of economic interests or tax benefits between income beneficiaries and remainder beneficiaries

42


Taxation of QSST

▪ When QSST disposes of S corporation stock (either through distribution or sale), trust treated as owner for income tax purposes

▪ Treas. Reg. § 1.1361-1(j)(8)

▪ Exception: Deductions under at-risk and passive loss rules, IRC §§ 465 and 469

▪ Any non-S corporation assets subject to subchapter J

43


Taxation of ESBT

▪ Treated as 2 separate trusts for tax purposes (Treas. Reg. § 1.641(c)-1)

– S portion and non-S portion

– Either portion may be treated as owned by a grantor and subject to the grantor trust rules under subpart E

▪ S portion treated as a separate taxpayer and subject to special rules under IRC § 641(c):

– Highest trust rate of tax applied (IRC § 641(c)(2)(A))

– Exemption amount under IRC § 55(d) is zero

– If ESBT owns stock in more than one S corporation, income, deductions and credit aggregated to determine tax liability

44


Taxation of ESBT

▪ Non-S portion taxed under subchapter J

– Distributions to beneficiary from either the S portion or the non-S portion may carry out DNI to the extent of the non-S portion

▪ Grantor portion subject to grantor trust rules:

– Grantor portion subject to grantor trust rules - income and deduction items allocable to this portion taxable directly to grantor

45


Terminating an S Corporation Election - IRC § 1362(d)(1)

▪ May be made effective as of the 1st day of the tax year if made by the 15th day of the 3rd month of such tax year; otherwise, effective on the 1st day of the following tax year or another prospective date

– Must be a stated day, month and year as opposed to a particular event - Treas. Reg. § 1.1362-2(a)(2)(ii)

– Requires more than 50% shareholder approval

▪ post termination transition period (IRC § 1371(e)(1)) allows for post-termination distributions of cash to be applied against remaining AAA for 1 year

▪ May not elect S status for 5 years (IRC § 1362(g))

46


Inadvertent Termination

▪ If at any time an S corporation fails to meet the requirements under IRC § 1361 or its passive income exceeds the passive income limitation, the S election is terminated

▪ Termination effective on date of triggering act

▪ May request relief for inadvertent termination by private letter ruling

47


Late Relief under Rev. Proc. 2013-30

▪ request must be made within 3 years and 75 days of the intended effective date

▪ requesting entity must file an election form with the following:

– reasonable cause / inadvertence statement that is signed (by income beneficiary or Trustee) under penalties of perjury describing (i) reasonable cause for failing to timely file the QSST/ESBT election and (ii) diligent actions to correct the error once it was discovered

– statement that the trust meets the appropriate QSST/ESBT requirements

– statement from all the shareholders that they reported their income on all affected tax returns consistent with the S corporation election during the period between the date the S corporation election was to have become effective or was terminated and the date the election is actually effective

▪ the election form must contain the statement “FILED PURSUANT TO REV. PROC. 2013-30” at the top

48


Planning Considerations▪ Only certain types of trust are eligible to hold S corporation stock and

these trusts must comply with several technical requirements in order to avoid jeopardizing a corporation’s S election

▪ Important to keep these rules in mind during estate planning and administration because a corporation’s S status may be jeopardized when a shareholder dies and the stock (i) is transferred to an individual who is not eligible to be a shareholder; or (ii) is transferred to a trust that is not eligible to be a shareholder or has not made the proper election

▪ Important to include language in estate planning documents that will allow a trust to qualify as an S corporation shareholder even though the trust does not currently own S corporation stock

▪ Include provisions in estate planning documents to give trustees the flexibility to deal with S corporation stock, QSSTs and ESBTs (i.e., power to divide trusts, power to decant, etc.)

49


Planning Considerations

▪ If there is a risk of inadvertent termination, think about a disclaimer

▪ In light of the fact that an S corporation election could be invalidated by future shareholders, it is important to have shareholder agreements which define shareholders’ rights and obligations with respect to the stock and the S corporation election, including restrictions on shareholders that may terminate S corporation status

▪ An estate may receive a step-up in basis in the shares of S corporation stock, but note that the inside basis of the property of the S corporation will not receive a corresponding step-up --- there is no S corporation equivalent to an IRC § 754 election

50


Charitable Planning Considerations

▪ When leaving S corporation stock to charity, consider the charity’s exit strategy:

▪ Typically, public charities will not want to hold stock in an S corporation indefinitely -- if a charity is willing to accept the stock donation it will typically look for an exit from the investment shortly after receipt

▪ Private Foundations are subject to excess business holding rules and typically are required to divest within 5 years of receipt, if not sooner, unless meeting an exception to the excess business holding rules

▪ Private Foundations are also subject to self-dealing rules -- when devising a charitable bequest or gift of S stock to a private family foundation, keep in mind the self-dealing rules and try to take advantage of the estate administration exception or the redemption exception in order to provide the foundation with an exit that is favorable to both the remaining S corporation owners and the foundation

51

Documents

S Corp Issues for Trusts and Estates: Qualified …media.straffordpub.com/products/s-corp-issues-for-trusts...2020/07/01 · S Corporation Issues for Trusts and Estates: Qualified