Can a Trust Really Own an S-Corp? – Avoid This Mistake + FAQs

Yes – a trust can own stock in an S corporation, but not every trust qualifies.

Under federal S-Corp tax laws (primarily IRC §1361), S corporations are limited to “allowable” shareholders. Generally, only individuals (U.S. citizens or residents), certain trusts, and estates can be shareholders of an S corp. Corporations, partnerships, and non-resident aliens are not allowed as S shareholders. So where do trusts fit in?

The IRS permits specific types of trusts to own S corp shares without jeopardizing the S election. These include:

• Grantor Trusts – Revocable living trusts or other grantor trusts (where the trust’s income is taxed to the grantor).
• Qualified Subchapter S Trusts (QSSTs) – Trusts with one beneficiary who receives all income.
• Electing Small Business Trusts (ESBTs) – Trusts that elect to be taxed in a special way to hold S stock.
• Testamentary Trusts (for a limited time) – Trusts created by a will at death, which can hold S stock temporarily.
• Voting Trusts – Certain voting trusts pooling shares can qualify if all beneficiaries are eligible.
• Qualified Retirement Trusts (ESOPs) – Employee Stock Ownership Plan trusts (a type of tax-exempt trust) can own S corp stock (allowed since 1998).

If your trust is one of these allowed types (and meets all sub-requirements), it can be a shareholder in an S corporation. The trust essentially steps into the shoes of an individual shareholder for S-corp eligibility purposes. However, if a trust that does not qualify ends up owning S corp shares, the S corporation will lose its S status and be taxed as a regular C corporation – a potentially expensive mistake. In short: a trust can own an S corp, but only if that trust is structured to meet the IRS’s definition of a “qualified” trust shareholder. Next, we’ll break down each type of allowable trust and the legal pitfalls to watch out for.

Legal Pitfalls When a Trust Owns S-Corp Stock

Owning S-corp stock through a trust can achieve estate planning and asset protection goals – if done correctly. But beware of several legal pitfalls that can accidentally terminate your S corporation’s status or create unwanted tax problems:

• Ineligible Trust = S Corp Termination: If S-corp stock is transferred to a trust that is not one of the permitted types, the corporation’s S election automatically terminates on the date of the transfer. For example, putting shares into a standard irrevocable trust (with no QSST/ESBT election) will wreck your S corp status. The IRS won’t recognize the S election because an ineligible shareholder held stock. The result: the company becomes a C corporation, meaning corporate profits face double taxation.

• Missed Deadlines for Trust Elections: Some trusts require timely elections to qualify. A QSST or ESBT election must be filed within 2 months and 15 days (75 days) of the trust receiving S shares (or of the S-election effective date) to be valid. If a required election isn’t made in time, the trust is not a qualified shareholder and the S status can be lost. This is a common pitfall when a grantor dies – if the formerly revocable trust doesn’t elect QSST or ESBT within the post-death grace period, the S corp status will terminate. Always calendar these deadlines and file the appropriate election statement with the IRS.

• Multiple Beneficiaries or Classes of Beneficiaries: A standard trust often has multiple beneficiaries or complex distribution provisions. S corp rules require simplicity. For a QSST, there can only be one income beneficiary during the trust’s life. If your trust names several people to receive income simultaneously, it cannot be a QSST. You’d instead need an ESBT (which allows multiple beneficiaries). However, an ESBT has its own strict criteria (see below). Failing to choose the right trust type for the number of beneficiaries is a pitfall that can disqualify the trust. Tip: If you want each child or beneficiary to have S shares, sometimes setting up separate QSSTs for each or using an ESBT is necessary.

• Accumulation of Income: Trusts often accumulate income for future distribution – but not QSSTs. A QSST must distribute all of its income annually to its sole beneficiary. If the trust instrument or the trustee’s actions cause S corporation income to be accumulated in the trust (instead of paid out), the trust can violate QSST requirements. One saving grace: Rev. Rul. 92-20 clarified that a QSST can have a provision allowing accumulation only when the trust holds no S stock (for example, if the S stock is sold, the trust could then accumulate other income). Such a contingent clause “just in case” won’t disqualify the trust while it holds S stock. But generally, if the trust is holding S shares, all S income must flow out to the beneficiary each year. Pitfall: Make sure the trust’s governing document aligns with QSST rules – allow no discretion to accumulate S corp income.

• Non-U.S. Persons Involved: An S corp cannot have a nonresident alien as a shareholder. This extends to trusts – the beneficiaries or grantors must typically be U.S. persons for the trust to qualify. A grantor trust is only eligible if the grantor is a U.S. citizen or resident. A QSST’s beneficiary must be a U.S. resident/citizen as well. An ESBT is a bit more flexible: it can have a nonresident alien as a beneficiary of the trust, but that nonresident still cannot directly own the S stock or have purchased their interest. The trust itself must be a U.S. trust. In short, involving foreign persons in the ownership chain could inadvertently disqualify S status. If you plan to have non-U.S. beneficiaries, consult a tax expert about using an ESBT and ensuring compliance with all rules.

• Trust Ceases to Qualify Over Time: Even if a trust starts out eligible (e.g. a grantor trust while the grantor is alive), circumstances can change. Death, incapacity, or trust term expiration can change the trust’s status. A revocable living trust (grantor trust) is fine until the grantor dies – then it usually becomes irrevocable. An irrevocable trust by itself is not allowed as an S shareholder unless it now fits QSST or ESBT criteria. The tax law provides a 2-year grace period for such post-death situations (the trust can temporarily hold the shares), but by the end of that period the trust must convert to a QSST/ESBT or distribute the stock to an eligible owner. Failing to plan for this transition is a major pitfall. Always include a strategy in the estate plan: for example, language that the trustee must elect QSST or ESBT as needed, or perhaps automatically distribute shares to beneficiaries if the trust can no longer qualify.

• High Trust Tax Rates (ESBT Trap): If you elect to use an Electing Small Business Trust (ESBT), be aware of the tax cost. ESBTs pay tax on S corporation income at the trust’s rates, which hit the top 37% bracket at very low income levels (just over $14,000 of income, since trusts have compressed tax brackets). The trust cannot distribute S corp income to avoid that tax (unlike a QSST). This means an ESBT could result in significantly higher tax on S earnings compared to if an individual held the shares. While this isn’t a “legal” pitfall (it won’t ruin the S election), it’s a financial pitfall – a surprise tax bill if you didn’t anticipate it. It might still be worthwhile for non-tax reasons (like keeping control until beneficiaries reach a certain age), but it should be a conscious decision.

• Complexity and Administrative Burden: Using trusts as S corp shareholders requires extra paperwork and vigilance. QSST and ESBT elections must be filed with the IRS. The trustee must keep track of income allocations, file trust tax returns (Form 1041) if needed, and ensure compliance each year (such as the QSST distribution requirement or ESBT separate accounting for S corp vs other trust assets). If the trust is in place for many years, any change in beneficiaries or trust terms might require re-evaluating S corp eligibility. This complexity is not a deal-breaker but is a “soft” pitfall – failure to properly administer the trust could inadvertently cause issues. Solution: Work closely with a knowledgeable CPA or tax attorney to monitor the trust’s compliance annually.

By being aware of these pitfalls, you can structure the trust and S corp arrangement to avoid common mistakes. Next, let’s clarify the key terms and types of trusts that are allowed, so you can identify which trust option fits your situation.

Types of Trusts That Can Own S Corporation Stock (Key Terms Explained)

Not all trusts are created equal when it comes to S corporation stock ownership. Here are the key trust entities recognized by the IRS and S-corp law, and how each one works:

Grantor Trusts: The Simple (But Temporary) Solution

A grantor trust is a trust in which the grantor (creator) retains certain powers or interests such that, for tax purposes, the grantor is treated as the owner of the trust assets. Common examples include revocable living trusts used in estate planning. From the IRS’s perspective, a grantor trust is essentially “invisible” – all income is reported on the grantor’s personal tax return.

Why it matters for S corps: Because the grantor is deemed the owner, the IRS treats the S corp stock as if the grantor individually owns it. Therefore, a grantor trust qualifies as an S corp shareholder (IRC §1361(c)(2)(A)(i) includes trusts deemed owned by a U.S. person under the grantor trust rules). This is the simplest scenario: for as long as the trust is grantor-owned and the grantor is a U.S. citizen or resident, the S corporation’s status is safe.

Example: John creates a revocable living trust (which is a grantor trust) and transfers his 100% ownership of an S corp into it. While John is alive and competent, nothing changes tax-wise: the S corp income still goes on John’s 1040, and the S election remains valid.

Caution: A grantor trust’s S-corp eligibility is temporary – it lasts only as long as the trust remains a grantor trust. When the grantor dies or the trust otherwise becomes irrevocable (no longer tax-owned by the grantor), its status changes. At that point, the trust has a two-year window during which it is still an eligible S corp shareholder (a built-in grace period after a grantor’s death, per IRC §1361(c)(2)(A)(ii)). By the end of that two years, the trust must either distribute the stock to an eligible individual, or file an election to be a QSST or ESBT (if it meets those requirements) to continue as a qualified shareholder. If it fails to do so, the S election terminates. So, think of a grantor trust as a bridge – great for holding S stock during the grantor’s life, but requires action at death.

Qualified Subchapter S Trust (QSST): One Beneficiary, Pass-Through Taxation

A Qualified Subchapter S Trust (QSST) is a special trust defined by the tax code (IRC §1361(d)) to be an eligible S corp shareholder. The QSST is designed to benefit one individual and essentially treats that beneficiary as the direct owner of the S corp stock for tax purposes.

Key requirements for a QSST:

• Single Income Beneficiary: The trust can only have one income beneficiary during the life of the trust. (It can have remainder beneficiaries who receive the assets after the current beneficiary’s death, but only one person can receive income distributions at any time.)
• Distribute All Income: All of the trust’s income (during the income beneficiary’s life) must be distributed currently to that one beneficiary. The beneficiary cannot be skipped; they are entitled to the income.
• Beneficiary is U.S. Person: That sole beneficiary must be a U.S. citizen or resident (to satisfy S corp shareholder requirements).
• QSST Election: The beneficiary (or the trustee) must file a QSST election with the IRS within the required timeframe (generally 2 months + 15 days after the trust first receives S shares, or after a formerly grantor trust becomes a QSST). This election is a statement identifying the trust and affirming it meets QSST criteria.

If these conditions are met, the trust qualifies as a QSST and the S corporation’s income is taxed directly to the beneficiary (not to the trust). In essence, the trust is ignored for S corp income – much like a grantor trust, the individual beneficiary is treated as owning the stock. The beneficiary reports the K-1 income on their personal return each year.

Benefits of QSST: It keeps taxation simple (only one level of tax, at the beneficiary’s rate). It’s often more tax-efficient than an ESBT because the beneficiary might be in a lower tax bracket than a trust would be. QSSTs are commonly used when a parent wants to leave S corp shares to one child in trust; the trust gives some control/protection, but for tax purposes it’s as if the child owns the shares.

Important: The trust instrument for a QSST must be carefully drafted to require distribution of all income to the beneficiary. Also, the beneficiary’s QSST election is irrevocable (until they stop being a beneficiary). If the beneficiary dies or the trust terminates, the S stock can pass to another QSST or to an eligible shareholder, but a new election might be needed for a new trust.

Timing note: If an existing trust (like a living trust) converts to a QSST (say, at the grantor’s death for the benefit of a child), the new income beneficiary has 2 years and 2½ months from that date to make the QSST election. This generous window allows time for the estate to be administered. But don’t miss it – mark that date!

Electing Small Business Trust (ESBT): Multi-Beneficiary Flexibility, Higher Tax

An Electing Small Business Trust (ESBT) is another type of trust that can hold S corp stock. ESBTs were introduced to give more flexibility than QSSTs – they allow multiple beneficiaries or even beneficiaries that are not individuals (with some limits) – but they come with a unique tax treatment.

Key features and requirements of an ESBT:

• Election Required: Just like the name suggests, the trustee must make an ESBT election (by filing a statement with the IRS within 2 months and 15 days of the trust receiving S stock). Without this election, the trust is not an ESBT and would be disqualified as an S shareholder (unless it fits another category).
• Eligible Beneficiaries: An ESBT can have multiple beneficiaries. However, all beneficiaries must be “permitted S corp shareholders”: that means individuals, estates, or certain charitable organizations. Notably, nonresident alien individuals can be beneficiaries of an ESBT (Congress allowed this, which is an exception to the usual S corp rule forbidding nonresident owners). Also, beneficiaries cannot acquire their interest by purchase; it typically should be via gift, inheritance, etc., which is usually the case in family estate planning trusts.
• No Distribution Requirements: Unlike a QSST, an ESBT does not have to distribute income currently. The trust can accumulate income, allocate between income and principal, etc., according to the trust terms. This is useful if the grantor wants the trustee to have discretion or to retain income for future use.
• Separate Taxation of S Portion: The S corporation income that an ESBT receives is taxed inside the trust at the highest trust tax rate (35% prior to 2018, and 37% under current rates). The trust pays this tax on Form 1041. This portion of income does not get distributed as “income” to beneficiaries for tax purposes, even if the trust actually pays it out – it’s always taxed to the trust itself. The rest of the trust’s income (from other assets) is taxed under normal trust rules (either to the trust or passed through to beneficiaries depending on distributions).
• One ESBT per S Corp: If a trust owns stock in multiple S corporations, one ESBT election covers all. But a trust cannot be part ESBT and part something else for the same S corp shares – it’s either an ESBT for all its S corp holdings or not at all. (Technically, the ESBT election can cover just the S corp portion of a trust, which is how the law conceptualizes it: an ESBT can have other assets, but for tax purposes it’s as if the trust is split into an “S portion” and a “non-S portion.”)

Why choose an ESBT? ESBTs are useful in more complex estate plans. For example, a trust that provides income to a surviving spouse and then to children (multiple beneficiaries over time) cannot be a QSST (since only one at a time can get income). An ESBT could accommodate that. Or if a trust benefits both individual family members and a charity, an ESBT might be the only choice. Also, if the trust needs to allow accumulation of income (say for a minor beneficiary’s future needs), ESBT allows that whereas QSST does not.

Drawback: The clear downside is the potentially high tax on S corp income retained in the trust. Essentially, you trade tax efficiency for flexibility. However, creative planning can mitigate this: e.g., the S corp might pay higher salaries or rents to beneficiaries to shift income out of K-1 and into wages, etc., though those techniques must have economic substance and respect corporate law.

Counting beneficiaries: One technical note – for the 100-shareholder limit of S corps, each “potential current beneficiary” of an ESBT is counted as a shareholder. So if an ESBT has 3 children who could receive distributions currently, the IRS counts it as 3 shareholders (not one). This is different from a QSST (which counts as one – the single beneficiary). It usually isn’t an issue unless your S corp is close to the 100-owner cap.

Testamentary Trusts: An Estate’s Short-Term S Corp Holder

A testamentary trust is any trust created under a will (testament) when someone dies. Often, wills for business owners direct that S corporation stock be placed into a trust for a spouse or children. Upon the person’s death, this trust comes into existence and can become a shareholder.

By default, a testamentary trust is typically not a grantor trust (the grantor is deceased) and it may not yet qualify as QSST or ESBT (depending on its terms and elections). Recognizing this, the tax law gives estates and testamentary trusts a grace period to hold S stock temporarily:

• A trust that receives S corporation stock by will (i.e., from an estate) is allowed to be an S corp shareholder for up to 2 years from the date of death without making a QSST or ESBT election immediately. This gives time for the estate to settle and for the trustee to decide how to proceed.
• By the end of that 2-year period, the trust must either qualify and elect QSST or ESBT status (or become a grantor trust somehow), or the stock must be distributed out to eligible shareholders (like directly to the beneficiary).
• If neither happens by the deadline, the S election terminates immediately after the 2-year mark.

In practice, many estate planners will structure the testamentary trust with the intention to elect QSST or ESBT from the start. For example, a will might create a trust for a child that meets QSST criteria; after the parent’s death, the child (beneficiary) files a QSST election so the trust can hold the shares long-term. The 2-year rule is essentially a safety net to avoid immediate disqualification at a death.

Pitfall: Don’t assume the executor or trustee will handle this automatically. All involved should know that the clock is ticking once the stock goes into a testamentary trust. Coordination between the estate’s executor, the trustee, and tax advisors is key to either distribute the stock or file the right election in time.

Voting Trusts: Centralizing Control While Preserving S Status

A voting trust is a trust where legal owners of shares transfer their voting rights to a trustee, often to consolidate control for a period of time. The shareholders get trust certificates and typically still receive dividends, but the trustee votes the shares as a block. Voting trusts are sometimes used in corporate governance, especially if shareholders want to present a united front or ensure continuity (for example, all siblings put their shares in a voting trust so that one person can vote on behalf of everyone).

For S corporations, voting trusts are allowed shareholders if they meet certain conditions (IRC §1361(c)(2)(A)(iv)). Each beneficiary of the voting trust (i.e., each person who transferred their shares into the trust) must be an eligible S corp shareholder on their own (so no corporations or partnerships as beneficiaries, and no nonresident aliens). In essence, a voting trust is just a pass-through arrangement for voting; it doesn’t change the beneficial ownership. The IRS treats the original owners as the shareholders through the trust.

Requirements:

• All beneficial owners of the voting trust must consent to S corp election (just as if they held the shares outright).
• The trust should only exist to vote the shares and distribute dividends to the beneficial owners. It should not alter who gets the economic benefit.
• Each grantor/beneficiary of the voting trust is counted as a separate shareholder (the trust itself isn’t counted, it’s transparent for counting purposes).

Voting trusts are less about tax/estate planning and more about corporate control, but it’s good to know they won’t jeopardize S status if structured properly. Just ensure the trust agreement doesn’t inadvertently create any ineligible interests.

Other Permitted and Prohibited Trusts:

• Employee Stock Ownership Plan (ESOP) Trusts: These are a type of qualified retirement trust under IRC §401(a). Since 1998, ESOP trusts can own S corporation stock. An ESOP trust is a tax-exempt employee benefit trust that holds company stock for employees’ retirement. If an S corp sets up an ESOP, the ESOP trust can actually own anywhere from a small percentage up to 100% of the S corp’s shares. The S corp pays no federal income tax on profits attributable to the ESOP’s ownership (because the ESOP is tax-exempt) – a huge tax advantage. However, ESOPs have complex qualification rules and are beyond our scope here. For our purposes, it’s enough to note that an ESOP trust is an exception to the general “no trusts except QSST/ESBT” rule. The law explicitly allows ESOPs as S shareholders, recognizing them as a tool for broadening ownership to employees.

• Charitable Trusts and Organizations: What about charitable trusts or nonprofits owning S stock? Generally, charitable remainder trusts (CRTs) cannot own S corp stock – they are not eligible shareholders under current law (and attempting to put S shares into a CRT will terminate S status). Public charities (501(c)(3) organizations) also typically cannot be S shareholders unless the stock is held in an ESBT with the charity as one of the permissible beneficiaries. (There has been discussion about changing the law to allow CRTs to own S stock directly, but as of now it’s not allowed.) On the other hand, a grantor trust or estate can donate S stock to a charity, but once the charity owns it outright, the corporation would lose S status because a charity is a corporate entity (or, if it’s a trust, not one of the specifically allowed ones). If philanthropy is a goal, one strategy is to have the S corp convert to a C corp or LLC before a large charitable transfer, or use an ESBT that leaves some benefit to charity while maintaining the trust structure.

• Foreign Trusts: A trust established under foreign law (and considered a foreign trust for U.S. tax purposes) cannot be an S corp shareholder. Only trusts that are considered domestic trusts (meaning a U.S. court can exercise primary supervision over the trust and a U.S. person controls all substantial decisions) qualify. Essentially, if you have an offshore trust or any foreign element, it will not qualify for S stock ownership.

Having covered these trust types and terms, you can see that the IRS does allow trusts to own S corporations, but only via these specific channels. Next, we’ll illustrate a few real-world examples of how this plays out, and then we’ll compare the trust options side by side.

Real-World Examples: How Trust Ownership of an S Corp Works

To make the concepts concrete, let’s look at a few scenarios illustrating trusts owning S corp shares and the outcomes:

Example 1: Living Trust Holding S Corp Stock (Grantor Trust)
Maria is the sole owner of an S corporation (an interior design business). For estate planning, she transfers her shares into The Maria Revocable Trust (a living trust where Maria is the trustee and beneficiary during her lifetime). This trust is a grantor trust – Maria pays tax on all its income. Result: The S corporation status is unaffected. The IRS sees Maria as the shareholder (through the trust). Years later, Maria passes away, and the trust becomes irrevocable, now benefiting her two adult children. The moment Maria died, the trust ceased to be a grantor trust. The children’s trust does not qualify as a QSST (it has two beneficiaries) and no ESBT election was made yet. The 2-year clock starts ticking. Within that window, Maria’s trustee and advisors decide to split the trust into two separate trusts, one for each child, and elect each to be a QSST (each trust now has one beneficiary). They file the QSST elections well before the 2-year deadline. Outcome: The S corp remains an S corp continuously. Each child’s QSST now holds stock; each child pays tax on S corp income from their trust share. By planning the conversion and elections, the transition after Maria’s death is smooth.

Example 2: QSST for a Child’s Inheritance
John owns 50% of an S corporation (the other 50% is owned by his business partner). John’s will leaves his S shares in a trust for his daughter, who is 30 years old. The trust (call it “Daughter Trust”) is set up with terms to qualify as a QSST – John wanted to protect the shares in trust, but ultimately it’s for his daughter’s benefit. When John dies, the trust springs into existence and receives the S stock from John’s estate. John’s daughter, the sole beneficiary, promptly files a QSST election for Daughter Trust (actually the will’s executor or trustee might file it on her behalf, but she must sign consent). Outcome: The trust is now a QSST from inception. The S corporation continues without interruption. The daughter is treated as directly owning John’s 50% for tax purposes – she’ll report her share of S corp income. The trust will receive any distributions and pass them to her (or use them for her benefit as per trust terms, but cannot accumulate income). This arrangement allows John’s daughter to enjoy and be taxed on S corp income, while the trust structure protects the principal (stock) from creditors or imprudent spending. It’s a win-win: estate goals achieved and S corp status preserved.

Example 3: ESBT for Multiple Beneficiaries
The Lee Family S Corp is owned by three siblings. One sibling, Alice, passes away, and her one-third share is to be held in trust for Alice’s two minor children until they turn 30, per Alice’s estate plan. Alice’s trust cannot be a QSST because it has two current beneficiaries (the two kids). The trustee therefore opts to elect ESBT status for the trust. Within a couple months of Alice’s death, the trustee files the ESBT election statement with the IRS. Outcome: The trust is now an ESBT and can continue to own the S corp shares for as long as needed. Each year, the trust pays tax at the top trust rate on the S corp income allocated to that one-third share. The trustee may or may not distribute some of the trust’s remaining income or principal to the kids, but those distributions (if from non-S corp income or principal) follow normal trust tax rules. The S corporation remains an S, and Alice’s children will ultimately get the stock when they reach 30 (or however the trust is set to terminate). Despite the higher tax cost in the interim, this allowed Alice’s share to stay consolidated and managed by a trustee until her kids are mature. The alternative would have been giving stock outright to minors or terminating S status – which were less desirable outcomes.

Example 4: Ineligible Trust Causes an S Election Bust (and How to Fix It)
Consider XYZ Corp, a small S corporation. One of the shareholders, Tom (25% owner), transfers his shares to an irrevocable family trust he set up for his wife and kids. Tom didn’t consult a tax advisor – the trust was a standard family trust that did not qualify as QSST or ESBT (it had multiple beneficiaries and no elections). A year later, XYZ Corp’s CPA discovers that the S election actually terminated on the day Tom transferred his shares to that trust (because the trust was not an allowable shareholder). XYZ Corp has inadvertently been a C corp for the past year, meaning its profits should have been taxed at the corporate level! This is a nightmare scenario for the company and its owners, who have been treating it as an S corp unaware of the termination.

Fix: XYZ Corp’s lawyer rushes to request relief from the IRS for an inadvertent termination. The IRS has procedures (e.g., Revenue Procedure 2013-30) to forgive these mistakes if promptly corrected. Tom’s trust immediately makes an ESBT election (since QSST isn’t possible due to multiple beneficiaries). The corporation and shareholders agree to make any needed adjustments (like amending tax returns if required). Fortunately, the IRS grants relief and retroactively reinstates S status, contingent on the trust being treated as an ESBT from the date of the transfer. Lesson: An ineligible trust can blow up your S corp, but the IRS may offer one-time mercy if it truly was unintentional and corrected fast. Better yet, avoid the situation by planning ahead! Always ensure any trust shareholder is qualifying or will be made qualifying via timely election.

These examples show the importance of understanding trust types and acting within the allowed rules. Now, let’s compare the main trust options (Grantor vs QSST vs ESBT) to highlight their differences side-by-side.

Comparing Trust Options for S Corporation Ownership

Choosing the right trust vehicle involves balancing tax implications, control, and flexibility. Here’s a comparison of the key trust types that can own S corp stock:

As shown above, grantor trusts are simplest but have a built-in expiration (when the grantor dies). QSSTs and ESBTs are the main long-term solutions, each with trade-offs: QSST for simplicity and lower tax (one beneficiary only), ESBT for flexibility (multiple beneficiaries, accumulation) at the cost of higher taxes. Testamentary trusts and voting trusts serve more specialized or temporary roles, and ESOP trusts are a special breed for employee ownership. Choosing the right structure depends on your goals: Do you need to provide for multiple people? Is minimizing tax the top priority? How important is it to maintain control via a trust? The comparison above can guide that decision, often in consultation with an estate planning attorney.

State Law Variations: How State Rules Affect Trust-Owned S Corps

Thus far, we’ve focused on federal law (IRS rules) for S corporations and trusts. Federal law is paramount for determining if S corporation status is valid. However, state laws come into play in two key ways:

1. State Taxation of S Corporations: Not all states treat S corporations the same way the IRS does. While most states recognize the S election and allow pass-through taxation to shareholders, some do not. For example:

   • New Hampshire, Tennessee, Texas, and the District of Columbia historically either don’t recognize S-corps at all or tax S corps similarly to C corps at the state level. If your S corp is in one of these jurisdictions, the corporation might pay state tax on its earnings even if federally it’s an S corp. This means a trust shareholder might not receive a full pass-through of income for state purposes.
   • New York and New Jersey do recognize S corporations, but require a separate state S election. Each has its own forms and deadlines. If a trust is a shareholder, those states might require affirmations or additional paperwork (for instance, New Jersey may require an ESBT to also make a NJ-specific ESBT election for state income tax). Failing to attend to state filing requirements can result in the corporation being taxed as a C corp in that state, or other penalties, even while it remains an S federally.
   • California honors the S election but imposes a 1.5% franchise tax on S corp income at the entity level. If a trust beneficiary or trust itself is a California resident, the trust’s share of S income might also be subject to California personal income tax. One must consider how the trust is taxed by the state: states have varying rules for trust residency (often based on trustee location or domicile of the decedent) which will determine if the trust pays state tax on its income. In any case, California’s rules don’t prohibit trust shareholders; they just add another layer of tax considerations.

2. State Trust Law and Entity Law: State law governs the validity and operation of trusts and corporations. While any trust meeting IRS criteria can hold stock, state corporate law usually does not restrict who can be a shareholder (aside from special industries). Trusts can generally own shares under state law. But watch for:

   • Professional Corporations (PCs): Some states don’t allow non-licensed individuals or entities (including trusts) to own shares of certain professional S corps (like law firms, medical practices). If you have an S corp that is also a PC/PLC, ensure a trust is an allowable owner under your state’s professional licensing rules.
   • Community Property States: In community property states (like California, Texas, etc.), if an S corp owner is married, placing stock into a trust might involve community property considerations. If a joint revocable trust (husband and wife as settlors) holds S stock, the IRS often treats that as two grantor trusts (one for each spouse’s share). Special IRS rules allow a joint living trust of a married couple to be an S shareholder and count as one shareholder (the spouses are treated as one for the 100 shareholder count if filing jointly). State law defines community vs separate property which can affect how the trust is structured, but as long as it’s grantor-type, it’s fine.
   • State Income Accumulation Restrictions: A few states have laws about trusts accumulating income vs distributing (though these are usually aimed at rule against perpetuities or other fiduciary rules, not specific to S corps). Generally, if a trust must distribute income by law (like some states require income be paid to an income beneficiary unless the trust says otherwise), that can help meet QSST requirements. Conversely, if a trust is allowed to accumulate and does so against QSST rules, it’s the IRS rules that matter for S corp status. So state trust law and the trust’s terms need to mesh with the federal requirements.

In summary, state variations mainly affect how the S corp or trust is taxed at the state level, rather than whether the trust can hold shares (federally allowed trusts can hold shares in all states). It’s critical to file any necessary state-level S elections or trust elections. Also, plan for the state income tax impact: for instance, an ESBT paying tax at top federal rate will also pay at top state trust rates if the state taxes trust income. Or, if the trust beneficiaries live in different states, you may have multi-state tax filings. Work with a local expert in your state to ensure compliance on those fronts.

Frequently Asked Questions (FAQs)

Q: Can an irrevocable trust own S corporation stock?
A: Yes, but only if it’s structured to qualify (e.g. electing QSST or ESBT status). A standard irrevocable trust without these elections is not an eligible S corp shareholder under IRS rules.

Q: Can a revocable living trust hold S corp shares?
A: Absolutely. A revocable living trust is a grantor trust, so it’s an allowed S corp shareholder while the grantor is alive. After the grantor’s death, the trust must convert (QSST/ESBT) or distribute the stock within the allowed time.

Q: How long after the owner’s death can a trust keep S corporation stock?
A: Generally two years. Both a formerly revocable (grantor) trust and a testamentary trust can hold S shares for up to 2 years post-death without an election. By the end of that, the trust must elect QSST/ESBT or transfer the shares to avoid terminating the S status.

Q: What happens if a trust that doesn’t qualify becomes an S corp shareholder?
A: The S corporation’s election will terminate, turning it into a C corporation (taxable entity). The company and shareholders could face higher taxes (double taxation) unless they quickly fix the error and obtain IRS approval to reinstate S status.

Q: What is the difference between a QSST and an ESBT?
A: A QSST has one beneficiary who is taxed on all S corp income (the trust must pay out the income to them). An ESBT can have multiple beneficiaries and doesn’t require payouts, but the trust itself pays tax on the S corp income at the highest rate.

Q: Do trust beneficiaries count toward the 100-shareholder limit of an S corp?
A: It depends on the trust type. A QSST (single beneficiary) counts as one shareholder (the beneficiary). An ESBT counts each current beneficiary as a separate shareholder for the 100-owner limit. Grantor trusts count as the grantor. So, trusts won’t help you bypass the 100 shareholder cap.

Q: Can a non-US person be involved if a trust owns the S corp stock?
A: Directly, no – nonresident aliens cannot directly own S corp shares. For trusts, the primary beneficiary or grantor generally must be a U.S. person (for QSST/grantor trust). An ESBT can have a nonresident alien beneficiary indirectly, but the trust must be domestic and it pays the tax. It’s a complex exception – in most cases, involving non-US persons in S corp ownership is problematic.

Q: Why might someone use an ESBT instead of a QSST, despite the higher tax?
A: An ESBT allows multiple beneficiaries and accumulation of income. If an S corp owner wants a trust to benefit several family members or charities, or to retain earnings for flexibility, an ESBT can achieve that when a QSST cannot. It sacrifices some tax efficiency for greater estate planning flexibility.

Q: Can a trust avoid state taxes on S corporation income?
A: Not entirely. If the state recognizes S corporations, the trust (or its beneficiaries) will pay state tax on pass-through income similar to any shareholder. If the state doesn’t recognize S status, the corporation might pay state tax as a C corp. Some states tax S corp income at the entity level (like California’s franchise tax). Placing shares in a trust doesn’t eliminate state tax; you must plan for state fiduciary income tax on the trust or beneficiary’s returns.

Q: Should I consult a professional when setting up a trust to own S corp stock?
A: Yes. Given the complexity – from IRS elections (QSST/ESBT) and trust drafting to coordinating federal and state rules – it’s wise to consult an estate planning attorney and a tax advisor. They can ensure the trust is properly structured to qualify and help file necessary elections so that your S corporation retains its status and you meet all legal requirements. The cost of advice is minimal compared to the potential tax penalties of an S corp mistake.