If you own an S Corporation in San Luis Obispo and are considering an estate plan with trusts, there are important rules to navigate. Trusts are effective estate planning tools for avoiding probate, protecting assets, and reducing taxes—but if structured incorrectly, they can inadvertently terminate S Corp status, triggering unexpected tax consequences.
Compared to other counties, San Luis Obispo has more small business activity and, presumably, more S Corps than other counties, underscoring the importance of S corporation estate planning in San Luis Obispo.
| County | Total Small Business Establishments |
Population (2021) |
Establishments per 1,000 Residents |
|---|---|---|---|
| San Luis Obispo | 8,716 | 279,298 | 31.2 |
| Santa Barbara | 12,102 | 437,434 | 27.7 |
| San Diego | 90,078 | 3,274,954 | 27.5 |
| Los Angeles | 296,746 | 9,811,842 | 30.2 |
| Santa Clara | 48,524 | 1,886,595 | 25.7 |
What Is an S Corporation?
An S Corporation (S Corp) is a type of pass-through entity that allows income to be taxed at the shareholder level rather than at the corporate level, avoiding double taxation. To qualify, an S Corp must follow IRS rules under IRC § 1361.
Who Can Own S Corp Stock?
The IRS restricts who can be an S Corp shareholder under IRC § 1361(b)(1). Generally, only the following can own S Corp stock:
•Individuals (U.S. citizens and certain resident aliens)
•Certain trusts (but only if they meet strict IRS rules)
•Estates (after a shareholder dies)
Corporations, partnerships, and most trusts cannot own S Corp stock. If an ineligible shareholder acquires stock, the S Corp automatically loses its status and is taxed as a C Corporation, leading to double taxation.
Trusts That Can Own S Corp Stock (With Examples)
1. Grantor Trusts (Revocable Living Trusts)
A grantor trust is a trust where the grantor (person who created the trust) is treated as the owner for tax purposes (IRC §§ 671–679).
•The IRS ignores the trust and taxes income directly to the grantor.
•The trust must convert to a qualifying trust (e.g., QSST or ESBT) within two years after the grantor’s death (IRC § 1361(c)(2)(A)(ii)).
Example:
Sarah owns 100 shares in an S Corp and puts them into her revocable living trust. Since she is still alive, the IRS disregards the trust, and S Corp status is preserved. However, if she dies, her heirs must make an ESBT or QSST election within two years, or the S Corp status will be lost.
2. Qualified Subchapter S Trusts (QSSTs)
A QSST is a trust that can own S Corp stock if it meets four IRS rules under IRC § 1361(d):
1.The trust must have only one individual beneficiary.
2.The trust must distribute all income annually to that beneficiary.
3.The beneficiary must file an election within 75 days of the trust receiving the stock.
4.No principal distributions to anyone other than the one beneficiary during their lifetime.
Example:
Mike, a business owner, puts his S Corp stock into a QSST for his daughter, Lisa.
•Since Lisa is the only beneficiary and receives all income from the trust annually, it qualifies as a QSST.
•Lisa must file an election within 75 days of the stock transfer.
If Lisa forgets to file the QSST election, the S Corp status will be lost.
3. Electing Small Business Trusts (ESBTs)
An ESBT is more flexible than a QSST because it can have multiple beneficiaries, but it is taxed at the highest individual tax rate on S Corp income (IRC § 641(c)).
Example:
David puts his S Corp stock into an ESBT benefiting his three children.
•The trust can have multiple beneficiaries.
•The trustee must make an ESBT election within 75 days.
•All S Corp income is taxed at the top individual rate (currently 37%), which could be higher than if owned individually.
ESBTs offer flexibility but come with high taxes on undistributed income.
Pitfalls to Avoid (With Examples)
Choosing the Wrong Trustee or Beneficiary
•Only eligible trusts and beneficiaries can own S Corp stock.
•If stock is transferred to an ineligible trust, the S Corp status terminates immediately.
Example:
James’ will accidentally transfers his S Corp stock to a trust benefiting his grandkids, who are minors. The trust does not qualify as a QSST, ESBT or RLT. As a result, the IRS disqualifies the S Corp status, and the corporation becomes a C Corp overnight, leading to double taxation.
Missing QSST or ESBT Elections
•QSST and ESBT elections must be filed within 75 days of stock transfer (IRC § 1361(d)(2) & § 1361(e)(3)).
•Failure to file results in automatic S Corp termination.
An RLT Is Only a Temporary Solution for Holding S Corp Stock
•While the grantor is alive, an RLT is treated as a disregarded entity (grantor trust), meaning the IRS looks through the trust and treats the grantor as the shareholder.
•However, upon the grantor’s death, the trust is no longer a grantor trust, and its S Corp eligibility changes.
Example:
Michelle’s father dies, and she inherits S Corp stock in his trust. She forgets to make the QSST election within 75 days. As a result, the IRS reclassifies the business as a C Corp, doubling the tax burden.
Step-Up in Basis: Why It Matters for S Corps
A step-up in basis occurs when someone dies, and the tax basis of inherited assets is adjusted to fair market value (FMV) at the date of death under IRC Section 1014.
For S Corps, the S Corp stock itself receives a step-up in basis, but the assets inside the S Corp do not. However, the FMV to which the stock basis is stepped up is largely determined by the value of the company, which in turn is driven by the FMV of its underlying assets. If those assets have a low basis and substantial built-in capital gains, the company’s valuation will reflect that, often resulting in a lower step-up benefit than if the assets had a higher basis.
Example
Ellen owns an S Corp with:
•Stock worth $1 million (which receives a step-up in basis).
•Real estate inside the S Corp worth $3 million, originally purchased for $500,000.
At Ellen’s death, her heirs inherit the S Corp stock at its FMV of $1 million, but the real estate inside the corporation retains its original $500,000 basis. If the business sells the real estate, her heirs owe capital gains tax on $2.5 million in appreciation.
By contrast, an LLC structure would allow for a full step-up in basis on the real estate itself under IRC Section 743(b), potentially eliminating the capital gains tax upon sale.
Should You Convert Your S Corp to an LLC?
Key Considerations
•Converting to an LLC triggers immediate taxation. Conversion is treated as a deemed liquidation under IRC §§ 331 and 336, requiring the S Corp to recognize gains as if it sold all its assets.
•Compare tax rates before deciding. If capital gains tax today is lower than what heirs would face later, conversion may be advantageous.
Example:
John owns an S Corp worth $2 million and converts it to an LLC. The S Corp’s appreciated assets trigger a $500,000 capital gain immediately, resulting in a tax liability today instead of deferring it.
Planning Strategies for San Luis Obispo Business Owners
•Review Trusts Annually with your tax advisor – Ensure compliance with S Corp rules under IRC § 1361.
• Coordinate with Tax and Estate Advisors – Avoid IRS penalties.
•Consider LLC Conversion Carefully – Weigh step-up benefits against immediate tax costs.
Final Thoughts
S Corporations offer tax advantages but require careful estate planning. If you own an S Corp and are considering a trust or LLC conversion, consult with an estate planning attorney and tax professional to avoid costly mistakes.
If you are in San Luis Obispo and need help structuring your estate plan around an S Corporation or an LLC conversion, contact us today.
Here is an in-depth article about QTIPs I wrote for a lawyer audience.
