QSSTs vs ESBTs: When To Use One and Not the Other

If you are an S corporation shareholder, you may consider incorporating stock gifting into your estate planning. However, only a few trust types can hold an interest in S corporations, including qualified Subchapter S trusts (QSSTs) and electing small business trusts (ESBTs). This post covers what you need to know about QSSTs vs ESBTs, including their pros and cons.

Beneficiaries and Income

The primary difference between QSSTs and ESBTs is the number of beneficiaries. QSSTs may have only one lifetime income beneficiary. This means the beneficiary’s children cannot also be beneficiaries of that trust. In addition, all ordinary income from the trust must be distributed to the beneficiary yearly. 

On the other hand, ESBTs can have multiple beneficiaries. These may include individuals, estates, and charities eligible to hold S corporation stock. Another important difference is that ESBT income can accumulate in the trust without mandatory annual distribution requirements. 

Tax Implications

Beneficiaries report taxes differently depending on the type of trust. With a QSST, the beneficiary reports trust income and expenses on their individual income tax return. This means their income is taxed at the individual rate, which is typically lower than the trust rate. 

With an ESBT, the beneficiary reports income and expenses using IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. Although an ESBT is a single trust for administrative purposes, it is treated as two separate trusts for tax purposes.

The IRS treats the portion of the ESBT consisting of S corporation stock as one trust. For this trust, flow-through S corporation income is recognized at the trust level and taxed at the highest income tax rate. The IRS treats all other assets as a separate trust subject to the normal trust tax rules. 

Advantages and Disadvantages of QSSTs vs ESBTs

Deciding between QSSTs vs ESBTs involves a trade-off of two factors: flexibility and taxes. QSSTs have increased restrictions but typically lower tax costs, while ESBTs offer more flexibility but usually higher taxes.

Below are some specific advantages and disadvantages of the two types of trusts. 

Advantages of an ESBT Over a QSST:

• Multiple beneficiaries: ESBTs allow for multiple beneficiaries, whereas QSSTs allow only one income beneficiary during the life of the current beneficiary.
• No income distribution requirements: ESBT trustees can distribute income and principal at their discretion, while QSST trusts must distribute all ordinary income annually, regardless of need.
• Decreased risk exposure: Because QSST income must be distributed currently, it can unnecessarily expose the compounded value of the S corporation’s distributed income to lawsuits and marital claims against the beneficiary. 
• Increased taxable estate: QSST S corporation stock counts as the beneficiary’s property, so it may unnecessarily increase the value of the beneficiary’s taxable estate.
• More flexibility: The QSST beneficiary is treated as the owner of the trust’s share of S corporation stock, whereas the terms of the ESBT determine whether its beneficiaries are treated as owners.

Advantages of a QSST Over an ESBT:

• Potentially lower overall income tax: QSST beneficiaries are taxed at the individual rate, while ESBT beneficiaries are taxed at the trust rate.
• Beneficiary control of election: QSST beneficiaries can make the election, while trustees make the ESBT election. In addition, QSST beneficiaries can acquire their interest through purchase, while ESBT beneficiaries cannot. They must receive their beneficial interest through a transaction like an inheritance or a gift. 

Need Help Deciding? Contact Levy & Associates!

Levy & Associates is a team of tax professionals consisting of attorneys, accountants, and former IRS revenue officers. Whether you need help evaluating QSSTs vs ESBTs, want to understand corporate income taxes, or are interested in protecting inheritances from high taxes, we can help! Contact us online or call us at 800-TAX-LEVY for more information.