ESTATE PLANNING FOR S CORPORATIONS is limited in comparison to other entities, such as partnerships and C corporations, because S corporations can have only one class of stock and are precluded from a step-up in basis at death under 754 of the Internal Revenue Code of 1986 (hereinafter the "Code"). Notwithstanding these limitations, it is still possible to provide estate tax savings through an S corporation.
The discussion which follows details some pertinent planning possibilities as well as several pitfalls. Additionally, certain income tax provisions are described to provide a more detailed view of the area rather than just an abstract concept.
As a general rule, where there is more than one shareholder in an S corporation, it is critical for both income and estate tax reasons to have a shareholders agreement to govern the disposition of the stock.
Shareholders agreements are important to protect minority rights. A classic example is the situation concerning distribution of income earned by an S corporation. Assume that there are two shareholders: A, owning 60% of the stock and B, owning 40% of the stock; and all decisions for the corporation are made by majority vote of the shareholders. B lives day-to-day and has no savings, using all his income to support his lifestyle. The corporation earns $100,000 in its first year of its existence, but instead of distributing the income, the S corporation, with A voting in the majority, decides to accumulate the income for corporate needs. The result is that each shareholder shall receive a Form K-1 from the corporation, showing A earning $60,000 of ordinary income and B earning $40,000. However, because the income is being accumulated, no money is being distributed to the shareholders to allow them to pay their income tax. Consequently, B, because of his lifestyle, would be hard-pressed to pay the tax on the $40,000 of S corporate income.
If the shareholders agreement had provided that the S corporation is required to make a minimum distribution of funds each year so the shareholders will have enough money to pay their income tax, then B would not be in the quandary he is.
Income Tax Reasons for Shareholders Agreement
The income tax reason for a shareholders agreement is not to cause the S election to be lost because a second class of stock is created (discussed below) or that a shareholder will be in a position to terminate the S election. As to the income tax reason, 1362(d)(1)(B) prescribes that the S election can only be terminated by shareholders owning more than 50% of the S corporate stock. In reality, however, any shareholder owning any percentage of the stock can terminate the S election by simply transferring the stock held by the shareholder to a non-permitted person, such as a partnership, C corporation, another S corporation, etc. However, if there is a shareholders agreement in existence, all shareholders will be deprived of this opportunity since the shareholders agreement, by contract, will prevent transfers if the effect will be to destroy the S election. (It is to be noted, however, that if there is a more than 50% shareholder, he, she or it may object to this restriction, since by law a more than 50% shareholder would only have the right to terminate the S election.)
Second Class of Stock
In a shareholders agreement, care must be exercised to prevent creating a second class of stock under 1361. Reg. 1.1361-1(1)(2)(iii)(A) prescribes that "|a~greements...that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value" will not establish a second class of stock. Further, for price to be accepted by the proposed regulations, there must be a "good faith determination of fair market value."
Estate Tax Considerations
As everyone knows, great weight is given to the shareholders agreement to establish value of a decedent's stock at death. …