S Corporation Owners: How Your Estate Plan Can Terminate Your S Election
If you own S corporation shares, your estate plan has a tax job most plans never consider: keeping the S election alive after you die. Only certain shareholders are allowed. If your will or trust leaves the shares to the wrong kind of trust, the corporation can lose S status without anyone signing anything.
Who can own S corporation stock
An S corporation cannot have a shareholder that is not an individual, other than an estate, certain exempt organizations and the trusts the Code lists (IRC § 1361(b)(1)(B)). It also cannot have a nonresident alien shareholder or more than 100 shareholders (§ 1361(b)(1)(A), (C)). Any trust that will hold your shares has to fit one of the trust categories the Code lists (§ 1361(c)(2)(A)). The ones that matter most in estate planning are below.
Grantor trusts during your life
A trust treated as wholly owned by one individual who is a US citizen or resident can hold S stock, and that individual is treated as the shareholder (§ 1361(c)(2)(A)(i), (B)(i)). A typical revocable living trust fits, because the person who can take the property back is treated as its owner (§ 676(a)). The Treasury regulations illustrate the rule with a trust the grantor can revoke (Treas. Reg. § 1.1361-1(k)(1), Example 2(i)).
The two-year window after death
At your death, a revocable trust usually stops being a grantor trust. If it continues in existence, it can keep holding the shares for the 2-year period beginning on the day of death, with your estate treated as the shareholder (§ 1361(c)(2)(A)(ii), (B)(ii)). That treatment ends early if the trust transfers the shares to anyone other than your estate, so a separate trust that receives them needs its own permitted status from the day of the transfer (Treas. Reg. § 1.1361-1(k)(1), Example 2(ii)). A trust that receives stock under a will gets its own window: 2 years beginning on the day the stock is transferred to it (§ 1361(c)(2)(A)(iii), (B)(iii)).
If a valid § 645 election treats the revocable trust as part of your estate, the trust can hold the shares during the election period, and a trust that receives them from it during that period gets the same 2-year window as a trust under a will (Treas. Reg. § 1.1361-1(h)(1)(iv)(B); (k)(1), Example 3(ii)).
A trust meant to hold the shares longer must become one of the two long-term options below.
The qualified subchapter S trust (QSST)
A QSST is a trust for one person. During that beneficiary’s life there can be only one income beneficiary, principal can go only to that beneficiary, and if the trust ends early, everything goes to that beneficiary. All income must be distributed, or required to be distributed, currently to one individual who is a US citizen or resident (§ 1361(d)(3)).
The beneficiary (or the beneficiary’s legal representative) makes the election, not the trustee, separately for each corporation (§ 1361(d)(2)(A), (B)(i)). The statute lets the election take effect up to 2 months and 15 days before it is made (§ 1361(d)(2)(D)). The filing deadline comes from the regulations: generally within the 16-day-and-2-month period beginning on the day the stock is transferred to the trust (Treas. Reg. § 1.1361-1(j)(6)(iii)(A)). For a former grantor trust whose deemed owner’s estate is treated as the shareholder, the election can be filed at any time up to the end of the 16-day-and-2-month period beginning on the date the estate stops being treated as the shareholder. For a testamentary trust, that period begins on the day after the 2-year window ends (Treas. Reg. § 1.1361-1(j)(6)(iii)(C), (D)).
The electing small business trust (ESBT)
An ESBT suits a trust that needs flexibility, such as one that can sprinkle income among children. Its beneficiaries can only be individuals, estates and certain charities, and no interest in it can have been acquired by purchase (§ 1361(e)(1)(A)). The trustee makes the election (§ 1361(e)(3)), under the same deadline rules as a QSST election (Treas. Reg. § 1.1361-1(m)(2)(iii)). Each potential current beneficiary counts as a shareholder for the 100-shareholder limit (§ 1361(c)(2)(B)(v)).
The cost is tax. The S portion of an ESBT is taxed as a separate trust at the highest trust income tax rate, apart from capital gains rates, with no alternative minimum tax exemption (§ 641(c)(1), (2)(A)-(B)). Your CPA should compare a QSST and an ESBT before the trust is drafted.
Your estate
Your estate is itself a permitted shareholder (§ 1361(b)(1)(B)), but not indefinitely. For income tax purposes, an estate is treated as ended once administration is unreasonably prolonged, or once everything has been distributed except a reasonable reserve (Treas. Reg. § 1.641(b)-3(a)).
What a terminating event looks like
A common pattern: an owner’s revocable trust says that at death it continues, holding the shares, as one trust for three children, with the trustee free to pay income to whichever child needs it. That trust cannot be a QSST, because it has more than one income beneficiary. Nobody files an ESBT election. When the 2-year window closes, the corporation has a shareholder that is not permitted.
The corporation has stopped being a small business corporation, and the S election terminates on and after that date (§ 1362(d)(2)). The year splits into an S short year and a C short year (§ 1362(e)(1)). Without IRS consent, the corporation cannot elect S status again before its fifth taxable year beginning after the first taxable year the termination took effect (§ 1362(g)).
A QSST beneficiary who is not a US citizen or resident, or an election that never gets filed, can cause the same result.
Relief when a deadline is missed
The IRS can treat a corporation as having stayed an S corporation if the IRS determines the termination was inadvertent, steps were taken within a reasonable period after discovery to fix it, and the corporation and everyone who was a shareholder during the period agree to any adjustments the IRS requires (§ 1362(f)).
For late QSST and ESBT elections, Rev. Proc. 2013-30 offers a simplified route in place of a letter ruling, with no user fee. In general, relief must be requested within 3 years and 75 days after the intended effective date, the only problem must be that the election was filed late, the failure must have been inadvertent, and the parties must have acted diligently once it was found. The shareholders must state that they reported income consistently with S status (Rev. Proc. 2013-30, §§ 4.02, 6.01). Otherwise, the fallback is a letter ruling request (§ 3.02).
Pennsylvania follows the federal election
For tax years beginning after December 31, 2005, a corporation with a valid federal S election is automatically a Pennsylvania S corporation. One that wants out must file form REV-976, signed by all shareholders (PA Department of Revenue, Corporation Tax Bulletin 2008-01). The Department’s current S corporation guidance states the same rule.
What to do now
- Have your CPA confirm today’s shareholders of record, including any trusts.
- Decide in advance whether the trust that receives your shares is meant to be a QSST or an ESBT, and write the election deadline into the trustee’s instructions.
- Check that any shareholder or buy-sell agreement matches the plan.
For the wider picture, see our pages on estate planning for business owners and business succession planning, and our overview of trusts, including revocable trusts and irrevocable trusts.
Frequently asked questions
Can my revocable living trust own my S corporation shares?
Generally yes, during your life. A trust treated as wholly owned by one US citizen or resident is a permitted shareholder (§ 1361(c)(2)(A)(i)).
Who files the QSST election?
The beneficiary or the beneficiary’s legal representative, separately for each corporation (§ 1361(d)(2)). An ESBT election is filed by the trustee (§ 1361(e)(3)).
What if the election was never filed?
Relief may be available under § 1362(f). For a late QSST or ESBT election, Rev. Proc. 2013-30 offers a simplified procedure, generally within 3 years and 75 days of the intended effective date.
How we work with business owners
We review your shareholder records, trust documents and any shareholder agreement together, and work alongside your CPA so the trust, the elections and the returns line up.
Joseph F. Leeson III trained and practiced as a CPA before he practiced law, with four years in tax accounting. He holds a JD from Indiana University Maurer School of Law and an MBA in accounting from DeSales University. He was born and raised in Bethlehem.
Call 610-691-3350 or contact Leeson & Co. Before any work begins, we give you a written fee proposal.
This post explains general principles of federal and Pennsylvania tax law and is not legal or tax advice for your situation. Please speak to us and your CPA before acting on anything here.