How trusts hold family business interests

Grantor trusts holding S corporation stock

A nonforeign trust may hold S corporation stock without a QSST or ESBT election if the entire trust is treated under the grantor trust rules as owned by one individual who is a U.S. citizen or resident.

The deemed owner counts as the shareholder. Grantor trust status alone does not establish eligibility without those ownership and citizenship or residency conditions.

Temporary eligibility after death

A nonforeign trust meeting those grantor trust conditions immediately before its deemed owner's death, and continuing afterward, qualifies for two years beginning on the death date. The deemed owner's estate counts as shareholder during that period.

For a nonforeign trust receiving stock under a will, temporary eligibility instead lasts two years beginning when the stock is transferred. The testator's estate counts as shareholder during that period.

These are temporary categories, rather than permanent eligibility.

The QSST alternative

A qualified subchapter S trust, or QSST, is another eligible structure when a nonforeign trust meets all the following conditions and the beneficiary or legal representative makes a separate election for each corporation.

• All trust accounting income is distributed, or required to be distributed, currently to one individual who is a U.S. citizen or resident.
• The trust terms permit only one income beneficiary during that beneficiary's life.
• Any principal distributed during that life may go only to that beneficiary.
• The income interest ends at the earlier of the beneficiary's death or termination of the trust.
• If the trust terminates during the beneficiary's life, all its assets must go to that beneficiary.

Spouses who both qualify as U.S. citizens or residents and file jointly count as one beneficiary and must act jointly. A distribution satisfying the grantor's legal support obligation disqualifies the trust.

The beneficiary is treated as owner of the trust portion consisting of S corporation stock covered by the election.

The ESBT alternative

An electing small business trust, or ESBT, offers another structure if its beneficiaries meet the permitted categories, no beneficial interest was acquired by purchase, and the trustee makes a timely election.

Permitted beneficiaries are individuals, estates, and organizations described in section 170(c)(2) through (5). Organizations described in section 170(c)(1) qualify only with contingent interests and without being potential current beneficiaries.

Foreign trusts, tax exempt trusts, charitable remainder trusts, and trusts with an effective QSST election are excluded. Nonresident aliens may be beneficiaries and potential current beneficiaries.

A potential current beneficiary is generally someone entitled to receive income or principal, or who may receive it at someone's discretion. An unexercised power of appointment is disregarded when determining that status.

Potential current beneficiaries generally count as shareholders. If none exist, the trust counts as shareholder.

If the trust disposes of all its stock in a corporation, someone first becoming a potential current beneficiary within the preceding year is excluded from that corporation's shareholder count.

The consequence of losing eligibility

An ineligible trust shareholder can terminate S status from the date the corporation ceases to qualify as a small business corporation.

Inadvertent termination relief requires an IRS determination of inadvertence, corrective steps within a reasonable period after discovery, and agreement by the corporation and every affected shareholder to IRS required adjustments.

Relief covers the period specified by the IRS and is not automatic.

LLC distributions and management rights

In Minnesota, for example, transferring an LLC transferable interest gives the transferee the transferred distribution rights without itself giving management or ordinary information rights, subject to the charging order provision. Other states differ.

The company need not recognize the transferee's rights until notified of the transfer. During dissolution and winding up, the transferee is entitled to an account only from the dissolution date.

A transfer violating an operating agreement restriction is ineffective against a person who had notice of that restriction when the transfer occurred.

Except under the statutory dissociation provision identified in Sources, the transferor retains the other member rights and all member duties and obligations.

Trustee voting and business control

In Oregon, trustees voting corporate shares or exercising control over comparable business interests must act in beneficiaries' best interests. If the trust owns a business entity, trustees must elect or appoint directors or managers who will manage in those interests.

Other states differ.

Two related terms

A perspective on trust between people

As you consider the people involved in the family company's future, this talk offers a perspective on reliability in business relationships.

"people want to have put their guards down be able to trust you're going to do what you say you're going to do to do business together so much of business is just trying to figure out is this going to waste my time is this worth it is there really value here for the money"

Common questions