When structuring an S Corporation, it’s crucial to understand the restrictions on shareholder eligibility, especially concerning trusts. Under 26 U.S. Code § 1361, only specific types of trusts are permitted to hold S Corporation stock. Missteps in this area can inadvertently terminate an S election, leading to unintended tax consequences.

The Internal Revenue Code outlines several trust types that may qualify as S Corporation shareholders:

1. Grantor Trusts: These trusts are treated as owned by the grantor for income tax purposes. If the grantor is a U.S. citizen or resident, the trust can hold S Corporation stock. However, upon the grantor’s death, the trust remains eligible for only two years unless it qualifies under another permissible category.
2. Testamentary Trusts: Established by a will, these trusts can hold S Corporation stock for up to two years following the decedent’s death. Post this period, the trust must distribute the stock to eligible shareholders or qualify under another permissible trust category.
3. Voting Trusts: Created primarily to exercise the voting rights of stock, each beneficiary is treated as a shareholder for S Corporation purposes.
4. Qualified Subchapter S Trusts (QSSTs): A QSST must have only one income beneficiary who is a U.S. citizen or resident. All income must be distributed to this beneficiary annually. An election must be made to treat the trust as a QSST, and failure to meet these requirements can jeopardize the S Corporation status.
5. Electing Small Business Trusts (ESBTs): ESBTs can have multiple beneficiaries and offer more flexibility than QSSTs. However, the portion of the trust holding S Corporation stock is taxed at the highest individual income tax rate, and an election must be made to treat the trust as an ESBT.

Holding S Corporation stock in an ineligible trust can result in the termination of the S election, reverting the corporation to C Corporation status and subjecting it to double taxation. It’s imperative to ensure that any trust holding S Corporation stock complies with the eligibility requirements and that necessary elections are timely and properly filed.

At Twisdale Law, PC, we provide guidance to business owners and estate planners in North Carolina, South Carolina, and Tennessee on maintaining compliance with S Corporation shareholder requirements.

If you’re considering incorporating a trust into your S Corporation’s ownership structure or need assistance ensuring compliance with shareholder eligibility requirements, contact Twisdale Law, PC today. Our experienced team is here to help you navigate these complex regulations and protect your business’s tax status.