Can an Estate Be an S Corp Shareholder?

An S corporation provides the liability protection of a corporation with the benefits of pass-through taxation, meaning corporate income is taxed at the shareholder level. When a shareholder of an S corporation passes away, their shares are transferred to their estate. Federal tax law permits a decedent’s estate to be a shareholder in an S corporation. This allowance is not indefinite and is governed by specific regulations concerning the duration of ownership and the subsequent transfer of the stock to ensure the S corporation maintains its status.

The Estate as a Permissible Shareholder

Upon a shareholder’s death, their estate automatically becomes the owner of the S corporation stock and is considered an eligible shareholder under Internal Revenue Code Section 1361. This allows the S corporation to maintain its tax status without interruption. The estate can hold the stock for the period reasonably necessary to complete the administration, which includes gathering assets, paying debts and taxes, and distributing the remaining assets.

If the administration period is unduly prolonged, the IRS may determine that the estate has terminated for federal income tax purposes and has converted into a trust. This can be an issue because not all trusts are eligible S corporation shareholders, potentially leading to an inadvertent termination of the S corporation’s status.

During the administration period, the S corporation’s income, losses, deductions, and credits pass through to the estate. These items are reported on the estate’s income tax return, Form 1041, and the estate is responsible for any tax liability on the S corporation’s income during this time.

Transitioning Ownership from the Estate

As the estate administration process concludes, the executor must distribute the S corporation stock to the designated heirs. This transition must be handled carefully to prevent the termination of the S corporation’s status, as the stock must be transferred to an eligible shareholder. The most straightforward path is distributing the stock directly to an individual beneficiary, provided they are a U.S. citizen or resident.

A common alternative is to transfer the stock into a trust for the benefit of an heir. However, a transfer to an ineligible trust would immediately terminate the corporation’s S election. The two most common types of trusts that are permitted to hold S corporation stock after receiving it from an estate are a Qualified Subchapter S Trust (QSST) and an Electing Small Business Trust (ESBT).

Qualifying Trusts for S Corporation Stock

Qualified Subchapter S Trust (QSST)

A Qualified Subchapter S Trust (QSST) is a specific type of trust that can hold S corporation stock, provided it meets a set of requirements. A primary condition is that the trust can have only one income beneficiary at a time, and that beneficiary must be a U.S. citizen or resident. The terms of the trust must require that all income is distributed to that single beneficiary at least annually. This ensures that the S corporation’s taxable income flows through the trust and is taxed directly to the beneficiary.

The trust document must also contain provisions regarding the distribution of its principal. During the life of the income beneficiary, any distributions of the trust’s corpus, or principal, can only be made to that same beneficiary. The beneficiary’s income interest in the trust must last for their lifetime or until the trust terminates. If the trust terminates during the beneficiary’s life, all trust assets must be distributed to that beneficiary. These rules are in place to ensure a clear, single point of taxation for the S corporation income.

Electing Small Business Trust (ESBT)

An Electing Small Business Trust (ESBT) offers more flexibility than a QSST but comes with a different tax structure. Unlike a QSST, an ESBT can have multiple beneficiaries, and these beneficiaries can include individuals, estates, and certain charitable organizations. An ESBT is not required to distribute its income annually; the trustee has the discretion to accumulate income within the trust. This can be advantageous for beneficiaries who do not need the income immediately or for long-term wealth accumulation.

The tax treatment of an ESBT is unique. The portion of the trust that holds the S corporation stock is treated as a separate trust for tax purposes. This “S portion” of the trust pays tax on the S corporation income it retains at the highest individual income tax rate. This is a notable contrast to the QSST, where income is passed through and taxed at the beneficiary’s individual rate.

Making a Trust Election

Information and Documentation Required

Before a trust can become a valid S corporation shareholder, a formal election must be filed with the IRS. For either a QSST or an ESBT, the election statement must include specific information:

• The name, address, and taxpayer identification number (TIN) for the trust.
• The name, address, and Social Security Number (SSN) of the income beneficiary for a QSST election, or for all potential current beneficiaries for an ESBT election.
• The name and employer identification number (EIN) of the S corporation in which the trust will hold stock.
• The date on which the election is to become effective and the date the stock was transferred to the trust.

The person responsible for making the election—the beneficiary for a QSST or the trustee for an ESBT—must sign a representation confirming that the trust meets all the respective statutory requirements.

Completing and Filing the Election

The process for making the election differs slightly between the two trust types. For a QSST, the income beneficiary is responsible for making the election. This is done by filing a specific election statement with the IRS service center where the S corporation files its tax returns. Part III of Form 2553, Election by a Small Business Corporation, can be used for this purpose, or a separate statement containing all the required information can be prepared and filed.

For an ESBT, the trustee is responsible for filing the election. The trustee must prepare a separate election statement that includes all the necessary information and file it with the appropriate IRS service center. The deadline for filing either a QSST or an ESBT election is important; it must be made within the 16-day-and-2-month period beginning on the day the stock is transferred to the trust. Failure to file a timely election can result in the trust being an ineligible shareholder and the termination of the S corporation’s status.