Page 262 - TaxAdviser_2022

INDIVIDUALSTRUSTS & GIFTS
TES,
A
EST

income. Under Sec. 678, a person other of the trust each year, in order to avoid Under Sec. 678, it may be impossible in
than the grantor is treated as the owner annual taxable gifts by the beneficiaries certain situations to cause all the taxable
of any portion of a trust over which under Sec. 2514(e). In most states, the income allocable to an ESBT’s inter-
the person: beneficiaries’ annual withdrawal pow- est in the S corporation to be taxed to
■ Has a power (exercisable solely by ers will not be protected from lawsuits the trust’s beneficiaries. It is, of course,
himself or herself) to vest the corpus against the beneficiaries, but the lapsed impossible for income (including taxable
or the income from the trust in portions of the withdrawal rights will be income) not actually distributed by the
himself or herself; or so protected.8 S corporation to the trust (i.e., in the
■ Has previously partially released or It is doubtful that the income the way of dividends) to be withdrawable by
otherwise modified such a power ESBT beneficiaries do not elect to with- the trust’s beneficiaries. Thus, only the
and subsequently retains control of draw from the trust will be considered ordinary income of the S corporation
the trust that under the grantor trust divisible marital property, not just be- portion of an ESBT is withdrawable.
rules would cause the grantor to be cause it can be argued that it is property If a portion of the taxable income of
treated as the trust’s owner. received by way of inheritance or gift, the S corporation is not distributed to
Under Sec. 678, if the beneficiaries of but primarily because the property is the ESBT (i.e., as a result of working
an ESBT are granted the sole power to not actually owned by the beneficiaries, capital or other needs), and in effect is
withdraw the S corporation income that once the power to withdraw the same therefore allocable to trust corpus, this
is distributed to the trust annually, they has lapsed. Instead, and at best, it would retained taxable income of the S corpo-
are taxed on this trust income at their seem the following provision from the ration will be taxed to the ESBT at the
own tax rates regardless of whether they Uniform Marital Property Act should highest federal income tax rate. If the
withdraw it. An ESBT itself is not taxed apply: “The right to manage and control client’s family controls the S corpora-
on the income of the trust attributable marital property transferred to a trust is tion, one possible workaround to this
to the S corporation to the extent the determined by the trust.”9 situation would be for the S corporation
beneficiaries are taxed under Sec. 678. to first distribute this portion of the
If the beneficiaries of an ESBT are Advantages of a QSST over income to the ESBT and then have the
given withdrawal rights, each benefi- an ESBT trustee of the ESBT voluntarily invest
ciary’s rights should be designed to fully On the other hand, despite their desir- the same back into the corporation.
or partially lapse at the end of each year, able features, ESBTs have some poten- But if the client’s situation is such
but only to the extent of 5% of the value tial disadvantages compared to QSSTs. that this workaround is unavailable

8. For more information on the technical aspects of utilizing Sec. 678, including sample forms, see Blase, 6-7-8: Estate Planning With Section 678 of the Internal
Revenue Code (2022).
9. Uniform Marital Property Act, §5(c).

EXECUTIVE SUMMARY trust determine whether and to cause all the taxable income
what extent the beneficiaries allocable to the ESBT’s interest
• Both qualified Subchapter S are treated as the owners of the in the S corporation to be taxed
trusts (QSSTs) and electing small trust’s share of the S corpora- to the beneficiaries, rather than
business trusts (ESBTs) may hold tion’s stock. to the trust at the highest federal
an interest in an S corporation. income tax rate.
• Disadvantages of a QSST include
• A QSST may only have one that they can have only one • In some situations, it may be ap-
beneficiary, who is treated as the lifetime beneficiary and all the propriate for a trustee to modify
owner of the S corporation stock ordinary income of the trust must an existing QSST or ESBT using
held by the trust for which a ben- be distributed to the beneficiary a state decanting statute or other
eficiary election is made. currently, regardless of need. means.

• An ESBT may have multiple • A potential downside of an ESBT
beneficiaries. The terms of the is that it may be impossible to

44 May 2022 The Tax Adviser