S Corps and Electing Small Business Trusts
November 9, 2023
Estate planning can be difficult for families who own closely held businesses. This can be especially true when a family business is set up as an S Corporation. Unlike C Corporations, S Corporations are restricted in both the number and type of shareholders that are allowed. With a few exceptions, shareholders must be individuals.
One of the S Corporation shareholder exceptions is the Electing Small Business Trust. Electing Small Business Trusts, or ESBTs, may have multiple beneficiaries. In addition, an ESBT trustee can distribute both income and principal at his or her discretion. These factors distinguish ESBTs from Qualified Subchapter S Trusts and, in many cases, make ESBTs an effective vehicle for family financial planning purposes.
Electing Small Business Trusts are unique in that they are bifurcated, or two-part, for tax purposes. The S Corporation stock is treated separately from all other assets. Flow through S Corporation income is taxed at the trust level and at the highest income tax rate. An income distribution deduction is not allowed. This is a drawback of ESBTs, as the individual beneficiaries may not be in the top income bracket. The remaining (non-S) income is taxed based on the traditional trust income tax rules.
Many S Corporations with filing requirements in multiple states file composite returns on behalf of their shareholders. A composite filing eliminates the need for a shareholder included in the filing from having a separate filing requirement. Adding an ESBT as a shareholder can impact composite filings, however, as many states do not allow trusts to participate. This can create additional tax filings and should be considered with an ESBT election.
An Elective Small Business Trust may be a good option for S Corporation owners to consider when they are starting on their estate plans. ESBT’s come with increased flexibility, but also potentially higher overall income tax.
For any questions you might have about this topic, please contact us today for further guidance.
Bonnie is a Tax Senior Manager at Larson & Company. She specializes in tax preparation and planning for small businesses.