There are a number of restrictions limiting who can be an S Corporation shareholder. One of the broad restrictions is that the S Corporation shareholder must be living. There are, however, two exceptions. The first is that the estate of a deceased shareholder can continue ownership after the shareholder's death. The second is that certain trusts may qualify. Qualifying trusts include: 1) a trust that in its entirety is a grantor trust or a trust that distributes or makes available all of its income to its sole beneficiary who is treated as the owner of the trust under IRC Sec. 678; 2) a trust created primarily as a voting trust; 3) a trust with respect to stock transferred to it under the terms of a will, but only for 60 days beginning with the date of the transfer; 4) a trust that previously was a grantor or Sec. 678 trust and that continues after the deemed owner's death, but only for 60 days after his or her death two years if the trust's entire corpus was included in the gross estate); and 5) what is discussed in this article, a qualified Subchapter S trust" (QSST).

What sets the QSST apart from the other trusts mentioned is that the beneficiary of the QSST is generally someone other than the grantor or his or her estate. By using the QSST the grantor/shareholder can make a gift of part or all of the S Corporation stock so the beneficiary can enjoy the income therefrom, while voting power is in the hands of the grantor-appointed trustee.

What Exactly is a QSST?

A QSST is a trust which by the terms of its governing document: 1) distributes, or is required to distribute, all of its current income to its sole income beneficiary who must be a U.S. citizen or resident; 2) requires that during the life of the current income beneficiary there will be only one income beneficiary; 3) requires that any corpus which may be distributed during the life of the income beneficiary be distributed only to the current income beneficiary; 4) requires that the income interest of the current income beneficiary terminates on the earlier of the death of the income beneficiary or the termination of the trust; and 5) requires that upon termination of the trust during the life of the income beneficiary all corpus and income must be distributed to that beneficiary. le in tax

As with almost any rule in tax law, there are exceptions. The exceptions to the sole beneficiary requirement are twofold. First, under Sec. 663(c) shares in a single trust which are substantially separate and independent, as though separate trusts had been created, are treated as separated trusts and thus qualify to be QSSTs. Care is advised here as each separate trust represented by a share in a single trust is treated as one shareholder in applying the maximum 35 shareholder limit to retain S Corporation status. Second, successive income beneficiaries are permitted, but there may be only one current income beneficiary at a time. Extreme care is the watchword here-a successor beneficiary can revoke the Sec. 1361(d)(2) election (discussed below) which would void the "S" status of the corporation.

A Word of Caution

Once the S Corporation shares have been transferred to the trustee and are in the name of a trust in which the beneficiary election (detailed below) required to be a QSST has been filed, the requirements to retain the QSST status must be carefully adhered to. Should the QSST lose this status, the S Corporation will lose its tax preferred status as well. The trust will cease to be a QSST as of the first day of the taxable year immediately after the taxable year in which the income distribution requirement is not met.

In addition to the trust meeting all of the requirements, the beneficiary must file an election under Sec. 1361(d)(2) for the trust to be regarded as a QSST. Reg. Sec. 18-1361-1(a) states that the current income beneficiary, or his or her legal representative, must file the election with the service center where the corporation files (or will file) its income tax return within 61 days of the date on which the stock was transferred to the trust or within 61 days of the taxable year to which the election applies, whichever is later. The later will generally be the first S Corporation tax year. This regulation also states that the beneficiary's election must be filed after the corporation has filed its election to be treated as an S Corporation. This can play havoc with the 15th day of the third month filing deadline for "S" elections as the general deadline is greater than 61 days. The S" election should be decided upon and implemented quickly so that there is time for the beneficiary to file his or her election within the beneficiary's 61day deadline. If the S" election is filed timely (by the 15th day of the third month) but after the beneficiary's election, the S" election will be void for having a disqualified shareholder and another year will pass before "S" status can be elected.

Two Methods to Elect

There are two methods of making the beneficiary's election. If the stock in the corporation was transferred to the trust on or before the date the corporation filed its "S" election and both trust and corporation elections will have the same effective date, Part HI of federal Form 2553, Election by a Small Business Corporation, should be signed and filed by the current income beneficiary. When this is not the case (i.e., an S Corporation shareholder makes a gift of stock after the corporation has been an S Corporation for a number of years) an election must be filed by the beneficiary signing a statement which: 1) states the name, address and taxpayer identification number of the current income beneficiary, the trust and the corporation; 2) identifies the election under Sec. 1361(d)(2); 3) specifies the date on which the election is to become effective; and 4) provides information sufficient to show that the current income beneficiary is entitled to make the election (a copy of the trust instrument serves nicely). NOTE: A separate election must be filed for each S Corporation in which the trust is a shareholder.

After the trust is in place and all elections have been filed, the yearly trust income tax returns will have to be prepared on federal Form 1041 and any applicable state forms. The S Corporation income allocated to the trust is passed through to the current income beneficiary almost as though there was no trust at all. This is an important point especially if the S Corporation sustains a loss from "passive activities." In the case of a typical simple trust, any net passive activity loss is used to offset other trust income, if the transition rules apply (i.e., percentage phaseouts for activities started prior to October 23, 1986), while any unused loss is suspended in the trust pending future passive activity income. Since the purpose of the QSST is to effectively treat the current income beneficiary as the owner of the S Corporation stock, a net passive activity loss from the S Corporation to the QSST should be passed through to the current income beneficiary who will then apply the passive activity rules to his or her own particular situation.

S Corporations are very popular today due to the tax savings resulting from the lower individual tax rates compared to corporate tax rates. Additional income tax savings to the family as a whole, as well as estate tax savings can be achieved through the use of the QSST. As noted by the cautions above, care in the use of the QSST must be exercised and professional guidance is essential.

Dan A. Diers