Business owners can often be overwhelmed with working out the details of how they are going to get through the day, much less contemplating how their current choices on business organization may affect estate planning for their business and their families down the road.  An advantage to an S Corporation election can be the avoidance of double taxation of income (once when the corporation is taxed for this income and once when shareholders are taxed for the distribution of this income) while still retaining other benefits of incorporation.  However, along with this advantage, there are restrictions associated with an S Corporation election that may complicate certain estate planning objectives when it comes time to plan for the transfer of the business owner’s interest after his or her death.

One common estate planning tool used by business owners is to create a revocable trust.  Transferring assets to a revocable trust during life, and providing for the transfer of assets to the revocable trust through beneficiary designations, can permit:

1. assets to pass to heirs outside of the court probate process, simplifying administration and avoiding probate fees;
2. planning as to when and under what circumstances family members will inherit, including the creation of additional trusts that will be administered for the benefit of family members until certain conditions are met; and
3. coordination of various assets to effectuate intent as to who should benefit financially from the estate, in what amount, and how.

However, with an S Corporation election the federal government imposes restrictions on the types of trusts that may own an interest in an S Corporation.  This can complicate, or in some cases thwart, a business owner’s planned use of a revocable trust to provide for his or her family.

For example, the federal government does permit a “qualified subchapter S trust” to be a shareholder of S corporation stock.  However, the challenge for business owners is that the federal government imposes severe restrictions on the design of a “qualified subchapter S trust.”  In order to qualify to hold S corporation stock, a “qualified subchapter S trust” must:

1. have only one income beneficiary of the trust during the life of the current income beneficiary;
2. distribute any trust principal only to the sole income beneficiary during the life of the current income beneficiary;
3. provide for the termination of the income interest of the sole income beneficiary either on the sole income beneficiary’s death or when the trust terminates;
4. distribute all of the trust assets to the sole income beneficiary if the trust terminates during the life of the sole income beneficiary; and
5. name a sole income beneficiary who is an individual who must be a citizen or resident of the United States.

Possibly the biggest issue associated with the “qualified subchapter S trust” for many business owners is that they often desire to design their trusts to have more flexibility to provide for multiple family members in varying amounts and under various circumstances over the life of the trust.  This becomes an increasing issue to the extent that the corporate interest represents the dominate asset in the estate of the business owner.

Under federal law, a business owner may also consider making an “electing small business trust” the shareholder of S corporation stock.  In important ways the “electing small business trust” is a more attractive option for business owners developing their estate plans, including permitting the trust to have multiple beneficiaries and permitting the trustee discretion to either accumulate trust income or distribute trust income among the trust’s various beneficiaries.  However, substantial disadvantages of the “electing small business trust” include:

1. the requirement that all income of the trust must be taxed at the highest marginal federal income tax rates; and
2. for business owners wanting to provide for charities as a part of their estate plan, an “electing small business trust” may not be a charitable remainder annuity trust or a charitable remainder unitrust.

How may S Corporation restrictions complicate the estate planning you may want to complete now, or down the road?  A great time to consider these questions is when first forming the business.

[Legal advice not only involves an understanding of the law, but the application of the law to a particular set of circumstances or facts.  Typically blog posts are imperfect tools to address the subtlety and exceptions of the law that may apply in particular situations.  As a result, the information in this blog post does not represent legal advice.  If you are in a situation where you need or desire legal advice, we would be happy to help.  Check out our Contact Us page, and feel free to set-up a no-charge initial consultation.]