Leaving S Corporation Stock to a Special Needs Individual

An owner of an S corporation with a special needs child may be faced with a dilemma.  If the S corporation is a family business, much of the S corporation holder’s wealth may be held in the S corporation, but the business owner may feel strongly about treating all of his or her children equally in terms of gifts and inheritance.  S corporation stock also may have a large potential for appreciation, which makes it an attractive asset to give to younger family members while the value is comparatively low.  However, the rules regarding who can be a shareholder of an S corporation are strict.  An S corporation is limited to 100 shareholders, all of whom must be individuals (none of whom are nonresident aliens), charitable organizations, a decedent’s estate during the period of administration or certain kinds of trusts.

When a family member desires to make a gift to a special needs individual, a gift to a special needs trust for the benefit of the disabled person is the most effective way to make the gift without disqualifying the beneficiary from receiving government assistance.  This is sometimes called a “third party special needs trust” because the trust is established with gifts from a third party for the benefit of the special needs individual.  A special needs trust allows the trustee to make distributions for the benefit of the disabled beneficiary to provide for expenses other than those related to basic support.  The specific form of a third party special needs trust depends on state and federal law.  While there are other kinds of special needs trusts, a third party special needs trust will provide the most flexibility in terms of owning S corporation stock for the benefit of a disabled person.

A person establishing a special needs trust that will hold S corporation stock has options for qualifying the trust as an S corporation shareholder.  One option is for the special needs trust to be prepared as a “grantor trust,” which is taxed to the grantor for income tax purposes.  An advantage of a grantor trust as an S corporation shareholder is that the trust can grow tax-free while the grantor’s estate is reduced by the tax payments on behalf of the trust.  A disadvantage of establishing a special needs trust as a grantor trust is that the trust will cease to be a grantor trust after the death of the grantor, which will cause problems with the status of the S corporation if the special needs trust does not qualify as another type of trust permitted to hold S corporation stock.

A second option for a special needs trust holding S corporation stock is to qualify as an Electing Small Business Trust (“ESBT”).  For a trust to qualify as an ESBT, all beneficiaries must be individuals, estates or charities, no interest in the trust may be acquired by purchase and the trustee must file an election to qualify the trust as an ESBT.  The disadvantage of an ESBT as an S corporation shareholder is that the portion of the ESBT holding S corporation stock is automatically taxed at the highest trust tax rate.  The advantages of qualifying a special needs trust as an ESBT are that the status of the trust will not be affected by the death of the grantor and an ESBT allows for a great deal of flexibility in trust terms.  A practitioner preparing a special needs trust that is also intended to qualify as an ESBT should take care to review the requirements for a special needs trust under state law to ensure that they will not conflict with the requirements of an ESBT.