What Should an Estate Plan for an S Corporation Look Like?
By: Barry E. Haimo, Esq.
May 20, 2021
If you are a small business owner, you are likely to own your business through a business entity such as a corporation or limited liability company (LLC).
You might also choose to have your business entity taxed as an S corporation, meaning that the corporation is not taxed at the entity level, but rather that the taxation of the business’s income is passed through to its owners.
Although taxing your business entity as an S corporation holds significant advantages for you as a business owner, your estate must be planned carefully to avoid unanticipated tax consequences for your heirs.
S Corporations: Requirements and Advantages
First, what is an S corporation? This refers not to a type of corporation or business, but rather to a type of income taxation. This generally creates lower tax rates for the business owner, and avoids tax consequences such as self-employment taxes or corporation-level taxes.
In order to be eligible for S corporation status, a business must be owned by natural persons — in other words, by people rather than by other business entities.
Estate Planning for S Corporations
Although an S corporation must generally be owned by individuals, there are some exceptions to that rule. One of which is living trusts.
Living trusts are ignored by the IRS for income-tax purposes, meaning that an individual can hold their S corporation stock in a living trust. However, after the guarantor’s death, beneficiaries can generally only hold their stock in the living trust for two years.
BHowever, beneficiaries can hold S corporation stock in a living trust for longer than two years so long as the living trust meets certain criteria:
- The trust is an electing small business trust (ESBT), in which all beneficiaries are individuals or estates
- The trust is a qualified subchapter S trust (QSST), which has only one income beneficiary that can receive trust principal distributions throughout their life
Beneficiaries can also transfer S corporation stock to certain other entities — for example, charitable organizations — and avoid tax consequences.
Loss of S Corporation Status
Should shares of an S corporation be transferred to the wrong type of trust or other business entity, this can result in loss of S corporation status.
This has significant tax consequences for both your estate’s beneficiaries and the other shareholders of the business:
- The S corporation status is lost, meaning that a double tax regime will apply. This means that income generated by the corporation itself will be taxed at a rate of 15-23.8%, and any income transferred to the shareholder will be taxed a further 21%. This applies to all shareholders.
- Remaining shareholders still operating the business will be further subjected to self-employment taxes.
- Even if your share of the business is transferred back to a qualified stakeholder, the business cannot seek S corporation status for five years.
Clearly, the criteria for maintaining S corporation status are complex, and any breach of these criteria due to poor estate planning can be costly not only to your beneficiaries, but also to other shareholders. It’s important to make sure your business tax choices are in line with your estate planning goals.
Interested in learning more about estate planning for S corporations? Get in touch.
Barry E. Haimo, Esq.
Strategic Planning With Purpose®
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