How the Tax Reform Affects Trusts Owning S Corporation Stock – Spring 2018

If you are the trustee or beneficiary of a trust that owns S corporation stock, you need to know about the changes affecting the trust under the Tax Cuts and Jobs Act, which went into effect on January 1, 2018.

Two types of trusts can own S corporation stock: an “electing small business trust” (ESBT) and a “qualified subchapter S trust” (QSST). To qualify as an ESBT or a QSST, a trust must meet several requirements; otherwise the corporation risks losing its status as an S corporation.

Two changes specific to ESBTs:

  • Under the prior law, an ESBT was prohibited from having a non-resident alien individual as a potential current beneficiary. Under the new law, a non-resident alien individual is permitted as a potential current beneficiary. If you previously took steps to exclude a non-resident alien as a beneficiary of an ESBT, now you can include that individual.
  • With respect to the deductibility of charitable contributions, ESBTs are now subject to the same rules that apply to individuals, so that the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.

Section 199A Qualified Business Income Deduction

Trusts that have business income from a sole proprietorship, partnership, limited liability company, or S corporation qualify for a deduction of up to 20% of qualified business income, subject to limitations related to taxable income, W-2 wages paid to employees of the qualified trade or business and the amount of qualified property employed in the business. The new qualified business income deduction is set to expire after 2025.

  • For an ESBT, which pays tax on all of its S corporation income even if distributed to the beneficiaries, the new qualified business income deduction for the ESBT portion of the trust will reduce the ESBT income, which may reduce the ESBT’s tax rate and, therefore, the benefit from the deduction. The highest income tax rate is now 37%, plus 3.8% net investment income tax may apply.
  • For a QSST, because the S corporation income is taxed to the beneficiary, the qualified business income deduction will be based on the beneficiary’s taxable income and reported on the beneficiary’s tax return.

The Tax Cuts and Jobs Act makes substantial changes to the Internal Revenue Code. If you are the trustee of an ESBT or a QSST, you need to carefully evaluate the impact of the changes on taxation of the trust and its beneficiaries. These changes can be complex and calculating their impact will require consultation between the trustee and the trust’s tax advisor.

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