Is Your Estate Plan Jeopardizing your S-Corporation?

Many of us are familiar with the basic S-corporation mantra – avoid the so-called double taxation of regular C-corporations, all while maintaining the limited liability and practical advantages of a corporation. While many business owners engage in detailed planning to ensure compliance with Subchapter S of the Internal Revenue Code in order to maximize the tax benefits of being an S-corporation, the same level of diligence is often ignored when it comes to that business owner’s personal estate plan, and ultimately, their business succession plan.

For a corporation to maintain its S-corporation eligibility, it must have fewer than 100 total shareholders, all of which must be individuals, estates, certain types of trusts, or certain tax-exempt organizations. Today, often with the best intentions, business owners are executing wills or trusts as part of their estate plan, but without giving any thought as to whether their trust qualifies as a permissible S-corporation shareholder.

A permissible shareholder trust may include voting trusts, grantor trusts (including for up to 2-years following your death), testamentary trusts receiving the S-corporation stock by way of your will, qualified subchapter S trusts and electing small business trusts. In the most common scenario, in order for a grantor trust, such as a joint revocable trust, to remain an S-corporation shareholder, the trust should allow for the distribution of the S-corporation stock to a permissible shareholder within two years after your death. Following that 2-year period, other planning techniques may be implemented by your attorney or CPA to protect permissible S-corporation status.

It’s a shame to see clients invest significant time, expertise and resources into maximizing the tax benefits of their S-election, only to see it squandered by a lack of cohesion with their personal estate plan. As outlined by Sydney and Judith Traum in their S Corporation Answer Book, here are some simple provisions you should consider implementing in your trust to ensure your efforts are not wasted:

  • A provision requiring the personal representative to comply with the terms of any shareholders’ or buy-sell agreement that may have been entered into by the shareholder before his or her death;
  • Provisions preventing S-corporation shares from being distributed to a nonqualified shareholder;
  • Provisions preventing the distribution of shares to a trust that does not qualify as an S-corporation shareholder, and authorizing placement of the shares in a separate trust for the same beneficiary with provisions that qualify the trust as a shareholder of S-corporation stock;
  • Provisions authorizing the fiduciary/trustee to distribute the stock to a qualified shareholder instead of holding it in a trust that will not qualify as an S-corporation shareholder;
  • Provisions permitting the fiduciary/trustee to sell the S-corporation stock to a qualified shareholder instead of holding it in a trust that will not qualify as an S-corporation shareholder;
  • Provisions authorizing the fiduciary/trustee to amend the provisions of any trust holding S-corporation stock to permit the trust to qualify as an S-corporation shareholder; and
  • Provisions authorizing a trustee to make an ESBT election.

As you consider implementing such provisions designed to facilitate the ongoing maintenance of your S-corporation, and the ongoing qualification of your trust and/or your beneficiaries as permissible S-corporation shareholders, the result may be that your S-corporation stock will represent a substantial portion of the total assets/investments owned by your trust after your death. Accordingly, it may be wise to consider whether a trustee’s historical duty to diversify trust assets and investments is at odds with continuing to hold a single asset as such a large percentage of your overall estate.

To protect against any such potential conflict, consider adding a section to your trust authorizing and directing your trustee to retain such business interest, and indeed, to maintain the S-corporation nature thereof. Specific direction in this regard may help the trustee avoid a claim that the trustee has breached its fiduciary duties to the trust and the beneficiaries by failing to diversify the trust assets.

By giving some thought to these post-death provisions of your estate plan, you will ensure that your company, and the next generation of shareholders, are well-positioned to continue to enjoy the tax benefits of your S-corporation in the future.

This article was published in the June 2015 edition of The Business News.