CSG Law Alert: Estate Planning Challenges With S Corps
Tax and estate planning for a shareholder in an entity taxed as an S corporation (S corp) requires careful attention. Restrictions on S corp ownership can limit planning opportunities and complicate trust and estate administration. Further, required pro rata distributions and tax recognition on certain in-kind distributions from an S Corp may impede gifting appreciated property owned by the S corp. Moreover, S corp shareholders do not benefit from an inside tax basis adjustment available to owners of other pass-through and disregarded entities.
Ownership Restrictions
An entity1 must satisfy the requirements of a small business corporation under Section 1361 to elect to be taxed as an S corp for pass-through tax treatment.2 Only individuals, tax-exempt organizations, qualified plans, estates and certain trusts are permitted shareholders in a small business corporation.3 Therefore, when transferring stock in an S corp, it is essential to confirm the proposed recipient is a permitted shareholder. Gifting shares in an S corp to an individual through lifetime gifting or upon the death of the shareholder generally does not cause any tax issues because natural persons that are either U.S. citizens or residents are permitted shareholders. However, transferring shares in an S corp to a trust requires further analysis and work.
Three (3) types of trusts are permitted shareholders in an S corp: (1) a trust wholly taxed as a grantor trust for income tax purposes, (2) an electing small business trust (“ESBT”) and (3) a qualified subchapter S trust (“QSST”).4 Additionally, a testamentary trust and a grantor trust that ceased being taxed as a grantor trust as a result of the grantor’s death are permitted shareholders in an S corp for a limited period of time because the decedent is temporarily deemed the owner of the shares. An estate can own shares in an S corp during the reasonable course of the administration of the estate and a testamentary trust can own the shares for two years following the date of the decedent’s death.5
Prior to gifting any shares of an S corp to a trust, the tax treatment of the recipient trust must be determined. Most lifetime trusts are prepared as grantor trusts for tax and planning purposes, while almost all trusts established after the transferer’s death are taxed as non-grantor trusts. When shares in an S corp are transferred to a grantor trust, no special elections are necessary because the grantor is the deemed owner of the trust’s S corp shares. On the other hand, non-grantor trusts (either lifetime or testamentary) receiving shares in a S corp must make an election to be taxed as an ESBT or a QSST within the time periods provided under Treasury Regulation 1.1361-1. An ESBT and a QSST have different requirements under the Code. A trust may have the opportunity for either election or be limited to an ESBT election, the less restrictive of the two options.6
Transferring shares in an S corp therefore presents two challenges. First, the recipient of the shares must be a permitted shareholder. Second, the transfer must be made within certain time limitations depending on the tax treatment of the transferee and transferor. Missing either of these requirements may cause termination of the entity’s S corp status and the entity will be converted to a C corporation. This conversion normally results in tax recognition, which necessitates careful planning and attention when S corp shares are being transferred.
Tax Recognition on In-Kind Distributions
An S corp recognizes gains when appreciated property is distributed to a shareholder from an S corp under Section 311(b). The distribution is treated as a sale between the S corp and the shareholder for income tax purposes. Gains are calculated on the difference between the fair market value of the property and the S corp’s tax basis in the property and can be taxed at either capital gains or ordinary income tax rates. These gains are distributed and taxed to the shareholders of the S corp on pro rata basis.7
This tax recognition event creates issues when a shareholder wants to transfer appreciated property held in an S corp, but not the S corp shares. For example, the S corp may own a real estate portfolio, and the shareholder is only interested in transferring one of the properties. Assuming that the property’s fair market value exceeds its adjusted tax basis, the property cannot be transferred or distributed from the S corp without a tax recognition event. For this reason and the basis adjustment discussed below, an S corp is an undesirable entity for holding real estate.
Planning opportunities are limited where an S corp owns a real estate portfolio. The shareholder can either gift his or her shares (transferring the underlying property of the S corp indirectly) or can receive a distribution of the underlying property and recognize tax. The latter option is trickier when there are multiple shareholders in the S corp because under Code Section 1366, the shareholders must generally receive pro rata distributions from the S corp based on their interests in the S corp. If shareholder A wants to receive an in-kind distribution from the S corp, Shareholder B must also receive a distribution of equivalent fair market value based on each shareholder’s ownership in the S corp.
In limited circumstances, the S corp may qualify for a tax-free reorganization under Section 368, permitting property to be transferred from the original S corp to a separate entity as a spin-off. Instead of distributing the desired property to the shareholder, the S corp could transfer the property to a spin-off entity as part of a tax-free divisive D reorganization under Section 368. The shareholder of the spin-off entity could then transfer his or her shares, indirectly transferring the property held in the spin-off entity, without tax recognition. However, these reorganizations are closely scrutinized by the IRS and generally require a business purpose for the reorganization.
No Inside Basis Adjustment
Upon the death of a decedent, the property that is included in the decedent’s gross estate for estate tax purposes receives a tax basis adjustment under Section 1014. Generally, property included in a decedent’s gross estate receives a basis adjustment to such property’s date of death fair market value. An ownership interest in an entity (i.e., shares, units, membership, or partnership interests, etc.) receives a tax basis adjustment to fair market date of death value. For example, if a decedent owned 100 shares in X corporation with a tax basis of $1,000 that was reported as having a fair market value of $10,000 on the estate’s estate tax return, the tax basis in each share would be stepped-up from $10 to $100. For an entity, this basis adjustment is referred to as the outside basis adjustment.
Alternatively, an inside basis adjustment occurs when the property held in the entity receives a basis adjustment. Section 754 permits entities taxed as partnerships to elect to adjust the inside basis of a partner’s interest in the property held by the partnership. For example, if a decedent owned 50% of a partnership which held real property with a date of death fair market value of $1 million, the partnership could make a 754 election to adjust the decedent partner’s interest in the real property to $500,000. While unclear under the Code and a point of argument among tax practitioners, disregarded entities such as single member LLCs may also receive an inside basis adjustment.
An S corp cannot receive an inside basis adjustment upon the death of the shareholder. Only an entity taxed as a partnership can make a 754 election, while disregarded entities may receive an inside basis adjustment if, as many practitioners believe, Revenue Rule 99-5 applies. The inability to receive an inside basis adjustment by the S corp is a strong argument against an S corp owning appreciable property for tax and planning purposes. Because there is no inside basis adjustment available to an S corp, on the death of a shareholder, the shareholder’s beneficiaries do not benefit from a new inside tax basis for depreciation purposes nor do they reduce recognition of a gain on the sale of the S corp held property.
Conclusion
While S corps do provide income tax benefits to their shareholders, they create issues for trust and estate planning and administration. Caution must be taken when transferring shares in an S corp because permitted shareholders are limited, and certain transfers require elections by specific deadlines. Far too often, shares in an S Corp are improperly transferred to an entity that does not qualify as a shareholder or deadlines are missed for necessary elections. These improper transfers can be caught years later, compounding negative tax consequences.
S corps holding appreciated property also present challenges in gift and tax planning. Once appreciated property is held in an S corp, there is little planning that can be accomplished to remove the property from S corp ownership without tax recognition. This issue is compounded by the fact that an S corp cannot receive an inside basis adjustment. The shareholders in a S corp therefore miss out on this significant tax benefit upon the death of a shareholder.
1 While most S corps are corporations, an LLC may also elect to be taxed as an S corp. For brevity, references to ““stock” or “shares” include any form of equity interest in an S corp.
2 References to a “Section” are to a section of the Internal Revenue Code of 1986, as amended (the “Code”).
3 I.R.C. § 1361(b)(1)
4 I.R.C. § 1361(c)(2)
5 See Treas. Reg. § 1.1361-1
6 While outside the scope of this article, some states have separate reporting and election requirements for S corp shareholders.
7 I.R.C. § 1368