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Change in Ohio Taxation of Electing Small Business Trusts

In recent years many shareholders of Ohio-based S corporations have taken advantage of a tax planning structure using grantor trusts which obtained electing small business trust ("ESBT") status for federal income tax purposes. The shareholder would place his or her S corporation shares in the ESBT. The S corporation income would then be taxed at the ESBT level for federal income tax purposes. There would be no Ohio tax on such income. The ESBT would be established as a revocable "grantor trust" to maximize flexibility. This tax planning structure is now under attack by the Ohio Department of Taxation and may also be invalidated by the Internal Revenue Service.

The Internal Revenue Service is considering the publication of rules which would prohibit a grantor trust from electing ESBT status. It is anticipated that any such rules will be effective retroactively to January 1, 2000. In the meantime, the Ohio Department of Taxation has issued a press release stating that for taxable years beginning on or after January 1, 2000, the Income Tax Audit Division will require S corporation income attributable to shares held in a grantor trust ESBT to be passed through to the individual who established such a trust. In short, the Ohio Department of Taxation has independently determined that grantor trusts cannot elect ESBT status and, therefore, S corporation income allocable to grantor trusts will be taxable to the grantor for both federal and state purposes. Ohio's withholding tax rules for S corporation distributions will also be applicable.

As a result of the IRS rule changes which are reportedly pending and the policy announcement by the Ohio Department of Taxation, this tax planning structure will most likely no longer be of use effective January 1, 2000. Consequently, individuals who have taken advantage of the structure may wish to revoke the grantor ESBT and once again hold their S corporation shares in their own name. Because grantor trusts are revocable, the structure can be unwound without tax consequence and at a minimal cost.

However, it may be prudent to wait until the IRS rules are issued. If the IRS does not prohibit grantor trusts from achieving ESBT status, there could be some question whether the Ohio Department of Taxation's legal interpretation is correct and whether it can unilaterally change the tax treatment of this structure without legislative authority. We would recommend maintaining such structures in place for the time being but we caution our clients to recognize that the S corporation income flowing through the structure may well be subject to Ohio personal income tax and withholding tax for the year 2000 and thereafter. This fact should be kept in mind with respect to Ohio withholding tax and estimated tax obligations starting this year.

Currently, only grantor trust ESBT's will be subject to these new rules. Therefore, there may still be tax planning opportunities for individuals who are willing to place their S corporation shares in irrevocable non-grantor trusts which elect ESBT status. However, there could be significant gift tax consequences to such an approach and that alternative should only be considered in light of a careful analysis of an individual's particular tax and estate planning circumstances.

This Client Alert is intended to convey information on a topic of interest to employers. Although prepared by professionals, this publication should not be used as a substitute for legal counseling in specific situations. Readers should not act upon the information contained in this publication without professional guidance.

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