What steps can you take if a trust mistakenly becomes an ineligible shareholder of your S corporation? Trusts typically become a potentially ineligible shareholder following the death of the owner or their spouse when a revocable trust held S corporation stock during the owner or owner’s spouse's lifetime. Subsequently after the death of the owner or owner’s spouse, an irrevocable and non-grantor trust becomes the shareholder of the S corporation. 

Such trusts unfortunately do not qualify as an eligible shareholder after a two-year period following the death of the owner or owner’s spouse, thus jeopardizing the S corporation’s S status. 

To maintain the S corporation status, all shareholders must be eligible under IRS rules — specifically, they must be individuals, estates, certain types of trusts or tax-exempt organizations. Two types of trusts that qualify as S corporation shareholders are:

  • Qualified Subchapter S Trusts (QSSTs)
  • Electing Small Business Trusts (ESBTs) 

Without prompt action, an S corporation’s status could be terminated, creating costly tax consequences and administrative burdens. Understanding how to remedy this through a QSST or an ESBT is key to maintaining compliance and protecting shareholder value. 

 

OVERVIEW OF QSSTS AND ESBTS

What is a Qualified Subchapter S Trust (QSST)?

According to 26 USC § 1361(d)(3), to qualify as a QSST, the terms of the trust must require that:

  • During the life of the current income beneficiary, there will only be one income beneficiary of the trust
  • Corpus distributions during the current income beneficiary’s life can only be made to that beneficiary
  • The current income beneficiary’s income interest must terminate on the earlier of the current beneficiary’s death or the termination of the trust
  • If the trust terminates during the current income beneficiary’s life, the trust’s assets are all distributed to the current income beneficiary (per §1361(d)(3)(A) and §1361(d)(4)(A))
  • In addition, it is required that all of the trust’s income must be either distributed or required to be distributed currently to only one individual who is a citizen or resident of the U.S. If the trust fails to meet the income distribution rule but continues to meet the four other requirements listed above, the qualified trust’s status terminates on the first day of the next taxable year after the disqualifying event occurs (stated in §1361(d)(4)(B))

In many cases, S corporation stock may be transferred to a trust that does not technically meet the QSST requirements. In these situations, the IRS has ruled that the trust may be reformed into a QSST by removing the disqualifying features (see Example 7 of Reg. §1.1361-1(k)(1) and PLR 9025086). 

However, the IRS has ruled that neither a charitable remainder unitrust nor an IRA trust can qualify as a QSST (per Rev. Rul. 92-48 and Rev. Rul. 92-73). 

What is an Eligible Small Business Trust (ESBT)?

According to 26 CFR § 1.641(c)-1, an ESBT can have multiple beneficiaries and trust income can be accumulated and distributed among multiple beneficiaries. ESBTs are more flexible compared to QSSTs but also more complex.   

A trust is eligible to be an ESBT if no interest in the trust was acquired by purchase, and all of its beneficiaries are individuals, estates or charitable organizations. 

The following trusts are not eligible to be ESBTs:

  • QSSTs (QSSTs might be able to be converted to ESBTs)
  • Tax-exempt trusts
  • Charitable remainder annuity trust or charitable remainder unitrust

 

ELECTIONS

How to Make a QSST Election

For a trust to be treated as a QSST, a separate election must be made for each S corporation in which the trust owns stock (stated in §1361(d)(2)). Either the current income beneficiary or a legal representative, if one is appointed, can make the QSST election. The election must be filed with the IRS service center where the S corporation files its income tax return. The election must also:

  • Contain the name, address and the taxpayer identification number of the current income beneficiary, the trust and the corporation
  • Identify the election as an election under §1361(d)(2)
  • Specify the date on which the election is effective (not earlier than 15 days and two months before the date on which the election is filed)
  • Specify the date(s) on which the stock of the corporation was transferred to the trust
  • Provide all the information necessary to show that the current income beneficiary is entitled to make the election (per Reg. §1.1361-1(j)(6)(ii))

The election is due within two months and 15 days after the S corporation stock is transferred to the trust. If the trust holds stock of a corporation that makes an S election, it is due within two months and 15 days after the S election is effective. Additionally, if the trust ceases to be a grantor trust that was a shareholder of the S corporation and meets the requirements of a QSST, the election must be filed within two months and 15 days from the date the trust ceases to be a grantor trust. 

If a QSST election is missed or filed late, automatic relief may be available under Rev. Proc. 2013-30 and Rev. Proc. 2003-43, which outline a simplified procedure for obtaining relief. If the requirements for relief are not met or relief is denied, the only remaining option is to request a private letter ruling from the IRS.

How to Make an ESBT Election

The ESBT election is made by the trustee and applies to the taxable year of the trust for which it is made and all subsequent years, unless revoked with the Treasury Secretary’s consent (under §1361(e)(3)).

The trustee of the trust makes an ESBT election by signing and filing a statement that (according to Reg. §1.1361-1(m)(2)(ii)): 

  • Contains the name, address and taxpayer identification number of all potential current beneficiaries, the trust and the S corporation(s) in which the trust owns the stock(s)
  • Identifies the election as an election made under §1361(e)(3)
  • Specifies the date on which the election is to become effective (not earlier than two months and 15 days before the date on which the election is filed)
  • Specifies the first date(s) on which the trust owned the stock of the S corporation(s)
  • Provides representations signed by the trustee(s) that all potential current beneficiaries meet the shareholder requirements of §1361(b)(1), and the trust meets the definitional requirements of an ESBT under §1361(e)(1) 

The ESBT trustee must file the ESBT election within the time requirements prescribed for QSST elections (generally the two month and 15-day period beginning on the day the stock is transferred to the trust) (under Reg. §1.1361-1(m)(2)(iii)).

Rev. Proc. 2013-30 and Rev. Proc. 2003-43 provide a simplified procedure for taxpayers seeking relief for late elections. To qualify for late ESBT election relief, the requesting entity must submit the appropriate election form along with a statement that includes the information required under Reg. §1.1361-1(m)(2)(ii). The statement must also confirm the following:

  • All potential current beneficiaries meet the requirements of §1361(b)(1), and the trust satisfies the requirements of an ESBT under §1361(e)(1)
  • All shareholders, during the period between the intended effective date of the ESBT election and the date the completed election form is filed, have reported their income on affected returns consistent with the S corporation election effective for that period

 

TAXATION OF QSSTS AND ESBTS

How is a QSST Taxed?

The beneficiary of the QSST is treated as the owner of the portion of the trust consisting of S corporation stock for purpose of §678(a) (per §1361(d)(1)(B)). Therefore, the S corporation’s allocable income flows directly through to the QSST beneficiary as the deemed S corporation shareholder, rather than being treated as trust income. The QSST beneficiary reports the S corporation’s items of income, deductions and credits directly on their individual income tax return, not on the trust’s Form 1041. However, any gain on the sale of the S corporation stock by the QSST is taxed to the trust itself, not the income beneficiary. 

How is an ESBT Taxed?

An ESBT is essentially treated as two separate trusts for purposes of determining its income tax liability. The two separate trusts are referred to as the “S portion” and the “non-S portion.” The S portion items are not included in the computation of the ESBT’s distributable net income (DNI) (under Reg. §1.641(c)-1(a)).

The non-S portion of the trust is taxed under the regular trust income tax rules. Distributions from this portion are deductible in calculating its taxable income, but only up to the amount of DNI. However, DNI does not include any income attributable to the S corporation stock (stated in Reg. §1.641-(c)-1(i)).

The S portion is the portion of the trust that consists of S corporation stock. The tax attributable to the S corporation stock held by an ESBT is determined under special rules. The tax on the S portion is determined by reference to the general rules for the taxation of trusts but with the following modifications:

  • The highest tax rate applicable to a trust or an estate applies (according to §641(c)(2)(A))
  • The AMT exemption amount is zero
  • The only items of income, loss, deduction or credit taken into account are:
    • Income, deduction and credit from the S corporation
    • Gain or loss from the disposition of S corporation stock (including gain when distributions are in excess of basis, except that capital losses are allowed only to the extent of capital gains)
    • State or local income taxes and administrative expenses allocable to the S corporation stock
    • Any interest expense paid or accrued on indebtedness incurred to acquire stock in an S corporation
  • No deduction is allowed for amounts distributed to the beneficiaries. This income is not included in the trust’s DNI and is not included in the beneficiary’s income
  • If the ESBT owns stock in more than one S corporation, the regulations aggregate the income, deductions and credits from the various S corporations in determining the ESBT’s tax liability

If a trust may be characterized as either a grantor trust or an ESBT, the grantor trust rules take precedence. 

 

THE BOTTOM LINE

If your trust has unintentionally become a shareholder in an S corporation, immediate action is critical to preserve your S status and avoid unexpected tax exposure. The two primary solutions — QSST or ESBT elections — each carry distinct qualification rules, filing deadlines and tax implications.

GHJ’s High Net Worth Practice helps clients assess which structure fits their specific situation, manage the election process within IRS timelines and maintain ongoing compliance with confidence. The team’s expertise ensures that the S corporation status remains intact, minimizing risk and simplifying the complex trust and tax considerations that follow a change in ownership.