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With OBBBA introducing more phase-outs of tax benefits based on various income measurements, shifting income has become more important than ever. 

Partnership (LLC) owners can use nongrantor trusts to maximize their qualified business income deduction, to shift income, and to obtain other tax benefits.

From part II.J.11. Trust Business Income Tax Nuances – Should Nongrantor Trust Hold Business Interest?:

Subject to part II.J.9.c Multiple Trusts (collapsing multiple trusts into a single trust in certain situations), nongrantor trusts have the following possible advantages relative to grantor trusts:

• Multiple applications of part II.E.1.c.v.(a) Taxable Income “Threshold Amount” as described in part II.E.1.f Trusts/Estates and the Code § 199A Deduction – especially subparts II.E.1.f.i Nongrantor Trusts Other Than ESBTs and II.E.1.f.v Example Using Trusts to Split Income.
• Multiple applications of caps on state and local tax under part II.G.4.n Itemized Deductions; Deductions Disallowed for Purposes of the Alternative Minimum Tax, which issue can be ameliorated for state income tax earned on partnerships and S corporations under part II.G.4.n.ii Pass-Through Entity Tax (PTET).
• Part II.L.6 SE Tax N/A to Nongrantor Trust, which has become more important because the Tax Court, by ignoring legislative history, has undermined part II.L.4 Self-Employment Tax Exclusion for Limited Partners’ Distributive Shares.  For rates, see part II.L.2.a.i General Rules for Income Subject to Self-Employment Tax.
• Multiple capital gain exclusions under part II.Q.7.k Code § 1202 Exclusion or Deferral of Gain on the Sale of Certain Stock in a C Corporation
• Income shifting between the trust and beneficiaries, as described in part II.J.3 Strategic Fiduciary Income Tax Planning (especially part II.J.3.a Who Is Best Taxed on Gross Income), including that increasing a beneficiary’s adjusted gross income can:
  • Reduce itemized deductions (including the charitable income tax deduction or the Code § 68 2/37 deduction of itemized deductions)
  • Cause AMT exemption to be phased out
  • Cause personal exemption to be phased out (2026+)
  • Increase 3.8% net investment income (NII) tax. See part II.I.3 Tax Based on NII in Excess of Thresholds
  • Increase Medicare premiums
  • Adversely affect college financial aid on FAFSA form

However, if the trust holds S corporation stock, then flexibility is subject to constraints under part III.A.3.e QSSTs and ESBTs.

Note that trusts get into the highest income tax bracket quickly; when accumulating income tends to be most attractive when it would be taxed in the highest bracket if distributed to the beneficiary anyway, but such a beneficiary might already be fully impacted by most of those items.

• Possibly enhanced charitable deduction for cash distributions, subject to many issues in parts II.Q.6 Contributing a Business Interest to Charity and II.Q.7.c S Corporation Owned by a Trust Benefitting Charity.  However, except for an ESBT’s pass-through the relevant S corporation’s charitable contributions or donations attributable to unrelated business taxable income generated by a partnership, a nongrantor trust cannot deduct unrealized long-term capital gains on contributed property; see parts II.J.4.c.i.(a) General Overview of Code § 642(c) and II.G.4.g Limitations on Deducting Charitable Contributions.

Grantor trusts can save estate tax by income tax burn-off of the deemed owners’ income.  Contrast part III.B.2.b General Description of GRAT vs. Sale to Irrevocable Grantor Trust with part III.B.2.a Tax Basis Issues When Using Irrevocable Grantor Trusts; note, however, that this benefit can be undermined in part when employing part II.G.4.n.ii Pass-Through Entity Tax (PTET).  Some clients may be well under the estate tax threshold, so nongrantor trust status is not an estate tax detriment at all.

Grantor trusts can acquire high-basis assets by swapping low basis assets with their deemed owners (see parts III.B.2.d Income Tax Effect of Irrevocable Grantor Trust Treatment, which can be facilitated by part III.B.2.h.iii Swap Power – Code § 675(4)(C)), whereas a swap between a nongrantor trust and its grantor would be taxable.  A nongrantor trust can toggle into grantor trust status to permit that swap, then perhaps toggle back into nongrantor trust status.

Nongrantor trusts have more complex rules regarding participation to avoid the passive loss rules or net investment tax, in addition to other issues.  See parts:

• II.K Passive Loss Rules, especially subpart II.K.2 Passive Loss Rules Applied to Trusts or Estates Owning Trade or Business
• II.I 3.8% Tax on Excess Net Investment Income (NII), especially subpart II.I.8 Application of 3.8% Tax to Business Income
• II.J.13 Applying 3.8% Tax to Trusts Owning Businesses Other than S Corporations If the Beneficiary is Active But the Trustee Is Not
• II.J.14 Application of 3.8% NII Tax to ESBTsII.J.15 QSST Issues That Affect the Trust’s Treatment Beyond Ordinary K-1 Items
• II.J.16 Fiduciary Income Taxation When Selling Interest in a Pass-Through Entity or When the Entity Sells Its Assets
• II.J.17 Planning for Grantor and Nongrantor Trusts Holding Stock in S Corporations in Light of the 3.8% Tax
• II.K.3 NOL vs. Suspended Passive Loss – Being Passive Can Be Good, noting that suspending passive losses may be helpful – especially since 2017 tax law changes limit the use of net operating losses.  Thus, a partner who materially participates in a business might consider moving nonvoting interests into a nongrantor trust, using a trustee who does not materially participate.  When doing so, the tax preparer should develop a position that for that taxpayer is consistent regarding the application of subpart II.J.11.a.ii.(b) Beneficiary’s Ability to Deduct Depreciation That Generates Net Loss to the main topic of part II.J.11.a.ii Allocating Depreciation to Beneficiaries (Including Surprising Result Regarding Losses).

In light of these issues, when using a partnership, consider that a nongrantor trust helps save annual income tax in the following areas, some of which are mentioned above:

• Avoiding self-employment tax
• Making the beneficial owner not be a partner:
  • Being an employee can provide better fringe benefits; see parts II.P.2 C Corporation Advantage Regarding Fringe Benefits and II.C.8.b Consequences of Incorrectly Reporting Partner Compensation on a W-2 Instead of As a Guaranteed Payment.
  • However, the beneficial owner would need to take care to get expenses reimbursed; whereas a partner can deduct unreimbursed partnership expenses (Form 1040, Schedule A, Part II, code “UPE”), an employee’s business expenses are miscellaneous itemized deductions (see Code § 62(a)(1) and Reg. § 1.67-1T(a)(1)(i)), which are not deductible after 2017 tax law changes made permanent in 2025 (see part II.G.4.n.i Itemized Deductions).
  • Wages can help support the 20% deduction for qualified business income.  See part II.E.1.c Code § 199A Pass-Through Deduction for Qualified Business Income, especially subparts II.E.1.d Partnerships Compared to S Corporations for Code § 199A and II.E.1.c.vi Wage Limitation If Taxable Income Is Above Certain Thresholds (and, within that, subpart II.E.1.c.vi.(a) W-2 wages under Code § 199A).  If a partner receives a salary, that is taxed as a guaranteed payment, which is neither qualified business income nor wages; see parts II.C.8.a Code § 707 – Compensating a Partner for Services Performed and II.E.1.c.ii.(c) Items Excluded from Treatment as Qualified Business Income Under Code § 199A.
• Multiple applications of the Code § 199A Taxable Income “Threshold Amount”
• Income shifting between the trust and beneficiaries.  A nonresident trust might save income tax on the sale of a partnership interest; see part II.J.3.e.ii.(f) Business Income; Fielding (MN 2018); Metropoulos (CA 2022).

Of course, nongrantor trusts can cost extra tax as well, so one needs to consider all factors.

If the client has an existing business, consider having the client’s parents contribute a small amount to a new nongrantor trust and forming a new partnership for business expansion.  See part III.B.1.a.vii Business Expansion into New Location.  The client might also use an incomplete nongrantor trust.

The client could also do a sale to an irrevocable grantor trust, then turn off grantor trust powers after the note is repaid.  Of course, the client would not be a beneficiary.  See parts III.B.2.d Income Tax Effect of Irrevocable Grantor Trust Treatment and III.B.2.h How to Make a Trust a Grantor Trust Taxed to a U.S. Citizen or Resident.

If the client is young enough to have a parent who has substantial life expectancy, consider doing a sale to a beneficiary deemed owned trust. When the note is sufficiently paid down, a grantor trust power is added to convert it briefly to a grantor trust with the parent as a deemed owner, deactivating the beneficiary being the deemed owner. The parent then quickly turns off the grantor trust power, so as not to cost the parent too much. See parts III.B.2.i.i Designing Trust Wholly Owned by Beneficiary from Inception, III.B.2.i.ii Building Up Trust Wholly Owned by Beneficiary from Inception, and III.B.2.j Tax Allocations upon Change of Interest in a Business.

Some of these strategies might involve loans (part III.B.1.a.i Loans) and loan guarantees (part III.B.1.a.ii Loan Guarantees).  Loans from an existing business might be more handy than personal loans.

With OBBBA introducing more phase-outs of tax benefits based on adjusted gross income (AGI), controlling AGI has become more important than ever.

To prevent trust distributions from carrying out income to beneficiaries, a trust can contribute all of its assets to an S corporation and make an electing small business trust (ESBT) election. 

From part II.J.4.h.i. Trapping Income in Trust Notwithstanding Distributions – ESBT:

Just as in part II.J.4.g Making the Trust a Complete Grantor Trust as to the Beneficiary, the trust forms an S corporation, only this time makes an electing small business trust (ESBT) election or creates another trust.  This may be especially helpful when:

• The beneficiary is already in the top federal tax bracket and would benefit from not having more income, due to reductions in tax or other benefits from that inclusion.  See parts II.J.3 Strategic Fiduciary Income Tax Planning (especially various subparts thereunder) and II.J.11 Trust Business Income Tax Nuances – Should Nongrantor Trust Hold Business Interest?
• The trust is not subject to state income tax, but the beneficiary is.  See part II.J.3.e State and Local Income Tax.  Missouri resident trusts are taxed as nonresident trusts; see part II.G.29.b Missouri Taxes All Trusts as Nonresident (2026+).

The trust’s distributive share of S corporation income is taxed to the trust, even if distributed to the beneficiary. The trust would deduct S corporation contributions to charity using the Code § 170 rules instead of Code § 642(c), which means that contributions of appreciated property could be fully deductible rather than limited to basis. The contributions must be less than substantially all of the S corporation’s assets.

To better control the effect of distributions, if the trust reinvests its distributions in taxable investments then it should divide and put those assets in a separate trust.

If circumstances change, the trust could toggle to being taxed to the beneficiaries.

Before engaging in this approach, be careful to plan an exit strategy upon termination.

This strategy involves considerations similar to those described in part III.A.3.e.vi.(b) Disadvantages of QSSTs Relative to Other Beneficiary Deemed-Owned Trusts (Whether or Not a Sale Is Made).

Consider the disadvantages of an S corporation as an investment vehicle that is shared among family members:

• Take Care to Make Formation of Corporation Nontaxable. See part II.M.2 Buying into or Forming a Corporation.
• Inability to Divide S Corporation.  An S corporation that does not engage in a trade or business would not be able to be divided income-tax free under Code § 355.  This would trap all family members in a single investment entity, unable to manage investments suitable for each person’s goals.
• Tax Cost of Distributing Investments. A distribution of investments would be taxed as a sale.   Thus, distributing marketable securities to family members so that they go their separate ways would subject them to capital gain tax on the deemed sale of the investments. Distributing depreciable property might subject them to tax on ordinary income.
• Inability to Swap. Although a beneficiary does not recognize gain or loss when selling S corporation stock to a QSST, the trust would recognize income on selling S corporation stock back to the beneficiary.
• All Income Must Be Distributed. A QSST must distribute to its beneficiary all of its trust accounting income.  This can be controlled by the S corporation not making distributions to the trust.  The IRS might argue that the beneficiary’s failure to compel the trustee to compel a distribution from the S corporation constitutes a gift.  Note, however, that the IRS considers 3%-5% to be a reasonable range for income distributions, so the IRS should view any distributions within that range as sufficient.   If distributions were below this range, the IRS would argue that the lapsing withdrawal right 5-and-5 safe harbor of Code § 2514(e) that appears to protect such a small lapse is calculated in a way that does not provide much protection.
• Personal Use Assets. Placing personal use assets inside an S corporation would require the charging of rent.  The S corporation would recognize rental income, and those paying rent would not be able to deduct that rent.  If the beneficiary uses a trust asset for personal purposes, he does not need to pay rent, since the point of the trust is to benefit him.

These limitations are not imposed on trusts that don’t use an S corporation.  When their assets are divided among family members, the division is done on a tax-free basis and they can each go their separate ways quite easily.

If a beneficiary wants to make significant annual charitable contributions through the trust (instead of applying the beneficiary’s deduction limitations)  and the trustee agrees, but they want to avoid issues with exit strategies, the trust could fund the S corporation with the marketable securities to be contributed and other assets that would generate enough taxable items to absorb the full charitable deduction, applying the individual contribution limitations; then the S corporation could invest the remaining assets that would generate their returns through income rather than capital appreciation.  Thus, upon exit, the S corporation’s assets would have value relatively close to basis, so liquidation would not have serious income tax detriment.

Income tax difficulties in splitting an S corporation after the beneficiary’s death might be addressed as follows:

• Form a Partnership. By forming an entity taxed as a partnership with the beneficiary, other family members, or other trusts, a QSST might be able to access investment opportunities not otherwise available to it or might be able to facilitate their access to investment opportunities not available to them.  Although such a partnership could preserve the expected annual cash flow, the commitment to retaining funds in the partnership would reduce the fair market value of the S corporation’s partnership interest. This value reduction would also reduce the tax if the corporation distributes some or all of its assets when the QSST divides upon the beneficiary’s death.  Such a partnership should be formed well in advance of the beneficiary’s death. When the beneficiary dies, perhaps the S corporation would distribute some of its partnership interests right away so that the trust could immediately fund part of the bequests; then, later, after the trustee is satisfied that all tax and other fiduciary liabilities have been resolved, the S corporation could distribute the remaining partnership interests.   Furthermore, the partnership could later divide in a variety of ways on a tax-free basis, so that each family member can implement his or her own investment strategy over time; however, if the family members do not have strategies that either are consistent with each other’s or complement each other’s, pursuing different investment strategies would rend to require asset sales that might generate capital gain tax.
• Create Separate Corporations. Suppose a trustee decides to contribute its assets to an S corporation with the expectation that the beneficiary will make a QSST election.  Instead, consider forming a separate S corporation for the future benefit of each of the beneficiary’s children, which together create an LLC that holds the trusts’ assets.  When the beneficiary dies, each of the beneficiary’s children will be allocated a separate S corporation, thereby eliminating the need to divide the corporation or distribute its assets. The LLC can then liquidate, distributing its assets to each separate S corporation as described in the text accompanying fn. 6266. This solution merely postpones the issue, because these issues would need to be addressed when a child of the beneficiary dies (or if a child predeceases the beneficiary, but that postponement might be sufficiently beneficial to address concerns for a while).
• Marital Trust Doesn’t Have This Problem. If a marital deduction trust that holds 100% of an S corporation, then the S corporation stock gets a basis step-up, which essentially passes through in a nontaxable (because of the basis step-up) liquidation, subject to certain qualifications; see part II.H.8.a Depreciable Real Estate in an S Corporation – Possible Way to Replicate Effect of Basis Step-Up If the Stars Align Correctly, subject to the caveats in part II.H.8.a.i.(b) Challenging Issues When S Corporation Liquidates Holding Depreciable Property or Other Ordinary Income Property.  This is one of the few times when I like to have an LLC elect S corporation status, because the S corporation status can be revoked, resulting in a constructive liquidation, retroactively within 75 days after the beneficiary spouse’s death.

See also parts II.A.2.d.ii Estate Planning and Income Tax Disadvantages of S Corporations, II.A.2.d.iii Which Type of Entity for Which Situation? and III.A.3.d Special Income Tax Issues Regarding Bequeathing S Corporation Stock and Partnership Interests.

When investing a trust’s assets in an S corporation, note that the determination of income changes.  Under both the Uniform Fiduciary Income & Principal Act (“UFIPA”) and the 2008 amendments to the Uniform Principal & Income Act (“UPIA”), distributions from the S corporation will constitute income.  These distributions may be smaller or larger than the trust accounting income that the investments may generate.  Ultimately, however, the trustee usually may use a power to adjust to make income distributions fair; see part II.J.8.c.i.(a) Power to Adjust.  When the trust was originally a discretionary trust, the trustee needs this ability to adjust income to whatever distributions would have been absent this strategy.

If the beneficiary fails to object to a reduction of income distributions from a mandatory income trust, has the beneficiary made a gift?  CCA 202352018 suggested that a beneficiary’s failure to object to adding a beneficial interest to the trust would be a gift of some indeterminate value.   However, no beneficial interest is changing as a result of the ESBT Strategy; rather, the administration of the existing beneficial interest is changing. Reg. § 25.2514-1(b)(1) provides:

The mere power of management, investment, custody of assets, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity, whereby the holder has no power to enlarge or shift any of the beneficial interests therein except as an incidental consequence of the discharge of such fiduciary duties is not a power of appointment.

When determining whether the beneficiary’s failure to object to a reduction of income distributions from the Trusts is a gift, the existence of a power of appointment is tantamount to a successful argument of gift tax consequences, and a trustee’s power to adjust between income and principal is not a power of appointment. In short, the beneficiary can avoid gift tax consequences by proving that both of the following apply:

• The flexibility in the trust agreements and applicable state law are consistent with the strategy.
• Based on the trust agreements and applicable state law, the beneficiary would have an uphill battle in arguing for more income.

If a client wants her estate to sell her business interest and then distribute it to charity, placing conditions on the bequest may create uncertainty regarding the charitable estate tax deduction.

From part III.B.8.b. Funding and Administering Testamentary Charitable Lead Trusts with Business Interests:

Part II.Q.6 Contributing a Business Interest to Charity describes many issues when giving or bequeathing business interests to charities, some of which are explored further below in this part III.B.8.b.  For now, note that restricting a charitable bequest of a business interest may violate part II.Q.6.f.iii Charitable Partial Interest Prohibition.  Requiring that the asset be sold before distributing to charity makes me uncomfortable in light of part II.Q.6.f.iii.  On the other hand, using a shark-fin charitable lead trust (“CLT”) implicitly allows the estate plan to require that the asset be sold before distributing to charity. A CLT makes payments to charity for a period and then passes to individual remaindermen, and a shark-fin CLT provides smaller initial payments and then, when the business interest is expected to be sold, a large payment; see part III.B.8.a. General Overview of Rules Governing Charitable Lead Trusts.

A CLT is one way to avoid the charitable partial interest prohibition when transferring a partnership and the main charitable split-interest tool for transferring S corporation stock, which a charitable remainder trust cannot hold.  The fact that the CLT’s payments can be expressed as a percentage of the assets to be used to fund the CLT provides flexibility in case the asset values are not as originally planned.

When the business might not be sold for several years, funding the initial substantial but significantly lower charitable distributions may be challenging.  The estate plan might provide for other assets to fund those charitable distributions; although business income may suffice, other assets may be needed if business income falls short.  Consider using a donor advised fund or private foundation to receive the CLT’s distributions, so that the trustee of the CLT can limit the number of beneficiaries to whom the trustee must account and to take into account any variability of payments.

Below are parts:

• III.B.8.b.i How Long an Estate or Post-Mortem Revocable Trust Can Hold Stock in an S Corporation
• III.B.8.b.ii. Income Tax Issues Before and After Funding Testamentary Charitable Lead Trusts with Business Interests

From part III.B.8.b.i. How Long an Estate or Post-Mortem Revocable Trust Can Hold Stock in an S Corporation:

If a probate estate or a qualified revocable trust that makes a Code § 645 election to be taxed as an estate held the S corporation stock before transferring it to the CLT, the CLT can hold the stock for two years before making an ESBT election.  See part III.A.3.c Deadlines for Trust Qualifying as S Corporation Shareholder.  As described in part III.B.8.b.ii. Income Tax Issues Before and After Funding Testamentary Charitable Lead Trusts with Business Interests, avoiding an ESBT election for as long as possible is critically important to maximizing charitable or other deductions.

As to holding the stock during the Code § 645 election, see part III.A.3.b.ii A Trust That Was a Grantor Trust with Respect to All of Its Assets Immediately Before the Death of The Deemed Owner and Which Continues in Existence After Such Death.  Bottom line: generally one would bequeath the stock to the estate as of 6 years and 9 months after death, and the estate can hold the stock for as long as the Code § 6166 election is in place.

Thus, the estate plan would provide:

• If the stock is sold and cash proceeds received by 6 years and 9 months after death, the proceeds pass to the CLT.
• If the stock is not sold by then, it passes to the estate, and the will bequeaths the stock to the CLT.

If a revocable trust that did not file a Code § 645 election or an irrevocable grantor held the stock immediately before the deemed owner’s death, the trust can hold the stock for only two years before either making an ESBT election or transferring the stock to the CLT.  Part III.A.3.b.ii A Trust That Was a Grantor Trust with Respect to All of Its Assets Immediately Before the Death of The Deemed Owner and Which Continues in Existence After Such Death.

If a revocable trust that did not file a Code § 645 election or an irrevocable grantor held the stock immediately before the deemed owner’s death, the trust can hold the stock for only two years before either making an ESBT election or transferring the stock to the CLT.  Part III.A.3.b.ii A Trust That Was a Grantor Trust with Respect to All of Its Assets Immediately Before the Death of The Deemed Owner and Which Continues in Existence After Such Death.

From part III.B.8.b.ii. Income Tax Issues Before and After Funding Testamentary Charitable Lead Trusts with Business Interests:

If one bequeaths S corporation stock, consider expressly providing that any distributions with respect to that stock are to be passed on to the beneficiary receiving that stock.  Not only does such a provision ensure fairness if the trust/estate administration lasts any significant amount of time, but it also prevents a potentially unfair tax result from occurring.  See part III.A.3.d.i Various Fiduciary Income Tax Issues Regarding Bequeathing S Corporation Stock and Partnership Interests.

If the business interest is taxed as a partnership, the fiduciary holding the partnership interest can take a distribution deduction for cash paid to the CLT and pays tax on any K-1 income not paid to the CLT.  See parts II.J.1 Trust’s Income Less Deductions and Exemptions Is Split Between Trust and Beneficiaries and III.A.4 Trust Accounting Income Regarding Business Interests, especially subpart III.A.4.a General Strategies Regarding Fiduciary Income Taxation of Business Interests.

If the business interest is stock in an S corporation, then, before an ESBT election is required to be made (see above part III.B.8.b.i How Long an Estate or Post-Mortem Revocable Trust Can Hold Stock in an S Corporation), the fiduciary holding the S stock would apply the above rules.  If an ESBT election is in place, the fiduciary can deduct distributions to the CLT only against income other than from the S corporation K-1.  See part III.A.3.e.ii.(b) ESBT Income Taxation – Overview.

The CLT receives a deduction for amounts paid to charity, but the nature and amount of the deduction depend on whether the CLT has unrelated business income (“UBI”).  See part II.Q.7.c.i.(b) Business Income Limiting Trust Charitable Income Tax Deduction.  UBI includes:

• All S corporation K-1 income, without regard to its nature
• Partnership K-1 income, generally to the extent it constitutes business income or debt-financed income.

Charitable contributions from UBI are subject to the individual income tax limits.  See parts II.G.4.g.i.(a) Planning after 2025 – Limitations Imposed by OBBBA and II.J.4.c.ii Individual Contribution Deduction Requirements and Limitations.

Other charitable deductions are deductible to the extent that they could plausibly have come from gross income.  See parts II.J.4.c.i Estate or Nongrantor Trust Contribution Deduction Requirements and II.Q.7.c.i.(a) Contribution Must Be Made from Gross Income, which also explains that deductions are limited to basis that was invested after the trust earned gross income.