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March 1993

Estate planning for S shareholders.

by Keiser, Laurence

    Abstract- Election of the S status can help a corporation lessen its tax liability by having its income taxed at the individual level rather than at the more costly corporate level. The downside of the S status is that it creates serious estate planning problems for S corporation shareholders, particularly in the areas of succession, shareholder agreements, valuation, post mortem planning and basis considerations. Careful planning is needed to avoid the traps that come with ownership of S corporation stock. In the area of succession, for instance, pitfalls may be avoided by transferring shares to trusts. This solves the problem of parents who do not wish to saddle their heirs with the responsibility that goes with direct ownership of S corporation shares. When it comes to shareholder agreements, caution must be observed so that accidental terminations can be avoided if the S corporation has more than one shareholder. Other planning strategies are discussed.

Estate planning and administration for owners of S corporations have some unique problems. Succession, shareholder agreements, valuation, post-mortem planning, and basis considerations are the subjects for this month's article. If careful planning takes place, the benefits of S corporation status can pass through to the estate.

In the past few years, many small corporations have elected to be treated as S corporations. Part of the reason is to escape income taxes at the corporate level and take advantage of individual income tax rates which remain somewhat lower than corporate rates. S corporations can avoid the problems of corporate tax on sale or liquidation and the built-in-gains tax under IRC Sec. 1374. They continue to provide shelter from the problems of unreasonable compensation paid to officer shareholders and unreasonable accumulation of surplus.

Ownership of S corporation stock presents unique estate planning considerations and some estate administration problems. Succession, shareholder agreements, valuation, post mortem planning, and basis considerations are some of the most troublesome areas that challenge taxpayers and their advisors when doing estate planning for S corporation shareholders.


Gifts of business interests serve several purposes. All businesses need some type of succession planning, providing for 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 younger family members. Since an S corporation distributes income to shareholders, this income passes into the hands of younger generations instead of accumulating in the taxable estates of senior shareholders.

Parents are often reluctant to give direct ownership of shares to their children. They certainly do not want the children to have a voice in business affairs disproportionate to their wisdom, nor receive significant income that they have not earned. Custodial accounts under state gifts-to-minors acts are not helpful as they terminate at age 18 or 21 in some states.

Non-voting stock provides some relief. While an S corporation may have only one class of stock, S corporations are presently allowed to issue non-voting shares as long as there are no other differences in beneficial interests.

Trusts may be a better answer. Voting trusts can qualify as S shareholders. However, a transfer of stock to a voting trust where the transferor is the trustee will cause inclusion in the transferor's estate under IRC Sec. 2036(b). The other types of trusts which can be S shareholders are the following:

* A Grantor trust, all of which is deemed to belong to a U.S. person, whether the transferor or another;

* A Grantor trust which continues on the death of the deemed owner, but only for 60 days starting on the date of death or two years from the date of death if all the corpus of the trust is included in the estate of the deemed owner;

* A trust to which stock is transferred by will, but only for 60 days following the date on which the stock is actually transferred to it; and

* A "qualified subchapter S trust."

Special rules are provided for the "qualified subchapter S trust" (QSST), defined as a trust, all the income of which is distributed, or required to be distributed, currently to one individual who is a U.S. citizen or resident, and the terms of which require that 1) there can be only one income beneficiary during the life of the current income beneficiary; 2) any corpus distributed during the life of the current income beneficiary may be distributed to such beneficiary only; 3) the income interest of the current income beneficiary will terminate on the earlier of the termination of the trust or the income beneficiary's death; and 4) if the trust terminates during the income beneficiary's lifetime, all the trust's assets will be distributed to such beneficiary.

If a trust qualifies as a QSST and the income beneficiary files the required election, the income beneficiary is treated as the owner of that portion of the trust property that consists of S corporation stock. The QSST election is irrevocable, and is effective up to 2 months and 15 days before the date the election was made. Separate share trusts under IRC Sec. 663(c) are treated as separate trusts for this purpose.

Drafting a QSST requires care and the IRS has drawn some subtle distinctions. For example, in Rev. Rul. 89-55, IRS reviewed a trust whose terms provided that in the event the trust did not hold shares of an S corporation, the trust could terminate during the life of the current income beneficiary and distribute its corpus to persons other than the current income beneficiary. The IRS ruled this did not meet the strict requirement relating to corpus distributions and the trust did not qualify. On the other hand, a provision in a trust agreement that authorized the trustee to distribute or accumulate income and add it to corpus in the event the trust did not hold shares in an S corporation did not violate the QSST rules. Despite the authorization in the document, the trustee could nevertheless distribute all the income. In Rev. Rul. 92-20, the IRS ruled that the trust qualification would not fail because of permissive language in the document.

Another caveat is family succession. When stock is transferred to all the children, whether outright or in trust, the situation must be considered where some, but not all, of the children become active in the management in the business. Having some children active while others are not often creates resentment and sometimes leads to litigation. This is a major reason for having the children's interest represented by non- voting stock. A buy-sell agreement should provide for the sale or redemption of the shares of a child who does not, by a certain age, become active in the management of the corporation.

Because a QSST is a simple trust, all the income must be currently distributed. A problem can arise if an S corporation does not make a distribution to the trust, but the child, through the trust, is taxed on the trust's share of the S corporation taxable income. The child will not have assets to pay the taxes on the S corporation income. The problem would be avoided if, by agreement, the S corporation was required to distribute at least enough to pay the tax liabilities.

As noted earlier, an S corporation can only have one class of stock. Under recently issued IRS regulations, disproportionate distributions could create a second class of stock. If the corporation limits distributions of income to the QSST, it must similarly limit distributions to all shareholders, including the parents.

Grantor trusts can qualify without complying with the QSST rules for current distribution of income. An interesting planning possibility was outlined in PLR 9037011. An accumulation, i.e. complex, trust was set up, funded with S corporation shares, where the trustee had the power either to pay income among a class of beneficiaries or to accumulate the income and add it to principal. The trustee also had the power, exercisable in a non-fiduciary capacity, to substitute trust property of an equivalent value. This power made the trust a grantor trust under IRC Sec. 675(4)(C) and thus IRS ruled that it could hold the shares in an S corporation.

Although this power made the trust a grantor trust for income tax purposes, it is not a power which would cause the corpus of the trust to be included in the grantor's estate. An added estate planning benefit achieved: although income will pass to the children, the income tax will be payable by the grantor, further reducing the grantor's estate.

The trust must not be a disqualifying trust at the death of the grantor. Distribution should either be made outright to qualifying individuals or the trust divided into separate trusts, each qualifying as QSSTs. The grantor trust may continue to own the shares for 60 days after the decedent's death.

The courts of some states have permitted reformation of trusts in order to qualify as QSST's (See, for example Matter of Zemsky, N.Y. Law Journal, Dec. 9, 1988, p.33). In Zemsky the Surrogate's Court modified a trust to create three separate sub-trusts in order to qualify as QSST's.

Shareholder Agreements

Where the S corporation has more than one shareholder, 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 status. A shareholder agreement may solve some of these worries.

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 number would cause the corporation, in total, to exceed the 35 shareholder limitation.

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.

Where liquidity is a problem, IRC Secs. 303 and 6166 can apply to S corporations. IRC Sec. 303 allows sale or exchange treatment of a corporate distribution in redemption of stock in an amount not in excess of Federal and state estate taxes (plus interest) and administration expenses. IRC Sec. 6166 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. Transfers of 50% or more of the stock, except for transfers to beneficiaries, could eliminate the deferral. Distributions of 50% or more in value could also eliminate the deferral.

To qualify under these sections, the interest in the closely held business must exceed 35% of the adjusted gross estate and only that percentage of the tax may be redeemed and/or deferred. The make-up and valuation of estate assets should be reviewed periodically to assure qualification.

Sometimes the estate or the heirs will continue as shareholders. The estate would like to maintain its power and share of the vote, but it must redeem shares to have money to pay taxes and expenses. The IRS has approved a reorganization plan (Rev. Rul 87-32) under which the corporation is recapitalized with non-voting shares and the other shareholders exchange a portion of their voting shares for non-voting shares. From then on, some of the estate's voting shares are redeemed restoring the voting balance that existed prior to death. The estate has fewer shares and therefore a smaller beneficial interest in the corporation, but has the same voting percentage as before. If the intention of the parties is to carry out such redemption, it should be included in a shareholder agreement as the surviving shareholders are otherwise not obligated to convert their shares.

If the buy-sell agreement is between unrelated parties, the price should be considered by IRS as binding for estate tax purposes. Inter-family agreements will be closely scrutinized and must pass the gauntlet of new IRC Sec. 2703 and its requirement that the agreement--

* Is a bona fide business arrangement;

* Is not a device to transfer property to family members for less than full consideration in money or money's worth; and

* Contains terms comparable to similar arrangements entered into arms length.

Reasonableness of the buy-sell price is also a factor under the IRS's new single class of stock rules. An agreement to sell shares "significantly" above or below their fair market value could cause the agreement to create a second class of stock.


Reduction of estate tax often depends on arriving at the lowest justifiable value for the corporation. The principles of valuation for an S corporation are no different from that of a C corporation. However, Rev. Proc. 59-60 does not really address S corporations and some care must be exercised.

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") as defined in IRC Sec. 1368 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.

Often, the treatment of the AAA account is addressed in the shareholder agreement. Many agreements require it to be paid out on death, or distributed over a period of time with interest.

Also, if the estate has qualified for deferred payment of estate tax under IRC Sec. 6166, distributions of AAA, alone or in connection with sales or transfers of stock, would eliminate the deferral if the total exceeds 50% of the value of the shares.

If adjusted book value or liquidation value is to be used, proper consideration should be given to the built-in-gains tax (IRC Sec. 1374). Fair market value is generally defined as what a willing buyer will pay a willing seller where both are aware of all relevant facts and neither are under any obligation to buy or sell. Obviously if the buyer could not get a step-up in basis to the purchase price without paying a tax, the buyer would take that tax into account in the offering price.

The IRS, in PLR 9150001, has refused to allow a valuation discount for the potential corporate tax in a C corporation context where the estate did not establish that a liquidation was contemplated.

Although tax advisors may seriously question the validity of this ruling, they may wish to contrast the C corporate tax with the S built- in gains tax which can be eliminated after ten years of continuous S status. If death occurs while the tax would be applicable, does the fact that the tax might be eliminated after the appropriate waiting period affect the discount? Again, if fair market value is what a willing buyer would pay a willing seller, a buyer would still demand some discount since the potential built-in gain restricts his freedom to deal with the stock. Although this question remains unanswered, it is reasonable to assume that the IRS position would be to disallow any discount.

Post-Mortem Planning

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.

An estate is an eligible S shareholder during the period of administration. If administration is unduly prolonged, the IRS may treat the estate as terminated and look to the beneficiaries as the shareholders |Old Virginia Trust Co. Inc. v. Commissioner, 367 F.2d 276 (4th Cir. 1966).

A marital deduction trust ("QTIP") will, by definition, qualify as a QSST. There is only one income beneficiary, the spouse, and there can be no corpus invasions for anyone other than the spouse. A credit shelter trust may or may not. If there is any power to accumulate income, the trust obviously will not qualify. Remember that QSST status is elective. The election must be made within 75 days of the transfer of the stock.

There are also income tax considerations. When a shareholder dies in the middle of an S 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.

Passive Activity Rules Kick In

The passive activity loss rules also come into play at time of death. Any unused passive activity losses carried forward lose their treatment as passive losses and are available as deductions on the decedent's final income tax return. However, the losses allowable must be reduced by any step-up in basis allowed to the estate, or heir, to fair market value at date of death under IRC Sec. 1014.

The estate, as a shareholder, may have to pay tax on the undistributed taxable income of the S corporation even though there may be no cash distribution. A shareholder agreement can help here, requiring a cash distribution sufficient to pay taxes.

Although recent legislation purports to make S corporations more like partnerships, there are still obvious differences. One difference involves the so-called Sec. 754 election in a partnership. When a partner dies, the partnership can elect to step-up the basis of partnership properties to the fair market value of the deceased partner's interest. This basis step-up is fully allocated to the estate or the heirs. This will get the estate more depreciation deductions, but more importantly, will reduce the amount of gain that has to be reported on the sale of that property.

The unavailability of such a step-up can create an inequity for the S corporation shareholder. Suppose an S corporation owns real property with a fair market value of $200,000, an original cost of $150,000 and basis of $50,000. There are no other assets and liabilities. The shareholder's basis is $50,000 but will be stepped up to $200,000, the fair market value at date of death.

If the property is sold for $200,000 (and we assume no corporate level taxes), the corporate gain which would pass through to the estate is $150,000. This would increase the shareholder's basis to $350,000. When the corporation liquidates, it will distribute $200,000 against the basis of $350,000 creating a $150,000 capital loss. The liquidation must happen in the same year as the sale so that the shareholder's capital loss will offset the capital gain passed through the corporation. Otherwise, the effect is that the estate's step-up in basis will be converted to a possibly unusable capital loss.

Tax Savings at a Price

Ownership of stock in an S corporation often results in tax savings over what would be payable as a shareholder in a C corporation; but at a price. The price is the extra watching and care that must be invested to see that benefits are preserved. When creating an estate plan, or in administering the estate, the tax advisor must be conscious of the effect of all transactions on the corporation's S status.

Laurence Keiser, LLM, CPA, is a partner in the New York City and White Plains law firm of Greenfield Eisenberg Stein & Senior, specializing in tax planning litigation, estate planning, and administration.

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