An S corporation is a business that elects to obtain a special tax status granted by the IRS. Most businesses that can be taxed as a corporation can apply to be taxed as a partnership, which is treated as a disregarded entity. Instead of the business paying taxes on its annual income, the profits and losses are divided among the shareholders to include on their personal returns. This enables the S-corp to avoid the “double-taxation” that a corporation faces. In exchange for these benefits, an S-corp is subject to several restrictions, including which entities can own shares in the business. Based on these restrictions, it is fair to question whether a trust can own S-corp shares.
Definition of Trusts
A trust is a legally distinct entity that manages assets for the benefit of select beneficiaries. The trust property is donated by a grantor, who determines who will benefit from the property and under what conditions. The grantor will also appoint a trustee. The trustee will legally “own” and manage the property on the beneficiaries' behalf. Trusts are generally used when beneficiaries are unable to manage the property on their own. While this is the basic form of a trust, there are many different types, with specific characteristics that set each apart.
S-Corp Ownership Restrictions
An S-corp is bound by two key ownership restrictions. First, an S-corp may have no more than 100 shareholders. Also, partnerships, corporations and non-resident aliens may not own stock in an S-corp. Individuals, estates and certain trusts may own shares in an S-corp, however. These restrictions on who can own S-corp stock are included to ensure the business’s income is taxed by the IRS the year it is earned.
Read More: S Corporation Restrictions
Types of Trusts
There are six types of permissible trusts under section 1361(c)(2) of the U.S. tax code, and additional permissible trusts defined by section 1361(d). The first type of trust is a grantor trust -- or, any trust in which the person who donated the property retains the ability to direct how the trust property is distributed. Revocable trusts and trusts created through a will can hold S-corp stock for up to two years after the grantor’s death without violating the IRS’s ownership restrictions. Two additional types of trusts that can own stock are Qualfied Sub-Chapter S Trusts (QSSTs) and Electing Small Business Trusts (ESBTs). Trusts that are used only to consolidate the voting power of the shares of multiple owners are also permissible. Finally, any retirement account held in trust by a bank or depository institution can hold S-corp stock.
Qualified Sub-Chapter S Trusts
A trust must elect to be a QSST either within two and a half months after the trust becomes a shareholder or two and a half months after the beginning of the S-corp’s first taxable year. To qualify, the trust can only have one beneficiary that benefits from the S-corp stock; if the trust terminates, that beneficiary must get all of the trust’s assets. This beneficiary must be either a citizen or resident of the United States. If the beneficiary does not meet the S-corp’s ownership restrictions, the business could lose its tax status.
Electing Small Business Trusts
To qualify as an ESBT, the beneficiaries cannot have bought their interest in the trust, and all of the beneficiaries must be individuals, estates or charitable organizations. Like a QSST, a trust must elect to be an ESBT within two and a half months of either the trust becoming a shareholder or the business becoming an S-corp. An ESBT is actually composed of two separate trusts -- one with the S-corp stock and the other containing any other assets. The S-corp trust is not a grantor trust and is taxed, subject to different rules regarding the trust.
Number of Shareholder Restriction
Regarding the 100 shareholder limitation, what constitutes a “shareholder” depends on the type of trust. For grantor trusts, revocable trusts, trusts created through a will, QSSTs and retirement account trusts, the trust only has one shareholder. For voting trusts and ESBTs, the number of beneficiaries of the trust equals the number of qualifying shareholders for the S-corp restriction test.
- Internal Revenue Service: S Corporations
- Raymond James & Associates: Trust Basics
- Internal Revenue Service: Instructions for Form 2553 – Election by a Small Business Corporation
- Oregon State Bar: Estate Planning with S Corporation Stock
- Internal Revenue Service: Abusive Trust Tax Evasion Schemes – Questions and Answers
- Legal Information Institute: US Tax Code 26 USC Sec. 1361 – S corporation defined
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.