Certain trusts are eligible to own an S corporation—but beware, restrictions apply.
An S corp. is a legal entity just like a C corporation, but it has several distinct advantages. An S corp. provides shareholders with limited liability protection, and it is not subject to double taxation because profits and losses are divided between the shareholders and reported on individual income tax returns.
An S corp. also has restrictions that do not apply to C corporations, including limits on who can own shares. If you manage a trust, an S corp. may be a good investment, provided that the trust can legally hold title to the company's shares.
Ownership Restrictions for S Corporations
The primary reason for ownership restrictions is to ensure that the business's generated income is reported to the International Revenue Service (IRS) each year. Because S corporations do not pay taxes on income generated by the company, individual owners must report the income on their tax returns. Only estates, individuals, and certain trusts can own shares in an S corp. Corporations, partnerships, and non-resident aliens cannot own stock.
Also, S corporations cannot have more than 100 shareholders. If the trust is a grantor trust, testamentary trust, qualified Subchapter S trust (QSST), revocable trust, or retirement account trust, the trust counts as one shareholder. However, the number of beneficiaries of an electing small business trust (ESBT) or voting trust are all counted as shareholders for an S corp.
If you fail to comply with these strict ownership rules, your S corp. will lose its tax advantages.
Grantor Trusts and Testamentary Trusts
By establishing a grantor trust, you retain control over the management of its assets. Grantor trusts may hold S corp. stock; however, careful planning is required to avoid causing the company to lose its status if you pass away or become incapacitated.
Under these circumstances, the trust becomes an irrevocable trust. An irrevocable trust is not permitted to own S corp. stock. The trust is given a two-year grace period after the grantor's death to distribute the stocks or elect to become a QSST or an ESBT. If the irrevocable trust holds the shares for longer than two years, the IRS revokes the S corp. status.
You can create a testamentary trust through a will. To do this, you simply direct that shares of an S corp. be transferred to a trust upon your death. However, like grantor trusts, testamentary trusts can only hold the shares for up to two years after the trustee's death without jeopardizing the S corp. status.
Qualified Sub-Chapter S Trusts
A QSST may hold stock in an S corp. provided it meets certain requirements. The trust must elect to become a QSST either within two and a half months of the beginning of the company's first taxable year or two and a half months after the trust becomes a shareholder.
In addition, the QSST must have only one beneficiary. This beneficiary must be a U.S. resident or citizen and must receive that stock if the trust terminates.
Again, if all requirements are not met, your S corp. can lose its tax status.
Electing Small Business Trusts
ESBTs can also hold shares of an S corp. with a few additional requirements:
- An ESBT must make the election within two and a half months of owning the stock or the company becoming an S corp.
- There may be more than one beneficiary, but all beneficiaries must be estates, individuals, or charitable organizations.
- None of the beneficiaries are permitted to purchase their interest in the trust.
- The ESBT is comprised of two trusts. The trust holding the S corp. shares is not a grantor trust. That trust is taxed and subject to different terms.
Certain trusts may own an S corporation, but the restrictions must be taken into account or your company risks losing the favored S corp. taxation status.
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