By Doug Lloyd
on August 22nd, 2016
Posted in Estate Planning
In many states, Living Trusts are a person’s key estate planning document. Living Trusts are created to hold assets
during life and then dispose of those assets at death according to the person’s
directions (here, we will call the person making the Living Trust the
“Grantor.” Living Trusts thus operate much like a Will, but, unlike a
Will, Living Trusts have the benefit of avoiding probate. This makes them
common in states where it is favorable to avoid the probate process.
In order for a Living Trust to function as intended,
it must be funded with the Grantor’s assets. In other words, those assets
must be retitled in the name of the Living Trust so that the Trust owns them at
death rather than the Grantor. This requires the Grantor not only to
retitle real property, bank, and investment accounts, but also any business
interests owned by the Grantor such as LLC interests or stock in an S
corporation. When a Living Trust becomes the owner of S corporation
stock, there can be resulting difficulties for the Grantor’s heirs and for the
S corporation itself.
The fundamental problem is that trusts and S corporations do not play well together.
Although a trust (including a Living
Trust) can be a permitted shareholder in an S corporation, only certain kinds
of trusts are so permitted under Section 1361 of the Internal Revenue
Code. With a few exceptions, those trusts are known as either a “grantor” trust, a “QSST” (or qualified subchapter S trust), or an “ESBT” (or electing small business trust). If a trust
is a grantor trust, a QSST, or an ESBT, it can be a qualified shareholder in an
S corporation. If a trust is not one of the trusts specifically
authorized by the Internal Revenue Code, however, and becomes a shareholder,
the Corporation ceases to be a qualified S corporation and will be taxed as an
ordinary C corporation.
Unfortunately, a trust may initially be a qualified shareholder but, as time passes and circumstances change, it can lose its status as a qualified shareholder. This can easily happen unbeknownst to the Grantor, the Grantor’s heirs, or the Company, and can cause real headaches (and back taxes) when it is discovered.
This is a particular problem for a Living Trust.
The rules and regulations regarding trust shareholders in S corporations are
detailed and complex, and many good CPAs, attorneys, and other professionals
are unaware of how these rules impact a Living Trust over time. A Living
Trust is normally a long-lived trust that sees significant changes when the
person who creates the Trust either becomes incapacitated or dies. These
major events can have significant tax ramifications.
For example, almost all Living Trusts are, at the time they are
created, grantor trusts. This is because a person who creates a Living
Trust normally retains the right to revoke the Living Trust and retains the
right to benefit from the Living Trust’s income and principal during
life. Those retained rights are what make a Living Trust a grantor trust under
the grantor trust rules of the Internal Revenue Code.
These retained rights, however, can and do
change. Consider the example of a single woman (“Ms. Jones”) who creates
a Living Trust. As with most Living Trusts, Ms. Jones names herself as
the initial Trustee and retains the right to revoke the Living Trust as long as
she has capacity. But what happens if Ms. Jones becomes
incapacitated? If she no longer has the power to revoke the Trust, and if
her power of attorney (or applicable state law) does not specifically provide
that the Trust can be revoked by her agent, the Trust may no longer be
revocable, causing it to lose grantor trust status.
Fortunately, in many
cases, Ms. Jones would still retain the right to benefit from the income and principal
of the Trust for her lifetime, in the discretion of the successor
Trustee—another way in which the Living Trust would typically continue as a
grantor trust. But, for that rule to apply, the successor Trustee
authorized to make discretionary distributions to Ms. Jones, after she becomes
incapacitated, must be considered a “nonadverse” party under Section 677 of the
Internal Revenue Code. If Ms. Jones’ only daughter is named as the
successor Trustee, and is also the sole recipient of the Living Trust’s assets
when Ms. Jones dies, her daughter would likely be considered an adverse party
for tax purposes! Thus, Ms. Jones’ incapacity could still result in a
loss of grantor trust status for the Living Trust.
There are even more serious risks when a Grantor dies.
For example, consider what happens when a married couple creates a Living Trust
and one spouse dies. At that point, many (if not most) Living Trusts
enter an administrative period until the Trust assets can be divided and
distributed in two separate shares—a share for the surviving spouse and a share
for the deceased spouse. The surviving spouse’s share usually continues
to be held in a new revocable “Survivor’s Trust” while the deceased spouse’s
share is often held in one or more new irrevocable trusts for the survivor’s
benefit, referred to as the “Credit Shelter Trust” or “Bypass Trust” and/or a
“Marital Trust.”
At this point, any number of issues can arise. If
S corporation stock stays titled in the name of the original Living Trust for
more than 2 years from the date of death, the Company’s S corporation status
could be lost because the Living Trust ceased to be a grantor trust at death
(at least as to the deceased spouse’s share of the Trust) and such former
grantor trusts have only a 2-year grace period under the Internal Revenue Code
to continue to hold S corporation Stock. Furthermore, if S
corporation stock is used to fund the Credit Shelter or Marital Trust, those
trusts are, by definition, not grantor trusts and must qualify as either a QSST
or an ESBT.
This includes making a timely QSST or ESBT election with the
IRS. Advisors sometimes assume a trust qualifies as a QSST or ESBT when
it does not (for example, a trust may meet all the basic requirements of a QSST
but if the trust gives the beneficiary a lifetime power of appointment, the
trust clearly will not qualify as a QSST under the Treasury Regulations) or may
be unaware a formal election must be made and filed with the IRS. Lastly,
many attorneys anticipate that a Credit Shelter or Marital Trust may be the
recipient of S corporation stock and thus include “savings” language in the
boilerplate provisions of the Living Trust document to ensure that such Trusts
qualify as either a QSST or ESBT. A little-known IRS Revenue Ruling, however,
demonstrates that many QSST savings clauses are technically deficient, and may
force an ESBT election in circumstances when a QSST election would be
preferable or, worse, may leave no election available.
Fortunately, a little bit of review and foresight with
respect to a Living Trust that owns S corporation stock can prevent these types
of issues from arising. And, even when an issue has already arisen and S
corporation status appears to have been lost, specific relief procedures are
provided by the IRS. Relief can thus often be obtained when there has
been an inadvertent termination of a Company’s S corporation status.
If you have any questions about your
Living Trust (or any other trust) and its ownership of S corporation stock, the
trusts and estates lawyers at DWT would be happy to help you analyze the
issues.
Doug Lloyd is an estate-planning lawyer who focuses his practice
on assisting clients with the tax-efficient transfer of wealth to family
members. His experience includes creating comprehensive estate plans, estate
and gift tax planning, and probate administration. Doug believes that each
individual’s estate plan is unique and should be implemented to accomplish
family and personal goals, as well as an efficient tax strategy. Consequently, Doug
regularly assists clients with the preparation of wills and trusts that
accomplish both tax and family goals. Contact Doug via email at
DougLloyd@dwt.com or directly at 206.757.8087.
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