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The Key Person

The closely held corporation is often a fragile creature. Too often, its continued success and well-being are overly dependent upon the continued involvement of one individual – namely, the founder and principal owner of the corporation’s business.

This strong-willed individual may be responsible for the day-to-day management and operation of the business. Their relationships with the customers and vendors of the business, and with the business community generally, may represent a significant part of the corporation’s goodwill.

The individual’s mere presence in the business may prevent infighting among any would-be successors, with whom they may have been reluctant to share any significant responsibilities or relationships.

Estate Administration

The death of this individual may result in more than a temporary disruption in the well-being of the business.

In the absence of an anointed successor, the remaining shareholders of the corporation, perhaps including members of the decedent’s family, may determine that their best option is to sell, liquidate, or otherwise dispose of the business.

However, in almost every instance, this disposition will be deferred until the administration of the decedent’s estate has been completed.

In many cases, the IRS will examine the estate tax return filed by the decedent’s estate; in the process, it will consider any gifts previously made by the decedent.[i]

In other cases, members of the decedent’s family may become embroiled in litigation regarding the disposition of the decedent’s estate, including the stock of the corporation, among them.

In still others, disputes may arise concerning the interpretation of a shareholders’ agreement to which the decedent was a party.[ii]

In other words, the administration of the decedent’s estate may last several years.[iii]

An extended period of estate administration is rarely, if ever, good for the business formerly owned and operated by the decedent. Because of distractions similar to those described above, the decedent’s immediate successors, and even their advisers, may overlook certain income tax-related items, especially those that are not under their direct control.

This state of affairs presents certain unique challenges to a corporation that has elected to be treated as an S corporation for tax purposes, some of which may not become apparent until late in the administration of the estate. Indeed, the parties in interest may not recognize the existence, let alone the significance, of the issue until they have begun preparing for the disposition of the business.

Unfortunately, the failure to address these challenges on a timely basis may have significant economic consequences for the corporation’s shareholders that cannot be redressed.

The S Corp Election

Among the most important of these challenges is the preservation of the corporation’s election to be treated as an S corporation; specifically, ensuring (i) any trusts[iv] that held shares of stock in the corporation prior to the decedent’s death continue to qualify as shareholders of an S corporation, and (ii) any trusts to which such shares are transferred as a result of the decedent’s death are eligible to be shareholders of an S corporation.

It’s not as straightforward as it sounds. Let’s consider a not atypical dispositive scheme.

Once Upon a Time

It is not uncommon for the principal shareholder and their spouse, who may also own shares of stock in the corporation, to have created separate revocable trusts to which they have contributed some or all of their shares.

Under the terms of these trusts, the predeceasing spouse’s shares may be used to fund a credit shelter trust and a marital trust.

During the life of the surviving spouse, the marital trust may be required to distribute all its income to the surviving spouse, who is also the only beneficiary to whom the trust’s income or corpus may be distributed while they are alive.[v]

Upon the death of the beneficiary-surviving spouse, the trust may continue for the benefit of their surviving issue.[vi]

The dispositive provisions of the credit shelter trust may mirror those of the marital trust,[vii] or instead they may authorize the trustee to distribute income and/or corpus among the members of a class of beneficiaries that will usually consist of the surviving spouse and their issue with the predeceasing spouse.

It is also not uncommon for the principal shareholder to have made gifts of stock in trust for the benefit of one or more of their issue, or the shareholder may have sold shares of stock to a such a trust, often in exchange for a promissory note.[viii]

In the case of a sale, the purchasing trust is generally drafted as a grantor trust; meaning the shareholder who created and funded the trust reserved certain rights, or granted certain rights to another, as a result of which the shareholder continues to be treated as the owner of the transferred shares for purposes of the income tax.

In the case of a transfer by gift, the trust may or may not have been drafted as a grantor trust.[ix]

Decision Time? Oops

In each of these common scenarios, the executor of the deceased shareholder’s estate, the trustee of the lifetime or testamentary trust to which shares were transferred, or the beneficiary of the trust – individuals who are not necessarily involved in the management of the S corporation – will have to determine whether the trust in question is eligible to hold shares of stock in an S corporation or whether they must file an election with the IRS to qualify the trust as a permitted shareholder.

Even in the best of circumstances, these individuals will sometimes forget to make the appropriate election or are completely ignorant of the need for one. If the administration of the decedent’s estate is complicated, for example, by an IRS audit or by the threat or initiation of litigation, the risk of a missed election will probably increase.


The frequency with which these elections are missed is evidenced by the IRS’s efforts over the years to provide simplified procedures pursuant to which taxpayers may obtain relief from the termination of their corporation’s S election that would otherwise result from an untimely election with respect to a shareholder-trust.

Under the latest iteration of these procedures, the request for relief from a late election must be made within 3 years and 75 days after the date on which the election is intended to be effective.[x]

Notwithstanding this generous procedure, the IRS continues to receive many requests for relief under its general authority to grant extensions for regulatory elections that do not come within the purview of the procedure,[xi] and it continues to issue letter rulings in response that allow late trust elections in situations where the requesting taxpayer can establish that they acted reasonably and in good faith.[xii]

So why do trust elections continue to plague S corporations?

Trusts that May Hold S Corp. Stock

Before considering this question, let’s review the basic rules applicable to trust ownership of S corporation stock.

Grantor Trusts

A grantor trust is a trust, all of which is treated, for income tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.[xiii]

If the trust continues after the death of the deemed owner of the grantor trust, the trust may continue to hold the S corporation stock, but only for the 2-year period beginning on the day of the deemed owner’s death.[xiv] In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.[xv]

After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

For example, if the trust satisfies the requirements of a QSST (see below), and intends to become a QSST, the QSST election may be filed no later than the end of the 16-day-and-2-month period beginning after the second anniversary of the deemed owner’s death.[xvi]

Formerly Revocable Trust

If the trustee of a “qualified revocable trust” that holds S corporation stock and the executor of the related estate together elect,[xvii] by the due date of the income tax return for the first tax year of the estate, to treat the trust as part of the decedent’s estate – not as a separate trust – for income tax purposes, the trust may continue to own the S corporation stock until the later of (i) two years from the decedent’s date of death  or (ii) the date which is six months after the date of final determination of the estate tax liability imposed upon the decedent’s estate.[xviii]

In effect, this election allows a formerly revocable[xix] grantor trust (which is included in the decedent’s gross estate) to hold S corporation stock for more than two years after the death of the deemed owner. Such an election would prove extremely helpful in the case of an estate that, for example, expects to be involved in litigation regarding the disposition of the decedent’s assets.

At the end of such period, if the trust continues to hold the S corporation stock, it may be treated as a testamentary trust for a two-year period (see below).[xx]

Testamentary Trusts[xxi]

A trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will may hold such stock, but only for the 2-year period beginning on the day the stock is transferred to the trust.[xxii]

After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.


A qualified subchapter S trust (a “QSST”), is a permitted S corporation shareholder if the trust satisfies the following requirements:[xxiii]

  • it distributes or is required to distribute all of its income[xxiv] to a citizen or resident of the United States,
  • the trust agreement requires that this individual be the only income beneficiary of the trust,[xxv]
  • it does not distribute any portion of the trust corpus to anyone other than the current income beneficiary during the income beneficiary’s lifetime (including upon termination of the trust),[xxvi]
  • the income interest of the current income beneficiary ceases on the earlier of such beneficiary’s death or the termination of the trust, and
  • the beneficiary of the trust files an election to treat the trust as a QSST.[xxvii]

In the case of a QSST with respect to which a beneficiary makes an election, the beneficiary of the trust is treated, for purposes of the grantor trust rules,[xxviii] as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the election is made.[xxix]

A QSST election is made by signing and filing an election statement with the applicable IRS Service Center. The QSST election must be made within the 16-day-and-2-month period beginning on the day that the S corporation stock is transferred to the trust.[xxx]

If the income beneficiary of a QSST who made a QSST election dies, each successive income beneficiary of that trust is treated as consenting to the election unless they affirmatively refuse to consent to the election. A successive income beneficiary includes a beneficiary of a trust whose interest is a separate share[xxxi] but does not include any beneficiary of a trust that is created upon the death of the income beneficiary of the QSST and which is a new trust under local law.[xxxii]

If the trust continues after the death of the income beneficiary, continues to hold S corporation stock, and does not otherwise qualify as an eligible shareholder, it will nonetheless be allowed to hold the S corporation stock until the expiration of the two-year period beginning on the day of the income beneficiary’s death.[xxxiii]

If, after such 2-year period, the trust continues to hold S corporation stock and does not otherwise qualify as a permitted shareholder, the corporation’s S election will terminate.

However, if the termination is inadvertent, the corporation may request relief from the IRS.[xxxiv]


An ESBT is defined as any trust:

  • which does not have as a beneficiary any person other than an individual, an estate, or certain charitable organizations;[xxxv]
  • no interest in which was acquired by purchase; and
  • with respect to which a timely election has been made.[xxxvi]

The portion of the ESBT which consists of stock in an S corporation is treated as a separate trust. The trust’s pro rata share of S corporation income is taxable to the trust at the highest income tax rate applicable to the income in question. The trust’s tax liability is determined without regard to any deductions other than those allocable to the S corporation.[xxxvii]

To qualify as an ESBT, the trustee of the trust must make an ESBT election by signing and filing an election statement with the IRS Service Center where the S corporation files its income tax return.[xxxviii] Generally, only one ESBT election is made for the trust, regardless of the number of S corporations whose stock is held by the ESBT. However, if the ESBT holds stock in multiple S corporations that file in different service centers, the ESBT election must be filed with all the relevant service centers where the corporations file their income tax returns.[xxxix]

The ESBT election must be filed within the 16-day-and-2-month period beginning on the day that S corporation stock is transferred to the trust.[xl]

A trust that ceased to be a grantor trust upon the death of the deemed owner or a testamentary trust may elect ESBT treatment at any time during the 2-year period described in those sections or the 16-day-and-2-month period beginning on the date after the end of the 2-year period.[xli]

An ESBT does not include a QSST or a charitable remainder trust.[xlii]

Failure to properly make an election to be treated as an ESBT or a QSST may result in a shareholder who is not an eligible S corporation shareholder holding stock of the corporation which, in turn, would cause an inadvertently invalid S corporation election or an inadvertent termination of an S corporation election.


In some cases, where it becomes necessary to reform the dispositive provisions of a trust that is treated as a QSST, the trust may be converted to an ESBT (and the QSST election revoked as of the effective date of the ESBT election) if the following requirements are met: (i) the trust meets all of the requirements to be an ESBT, (ii) the trustee and the current income beneficiary of the trust sign the ESBT election, (iii) the trust has not converted from an ESBT to a QSST within the 36-month period preceding the effective date of the ESBT election, and (iv) the date on which the ESBT election is to be effective cannot be more than 15 days and two months prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed.[xliii]

Similar rules apply for the conversion of an ESBT to a QSST.[xliv]

Is It an Estate – Or a Trust?

The foregoing discussion addressed “entities” that are recognized as trusts as a matter of state law. Unfortunately, S corporation eligibility concerns extend beyond such trusts.

An estate is an eligible S corporation shareholder. Upon the death of an S corporation shareholder, if the decedent’s stock in the corporation is held by the executor of their estate for purposes of administration, the estate will become a shareholder as of the date of the decedent’s death. This is true notwithstanding the fact that state law may provide that the legal title to the stock passes directly to the decedent’s legatees or heirs.

However, an estate cannot remain in existence indefinitely. Indeed, under IRS regulations, an estate will be considered terminated if the period of administration is unduly prolonged. The period of administration of an estate is the period actually required by the executor to perform the ordinary duties of administration, such as the collection of assets and the payment of debts, taxes, legacies, and bequests.

The IRS may contend that a corporation has ceased to qualify as an S corporation where one of its shareholders is, in effect, a testamentary trust, rather than an estate, where the executors have long since completed their duties as executors yet have continued to hold the stock; i.e., the estate has effectively converted into a trust.

Thus, the shareholders of the corporation have yet another item to track if they hope to prevent the loss of the S election.

So, back to the question posed earlier: why do trust elections continue to plague S corporations?

By now, it should be obvious. The rules governing a trust’s ownership of shares of stock in an S corporation are complex. In light thereof, it is easy to appreciate how an S corporation may inadvertently lose its status by virtue of a trust’s ceasing to qualify as a permitted shareholder.

Thankfully, Congress and the IRS have provided some relief from terminations resulting from certain events or omissions. Depending on the circumstances, the relief may be granted automatically to a qualifying taxpayer, while another may have to formally apply for a letter ruling.

However, this complexity and risk of a misstep highlight the importance of having a well-drafted shareholders’ agreement, one that restricts the transfer of stock so as to preserve the corporation’s S election, that requires the transferor-shareholder to disclose to the corporation the details of the proposed transfer (including copies of any will or trust) and of any elections contemplated well in advance thereof, that perhaps requires an opinion of counsel that the transfer will not jeopardize the S election, and that ensures the cooperation of all the shareholders in reinstating the election if necessary.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] The IRS may assess additional federal estate tax within three years (six years in the case of a substantial omission) of the filing of the estate tax return. The issuance of a notice of deficiency followed by the estate’s petitioning the Tax Court will suspend the running of the limitations period.

[ii] Have you ever encountered a situation in which the dispositive provisions of a will were at odds with the terms of the shareholders’ agreement? It isn’t pretty.

[iii] Then of course, one has to avoid encouraging the perception of a fire sale.

[iv] We’re talking about domestic trusts. In any case where stock is held by a foreign trust, as defined in IRC Sec. 7701(a)(31), the trust is considered to be the shareholder and is an ineligible shareholder. Reg. Sec. 1.1361-1(h)(2).

[v] This describes a QTIP trust under IRC Sec. 2056(b)(7). The predeceasing spouse’s estate may claim an estate tax marital deduction for the property passing to this trust. Under IRC Sec. 2044, the value of the trust will be included in the gross estate of the surviving spouse.

See also Reg. Sec. 1.1361-1(j)(4).

[vi] Often as a so-called “dynasty trust.”

[vii] It’s “QTIP-able,” which may be helpful where the exemption amount under state law is less than the federal exemption amount.

[viii] A GRAT is basically a sale of property in exchange for an annuity. There is a gift to the extent the value of the “reserved” annuity is less that the value of the property transferred to the trust.

[ix] Grantor trust status shifts the income tax liability to the grantor, thereby further reducing their estate while enabling the trust to grow without having to pay income tax until after the grantor’s death.

[x] Rev. Proc. 2013-30.

[xi] An entity that does not meet the requirements for relief under this procedure may seek relief by requesting a letter ruling. The procedural requirements for requesting a letter ruling are described in Rev. Proc. 2022-1.

[xii] Reg. Sec. 301.9100-3.

IRC Sec. 1362(f) grants the IRS authority to provide relief if (1) it determines that the circumstances resulting in the ineffectiveness or termination of the S election were inadvertent, (2) no later than a reasonable period of time after discovery of the circumstances resulting in the ineffectiveness or termination, steps were taken (i) so that the S corporation is a small business corporation, or (ii) to acquire the required shareholder consents, and (3) the corporation, and each person who was a shareholder of the corporation at any time during the period specified pursuant to Sec. 1362(f), agrees to make any adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the IRS with respect to the period. If a corporation is eligible for relief under this provision, then, notwithstanding the circumstances resulting in the ineffectiveness or termination, the corporation will be treated as an S corporation during the period specified by the IRS.

Reg. Sec.1.1362-4 sets forth additional guidance regarding inadvertent termination relief. Section 1.1362-4(b) provides that the corporation has the burden of establishing that, under the relevant facts and circumstances, the IRS should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the event took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard against such an event, tends to establish that the termination was inadvertent. Section 1.1362-4(c) provides that a corporation may request inadvertent termination relief by submitting a request for a letter ruling. Section 1.1362-4(d) provides that the IRS may condition the granting of a ruling request on any adjustments that are appropriate. Section 1.1362-4(e) requires that the corporation and all persons who were shareholders of the corporation at any time during the time specified by the IRS consent to any adjustments that the IRS may require.

If the corporation does not qualify for relief and loses its tax-favored status, it will become a C corporation, the income of which is subject to so-called “double taxation.”  If the corporation desires to re-elect S corporation status, it will generally have to wait five years before doing so. IRC Sec. 1362(g). When the “new” S election is made, the corporation will begin a new built-in gain recognition period. IRC Sec. 1374.

[xiii] IRC Sec. 1361(c)(2)(A)(i).

[xiv] IRC Sec. 1361(c)(2)(A)(ii).

[xv] Reg. Sec. 1.1361-1(h)(1)(ii).

[xvi] Reg. Sec. 1.1361-1(j)(6)(iii)(C).

[xvii] On IRS Form 8855. The election is irrevocable.

[xviii] Under IRC Sec. 645 and Reg. Sec. 1.645-1.

[xix] Of course, it becomes irrevocable at the death of the grantor.

[xx] Reg. Sec. 1.1361-1(h)(1)(iv)(B).

[xxi] Other than a grantor trust, a QSST, or an ESBT.

[xxii] IRC Sec. 1361(c)(2)(A)(iii).

[xxiii] The determination of whether the terms of a trust meet all of these requirements depends not only upon the terms of the trust instrument but also the applicable local law. Reg. Sec. 1.1361-1(j)(2)(ii).

[xxiv] In general, this includes distributions to the trust from the S corporation for the year in question but not the trust’s pro rata share of the corporation’s income under IRC Sec. 1366. Reg. Sec. 1.1361-1(j)(1)(i).

[xxv] If a husband and wife are income beneficiaries of the same trust, they file a joint return, and each is a U.S. citizen or resident, the husband and wife are treated as one beneficiary for purposes of this rule. If a husband and wife are treated by the preceding sentence as one beneficiary, any action required by this section to be taken by an income beneficiary requires joinder of both of them. For example, each spouse must sign the QSST election, continue to be a U.S. citizen or resident, and continue to file joint returns for the entire period that the QSST election is in effect. Reg. Sec. 1.1361-1(j)(2)(i).

[xxvi] If, under the terms of the trust, a person (including the income beneficiary) has a special power to appoint, during the life of the income beneficiary, trust income or corpus to any person other than the current income beneficiary, the trust will not qualify as a QSST. Reg. Sec. 1.1361-1(j)(2)(iii).

[xxvii] IRC Sec. 1361(d); Reg. Sec. 1.1361-1(h)(1)(iii) and Sec. 1.1361-1(j).

If a QSST ceases to meet any of the above requirements, it will cease to be an eligible shareholder as of the first day on which that requirement ceases to be met. However, if such a trust ceases to meet the income distribution requirement but continues to meet all of the requirements, its eligible status will cease as of the first day of the first taxable year beginning after the first taxable year for which the trust ceased to meet the income distribution requirement. Reg. Sec. 1.1361-1(j)(5).

[xxviii] IRC Sec. 678.

[xxix] Reg. Sec. 1.1361-1(j)(7)(i) and Reg. Sec. 1.1361-1(j)(8).

However, an income beneficiary who is a deemed section 678 owner only by reason of IRC Sec. 1361(d)(1) will not be treated as the owner of the S corporation stock in determining and attributing the income tax consequences of a disposition of the stock by the QSST.

[xxx] Reg. Sec. 1.1361-1(j)(6)(iii)(A).

A QSST election may be revoked only with the consent of the IRS. Reg. Sec. 1.1361-1(j)(11).

[xxxi] Within the meaning of IRC Sec. 663(c).
It should be noted that a substantially separate and independent share of a trust is treated as a separate trust for purposes of applying the trust eligibility rules under IRC Sec. 1361(c) and 1362(d).

[xxxii] Reg. Sec. 1.1361-1(j)(9).

[xxxiii] Reg. Sec. 1.1361-1(j)(7)(ii).

[xxxiv] IRC Sec. 1362(f); Reg. Sec. 1.1362-4.

[xxxv] For purposes of the ESBT rules, a beneficiary includes a person who has a present, remainder, or reversionary interest in the trust. Reg. Sec. 1.1361-1(m)(1)(ii).

[xxxvi] IRC Sec. 1361(e).

[xxxvii] IRC Sec. 641(c). Thus, there is no deduction for distributions made to beneficiaries.

[xxxviii] Reg. Sec. 1.1361-1(m)(2)(ii).

[xxxix] Reg. Sec. 1.1361-1(m)(2)(i).

[xl] Reg. Sec. 1.1361-1(m)(2)(iii).

[xli] Reg. Sec. 1.1361-1(m)(2)(iv).

[xlii] Reg. Sec. 1.1361-1(m)(1)(iv).

[xliii] Reg. Sec. 1.1361-1(j)(12).

[xliv] Reg. Sec. 1.1361-1(m)(7).