Choice of Small Business Trusts
While limited liability companies, taxed as partnerships, have been the standard choice for most businesses for decades, there are still millions of individually owned S-companies. For example, estate planning often (and in the authors’ view almost always) results in assets, including S-Corp stock, being held in trust. However, only certain types of trusts are allowed to hold shares in S corp over the long term: grantor trusts in relation to individual US taxpayers (which may be less widely used under the Tax Cuts and Jobs Act); qualified subsections S Trusts; and choosing Small Business Trusts or ESBTs under Section 1361 (c) (2) (A) of the Internal Revenue Code. In addition, some, but not all, tax-exempt companies may be S-Corps shareholders.
Practitioners should familiarize themselves with the intricate planning capabilities the law offers to determine how and if ESBTs should be used as part of a comprehensive wealth transfer strategy. The law raises the following important considerations:
- Reduction of the maximum individual tax rates to 37 percent.
- Possible application of pass-through deduction for qualified business income.
- Consideration for possible loss of S-Corp status to take advantage of lower corporate tax rates of 21 percent.
- New bonus write-offs and larger IRC Section 179 deductions that may flow to S-Shareholders, including an ESBT.
- Restrictions on the deductibility of state and local taxes by individuals and trusts that may lead to the verification of the location of some ESBTs and possible relocation to a state with a lower tax burden.
Contrary to many provisions of the law, the changes related to the ESBT will be made permanent.
ESBT Taxation Post-Act
The portion of a trust that owns shares of an S company with a valid ESBT election is treated as a separate trust, while the other assets are treated as if they were held by a separate trust which for income tax purposes is considered simple or complex could be treated. The ESBT is generally taxed on its share of the S company’s income at the highest tax rate imposed on individual taxpayers. The law has reduced this maximum rate to 37 percent, although the net capital gains tax of 3.8 percent according to Section 1411 of the law can also apply. If the new Act Section 199A pass-through deduction rules apply, S-Corp income may be eligible for an additional deduction of up to 20 percent, which will lower the effective tax rate.
Although distributions from a complex or simple trust would normally bring income to the recipient of the recipient, the net income of an ESBT (whether or not distributed by the ESBT) is not taxed to the beneficiaries of the ESBT. A beneficiary of a trust with an ESBT stake would only be taxed on the IRC Section 643 (a) net distributable income from the non-ESTB portion of the trust, if any.
Eligible beneficiaries of an ESBT generally include individuals, estates, and certain not-for-profit organizations that are eligible to hold shares in S corp directly. A non-resident non-resident may not be a shareholder in an S company and may not be a potential current beneficiary of an ESBT. The law expands the list of eligible beneficiaries of an ESBT to allow a non-resident alien to be a potential current beneficiary of an ESBT. A non-resident foreigner is still not an eligible shareholder of an S company.
Planning Consideration: If steps have been taken to exclude a non-resident alien from accidentally becoming a beneficiary of an ESBT, this can now be reversed to allow such participation.
Charitable contribution deduction for ESBT
An S company reports to each shareholder his or her proportionate shares in certain separately reported income, loss, deduction and credit items. For this purpose, charitable contributions (as defined in IRC Section 170 (c)) from an S company are shown separately. The deductibility of a charitable contribution from an S company depends on the shareholder.
Planning point: An S-company can only make deductible contributions if the relevant instruments of the S-company allow the board of directors to give charitable gifts.
Under previous law, the charitable contribution deduction that applies to trusts and not the individual’s deduction was for ESBTs. In general, a trust will be allowed to make an unrestricted charitable contribution deduction for amounts of gross income paid for a charitable purpose in accordance with the terms of the relevant instrument. A transfer of excess contributions is not permitted.
The law changes the deduction of charitable donations to an ESBT and provides that the rules applicable to individuals under IRC Section 170 should govern the deductibility of contributions to charitable causes attributable to the ESBT. Thus, the percentage of basic contribution restrictions and carryforward rules applicable to individuals apply to charitable contributions that are considered part of the proportion of an ESBT-Holding-S-Corp share. In addition, the ESBT should be able to deduct the fair value of long-term capital gain property given in kind to charity, subject to percentage restrictions in force. The IRC Section 170 Justification Rules appear to apply, although these rules generally do not apply to trusts.