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The Small
Business Job Protection Act of 1996 (the "1996
Act") contained the most extensive group of amendments
to the S corporation rules since the Subchapter S Revision
Act of 1982. One of the most significant amendments,
and one which most taxpayers have failed to take advantage
of, is the addition of the "electing small business trust" (ESBT)
to the list of permitted shareholders of an S corporation.
Prior to the 1996 Act, only four types of trusts were
permitted to be shareholders in an S corporation: (1)
Grantor Trusts, (2) Qualified Subchapter S Trusts ("QSSTs"),
(3) Certain Testamentary Trusts, and (4) Voting Trusts.
Of these alternatives, only the QSST has the potential
to be a legitimate estate planning vehicle. However,
the QSST has two primary drawbacks that discourage its
use. The first drawback is that only a single beneficiary
is permitted. This prevents the ability to allocate income
or principal unequally among family members with different
needs. The second drawback is that all QSST accounting
income must be distributed to the current income beneficiary
annually (i.e., the trust cannot accumulate cash). This
requirement may place a family member who is a minor,
has credit problems, has a disability, or who is in a
divorce situation in the position of receiving income
at an inappropriate time.
The ESBT is intended to facilitate family financial
planning by eliminating some of the deficiencies inherent
in the QSST. The ESBT allows the use of a single trust
with multiple potential current beneficiaries, such as
the grantor’s children and spouse or other relatives.
Unlike the QSST, the current distribution of all income
is not required in an ESBT. In addition, remainder beneficiaries
can be different from the income beneficiaries, and can
also include charities. Only individuals, estates, and
certain charities are eligible beneficiaries of ESBTs,
and no beneficiary can acquire its interest by purchase.
Although the ESBT provides a much needed estate planning
alternative in the S corporation area, the taxation of
ESBT income may be viewed as the only disadvantage of
using an ESBT. For income tax purposes, the ESBT is effectively
divided into a "corporate trust" containing the S corporation’s
stock, and the "remainder" of the trust containing all
other assets. Even though the entire trust must qualify
to be an ESBT, only that portion of the trust consisting
of the S corporation’s stock is subject to special
tax treatment under new Section 641(d) of the Code. The
portion of the ESBT which holds the S corporation’s
stock pays tax on the resulting taxable income at the
highest individual tax rate, subject to the limitation
on rates for capital gains.
Despite the additional tax that can result from the
use of an ESBT, the added estate planning flexibility
and options presented by the ESBT can easily outweigh
the additional tax cost. In addition, there is no additional
tax cost in situations where the current individual shareholders
are already paying tax at the highest individual tax
rate. If this is the situation, most estate plans that
involve a family-owned S corporation could be improved
by the addition of an ESBT.
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