Using Trusts and Subchapter S Corporations To Transfer Business Interests

If you are seeking to transfer business interests to the family, you may encounter complexities if your business is a corporation.

Specifically, there are restrictions on the types of trusts that may be shareholders in a subchapter S corporation, although recently the rules have been liberalized. In particular, these trusts will qualify as shareholders under current law:

• Electing Small Business Trust (ESMT).The problem here is that all of the trust's undistributed income is taxed at the highest possible marginal tax rate for individuals.
• Grantor Trust- Here, the parent will be taxed on all of the trust income. This may be desirable as an option in certain situations.
• Qualified Subchapter S Trust (QSST) - The rules here are similar to typical provisions found in trusts established for children. Basically, the rules require that a separate trust be established for each child, and that the income and principal within the trust be managed exclusively for that child. While this may seem to be a burden where there are several children, one trust instrument can create multiple trusts (i.e., only one document, executed once, is actually necessary).

Nevertheless, the limitation here is that the parent will not be able to create a single trust that will "spray" income among all of the children/beneficiaries unless an ESMT (which results in all income taxed at steep tax rate) or grantor trust (all income is taxed to the parent) is used.

None of these rules apply to the limited liability company (LLC). Thus, even with these changes for trusts and subchapter S corporations, the LLC is a simpler and more flexible alternative than the corporation when transferring interests to trusts.

In addition, if interests in the business are transferred to the next generation during the life of the parents, the remaining value in the estate of the parents at death will be relatively small.

When transferring the interest to an irrevocable children's trust, income tax rules governing trusts allow an experienced trust drafter to choose whether to have the income taxed to the children or taxed to the parent through the so-called "grantor trust rules." While income tax splitting can result in tax savings to the family, the grantor trust rules provide simplification because all of the income can be reported on the parent's income tax return. This is especially desirable where income is accumulated in the trust, rather than distributed to the beneficiaries. This is a very likely scenario, in this case, because trust income tax rates are higher than those that apply to individuals. In fact, many trust drafters intentionally make children's trusts subject to the grantor trust rules for this reason, by creating so-called "defective grantor trusts." (The term "defective" is used because, ordinarily, the children would be taxed on the trust's income, absent a defect in drafting the trust). With a defective grantor trust, the income from the trust is taxed to the parent, but the value of the trust assets is excused from the parent's taxable estate.