Posted by Stephenie Truong and John Reich
An Electing Small Business Trust (ESBT) can be useful to business owners who want to begin passing their S Corporation onto children or other beneficiaries. This irrevocable trust, which has the somewhat unique ability to hold S Corporation stock, offers not only estate planning opportunities, but also tax flexibility, continuity of ownership and another layer of asset protection for small businesses structured in this manner.
Shareholders of an S Corporation are usually limited to individuals, certain charitable entities or estates, but specific types of trusts are also allowed to own shares. As mentioned, an ESBT is one of them. An ESBT allows a business owner to transfer their ownership interest, or stock, to the trust, while still maintaining continuity of and control over the business. As such, and ESBT can help facilitate a smooth transition of ownership while it minimizes gift and estate taxes for owners. Note an ESBT is not allowed to purchase the shares of stock itself; the grantor must gift shares to the trust.
When deciding on a type of trust to hold S Corporation stock, it’s important to carefully consider the benefits and drawbacks of an ESBT.
The primary benefit when compared to other types of trusts is that an ESBT is allowed to distribute income to multiple beneficiaries. While other types of trusts automatically treat the sole beneficiary of the trust as the owner of the S Corporation, the terms of the ESBT’s trust agreement will determine how those beneficiaries are treated as stock owners. The ESBT also is not required to distribute all its income in the current tax year.
However, the ordinary income and capital gains attributable to the S Corporation income are taxed at the highest federal ordinary and capital gains rates. Depending on the income brackets of the beneficiaries, this could be inefficient from a tax perspective. Since income is recognized at the trust level, the ESBT does not receive a deduction for the distribution. That means the distribution of income is not subject to tax when it is distributed to the beneficiaries.
Additionally, be aware that income tax returns for an ESBT will be complex, as its income is broken into two portions (the S Corporation portion, and the non-S portion). The income attributed to the S-portion of the trust is taxed to the trust and subject to tax on its ordinary income at the highest federal tax rate. Net capital gains are also taxed at the highest federal capital gains rate. As mentioned, the S-portion of income does not allow a deduction for the distribution of income.
Another type of trust frequently compared to an ESBT is a Qualified Subchapter S Trust (QSST), so it’s important to mention within the ESBT discussion. There are considerable differences between the two trusts to evaluate during the estate planning process. The most significant relate to the distribution of income and the number of beneficiaries each trust allows. In terms of income distribution, the QSST is required to distribute all its ordinary income each year to the beneficiary, leading to the income being reported on the beneficiary’s return. The ESBT does not have to distribute all its income annually, helping minimize tax for its beneficiaries. Additionally, a QSST is limited to only one lifetime beneficiary, while an ESBT can have multiple. It’s also important to note it is possible to make an election to convert a QSST to an ESBT, if desired.
Deciding if an ESBT is right for your overall tax situation is a complex matter. It can, however, prove useful to business owners looking to plan for the next generation of leadership, protect assets and remain flexible from a tax perspective. It’s worth a discussion with your tax advisers and attorneys to determine if this is right for you.
Contact Stephenie Truong, John Reich or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.