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nly certain types of trusts are be beneficiaries of the trust, which is
Opermitted to hold an interest in There can be only one not the case for an ESBT.
an S corporation. Two of these are an ■ Unlike an ESBT, all the ordinary
electing small business trust, or ESBT, lifetime beneficiary income of a QSST must be distrib-
of a QSST, meaning uted to the beneficiary currently,
and a qualified Subchapter S trust, regardless of need, thus causing
or QSST. An ESBT is allowed as a that the beneficiary’s potentially unnecessary:
children cannot also
shareholder under Sec. 1361(e), which • Buildup of the QSST beneficiary’s
was added by the Small Business Job be beneficiaries taxable estate by the compounded
Protection Act of 1996.1 The provision value of the QSST’s share of the S
was initially praised by advisers and of the trust. corporation’s distributed income;
• Exposure of the compounded
their business owner clients because
value of the QSST’s share of the
it did not include the two major S corporation’s distributed income
restrictions of the QSST, which taxed on the entirety of the trust’s share to potential lawsuits against the
was created by legislation Congress of the S corporation’s income, regardless QSST’s beneficiary;
of whether the income is distributed to • Exposure of the compounded
passed in 1982.2 Those two primary
the trust. value of the QSST’s share of the
restrictions of the QSST were that the
An ESBT is handled differently S corporation’s distributed income
trust could only have one beneficiary
under the Code. With an ESBT, wheth- to potential marital rights of the
and that all the ordinary income of the er and to what extent the beneficiaries QSST beneficiary’s former spouse;
trust needed to be distributed currently of the trust are treated as owners of the and
to the sole beneficiary. This article trust’s share of the corporation’s stock • Full access to the S corporation’s
for purposes of Sec. 678(a) is up to the distributed income to an under-
compares the relative advantages and
drafter of the trust. The Code provides aged, spendthrift, or special-needs
disadvantages of a QSST versus an
merely that an ESBT is a permissible QSST beneficiary.
ESBT in estate planning.
shareholder of an S corporation.5 The ■ Because the clients will most likely
ESBT and its beneficiaries are then not want the income generated by
Tax treatment of QSSTs taxed under Sec. 641(c). The relevant all their other assets, including IRA
and ESBTs regulations clarify that, although in and 401(k) plan benefits, to be
The permissible shareholders of an S general the ESBT’s portion of the S automatically distributed to the trust
corporation include a “trust all of which corporation’s income will be taxed at the beneficiary, two separate trusts (or at
is treated … as owned by an individual highest federal income tax rate, taxation least two separate shares of one trust)
who is a citizen of the United States” of the trust’s beneficiaries at their own will normally need to be established
(Sec. 1361(c)(2)(A)(i)). A QSST with income tax rates under Sec. 678(a) takes for each beneficiary.
respect to which a beneficiary makes an precedence over this general rule.6 Given the above-described limita-
election is treated as a trust described tions of a QSST, the option of using
in Sec. 1361(c)(2)(A)(i).3 For purposes Advantages of an ESBT over an ESBT for holding S corporation
of Sec. 678(a), the beneficiary of such a a QSST interests in trust may need to be ex-
trust is treated as the owner of that por- Compared to ESBTs, QSSTs gener- plored more than it has been in the
tion of the trust that consists of stock in ally have significant disadvantages.7 past. Judicious use of Sec. 678 in the
an S corporation with respect to which These include: drafting of an ESBT, for example, can
the beneficiary makes the election.4 As ■ There can be only one lifetime largely eliminate the relevance of the
the deemed owner of the trust’s S corpo- beneficiary of a QSST, meaning that maximum federal trust income tax rate
ration’s shares, the QSST beneficiary is the beneficiary’s children cannot also on the trust’s share of the S corporation’s

1. Small Business Job Protection Act of 1996, P.L. 104-188. 6. Regs. Sec. 1.641(c)-1.
2. Subchapter S Revision Act of 1982, P.L. 97-354, §2. 7. One notable exception is where a QSST is being used in conjunction with a
3. Sec. 1361(d)(1)(A). qualified terminable interest property (QTIP) trust, where only the surviving
4. Sec. 1361(d)(1)(B). spouse can be a lifetime beneficiary and all the trust’s ordinary income must
5. Sec. 1361(c)(2)(A)(v). be distributed to the surviving spouse currently.

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