Estate Planning for S Corporation Shareholders

By Lochrary, Paul J. | The National Public Accountant, June 1990 | Go to article overview

Estate Planning for S Corporation Shareholders


Lochrary, Paul J., The National Public Accountant


Estate Planning for S Corporation Shareholders

The small business corporation (commonly referred to as the S corporation) is a form of business ownership that may provide substantial income tax benefits to its shareholders. If properly planned, the income tax benefits generated from this form of business ownership can be substantial.

First, the taxable income of the S corporation is taxed directly to its shareholders according to their pro rata share of ownership in the corporation. As a result, the corporate entity avoids payment of corporate income tax. Instead, the income is reported directly by the shareholders on their individual income tax returns, as are losses of the S corporation which are reported directly by the shareholders on their individual return. In this way, the double taxation normally accorded the income of a regular C corporation is avoided. If the individual shareholder is in a lower tax bracket than the corporation, an overall income tax saving is achieved.

Second, when a shareholder dies and the estate becomes the owner of the S corporation stock, the passive loss rules may apply. If the estate has substantial passive income, the losses from any passive activities of the S corporation may be used to offset the passive income, achieving a reduction or elimination of income tax liability for the estate.

Third, if a shareholder dies and the estate owns the S corporation stock, the estate will receive a stepped-up basis on the value of the stock. This step-up in basis may be sufficient enough, from a tax perspective, to permit a deduction of losses that the decedent could not have deducted if the step-up in basis had not occurred. This is especially true when the amount of the deductions exceeds the decedent's basis in the stock.

If these tax benefits are to remain viable for the shareholders of the S corporation, as well as for the beneficiaries of estates containing S corporation stock, proper lifetime planning is imperative. Without it, the corporation could inadvertently lose its S corporation status and the tax benefits associated with this form of ownership. This article focuses on planning strategies that may be used for a transfer of S corporation stock from a shareholder or a shareholder's estate.

Pitfalls to Avoid

A corporation does not become an S corporation without proper planning. An election must be made by the shareholders to treat their corporation as an S corporation for income tax purposes. To be considered for S corporation treatment, the business entity must meet a number of Internal Revenue Code eligibility requirements. Code Section 1361 requirements prohibit a business entity from becoming an S corporation if the corporation:

1. Has more than 35

shareholders; 2. Has a nonresident alien or a

nonhuman entity (such as a

partnership) as shareholder

(Certain kinds of trusts, as

explained later, are excluded

from this nonhuman entity

category.); and 3. Has more than one class of

stock.

If a corporation possesses any of these characteristics, it cannot elect S corporation treatment. Proper planning, therefore, becomes imperative to ensure that none of these situations occurs.

Well-meaning stockholders who wish to benefit their beneficiaries and younger family members through transfers of S corporation stock may be unaware that they are jeopardizing the corporation's eligibility to qualify as an S corporation. The following kinds of transactions most frequently result in disqualification for S corporation treatment:

1. Transfers to disqualified shareholders under Code Section 1361 (b) (1) (B). This would include both lifetime gifts and testamentary transfers of S stock to an ineligible corporation, a partnership, a nonresident alien or any kind of trust that is not exempted under the qualification rules. …

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