How to Transfer S-Corp Shares to a Trust

An S-corporation offers liability protection while allowing profits and losses to pass directly to owners’ personal income without being taxed at the corporate level. For estate planning, transferring S-corp shares to a trust is a common strategy to manage assets and ensure a smooth transition to beneficiaries, which can help avoid probate. The Internal Revenue Code imposes strict limitations on who can be an S-corp shareholder. An improper transfer to an ineligible trust can terminate the company’s S-corp status, causing the business to be taxed as a C-corporation and leading to double taxation.

Eligible Trusts for S-Corp Stock

The Internal Revenue Code defines which types of trusts are permitted to own S-corporation stock. The most common eligible trust is a grantor trust. The individual who creates the trust, known as the grantor, is treated as the direct owner of the S-corp shares for all income tax purposes. This structure is popular for revocable living trusts, where the grantor retains control over the assets during their lifetime. Because the IRS disregards the trust for tax purposes and attributes all income to the grantor, the S-corp status remains intact.

A testamentary trust, created under a will, can also hold S-corp stock. This trust comes into existence upon the death of the individual, but its eligibility is temporary. A testamentary trust is permitted to be an S-corp shareholder for a period not exceeding two years from the date the stock is transferred into it. Before this period ends, the shares must be distributed to an eligible individual or a different qualifying trust.

A voting trust is formed to consolidate the voting power of multiple shareholders. In this structure, shareholders transfer their shares to a single trustee who votes on corporate matters. The individual beneficiaries are still treated as the owners for tax purposes and must meet the standard S-corp shareholder requirements.

A Qualified Subchapter S Trust (QSST) is an option for holding S-corp shares. It can have only one current income beneficiary, who must be a U.S. citizen or resident. All accounting income earned by the trust from the S-corp must be distributed to that beneficiary annually. The beneficiary, not the trust, is responsible for paying income tax on that distribution at their personal income tax rate.

The Electing Small Business Trust (ESBT) can have multiple beneficiaries, and these beneficiaries do not need to be individuals; they can include certain other trusts. The trustee of an ESBT has discretion over income distributions, meaning the income can be accumulated within the trust rather than being paid out each year. The trust itself is responsible for paying taxes on the S-corp income it retains, and this income is taxed at the highest marginal rate for trusts.

Comparing QSST and ESBT

The choice between a Qualified Subchapter S Trust (QSST) and an Electing Small Business Trust (ESBT) depends on the shareholder’s goals for beneficiaries and income management. A QSST is restricted to a single income beneficiary at a time, making it a straightforward option for leaving shares to one person. In contrast, an ESBT can have multiple beneficiaries, making it suitable for creating a “pot” trust that can make discretionary distributions among a group of beneficiaries.

The tax treatment of income also differs. With a QSST, all S-corp income flows through the trust directly to the sole beneficiary and is reported on their personal tax return. For an ESBT, the S-corp income retained by the trust is taxed at the trust level. This income is subject to the highest possible federal tax rate for trusts. For example, if an S-corp generated $50,000 of income for the trust, a QSST beneficiary in a 24% tax bracket would pay $12,000 in tax, while an ESBT would pay tax at the top rate of 37%, resulting in a tax of $18,500 on the same income.

A QSST operates under a mandatory distribution rule; it must distribute all of its accounting income to the beneficiary at least annually. This removes any discretion from the trustee to hold back income for future needs. An ESBT grants the trustee the power to decide whether to distribute or accumulate income. This discretion is useful when beneficiaries are minors or if the goal is long-term growth.

While both can hold S-corp stock, a QSST is more restrictive in its ability to hold other types of income-producing assets. An ESBT is more versatile and can hold a variety of other investments alongside the S-corp shares without violating its eligibility. This makes the ESBT a more integrated tool for broader wealth management.

Documentation and the Filing Process

The transfer process begins with a review of the trust agreement. The document must contain specific provisions that align with the requirements of either a QSST or an ESBT. For a QSST, this means language that mandates annual income distribution to a single beneficiary. For an ESBT, the trust document must permit the accumulation of income and allow for multiple beneficiaries if desired. An attorney specializing in estate planning should review the trust to ensure it qualifies.

A signed stock transfer agreement or assignment of stock is required to execute the change in ownership. This document serves as the official record of the transaction, detailing the number of shares being transferred, the date of the transfer, and the identities of the transferor and the transferee. The S-corporation’s stock ledger must be updated to reflect the new ownership, and the corporation’s bylaws may need to be reviewed to permit a trust as a shareholder.

For a QSST, the beneficiary must file an election with the IRS. This form requires the name, address, and taxpayer identification number (TIN) of the trust, beneficiary, and S-corporation, and must be signed by the beneficiary. The QSST election form must be filed with the IRS service center where the S-corporation files its annual tax return. There is a strict deadline for this filing: it must be submitted within the 2-month and 16-day period beginning on the day the shares are transferred to the trust.

For an ESBT, the trustee makes the election through a statement attached to the trust’s annual income tax return. The trustee prepares a statement that includes the names and addresses of the trust and corporation, a clear declaration of the ESBT election, and the date the trust first owned the S-corp stock. The election statement is attached to the trust’s annual income tax return, Form 1041, for the first tax year it owns the stock. The election is considered timely if the tax return is filed by its due date, including any extensions.

After the election is filed, the trust must file its own annual income tax return, Form 1041. This is required for every year the trust holds the S-corp stock and must report the income passed through from the corporation.