Many small-business owners own their businesses through a business entity, like a corporation or limited liability company (LLC). And many have chosen to have their business entity taxed as an S corporation. Most likely chose this tax treatment because it offered income-tax advantages to them during their lives, without any thought to how that choice might affect their estate plan. There’s nothing wrong with that, but it is important to understand what estate-planning effects that choice can have. This post explains just that.

S Corporations: Requirements and Advantages

But first, what is an S corporation? Contrary to a popular misconception, the term “S corporation” refers to a type of income taxation, not a type of business entity. For example, many LLCs are taxed as S corporations, even though LLCs are not technically corporations. To qualify for taxation as an S corporation, a business entity must meet certain requirements. Generally speaking, the business entity must have only one class of stock, no more than 100 owners, and those owners must be natural persons who are U.S. citizens or resident aliens. I’ll return to the natural-person requirement momentarily, but let’s look at the advantages of choosing taxation as an S corporation first.

S corporations offer three advantages to small-business owners. First, unlike entities taxed as C corporations, the income of an S corporation is not taxed at the entity level. Instead, it’s “passed through” to the owners, regardless of whether the entity distributes money to the owners. That means the owners recognize, and pay tax on, the entity’s income in proportion to their ownership interests in the entity. Second, also unlike C corporations, the owners of an S corporation are not taxed on distributions from the entity. That’s because they were already taxed when the entity earned the income. Finally, S corporation income is not subject to self-employment taxes, unlike income earned by entities taxed as partnerships or disregarded for tax purposes. However, to prevent abuse of this last advantage, the IRS requires that owners who work for their own S corporation receive reasonable compensation for that work. The compensation will be in the form of wages, which are subject to FICA taxes. Still, taxing a business entity as an S corporation can be an attractive choice for small-business owners because of these advantages. But how does that choice affect estate planning?

S Corporations and Estate Planning

As I mentioned earlier, to qualify as an S corporation, a business entity must generally have owners who are all natural persons (i.e., individuals). However, there are some exceptions to that rule. Living trusts are an important one. Because living trusts are ignored by the IRS for income-tax purposes, a person can hold his or her S corporation stock in a living trust. After the grantor’s death, however, the trust can only continue to own the stock for a period of two years, unless it qualifies as an electing small business trust (ESBT) or a qualified subchapter S trust (QSST).

An ESBT is a trust in which the beneficiaries are all individuals, estates, and certain kinds of organizations, and no interest in which was acquired by purchase. If those requirements are met, the trustee can elect to treat the trust as an ESBT. But the advantage of holding the S corporation stock in an ESBT is offset by increased taxes due on the S corporation income “passed through” to the trust.

A QSST is a trust that has certain terms included in it. Specifically, the trust can only have one income beneficiary, and that person is the only person who can receive distributions of trust principal during his or her life. In addition, all the income of the trust must be distributed to the beneficiary at least annually. The beneficiary of a trust with those terms can elect to have the trust treated as a QSST. In that case, the S corporation income is taxed to the trust beneficiary, not the trust.

These explanations only scratch the surface of the requirements for, and taxation of, trusts that can hold interests in S corporations. The bottom line is what it usually is: You need to have a plan. If you own a business entity taxed as an S corporation, you need to be careful to design your estate plan around the special requirements that come with that ownership. There are a few different ways of doing that, all of which I will be happy to discuss with you when you contact me.