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S Corporations: The Medium Is the Message (Part 2)

Last month I described some of the pros and cons of S corporation status and Congress’ efforts to massage the rules to help family-owned businesses. The most tempting changes are revealed this month.

In my experience, the most vexing problem with S corporations has been their inflexibility for estate planning purposes. “Whoa!” say both of my avid readers. “Last month you said that some estate planning works best or only with S corporations.” That’s true, but S corporations are terribly inflexible for the all-important, non-tax-aspects of estate planning.

The key problem has been that only two kinds of trusts can own S stock. Both create problems. One is a “grantor trust.” Many advisors steer clear of this trust. One reason is that the trust’s grantor (its creator) is taxed on all of the trust’s income even though he or she must give up all economic rights to that income to avoid estate tax. That’s tough to stomach from a cashflow standpoint. However, paying your kid’s tax on their shares of the business’ income is great for estate planning, because it reduces your estate.

The second acceptable trust is the “Qualified Subchapter S Trust.” Unfortunately, QSSTs are abysmal from a family standpoint. In its infinite wisdom, Congress decided that these trusts must distribute all of their income annually. It doesn’t matter whether your kid is a valedictorian or an irresponsible spendthrift, the income must be distributed. Furthermore, a QSST can have only one beneficiary. A new child or grandchild can’t share in a previously-created QSST. They’re left out in the cold. It’s a statutory version of tough love.

ESBTs - A Family Planning Aid Fortunately, Congress now debuts a new acronym. Despite its flaws, I think a standing ovation may be appropriate. The ESBT (Electing Small Business Trust) overcomes most QSST deficiencies. It can accumulate income and can have multiple beneficiaries, including future-born kids and grandkids. The trustee can have discretion to distribute disproportionately among the beneficiaries (i.e., distribute more to the special-needs child and less to surfer boy).

The ESBT pays the tax on its share of S corporation income and on gain from selling the S corporation stock. That income and gain then can be distributed to the beneficiaries tax-free. As a major boon to family business secrecy, the ESBT is not required to inform its beneficiaries about their shares of S corporation income. (I merely report, and pass no judgment about the wisdom of Congress’ action.)

The downside is that ESBTs must pay tax at the maximum individual rates. Therefore, companies with lower-bracket shareholders may be disadvantaged by using ESBTs.

The ESBT continues to be subject to the “normal” rules for non-S corporation income. Non-S income is taxed to the trust or is passed through for taxation to the beneficiary if it is distributed. However, Congress neglected to provide an ordering rule. We don’t know whether an ESBT’s distribution comes from its S corporation income (nontaxable to the beneficiary) or from other income (taxable to the beneficiary and deductible by the trust). We also don’t know how to allocate trustee fees and other expenses between the S corporation part of the trust and the rest of the trust’s activities. No doubt, the IRS will get taxpayer-friendly rules out on these issues right away.

Existing trusts may elect to be taxed as ESBTs. That’s a real benefit for families with C corporation stock held by trusts which are grandfathered from generation skipping tax (GST). These families don’t need to give up the benefits of GST grandfathering (i.e., by distributing the stock from the trust) in order to elect S status. However, we must await rules from the IRS concerning how a trust elects to be taxed as an ESBT.

New Rules For The 90's S corporations get a 1990\'s face lift with new rules permitting charities to own S corporation stock. Public charities and private foundations may own S corporation stock after 1997. However, these organizations must pay tax on their shares of the S corporation’s income. Even so, this change enables S shareholders to obtain the same deduction advantages as C shareholders when they contribute stock to charity. Note that charitable remainder trusts may not be S shareholders, even under the new rules.

ESOPs, pension, profit sharing and stock bonus plans also may own S corporation stock. Like charities, the plans must pay tax on their shares of S corporation income. Unfortunately, the employees also will be taxed when that income is distributed from the plan. This double tax is analogous to the double tax on C corporation earnings (taxed once when earned by the corporation and then again when distributed from the benefit plan).

Act Quickly So, Congress has enhanced the benefits of electing S corporation status. When I took high school journalism, I never understood the meaning of Marshall McLuhan’s statement that, “The medium is the message.” It sounded like a reporter who believed that his paper was more important than the news. Well, I certainly don’t believe that the form in which you conduct business is more important than the business itself. However, there are important considerations in selecting your business structure.

Maybe you should massage the numbers and take another look. Check with your tax advisor about effective dates and other important changes specific to your business. And, act quickly. President Clinton has suggested that the conversion to S corporation should be even more painful than I described last month.




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