Transferring S Corporation Stock into a Living Trust

An S corporation (S Corp) is a type of corporation that meets specific Internal Revenue Code requirements, offering the benefits of pass-through taxation to its shareholders. This means profits and losses can be passed through directly to shareholders’ personal income without being subject to corporate tax rates.

There are two types of trusts that can own S corporation stock:

1. Electing small business trusts (ESBT)
2. Qualified subchapter S trusts (QSST)

A living trust can own S corporation stock if it meets specific conditions set forth by the IRS. The trust must be a grantor trust, meaning the person who created the trust is considered the owner of the trust’s assets for income tax purposes. The trust must also comply with IRS rules for S corporation ownership, which are designed to ensure that the number and type of shareholders meet certain criteria.

An owner of a small, family business taxable as an S Corp typically wants to own their stock in a living trust so that the stock will pass to their heirs without probate. A prolonged probate proceeding may substantially interfere with a smooth business continuation after the owner’s death.

Your living trust can own S Corp stock during your lifetime because the IRS considers you, individually, to be the stock owner for tax purposes. But, there are income tax issues when your living trust becomes irrevocable after your death.

ESBT

An Electing Small Business Trust (ESBT) is a special type of trust permitted to hold S corporation stock, allowing the income generated by the S corporation to be taxed at the trust level rather than passing through to individual beneficiaries. This arrangement provides flexibility in estate planning and the distribution of income to beneficiaries, while still respecting the S corporation’s eligibility criteria and avoiding corporate taxation levels.

Under IRS rules, the trust’s beneficiaries must be individuals, estates, or certain charitable organizations that could be S corporation shareholders. The trust must elect ESBT status with the IRS, and it is subject to a special tax regime where the S corporation income is taxed at the trust level, regardless of whether it’s distributed to beneficiaries.

QSST

A Qualified Subchapter S Trust (QSST) is a trust that meets specific IRS requirements to hold S corporation stock. It requires that all income attributable to the S corporation shares be distributed to a single beneficiary, who is taxed on this income.

To qualify as a QSST, a trust must ensure that there is only one income beneficiary, who must receive all income from the trust annually. Additionally, the trust’s income must be taxable to that beneficiary, and the trust must make an election to be considered a QSST with the IRS.