Tax Reform Update: ESBT v. QSST to Hold S-Corporation Stock

Many closely held businesses are set up as S-Corporations to avoid the double taxation of regular “C” corporations. Estate planners have long utilized Electing Small Business Trusts (ESBTs) to allow parents to pass their S-Corporation stock in such businesses to their children and grandchildren.

The ESBT is especially attractive for this purpose because it allows tremendous flexibility in administering the future cash flow of the family business. For instance, the Trustee can be given wide latitude each year in controlling distributions from the company to the ESBT, accumulating income in the trust, or distributing it among multiple beneficiaries (children and grandchildren, for instance).

The cost of this flexibility however, is that the ESBT is taxed on all the S-Corporation income each year, AT THE HIGHEST INCOME TAX RATE, 39.6%.

Now, enter Tax Reform. Both the House passed bill and the Senate version, which is currently being debated, provide that income will be taxed at lower rates. In addition, both plans include tax relief for so-called “pass-through businesses,” including S-Corporations. However, the taxation of ESBTs will remain at the highest tax rate under both plans. This increases the gap between proposed new lower tax rates and the tax rate of the ESBTs. For instance, under the House bill, $114,400 of income would be taxed at less than a 10% effective rate for a married couple, while the same income from an S-Corporation in an ESBT would be taxed at 39.6%. This would result in an additional tax of over $34,000 that could be saved by abandoning the use of the ESBT if Tax Reform is enacted.

One way this could be accomplished is to review the trust document to determine if the Trustee has the power to re-arrange the interests of the trust beneficiaries in a way that allows for the use of Qualified Subchapter S Trusts (QSSTs). In a QSST, the beneficiary, and not the Trust, is taxed on the income of the S-Corporation at the beneficiary’s own income tax rates, which under Tax Reform could be much lower than the highest tax rate applicable to ESBTs. If multiple beneficiaries are involved, a separate share trust can be allocated for each beneficiary to allow for qualification of a QSST for each beneficiary. This carries the added benefit of utilizing the lower tax brackets of multiple beneficiaries. If the Trustee holds voting control of the S-Corporation, he or she can manage the timing and amount of distributions from the corporation to the beneficiaries, to mimic the results of ESBT status, but without the burdensome tax costs. If the trust document is not helpful, the Trustee can petition for a judicial modification under Probate Code Sections 15403, 15404 or 15409.

Some creative tax planning here could save substantial tax dollars for the trust and its beneficiaries. In fact, a Trustee who fails to consider the impact of Tax Reform, does so at his or her peril.