Closely Held Business Alert: Estate Planning For S Corporations Owners
Operating as an S corporation is the favored choice of many closely held
business owners eager to escape the double taxation associated with C corporations.
However, it is important to note that making that choice will restrict the available estate
planning options of the S corporation shareholders, both in terms of lifetime transfers
and transfers at death, especially if the closely held business wishes to remain an S
Thus, careful planning is required to circumvent the traps that come with
ownership of S corporation stock. Concerning succession planning, for instance, pitfalls
may be avoided by transferring shares to trusts. When it comes to shareholder
agreements, caution must be observed so that accidental terminations of the S
Corporation election are avoided.
Gifts of business interests serve several purposes. All businesses require
succession planning to provide an orderly transfer of ownership to future generations.
For the business that is increasing in value, gifts have a “freezing” aspect as well,
transferring future appreciation to the next generation. Since an S corporation
distributes income directly to its shareholders, this income passes to the younger
generation instead of accumulating in the taxable estates of senior shareholders.
However, parents are often reluctant to confer direct ownership to their children.
They are concerned about giving their children a voice in business affairs
disproportionate to their wisdom. In addition, if the beneficiary-recipient has
creditor/liability issues (i.e., divorce, IRS liens, etc.), it is realistic to assume that the S
corporation stock may end up in unintended hands.
A preferred alternative to an outright gift is to employ a trust to serve as the
gifting vehicle. If structured correctly, the trust can qualify as an eligible S corporation
shareholder while providing a layer of asset protection to the beneficiaries. Depending
on the trust terms, gifts of the stock made to the trust can also qualify for the annual gift
An additional caveat with family succession involves situations where some, but
not all, of your children become active in management of the S corporation. When
stock is transferred to your children, whether outright or in trust, having some active
while others are not often creates resentment and sometimes leads to litigation. A buysell
agreement should provide for the sale or redemption of the shares of any child who
does not, by a certain age, become active in management.
Transfer upon Death
If no buy-sell arrangement exists upon the S corporation shareholder’s death,
stock held individually or as a tenant-in-common will be distributed as provided in the
decedent’s will (or revocable living trust). Thus, estate planning documents for an S
corporation shareholder should ensure that the S election will not be jeopardized as a
result of death. The will (or revocable living trust) should provide that the
executor/personal representative has discretion to account for the needs of the
beneficiaries while considering the impact of the distribution on the S corporation.
Additionally, the executor/personal representative should possess the authority to enter
into agreements with the other S corporation shareholders regarding elections,
distributions, transfer restrictions, and other matters.
Care must be taken to avoid inadvertent terminations. New owners should not
transfer stock to ineligible shareholders or take other actions which might be
inconsistent with S corporation status. A shareholder agreement may solve some of
The threshold question is whether the estate of a deceased shareholder is to be
bought out or continue as a shareholder. A buy-out is the easiest method from the
standpoint of maintaining the S election. If the estate is to continue as a shareholder,
the shareholder agreement must prohibit transfers to ineligible shareholders or to a
number of shareholders which would cause the corporation, in total, to exceed the 100
If a buy-out is contemplated, the question is whether there should be a
redemption or a purchase by the surviving shareholders. On the whole, the tax
consequences are the same. However, a purchase by shareholders may provide those
shareholders with a valuable step-up in basis.
If the deceased shareholder’s interest in the S corporation exceeds thirty-five
percent (35%) of the decedent’s adjusted gross estate, that percentage of the total
estate tax due may be deferred under the Internal Revenue Code (“IRC”). The IRC
allows for installment payment of estate taxes with interest only payable for five years.
Thereafter, the estate pays the tax equally over ten years with interest on the
outstanding balance. The make-up and valuation of estate assets should be reviewed
periodically to assure qualification.
Reduction of a decedent’s estate tax often hinges on arriving at the lowest
justifiable value for the S corporation. The valuation principles for an S corporation do
not differ from those of a C corporation. For example, if a price-earnings multiple was
being applied to net income, hypothetical federal, state, and local taxes should be
factored in. The value should include the corporation’s accumulated adjustments
account (“AAA”) and reflect its tax attributes. For state law purposes, the AAA is really
only earned surplus. However, there are some advantages to the AAA since it has
already been taxed as income to the decedent. Tax-free distributions can be made to
the estate, and amounts equal to the AAA can be bequeathed to beneficiaries other
than those who inherit the stock.
Estate Administration Considerations
When the assets of a decedent include the stock in an S corporation, the
executor must consider many factors.. The executor must first determine whether it is
prudent to retain the S election and if not, whether the executor has the power to
terminate the S election. If termination is preferred, the executor must determine how
and when the election can be terminated. There are also income tax considerations.
When a shareholder dies in the middle of an S corporation tax year, the general rule is
that profit or loss will be allocated on a per share-per day basis. However, if all
shareholders agree, the corporation can determine income on a specific accounting as
of date of death. It may be beneficial to get more income or loss on the shareholder’s
final return. This is possible with proper planning.
HLGR’s Closely Held Business Team
If you own S corporation stock and are thinking about transferring it to your family
members, the use of trusts could prove extremely useful from a risk mitigation and tax
perspective. Satisfying the myriad of rules under subchapter S while minimizing your
estate tax exposure is where we have expertise. If you have any questions, please
contact our closely held business team leader, Randall L. Duncan, at 503-242-0000, or
Jonathan Mishkin, LLM, at 503-242-0000, and we will be glad to assist you.
Our firm’s Closely Held Business Alerts are intended to provide general information regarding recent
changes and developments in the closely held business area. These publications do not constitute legal
advice, and the reader should consult legal counsel to determine how this information may apply to any