Tax Implications of Trusts Holding Interests in Pass-Through Entities

Trusts are popular vehicles for estate planning, allowing individuals to pass on assets to their heirs while maintaining control over how those assets are distributed. However, when trusts own interests in S corporations and partnerships, there are specific tax implications and consequences that need to be considered. In this article, we'll discuss these consequences and provide guidance on how to plan for and manage them.

Eligibility to Hold S Corporation Stock

Not all trusts are eligible to hold S corporation stock. Only certain trusts, including grantor trusts, qualified subchapter S trusts (QSSTs), and electing small business trusts (ESBTs), can hold S corporation stock. The type of trust that is appropriate will depend on the specific circumstances of the individual's estate plan.

Grantor trusts are the most common type of trust used for estate planning. In a grantor trust, the grantor retains certain rights and powers, such as the right to revoke or amend the trust, which causes the trust to be disregarded for income tax purposes. As a result, any income generated by the S corporation is taxed to the grantor, rather than to the trust or its beneficiaries.

QSSTs and ESBTs are also eligible to hold S corporation stock. A QSST is a trust that is designed to hold S corporation stock for a single beneficiary. The beneficiary is the only person who can receive distributions from the trust, and all distributions must be made within two months of the end of the year in which they are earned. An ESBT, on the other hand, can have multiple beneficiaries, but it must meet certain requirements, such as having a valid election in place and meeting certain income and distribution requirements.

Taxation of Trusts Holding S Corporation Stock

When a trust holds an interest in an S corporation, the income generated by the corporation is passed through to the trust and taxed at the trust level. The trust must then distribute the income to its beneficiaries or pay the tax on the income itself. However, there can be a mismatch between the K-1 income reported by the S corporation and the income distributed by the trust.

For example, if the S corporation generates $100,000 of income and the trust distributes only $50,000 to its beneficiaries, the trust will be taxed on the full $100,000 of income, even though it only received $50,000. This can result in trapped income that cannot be distributed to the beneficiaries without incurring additional taxes.

To address this mismatch, trustees can make a Section 663(b) election, which allows the trust to deduct distributions made within the first 65 days of the year from the prior year's income. This can help ensure that the income reported on the K-1 matches the income distributed to beneficiaries.

Planning for Passive Loss Rules and Net Investment Income Tax

Passive loss rules limit the amount of losses that can be deducted from passive activities, such as rental income or investment income. When a trust holds an interest in a pass-through entity, such as an S corporation or partnership, these passive loss rules can apply.

Additionally, trusts are subject to the net investment income tax (NII), which is a 3.8% tax on investment income. To plan for these rules, trustees may need to carefully consider the timing of distributions and the amount of income generated by the trust.

Planning for the Sale of a Pass-Through Entity

When a pass-through entity, such as an S corporation or partnership, is sold, there are tax implications that need to be considered. The sale proceeds are passed through to the trust, which must then distribute the proceeds to its beneficiaries or pay the tax on the proceeds itself.

If the trust is a QSST, it may be subject to a tax on the sale of the S corporation stock. If the trust is an ESBT, it can avoid this tax, but it must meet certain requirements, such as having a valid election in place and meeting certain income and distribution requirements. If the trust is a non-grantor trust or estate, it will report the sale of the business on its tax return, and the beneficiaries will be taxed on any proceeds they receive from the sale.

To plan for the sale of a pass-through entity, trustees should consider the tax consequences and plan accordingly. This may involve timing the sale to maximize tax benefits, structuring the sale to minimize taxes, or making distributions to beneficiaries to spread out the tax liability.

Depreciation Deductions and Trusts

When a trust owns an interest in a pass-through entity, such as an S corporation or partnership, it is entitled to a share of the entity's depreciation deductions. These deductions can be passed through to the beneficiaries, even if they exceed the income distributed to them. However, the rules for passing these deductions through to beneficiaries can be complex, and trustees may need to seek guidance from tax professionals to ensure compliance.

Trustee Material Participation

Trustees who actively participate in the management of a pass-through entity may be able to offset passive losses generated by the entity. This is known as trustee material participation. However, the rules for trustee material participation can be complex, and trustees must be careful to ensure that they are meeting the requirements.

Frank Aragona Trust Case

In the Frank Aragona Trust case, the IRS challenged the trustee's material participation in a rental real estate activity. The court ultimately ruled that the trustee was not materially participating, which resulted in the disallowance of passive losses generated by the activity. This case highlights the importance of carefully documenting material participation activities and ensuring compliance with the rules.

State Income Taxation and Pass-Through Entity Tax Election

Trusts that own interests in pass-through entities may also be subject to state income taxation. Trustees should carefully review the rules in their state of residence to ensure compliance.

Additionally, some states allow pass-through entities to elect to pay taxes at the entity level, rather than passing through the taxes to the owners. This can be beneficial in certain circumstances, and trustees should consider whether this option is available and appropriate for their situation.

Common Questions

What are pass-through entities held by trusts?

Pass-through entities are businesses that do not pay taxes at the entity level, but rather "pass through" their income, deductions, and credits to their owners or beneficiaries, who report this information on their individual tax returns. Pass-through entities that are commonly held by trusts include S corporations, partnerships, limited liability companies (LLCs), and sole proprietorships.

What are examples of pass-through entities?

Examples of pass-through entities include small businesses, such as partnerships, S corporations, and LLCs, as well as sole proprietorships.

Are PTE refunds taxable?

Yes, PTE refunds are generally taxable to the beneficiaries of the trust that holds the interest in the pass-through entity.

Is Ptet worth it?

Whether or not Ptet is worth it depends on the specific circumstances of the trust and the pass-through entity in question. Ptet can provide tax savings for trusts that own interests in pass-through entities, but trustees must carefully consider the requirements and limitations of the Ptet rules to determine if it is appropriate for their situation.

What is the downside of Ptet?

The downside of Ptet is that it can be complex and requires careful planning and compliance to ensure that the requirements are met. Additionally, Ptet may not be appropriate for all situations, and trustees must carefully consider the specific circumstances of the trust and the pass-through entity in question.

How do I report Ptet on tax return?

Ptet is reported on Form 1041, which is the tax return for estates and trusts. Trustees must include a statement with the return indicating that the trust is electing to pay tax on behalf of the pass-through entity.

How does Ptet save on taxes?

Ptet can save on taxes by allowing the trust to pay taxes on behalf of the pass-through entity, which can result in a lower overall tax liability for the trust and its beneficiaries.

Who qualifies for Ptet?

Ptet is available to trusts that hold interests in pass-through entities that are subject to federal income tax. To qualify, the trust must make an election on Form 8993 and meet certain requirements, such as having a valid EIN and making timely estimated tax payments.

Is Ptet deductible in federal tax return?

Yes, Ptet is deductible on the federal tax return of the trust that holds the interest in the pass-through entity.

How is pass-through income taxed?

Pass-through income is taxed at the individual level, rather than at the entity level. The income, deductions, and credits of the pass-through entity are passed through to the owners or beneficiaries, who report this information on their individual tax returns.

What are the federal implications of pass-through entity tax?

The federal implications of pass-through entity tax include potential tax savings for trusts that hold interests in pass-through entities, as well as additional compliance requirements and limitations.

What is the IRS position on pass-through entity tax?

The IRS has provided guidance on the rules and requirements for Ptet, including the election process, compliance requirements, and limitations. Trustees must carefully review this guidance to ensure compliance with the rules and avoid potential penalties.

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Trusts that own interests in S corporations and partnerships can be subject to complex tax rules and consequences. Trustees must carefully consider the eligibility of the trust to hold S corporation stock, the taxation of the trust, planning for passive loss rules and net investment income tax, and planning for the sale of a pass-through entity. Additionally, trustees must be aware of the rules for passing through depreciation deductions, trustee material participation, state income taxation, and pass-through entity tax elections. By carefully considering these issues, trustees can ensure compliance with the tax rules and minimize tax liabilities for the trust and its beneficiaries.