Using trusts to transfer s corporation ownership to the next generation

S corporations are closely held companies that, ostensibly, do not pay any federal income taxes. Rather, they have elected to have income, deductions, gains and losses, etc. taxed directly to shareholders. There are advantages for the owner of the business, and there are also key considerations that cannot be overlooked.

With the continuing use of S corporations for income tax purposes, passing ownership to the next generation via the use of trusts presents estate planning options and can be an effective tax strategy. Only certain types of trusts can own shares in an S corporation so planning for which types of trusts will qualify to hold S corporation shares is essential.

S corporation shares can be used to fund a grantor retained annuity trust (GRAT), which can be a qualified S corporation shareholder. In a GRAT, the grantor of the trust (the shareholder of the S corporation) must retain a right to receive an annuity payment from the trust for a fixed number of years. Typically, estate planners suggest a three-year period. When the S corporation appreciates, the GRAT pays annuity payments to the grantor using the S corporation shares. Any remaining shares not needed to meet the annuity payments are permanently excluded from the grantor’s estate. The appreciation of the shares is key.

S corporation shares can also be used to fund an intentionally defective grantor trust (IDGT). IDGTs are also qualified as an S corporation shareholder. This planning tool satisfies the objective of removing an asset (S corporation shares) from a shareholder’s estate. To accomplish this, the S corporation shareholder sells shares to an irrevocable grantor trust (the next generation are the beneficiaries of the trust) and takes back a note. No income tax results on the sale since the grantor trust rules exempt gain when the shares are sold by the shareholder who is the grantor of the trust. The note is repaid via dividends to S shareholders. The payment of the note, in effect, constitutes a freeze of value of the S corporation shares, but the future appreciation of the shares is outside of the shareholder’s estate. Again, the appreciation of the shares is key.

IDGTs are not supported directly by the Internal Revenue Code but only by interpretations of case law and certain IRS rulings, so it is important to be aware of possible audit risks.

IDGTs and GRATs take careful planning. Both trusts achieve the objective of removing future appreciation of S corporation shares from the shareholder/grantor’s estate. IDGTs and GRATs are based upon having valuations performed reflecting the principles of valuation as stated in the IRS regulations and rulings. As a result, valuations are critically important.

As a final note, while President Obama has proposed changes to close the apparent “loopholes” in these trusts, Congress is not expected to act on the proposals.

Allison J. Shoemaker can be reached at Email or 215.441.4600.

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