S corporations have specific rules that have a significant impact on estate planning for its shareholders. The goal of making sure the corporation remains an S corporation in the event of a shareholder's death requires careful planning and understanding of the characteristics of and rules applicable to S corporations. Termination of S status can have adverse tax consequences since the tax attributes of the business no longer pass through to the shareholders.
The death of a shareholder is considered the termination of his or her interest in the S corporation. The corporate income is prorated between the decedent and the successor shareholder on a daily basis before and after death. Income allocated to the period before the death is included on the decedent’s final income tax return. Income allocated to the period after death is included on the successor’s income tax return.
The corporation may elect the interim closing of the books method. This divides the corporation’s taxable year into two separate years, the first of which ends at the close of the day the shareholder died. This election is available only if a shareholder terminates his entire interest in the S corporation, all the “affected shareholders” agree, and the corporation properly attaches the election to its tax return for the year. The interim closing of the books method can be used as a tax strategy to reduce taxable income.
A decedent’s estate is an eligible S corporation shareholder and there is no statutory limit to the length of time an estate can be an eligible S shareholder. Estates must justify the reasons for an unduly prolonged administration based on the facts and circumstances in order to avoid becoming a deemed trust that could potentially disqualify the S corporation’s status. If the estate elects a fiscal year other than the calendar year of the S corporation, it can achieve up to an 11 month deferral of income tax. The basis of S corporation stock acquired from a decedent is its fair market value at the date of death or alternate valuation date, if elected. A sale of the S corporation stock soon after a shareholder’s death is automatically deemed long-term and can lead to a nominal gain or loss by the estate or heirs.
Only certain trusts are permitted to own S corporation stock. A testamentary trust that receives S stock pursuant to the terms of a will can hold the stock for only two years beginning on the date the stock is transferred to it. Similarly, a trust existing before the death that met the requirements to be treated as a grantor trust can hold S stock for a two-year period beginning on the date of the death of the deemed owner of the trust. However, electing qualified Subchapter S trust (QSST) or electing small business trust (ESBT) status can keep the S election in effect after the two-year period expires.
The advantage of remaining an S corporation is that the tax attributes are passed through to the shareholder as opposed to being subject to a double tax, taxed at the corporation level and taxed a second time when distributions are made to shareholders.
Qualified Subchapter S Trust (QSST): A QSST is a trust in which all the income must be distributed to the trust’s income beneficiary because the income must be declared on that individual’s tax returns, not the trust returns. The trust may only have one income beneficiary during the lifetime of that beneficiary, and the beneficiary must be a U.S. citizen or resident. Any corpus distributions that might occur during the life of the current income beneficiary must only go to that beneficiary. An important part of qualifying for a QSST is the election. The current income beneficiary of the QSST must be the one to make the election and he/she must have consent from the other S-corporation shareholders.
An advantage of a QSST is when the objective of the trust is to provide income to a beneficiary but not allow control or access to corpus. This is often an advantage when the beneficiary is a minor. It also works well when the objective is to provide income to one beneficiary but reserve corpus to another beneficiary following the death of the first beneficiary. In the estate planning arena, examples of QSSTs include the Qualified Terminable Interest Property (QTIP) trusts and marital deduction trusts.
Electing Small Business Trust (ESBT): An ESBT can have more than one beneficiary and the income can be distributed or accumulated. In order to have this flexibility the trust is taxed on the income related to the S corporation at the highest individual tax rate on the ordinary income. This can be an issue if a beneficiary is a minor or low-income individual who gets taxed at lower marginal rates. An ESBT would be more beneficial to a beneficiary who already gets taxed at the higher marginal rates.
All trust beneficiaries must be individuals, estates, or charitable organizations to be S shareholders. An interest in an ESBT cannot be acquired by purchase. An interest in an ESBT generally must be acquired by gift, bequest, or transfer in trust. An individual can establish a trust to hold S-corporation stock and split income among family members.
Consult your tax adviser if you have any questions, as these rules are complicated and have many criteria.
• Michael J. Flood, CPA , MST, is a partner with Caufield & Flood in Crystal Lake. He can be reached at 815-455-9538 or via e-mail at Michaelf@cfcpas.com or through the website CFCPAS.com.