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With the federal and New York state tax exemptions being so high ($11.18 million and $5.25 million, respectively), clients with family businesses held in an S-corporation are less focused on reducing estate taxes and are more focused on avoiding probate and reducing future capital gains tax through obtaining a basis step-up.
To accomplish this goal, many S-corporation shareholders are placing their S-corporation shares into a grantor trust. This is an effective strategy since, at the time of the grantor’s passing, it allows the grantor’s estate to avoid probate and, if drafted correctly, may also allow the grantor to retain enough control that the shares will be included in the grantor’s estate resulting in a basis step-up.
However, as with every plan, attention must be given to the potential pitfalls.
S-corporations are subject to very strict rules, one of which places limitations on who or what entity can be a shareholder of an S-corporation. Therefore, it is crucial that your plan accounts for who may own the S-corporation shares in the future.
For instance, if S-corporation shares are put into a revocable grantor trust, once the grantor dies, the revocable grantor trust will change to an irrevocable trust. Under the rules applicable to S-corporations, an irrevocable trust may only hold S-corporations shares for a grace period of 2 years. After this 2-year period, the S-corporation status of the corporation will be revoked.
The IRS has made exceptions to allow certain types of trusts to own S-corporation shares without endangering the S-corporation status. One of the most common options is a Qualified Subchapter S Trust (QSST). With a properly drafted trust document, at the time of the grantor’s passing, the Trustee may elect for the trust to become a QSST.
However, QSST is also subject to certain requirements of its own, most notably: all of the income of the trust must be distributed, or be required to be distributed, to a single current income beneficiary who is a U.S. citizen or resident. As a result, each beneficiary would be taxed on the income that passes through the S-corporation.
S-corporations and QSSTs can be an extremely useful estate and business succession planning tool. If you are an owner of a business, whether held in an S-corporation or not, we recommend that you consult with an experienced tax attorney to help you decide what choices are right for your specific situation.