Your Estate Plan Can Accidentally Break Your S Corporation

Estate planning for a business owner involves more than deciding who receives the company after death.

For an S corporation shareholder, the estate plan also needs to preserve the corporation’s federal tax status.

An S corporation can lose its tax status when stock passes to an ineligible shareholder or to a trust that fails to make the required election on time. That can turn the company into a C corporation for federal tax purposes, creating a tax problem that the family did not intend.

This means a provision that looks completely reasonable in a will or revocable trust can create a serious tax issue when the business owner dies.

The Estate Plan Must Account for the S Corporation Rules

An S corporation can have only certain types of shareholders. Eligible owners generally include U.S. citizens and residents, estates, and specifically permitted trusts.

Partnerships, corporations, nonresident aliens, and many ordinary trusts cannot own S corporation stock. A transfer to an ineligible shareholder can terminate the company’s S election and cause it to become taxable as a C corporation.

Consider a business owner whose estate plan leaves everything to a revocable living trust. During the owner’s lifetime, the trust is generally treated as a grantor trust, with the owner treated as owning the trust assets for federal income tax purposes.

That arrangement can be compatible with S corporation ownership while the owner is alive. The problem arises after death.

A trust that qualified as a grantor trust immediately before the owner’s death can generally continue holding S corporation stock for only two years following the owner’s death unless it qualifies under another permitted shareholder category.

Similarly, a trust receiving S corporation stock under the terms of a will generally receives only a two-year window.

The two-year period provides time to administer the estate and restructure ownership. It is not a permanent solution.

Before the period expires, the stock normally must be:

• Distributed to an eligible individual shareholder;
• Sold or redeemed under a buy-sell agreement;
• Transferred to another eligible owner; or
• Held in a trust that qualifies as a QSST, ESBT, grantor trust, or another permitted trust.

Failing to act before the deadline can terminate the S election.

The Estate Can Temporarily Hold the Shares

A deceased shareholder’s estate is an eligible S corporation shareholder. This gives the executor time to collect assets, resolve debts, address tax filings, and distribute the deceased owner’s property.

Unlike the special two-year rules for certain trusts, the estate itself does not have a fixed statutory ownership period.

That does not mean the estate should be kept open indefinitely just to hold S corporation shares.

Extended estate administration creates its own tax, legal, administrative, and family complications. The executor should use the administration period to implement the permanent ownership plan rather than treating the estate as the long-term shareholder.

Use a Buy-Sell Agreement to Control the Transfer

A properly drafted buy-sell agreement is one of the most effective ways to prevent an unwanted transfer of S corporation stock.

The agreement can restrict transfers to ineligible owners and establish what happens when a shareholder dies, becomes disabled, retires, divorces, files bankruptcy, or wants to leave the company.

Two common structures are redemption agreements and cross-purchase agreements.

Redemption Agreement

Under a redemption agreement, the corporation purchases the departing or deceased shareholder’s stock.

The agreement should establish:

• The events that trigger a redemption;
• How the company will be valued;
• How frequently the valuation will be updated;
• Whether payments will be made immediately or over time;
• How the purchase will be funded;
• Whether the corporation has the first right to purchase the shares; and
• What happens if the corporation cannot complete the purchase.

Life insurance is frequently used to fund a redemption after a shareholder’s death. Under this structure, the corporation commonly owns the policies, pays the premiums, and receives the death benefits.

The insurance arrangement must be coordinated with the redemption agreement, the company’s valuation, and the shareholder’s estate plan. Simply purchasing life insurance without coordinating the documents does not create a complete succession plan.

Cross-Purchase Agreement

Under a cross-purchase agreement, the remaining shareholders purchase the deceased owner’s shares.

In a traditional arrangement, the shareholders own life insurance policies on one another and use the proceeds to complete the purchase. This structure can provide the surviving shareholders with additional tax basis in the purchased shares, but it becomes more complicated as the number of owners grows.

A cross-purchase agreement should address:

• Which shareholders have the right or obligation to purchase;
• How ownership percentages will change;
• The valuation formula;
• Life insurance ownership;
• Premium payment responsibilities;
• What happens if insurance proceeds are insufficient;
• Whether installment payments are permitted; and
• What happens when a shareholder leaves for a reason other than death.

Whether a redemption or cross-purchase arrangement is better depends on the company’s ownership, available cash, insurance structure, estate tax exposure, and long-term succession objectives.

Grantor Trusts Can Hold S Corporation Stock

A grantor trust can be an eligible shareholder when the entire trust is treated as owned by a U.S. citizen or resident under the grantor trust rules. For S corporation purposes, the deemed owner is treated as the shareholder.

This is why a revocable living trust can generally own S corporation shares during the owner’s lifetime.

However, grantor trust status often changes at death. The estate plan cannot stop with the conclusion that the trust is eligible today. It must also address what happens when the current owner is no longer treated as the owner.

The trust agreement should provide a clear path for the shares after death, including distribution, redemption, sale, or qualification under another eligible trust structure.

Testamentary Trusts Provide Only Temporary Eligibility

A testamentary trust is created under a will or receives property pursuant to a will. When S corporation stock is transferred to this type of trust, the trust generally qualifies as a permitted shareholder for two years beginning on the date the stock is transferred to it.

This gives the family time to reorganize the ownership, but it creates a hard planning deadline.

A testamentary trust intended to hold the stock longer must qualify under another category, such as a Qualified Subchapter S Trust or Electing Small Business Trust. The required language and elections should be addressed before the original shareholder dies — not discovered during the final weeks of the two-year period.

Qualified Subchapter S Trusts

A Qualified Subchapter S Trust, commonly called a QSST, is designed to hold S corporation stock for one primary income beneficiary.

A QSST generally must meet the following requirements:

• It must have only one current income beneficiary during that beneficiary’s lifetime;
• All trust income must be distributed, or required to be distributed, currently to that beneficiary;
• Any principal distributed during the beneficiary’s lifetime can be distributed only to that beneficiary;
• The beneficiary’s income interest must end at the earlier of the beneficiary’s death or termination of the trust; and
• If the trust terminates during the beneficiary’s lifetime, the trust assets must be distributed to that beneficiary.

For S corporation purposes, the income beneficiary is generally treated as the owner of the portion of the trust holding the S corporation stock.

The beneficiary — not the trustee — makes the QSST election. A separate election is required for each S corporation owned by the trust.

Timing is critical. When S corporation stock is transferred to a trust that intends to qualify as a QSST, the election generally must be filed within the applicable two-month-and-16-day period.

A late or missed election can jeopardize the corporation’s S status. A QSST can work well when the estate plan is focused on one spouse, child, or other beneficiary. Its required income distributions and single-beneficiary structure, however, limit the trustee’s flexibility.

Electing Small Business Trusts

An Electing Small Business Trust, or ESBT, provides more flexibility than a QSST.

An ESBT can generally have multiple beneficiaries, including individuals, estates, and certain charitable organizations. The trustee makes the ESBT election, which continues for future years unless revoked with IRS consent.

An ESBT can be useful when the shareholder wants to:

• Benefit several children or grandchildren;
• Allow the trustee to accumulate income;
• Make discretionary distributions;
• Protect beneficiaries from creditors;
• Address beneficiaries with different financial needs; or
• Maintain centralized control over the S corporation stock.

The additional flexibility comes with a tax cost. The portion of the ESBT holding S corporation stock is treated as a separate trust, and its ordinary taxable income is generally taxed using the highest applicable trust income tax rate.

A QSST is often more income-tax efficient when its restrictions fit the family’s objectives. An ESBT is often more flexible when control, asset protection, and multiple beneficiaries are the priorities.

Voting Trusts Can Separate Control From Economic Ownership

A voting trust can allow voting authority to remain centralized while the economic benefits of the shares belong to other eligible owners.

For a voting trust to qualify under the S corporation rules, it generally must be created through a written agreement that:

• Delegates voting authority to one or more trustees;
• Requires distributions from the stock to be paid to the beneficial owners;
• Requires the stock to be delivered to the beneficial owners when the trust terminates; and
• Terminates on or before a specified date or event.

A voting trust can be valuable when several children inherit a business but only one child is actively involved in operations. The arrangement can centralize decision-making without eliminating the other beneficiaries’ financial interests.

The beneficial owners must still be eligible S corporation shareholders. A voting trust cannot be used to place shares indirectly in the hands of an otherwise ineligible owner.

The Documents Must Work Together

An S corporation succession plan rarely fails because the family had no documents. It often fails because the documents were created separately and do not work together.

The following documents and arrangements should be reviewed as one coordinated plan:

• The will;
• Revocable and irrevocable trusts;
• Corporate bylaws;
• Shareholder agreements;
• Buy-sell agreements;
• Life insurance policies;
• Beneficiary designations;
• Powers of attorney;
• Business valuation provisions;
• Employment agreements; and
• Any restrictions on transferring company stock.

Each document can appear reasonable when reviewed independently while producing a poor result when combined.

For example, a will may leave shares equally to three children while the shareholder agreement requires the corporation to redeem those shares.

A trust may give a trustee broad discretion to distribute principal to several beneficiaries while the family assumes the trust qualifies as a QSST.

A life insurance policy may be owned by the wrong party for the intended buyout structure.

A Practical Planning Checklist

Every S corporation shareholder should be able to answer these questions:

1. Who receives the shares when the owner dies?
2. Is that person or trust an eligible S corporation shareholder?
3. Does the estate plan depend on a temporary two-year eligibility period?
4. Who is responsible for monitoring the deadline?
5. Is a QSST or ESBT election required?
6. Who must make the election?
7. Does the trust contain the required language?
8. Does the company have a current buy-sell agreement?
9. How will the company be valued?
10. Is there sufficient liquidity to complete the purchase?
11. Are the life insurance policies owned by the correct parties?
12. Who will control the company immediately after death?
13. What happens if the beneficiaries disagree?
14. Have the CPA, estate planning attorney, insurance professional, and financial adviser reviewed the same plan?

These questions should be addressed while the shareholder is alive and able to make decisions. After death, the family is forced to work within documents and ownership structures that already exist.

Estate Planning for an S Corporation Requires Specialized Coordination

A standard estate plan is not automatically an S corporation estate plan.

Business owners need documents that preserve the S election, provide liquidity, maintain control, protect the family, and create a workable succession process.

That requires coordination between the business owner’s CPA and estate planning attorney.

The objective is not simply to transfer the shares. The objective is to transfer them to the right owner, under the right structure, without accidentally changing the tax treatment of the entire company.

Review the trust, shareholder agreement, buy-sell terms, valuation method, and life insurance ownership together. A technically valid document can still produce an unintended result when it conflicts with the rest of the succession plan.