An S corporation is a corporation that meets several restrictions and elects to be taxed as a partnership. One of the restrictions deals with who can be a shareholder in an S corporation. Most trusts are not permitted to be shareholders of an S corporation, but there are a few exceptions. If a nonqualified trust acquires S corp stock, the S corporation immediately loses is special tax status.
Grantor trusts owned by a U.S. citizen or U.S. resident are permissible owners of S corp stock as long as the assets of the grantor trust, including any S corp stock, are treated as owned by the grantor. After the grantor's death, the trust is still an eligible S corp shareholder for up to two years. A grantor trust is a trust that the person who puts money or other assets in the trust maintains control over. As a result, the grantor is responsible for paying any resulting income taxes, rather than the trust's having to pay taxes.
Qualified Subchapter S Trusts
A qualified subchapter S trust may also own stock without jeopardizing the S corp status. To qualify, the trust must be a domestic trust and have only one beneficiary; the distributions of principal can only be made to that beneficiary; the beneficiary's interest in the trust must cease when the beneficiary dies or the trust is terminated; and if the trust is terminated during the beneficiary's lifetime, all of the trust assets must be given to the beneficiary. A qualified domestic trust is one which has at least one trustee who is a U.S. citizen or a U.S. corporation and which empowers that trustee to withhold income tax from any distributions. (26 USC 2056A) In addition, the trust must treat all income as being distributed to the beneficiary each year. For example, if the S corporation generates $50,000 of taxable income, the beneficiary must be treated as having received that $50,000 for tax purposes.
Electing Small Business Trusts
An electing small business trust (ESBT) is also permitted to own stock in an S corporation. An ESBT is less restrictive than a qualified subchapter S trust because even though it must still be a domestic trust, it can have multiple beneficiaries. However, all of the beneficiaries must be eligible to hold S corp stock in their own capacity, which includes U.S. citizens, U.S. residents and qualifying nonprofit organizations. The downside to using an ESBT is that the income is taxed at the highest marginal rate rather than the beneficiary's tax rate, which could be lower.
Sometimes, owners will pool their S corp stock and designate a trustee to vote on their behalf. However, the individual owners still are responsible for any taxes on the income generated by the stock. The voting trust is qualified to own S corp stock if the trust is created with a written agreement that delegates the right to vote to one or more trustees, requires the distributions from the S corp to be paid to the beneficial shareholders, requires that the stock ownership be returned to the original shareholders when the trust terminates, and sets a termination date or event for the trust.