What Are Qualified Subchapter S Trusts and Electing Small Business Trusts?
Qualified Subchapter S trusts and Electing Small Business trusts allow a grantor (the person who created a trust)to transfer shares he or she owns in a small business corporation into a trust. Both of these trusts must meet specific requirements regarding income beneficiaries and distribution. Both qualified Subchapter S trusts and Electing Small Business trusts must notify the IRS in a timely manner in order to own shares in a small business (or subchapter S) corporation.
Qualified Subchapter S Trusts (QSST): The role of the income beneficiary
In a Subchapter S corporation, the shareholders pay the income tax on income the corporation earns, not the corporation. The corporate income tax return (Form 1120S, U.S. Income Tax Return for an S Corporation) shows all the income for the year, and then splits it among all the shareholders. Each shareholder then declares his or her portion of the income on Form 1040.
In order for a trust to be a qualified shareholder (or qualified QSST), it must meet the following conditions:
The Subchapter S income must be distributed 100 percent to the trust’s income beneficiary because the income must be declared on that individual’s tax returns, not trust tax returns. Or if the trust is a grantor trust and doesn’t have a separate tax return, the grantor declares all items of income on his or her Form 1040.
The trust may only have one income beneficiary during the lifetime of that beneficiary. The beneficiary must be a U.S. citizen or resident. If the trust beneficiary is a nonresident alien (a citizen of another country who doesn’t live in the U.S.) or a corporation, that trust can’t be a QSST.
One trust instrument may create multiple QSSTs. If a trust instrument creates these so-called separate shares, each of the shares may qualify as Subchapter S shareholders, provided that the income beneficiaries fulfill the other requirements for S shareholders.
You have to let the IRS know that the trust and beneficiaries are qualified S shareholders. QSST elections generally must be filed with the IRS 2-1/2 months after the S corporation’s year-end. Failure to file jeopardizes the trust’s election. Additionally, if an S corporation has even one disqualified shareholder it could lose its S corporation designation entirely resulting in double taxation.
Electing Small Business Trusts (ESBT): Multiple income beneficiaries
Unlike QSSTs, Electing Small Business trusts are allowed to have multiple income beneficiaries, and the trust doesn’t have to distribute all income. Instead, in an ESBT, the following apply:
All beneficiaries must be individuals, estates, or charitable organizations.
The S stock may not be purchased by the trust.
The trust may not be a QSST or a tax-exempt trust.
Each potential income beneficiary counts towards the total allowable number of shareholders any S corporation may have.
In an ESBT, the trustee (not the beneficiary) makes the election, notifying the IRS of the name, address, and TIN for each trust beneficiary. Usually, you must file ESBT elections within 2-1/2 months of the corporation’s year-end.
Dealing with QSSTs and ESBTs can be tricky, so you should seek professional advice when filing elections. Making a mistake here jeopardizes not only the status of the trust’s election but also the corporation’s S election.