One of the tax projects that we are working on involves a couple where the husband passed away in 2012 who owned a successful small business. As we go through the process of trying to make sure all the appropriate steps were taken, my research leads me to potential issues related to S Corporations, Living Trusts and QSST elections. This is a simple thought experiment but the overall issue is likely to be a potential problem as baby boomer’s age and we find their estates have ownership of S Corporation stock.
Husband (H) was the owner of all the shares and owned the shares prior to his marriage to wife (W). The S Corporations shares were titled to the living trust of Husband. The shares, per the will, specified that half of the shares were to go to a marital trust and the other half directly to W. The marital trust stated that W could not sell the shares and they would all go directly to their 4 children at the time of her death.
Husband passed away in 2012. The problem beings when the 2012 return reports the S Corporation shares on the joint return which reported H as deceased and W as surviving spouse. The Company’s tax preparer changes the name and tax id number to W’s on the 1120-s K-1 in accordance to W’s statements and their understanding of the living trust document. All shares are now in W’s name and reported on her 1040 return as the preparer knew about the living trust arrangement.
This creates lots of problems. The will stated how the assets were to be divided and from the look of it, it wasn’t handled correctly. Possibly, the shares transferred directly to W through the living trust would be valid, but what about the shares that were supposed to be transferred to the marital trust? If the shares are owned by the marital trust, was a Qualified Subchapter S Trust (QSST) election filed with the IRS? Can the marital trust even qualify as a QSST because of the successor beneficiaries listed in the will?
If the QSST is considered invalid or isn’t made, then the S election is terminated. Without a valid S election, the income is no longer passed to the shareholders. Income is first taxed at the corporate level and then the dividends – the S Corporation distributions – are taxed to the shareholder at time of receipt.
The tax consequences can be significant. Let’s say that the Company made $1.0 Million in taxable income as an S Corporation. It distributes all $1.0 Million to the shareholders. The shareholders, W in this case, would pay about $390,000 in tax. Without a valid S election, the Corporation ends up being taxed on that $1.0 Million, which costs about $350,000 and then W is taxed on the $1.0 Million in dividends, which costs her personally about $200,000.
$550,000 in taxes compared to $390,000. And worse, the Company owed the tax but it may have distributed all its available cash, leaving W to wonder how she is going to pay the tax bill. And if she used the remaining $610,000 to pay her living expenses, she can’t even loan the money back to the Company to pay its tax bill.
And remember, this is for the last 5 years, so almost $800,000 in additional taxes could be owed.
If you own S Corporation stock and have it titled to your living trust, you may want to talk with your estate planning attorney or CPA to make sure instructions are available to make sure something like this doesn’t happen. Make sure your will aligns with your living trust and takes into consideration the fact that some assets have special rules about transfers to trusts. And if you need the name of a practicing attorney or accountant who specializes in trusts and estates in Oregon or Washington, let me know and I will send you a few contacts you can discuss your concerns with. Proper planning will make sure your wishes are carried out well and your beneficiaries receive what you planned for them.
Have a great weekend.