Practice Help: Making Late QSST and ESBT Elections

Small business corporations, aka S corporations[1], have been much more common than their C corporation counterparts since 1997.[2] S corporations are taxed much differently than their C corporations, with the defining characteristic being that S corporations are flow-through entities, as they are not taxed at the entity level and avoid the widely known “double taxation” of C corporations, whose income is taxed at the entity level as well as upon distributions to shareholders. While there are benefits to electing S corporation status, there are also certain restrictions that S corporations must abide by to avail themselves of these benefits.[3] One of these restrictions is that an S corporation may not have a shareholder who is not an individual, other than an estate, certain trusts, or certain tax-exempt organizations.[4] The scope of this article is limited to those certain trusts which can hold S corporation stock, and specifically, how to file late elections to have such trusts qualify as a trust eligible to hold S corporation stock.

Under Sec. 1361(c)(2)(A), the trusts that may be qualified shareholders of an S corporation are: (1) trusts treated as owned by a U.S. citizen taxpayer for Federal income tax purposes[5] (“Grantor Trusts”); (2) trusts that were Grantor Trusts immediately before the death of the deemed owner, but only for a period of two years, beginning on the day of the deemed owner’s death; (3) trusts to which stock has been transferred by a will, but only for two years; and (4) trusts formed primarily to exercise the voting power of stock transferred to them. If the trust does not fall under the above categories, it may still qualify as an S corporation shareholder by filing an election to be treated as a qualified subchapter S trust (“QSST”) or an electing small business trust (“ESBT”).

QSSTs and ESBTS, Generally

QSSTs and ESBTs are both permissible shareholders of an S corporation,[6] but there are distinct differences between the two. A QSST may only have a single beneficiary, and such beneficiary is treated as the owner of the trust under Sec. 678(a). As the deemed owner, the beneficiary is taxed on all the trust’s S corporation income (regardless of whether such income is distributed to the trust), and any income distributed to the trust must subsequently be distributed to the sole beneficiary.[7] ESBTs, on the other hand, may have more than one beneficiary and provide greater flexibility than QSSTs, as the applicability of Sec. 678 depends on the specific drafting of the trust. While the various differences between QSSTs and ESBTs are beyond the scope of this article, it is important to note that for a QSST election, the sole beneficiary is responsible for filing the election, while in the case of an ESBT, the trustee is responsible for such.

How to File, Generally

To elect to treat a trust as a QSST or ESBT, the trustee (in the case of an ESBT) or the income beneficiary (in the case of a QSST) must file an election with the IRS service center where the S corporation files its income tax return, and such election must contain:

1. the name, address, and taxpayer identification number of (i) the trust, (ii) the potential current beneficiaries[8], and (iii) the S corporation in which the trust holds stock;
2. an identification of the election as a QSST Election under Section 1361(d)(2) or an ESBT election under Section 1361(e)(3), as the case may be;
3. the date on which the election is to become effective (not earlier than 15 days and 2 months before the date on which the election is filed);
4. the date or dates on which S corporation stock was transferred to the trust; and
5. representations signed by the trustee (in the case of an ESBT) or the income beneficiary (in the case of a QSST) that the trust meets the definitional requirements of a QSST or ESBT, as the case may be.[9]

Due Date for QSST or ESBT Elections

An election to treat a trust as a QSST or ESBT must be filed within the 16 day and 2-month period beginning on the day that the S corporation stock is transferred to the trust.[10]

How to File Late Elections

If the deadline to file the QSST or ESBT election is missed, Revenue Procedure 2013-30 provides guidance on how to make an effective late election[11] and has proved especially useful to taxpayers, as prior to Revenue Procedure 2013-30, taxpayers had to seek a private letter ruling from the IRS, which came with substantial expense. The purpose of this article is to streamline the guidance provided by 2013-30 in the most user-friendly way. To file a late ESBT or QSST election, the following must be included in the appropriate election form:

1. A statement from the trustee of an ESBT or current income beneficiary of a QSST, as the case may be, that includes the information provided in the aforementioned numbered paragraphs;
2. In the case of a QSST, a statement from the trustee that the trust satisfies the QSST requirements of Section 1361(d)(3) and that the income distribution requirements have been and will continue to be met;
3. In the case of an ESBT, a statement from the trustee that all potential current beneficiaries meet the shareholder requirements of Section 1361(b)(1) and that the trust satisfies the requirements of an ESBT under Section 1361(e)(1) other than the requirement to make an ESBT election;
4. Statements from all shareholders stating that during the period between the date the election was to have become effective and the date the election is actually filed, they reported their income on all affected returns as if the election had been timely made;[12]
5. The election form must state at the top, “FILED PURSUANT TO REV. PROC. 2013-30”;
6. The election form must contain an “Inadvertence Statement” that states, (i) that the failure to timely file the election under Subchapter S was inadvertent, and (ii) the diligent actions taken to correct such failure;
7. The election form and inadvertence statement must each contain the following provision: “Under penalties of perjury, I (we) declare that I (we) have examined this election, including accompanying documents, and, to the best of my (our) knowledge and belief, the election contains all the relevant facts relating to the election, and such facts are true, correct, and complete,” and such provision is signed by the trustee (in the case of an ESBT) or by the current income beneficiary (in the case of a QSST); and
8. The election form must be submitted to the IRS Service Center within 3 years and 75 days after the effective date of the election.[13]

Conclusion

Elections to treat trusts as ESBTs or QSSTs are not difficult to make, but during trust administration, the necessity to file such may often be overlooked, particularly in instances where a trust was previously exempt from filing such election, such as upon the death of the grantor of a Grantor Trust. Luckily, Rev. Proc. 2013-30 provides relief to those who miss the two-month, fifteen-day deadline. While Rev. Proc. 2013-30 details the actions you need to take to obtain relief for late ESBT or QSST elections, it does so by cross referencing several sections which is not particularly efficient for practitioners. This article provides simple, streamlined guidance on how to appropriately file late ESBT and QSST elections.

[1] IRC Section 1361(a)(1).

[2] https://www.irs.gov/statistics/soi-tax-stats-s-corporation-statistics-1995-to-2013#:~:text=S%20corporations%20continue%20to%20be,reported%20in%20Tax%20Year%202002.

[3] IRC Section 1361(b)(1) provides that an S corporation (A) may not have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual, (C) may not have a nonresident alien as a shareholder, and (D) may not have more than 1 class of stock.

[4] IRC 1361(b)(1)(B).

[5] IRC Sections 671-678.

[6] IRC Section 1361(c)(2)(A).

[7] Treas. Reg. 1.1361-1(j)(1)(i).

[8] Note: For QSST Elections, this will be the sole current income beneficiary.

[9] These filing requirements are found in Treas. Reg. § 1.1361-1(j)(6)(ii) and Treas. Reg. § 1.1361-1(m)(2)(ii) for QSSTs and ESBTs, respectively.  The definitional requirements to be attested to by the trustee are found in Reg. 1.1361-1(j)(6)(ii)(E) and 1.1361-1(m)(2)(ii)(E), respectively.

[10] Treas. Reg. § 1.1361-1(j)(6)(iii); 1.1361-1(m)(2)(iii).

[11] See also Gray Edmondson’s article regarding Rev. Proc. 2022-19, which provides relief for other common issues regarding compliance with S corporation provisions: https://esapllc.com/rev-proc-2022-19/

[12] The requirements for information contained in paragraphs 1-4 may be found in Rev. Proc. 2013-30, Section 6.01.

[13] The requirements for information contained in paragraphs 5-8 may be found in Rev. Proc. 2013-30, Section 4.03.

Parker Durham, J.D., LL.M.

Parker practices in the areas of business, tax, and estate planning. Parker recently graduated with his Master of Laws in Taxation from the University of Florida Levin College of Law, and he is currently satisfying the requirements necessary to obtain his Certified Public Accountant license. View Full Profile.