The Internal Revenue Code limits the types of trusts (other than grantor trusts) that may hold S corporation stock. This article will discuss the issues involved in choosing between a qualified subchapter S trust (QSST) or an electing small business trust (ESBT).

A QSST is a trust that meets certain requirements imposed by the tax law, including the requirement that all income must be distributed (or be required to be distributed) to a single current income beneficiary who is a U.S. citizen or resident. Thus, if you want to transfer stock to each of your children, you would need a separate QSST for each child. Each child's trust would have to elect QSST status in order qualify as an S corporation shareholder and each child would be taxed on the S corporation income that passes through from the S corporation.

An ESBT is not subject to the one beneficiary rule, provided that the beneficiaries are limited to individuals (other than nonresident aliens), estates, and charities. Thus, a single ESBT that allows you or your trustee to make distributions to any one of your children can hold your S corporation stock.

An ESBT is taxed with respect to the income passed through from the S corporation as a separate entity at the highest tax rate (except for long term capital gain, which is taxed at the maximum capital gain rate). Thus, an ESBT would not allow your children to deduct their shares of the S corporation losses and would subject the S corporation's income to the highest tax rate, rather than your children's tax rates.