Articles

Estate Planning after the 2004 Tax Act Is Easier for Subchapter S Stock Interests Placed in Trusts

Glenn A. Henkel, JD, LLM, CPA

Printed with permission of Society of Financial Service Professionals

Professional advisers are often con-fronted with the question, "What form of entity should I use for my business operation?" In the closely held business context, there often appear to be two predominant choices—the LLC (limit­ed-liability company) or the S corpora­tion. Both of these choices provide the owner with individual protection from the claims against the entity. Further, each of these entities uses the "aggre­gate" approach to income taxation rather than the "entity" approach. In other words, rather than imposing an income tax on the entity income, the earnings are allocated to the owners on a percentage basis (as an "aggregate" of taxpayers). The income and deductions "flow through" to the owners for report­ing on their individual returns rather than imposing tax on the entity itself. This "pass-through" approach often results in a lower tax bill to the owners, and the pass-through entity routinely becomes the preferred choice.

For the adviser considering the estate plan, whether to recommend an LLC or S corporation often results in a recom­mendation to use an LLC. However, often little consideration is given to the estate plan of the owner in making the choice. Some clients are forced to oper­ate in an S corporation form because the business was formerly operating in corpo­rate solution. However, for new entities, the decision of LLC or S corporation is usually centered on income tax issues such as Social Security, the adviser's preference of filing Form 1120S over Form 1065, or other concerns. Before the passage of the American Jobs Creation Act (AJCA) of 2004, placing Subchap­ter S stock into a trust would result in difficult issues for the entity, as the per­mitted owners of S stock are limited by the tax code. By contrast, an LLC can be held in trust without similar concerns.

While there can be some issues sur­rounding the holding of an LLC interest in a trust, they pale by comparison to the issues for a shareholder of S corporation stock. Most importantly, if there is an improper transfer to a trust by an S cor­poration shareholder, not only could it adversely affect the donor shareholder, but it could adversely affect the other shareholders. With an S corporation, the S election is lost to the entity if the S sta­tus of the corporation is lost. The loss of the S status to the corporation can be the result of an inappropriate transfer, even if it represents only a small part of the cor­poration stock. Further, unless there is a corporate shareholder agreement, all shareholders can transfer their S stock to whomever they choose.

In order to "elect" treatment as an S corporation, the requirements of IRC Sec. 1361(b)(1) must be met for the entity to qualify as a small-business corporation. Two of the statutory requirements were recently relaxed by the AJCA of 2004. First, effective for years beginning after December 31, 2004, the previous limita­tion on the maximum of 75 shareholders was increased to 100 shareholders and, more importantly, all family members are treated as one shareholder. Thus, the insertion of multiple family members does not create any jeopardy to the S status. Second, the type of trusts permitted as shareholders has been increased.

For a trust to be a permitted shareholder, there are generally five separate choices. First, a trust can be a shareholder if the trust is a "grantor trust." Second, if the trust is merely designed to hold the stock for voting purposes, the trust is a permit­ted Subchapter S shareholder. Third, the Code allows a trust to be a shareholder if it qualifies as an electing small-business trust. A qualified Subchapter S trust is treated as a grantor trust for these purposes and is a permitted S shareholder. Finally, a Section 678 trust (by reference to IRC Sec. 678) is likewise treated as a grantor trust and is a permitted S shareholder.

One of the trusts commonly consid­ered in the estate planning context is the electing small-business trust (ESBT). The ESBT is a trust defined in IRC Sec. 1361(e) and is the result of criticism of earlier rules that made it difficult for many trusts to hold S stock. Before 1996, trusts could only qualify if there was one beneficiary. This tension for trusts was resolved in 1996 for ESBTs that "sprin­kle" income and principal among a num­ber of potential current beneficiaries (PCBs). All of the so-called PCBs are "counted" as shareholders for purposes of the 100 shareholder maximum. Thus a trust with many beneficiaries could be a problem for S status of the corporation. There are a number of requirements to qualify as an ESBT.

While an ESBT is an important plan­ning tool, many families choose to avoid ESBT status. An ESBT is subject to income tax at the highest marginal tax rate allowed. This tax is imposed at the ESBT level, and no deduction for distribu­tion of income to a beneficiary is permit­ted. From a practical standpoint, most tax-payers will choose to create a grantor trust or qualified Subchapter S trust if they can.

One of the confusing issues before the AJCA of 2004 on the use of an ESBT concerned the use of a power of appoint­ment, which is a right, exercisable in a nonfiduciary capacity, to distribute the trust assets. The AJCA of 2004 allows the trust to contain the power, and the class of permitted donees is ignored until the power is exercised. Also, to the extent that an ineligible shareholder becomes a trust beneficiary, the trustee will now have one year to rectify the situation.

The easing ofthis rule will be signifi­cant because some estate planners like to provide broad powers of appointment for the flexibility they provide. Even if the power allows someone to gift the trust assets to anyone other than "himself, his estate, his creditors, or the creditors of his estate," the trust assets are excluded from the taxable estate of the holder. This would allow for the trust to hold the stock in an ESBT without substantially limiting the number of people that can ultimately get the stock.

As a result of the AJCA of 2004, the ability to transfer Subchapter S stock among family members is eased. Further, as a result of the change to the ESBT provisions, a power of appointment in a trust is not considered until the power is exercised. Therefore, more trusts will qualify as ESBTs and more businesses that have shares held by trusts will quali­fy for Subchapter S status. These devel­opments will allow an estate planning adviser to more easily choose the S cor­poration as a business entity choice but, unless there are other reasons to use an S corporation, an LLC may still be a better alternative. Remember, none of the fore-going Subchapter S stock restrictions apply to the LLC.

Glenn A. Henkel, JD, LLM, CPA is an attorney practicing with Kulzer & DiPadova, P.A., based in Haddonfield, N.J., and is past chair of the New Jersey State Bar Association Real Property, Probate, and Trust Law Section.

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