I. Introduction
One of the main reasons to consider a partnership for owning a business rather than an S Corporation is the adverse impact upon death if the business is held by an S Corporation. Now there are solutions to this problem for S Corporation shareholders that tax advisers need to add to their toolbox. These solutions convert the tax status of the business from an S Corporation to a partnership for federal tax purposes, in a federal income tax-neutral manner. This can be accomplished through liquidation in the case of a deceased shareholder or reorganization prior to death of a shareholder.
A. Upon the Death of an S Corporation Owner
Specifically, upon the death of an S Corporation owner, the heirs are denied the benefits of receiving a step-up in bases in underlying corporate assets to fair market value. In a partnership, the heirs receive a full income tax-free step-up in basis for all of the underling partnership assets and the benefits of obtaining the income tax shelter from new large depreciation deductions. However, in an S Corporation when the owner dies, the shareholder heirs only receive a step-up of basis in the corporate stock equal to the fair market value of the company at the date of death. The underlying S Corporation assets retain the same pre-death tax bases even though the decedent estates in both cases have the same federal estate tax implications and costs. Therefore, the S Corporation heirs should consider promptly liquidating the corporation to also achieve an income-tax neutral stepped-up basis for the company’s assets. This same technique can also be considered if a surviving shareholder buys out the estate of a deceased shareholder.
B. Prior to Death of an S Corporation Owner
Alternatively, with proper tax and estate planning the S Corporation shareholders have reorganization options prior to death of an S Corporation shareholder to avoid heirs being denied the benefits of receiving a step-up in bases in underlying corporate assets to fair market value upon death. The reorganization options include, but are not limited to (i) a contribution by the S Corporation of its assets to a limited partnership or limited liability company in return for issuance of a preferred interest in such entity, or (ii) a sale of the assets of the S Corporation to a limited partnership or limited liability company in consideration of a note payable to the S Corporation. If the shareholder recently purchased the stock of an S Corporation without an IRC Section 338 Election, there is a statutory merger of the S Corporation into a limited partnership or limited liability company with such entity surviving the merger. This achieves the same result as the heirs of an estate who have a high stock basis without the underlying S Corporation assets having a stepped-up basis.
II. Achieving Step-up in Basis upon a Shareholder’s Death Through Liquidation
For the estate of an S Corporation shareholder, one of the major problems is the inability of the estate, and thus the heirs as shareholders, to achieve a step-up in basis for the underlying corporate assets. Upon death, the shareholder’s estate receives a stepped-up basis in the shareholder’s stock only equal to the fair market value of the company on the date of death. In contrast, a tax partnership (including a limited liability company (LLC) taxed as a partnership) obtains a stepped-up basis for the decedent’s partnership interest and for the decedent’s proportional interest in the underlying partnership assets through an election under sections 736 and 754.
S corporations can consider the planning option of liquidating the S Corporation or liquidating the S Corporation through a merger. Because partnership status is generally preferable to the S Corporation structure for tax purposes, the estate or heirs can also use this event to convert from an S Corporation to a partnership without the usual tax consequences of such a conversion. Under this planning technique, estates and the heirs holding S corporation stock have a unique opportunity to achieve multiple tax benefits. This article describes how this conversion to partnership status and stepped-up basis in assets can be structured with little, if any, tax cost to the estate and heirs. When an S Corporation liquidates, the corporation is treated as having sold all of its assets for their fair market value, typically resulting in taxable S Corporation gain. Likewise, the estate is treated as having sold its S Corporation stock for an amount equal to the fair market value of the assets it receives in the liquidation distribution from the S Corporation.
Fortunately, when the S Corporation recognizes taxable gain, that gain increases the estate’s basis in the stock in an amount equal to the taxable gain recognized by the S Corporation. This taxable gain is reported to the estate on the corporation’s final Schedule K-1 (Form 1020S). The estate’s tax basis in its S Corporation stock is increased to the fair market value of the S Corporation stock upon the death of the shareholder and further increased as a result of the deemed sale of the S Corporation stock upon the liquidation.
Simultaneous with the increase in basis from the liquidation, the estate recognizes a taxable loss equal to the taxable gain reported to the estate on the corporation’s final Schedule K-1. The loss on the deemed sale of the S Corporation stock in the liquidation is reported on the estate’s or heirs’ Schedule D (Form 1040 or 1041). Typically, the S Corporation gain on the Schedule K-1 (Form 1020S) reported on Schedule E (Form 1040 or 141) and the loss on the Schedule D (Form 1040 or 1041) will net out with no tax due by the estate or its heirs for the S Corporation gain on liquidation. Remarkably, the business will have a new step-up in basis in all of its assets which the heirs can contribute tax-free to a new partnership.
Consider the following hypothetical facts. Sam has two heirs and he owns 100% of Hardware Corporation (taxed as an S Corporation) with a basis in his stock of $5,000. When Sam dies, Hardware Corporation is worth $10 million and has a basis in its assets of $10,000. As a result of Sam’s death, Sam’s estate now has a stepped-up tax basis in the Hardware Corporation stock of $10 million (the fair market value of the stock on Sam’s death).
If Sam’s two heirs liquidate the corporation, Hardware Corporation will recognize gain in the amount of $9,990,000 from the deemed sale of its assets ($10 million value minus $10,000 basis). Hardware Corporation will report a gain of $9,990,000 to Sam’s estate on a Schedule K-1 (Form 1020S). Upon recognition of this gain by Hardware Corporation, Sam’s estate basis in the stock will increase by $9,900,000 because of the deemed sale gain, giving Sam’s estate an aggregate tax basis in the stock of $19,990,000 ($9,990,000 deemed sale gain + $10,000,000 step up to fair market value on death). The liquidation of Hardware Corporation on the Schedule D of Sam’s heirs will be reported as a loss of $9,990,000, calculated as the difference between the fair market value of the Hardware Corporation assets received by Sam’s heirs of $10 million and Sam’s estate’s stock basis of $19,990,000
It is anticipated that the Schedule K-1 gain recognized by Sam’s estate of $9,990,000 on Schedule E of the Form 1041 and the Schedule D loss on the Form 1041 recognized by Sam’s estate of $9,990,000 will mostly off-set each other even though they are reported on different Schedules. Some difference may occur because the Schedule D loss will be a capital loss but some of the gain on the Schedule K-1 may be ordinary income recapture. The benefit of the large depreciation or amortization deductions for the assets with stepped-up basis will far exceed the modest tax cost. To utilize the depreciation, Sam’s heirs can contribute the $10 million in assets tax-free to a new partnership (or LLC taxed as a partnership) under section 721. The benefit to the new partnership is the ability to depreciate $10 million of asset basis in the partnership compared to the $10,000 of asset basis in an unliquidated Hardware Corporation.