Estate Planning and Administration with S Corporations · 2018-03-02 · Chapter 2 Estate Planning and Administration with S Corporations1 AmeliA HeAtH US Trust, Bank of America Private

Online CLE

Estate Planning and Administration with S Corporations

1 General CLE credit

From the Oregon State Bar CLE seminar Advanced Estate Planning (2015), presented on June 12, 2015

© 2015 Amelia Heath, Jeff Chaidez. All rights reserved.

ii

Chapter 2

Estate Planning and Administration with S Corporations1

AmeliA HeAtH

US Trust, Bank of America Private Wealth ManagementPortland, Oregon

Jeff CHAidez

US Trust, Bank of America Private Wealth ManagementPortland, Oregon

1 This content represents thoughts of the authors and does not necessarily represent the position of Bank of America or U.S. Trust. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy. U.S. Trust operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. © 2015 Bank of America Corporation. All rights reserved.

Contents

I. Requirements to Make and Keep an S Election. . . . . . . . . . . . . . . . . . . . . . . . . . . 2–1

II. Estate Planning Techniques and Considerations with S Corporations. . . . . . . . . . . . . . 2–6a. Basic Estate Planning—Wills and Revocable Trusts . . . . . . . . . . . . . . . . . . . . 2–6b. Common Estate Planning Techniques and How They Work with S Corporation

Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–6c. Fiduciary Duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–8d. Treatment of Intangible Assets of S Corporation During Estate Administration . . . . 2–9

III. Income Tax Considerations for Trust and Estate Administration with S Corporations . . . 2–10a. Selecting a QSST vs. an ESBT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–10b. Section 645 Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–11c. Allocating Income in the Year of Death . . . . . . . . . . . . . . . . . . . . . . . . . . 2–12d. Family Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–13

IV. S Corporation Dispositions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–13a. Asset Sales (Timing of Asset Sales with Liquidation) . . . . . . . . . . . . . . . . . . 2–13b. Stock Purchases Treated as Asset Acquisitions—IRC § 338(h)(10) . . . . . . . . . . . 2–15c. S Corporation Stock Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–15

Appendix 1—QSST Election Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–17

Appendix 2—ESBT Election Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2–19

Chapter 2—Estate Planning and Administration with S Corporations

Advanced Estate Planning 2–ii


Advanced Estate Planning 2–1

I. Requirements to Make and Keep an S Election a. The company may have no more than 100 shareholders. IRC § 1361(b)(a)(A). Spouses

(and their estates) are treated as one shareholder. IRC § 1361(c)(1)(A)(i). Similarly, if individuals are ancestor and descendant (within six generations), have a common ancestor (within six generations), or are spouses or former spouses of such family members, they are treated as one shareholder. IRC § 1361(c)(1)(A)(ii) and (B)(i).

b. S corporations may have no more than one class of stock. IRC § 1361(b)(1)(D). S corporations may have voting and nonvoting stock, so long as there is only one class of stock. IRC § 1361(c)(4).

c. The type of corporation is not listed as an ineligible corporation in Internal Revenue Code section § 1361 (b)(2).

d. All shareholders must be eligible S corporation shareholders. The following types of

shareholders are eligible.

i. Individuals who are either U.S. residents or U.S. citizens. IRC § 1361(b)(1)(B) and (C).

ii. Estates. An estate is an eligible S corporation shareholder. IRC § 1361(b)(1)(B). Generally, it may remain so for a reasonable period of time to conduct administration. It cannot, however, remain in existence and remain an eligible shareholder indefinitely. See, e.g., Old Va. Brick Co. v. Com’r, 367 F2d 276 (4th Cir 1966).

iii. Certain types of domestic trusts. Foreign trusts (defined in IRC § 7701(a)(31))

are ineligible shareholders.

1. Grantor trusts. A “grantor trust” is a trust the assets of which are deemed to be owned by an individual settlor or beneficiary under IRC § § 671-679. A grantor trust may hold S corporation stock. IRC § 1361(c)(2)(A)(i). The deemed owner of the trust’s assets is treated as the shareholder for purposes of eligibility rules. IRC §1361(c)(2)(B)(i). Therefore, the individual deemed to own the trust assets must not be a nonresident alien. Common types of grantor trusts include

a. Revocable trusts during settlor’s lifetime. IRC § 676(a).

b. Trusts in which the settlor has retained an income interest or granted an income interest to his or her spouse. IRC § 677(a).

c. Trusts that grant any party the right, in a nonfiduciary capacity, to reaquire trust assets by substituting property of equivalent value. IRC §675(4)(C).



d. Trusts in which the settlor has retained the power to borrow assets of the trust estate without adequate interest or security. IRC § 675(2).

2. Revocable trusts within two years of death. If the entire corpus of a

revocable trust is includible in the settlor’s estate, then the revocable trust remains an eligible shareholder for up to two years following the settlor’s death. IRC § 1361(c)(2)(A)(ii). Once the eligibility period expires, if the trust retains ownership of the stock, then the trust is treated as the shareholder. Treas Reg § 1.1361-1(h)(1)(ii). The corporation’s S election will terminate if the trust is not then an eligible S corporation shareholder (e.g. whether it has made an election to be a qualified subchapter S trust or an electing small business trust). During the two year period of eligibility, the decedent’s estate is the deemed shareholder. IRC § 1361(c)(2)(B)(ii).

3. Testamentary trusts within two years of receipt of S corporation stock. A testamentary trust qualifies as an S corporation shareholder for two years beginning on the date that it receives the S corporation stock from the decedent’s estate pursuant to the terms of a will. IRC § 1361(c)(2)(A)(iii). A testamentary trust may continue as a permitted shareholder after the end of the two year period by becoming a qualified subchapter S trust or an electing small business trust. See Treas Regs § 1.1361-1(h)(3)(i)(D). The trust is the deemed owner of the stock. Treas Regs § 1.1361-1(h)(3)(ii).

4. Qualified Subchapter S Trusts (QSST). A QSST must meet these

requirements. Whether or not a trust qualifies as a QSST depends on the terms of the trust document and applicable local law. Treas Regs § 1.1361-1(j)(2)(ii).

a. Requirements.

i. All trust income is distributed to a single current income

beneficiary. IRC § 1361(d)(3)(B). That current income beneficiary is considered to be a shareholder for purposes of determining the number of shareholders of the corporation. IRC § § 1361(d)(1)(A).

1. If the trust agreement allows accumulation of

income but all income is in fact distributed, then the trust is not disqualified as a QSST. Rev Rul 92-20, 1992-1 C.B. 301.

2. If a distribution to an income beneficiary satisfies

the settlor’s support obligation to that beneficiary, the trust will cease to be a QSST on the date of distribution because the trust is a grantor trust. Treas Regs § 1.1361-1(j)(2)(ii)(B) and (C). (The



settlor is the deemed owner of the income portion of the trust under IRC § 677(b).)

ii. The single current income beneficiary is not a nonresident alien. IRC § 1361(d)(3)(B).

iii. There is only one current income beneficiary during that

income beneficiary’s lifetime. § 1361(d)(3)(A)(i). The trust may, however, have multiple beneficiaries if the separate and independent share rule of IRC section 663(c) applies. IRC § 1361(d)(3) (flush language).

iv. If any principal distributions are made during the current

income beneficiary’s lifetime, then the distributions are made to that current income beneficiary. IRC § 1361(d)(3)(A)(ii).

v. The income beneficiary’s interest terminates on the

beneficiary’s death or the trust’s termination, whichever is first. IRC § 1361(d)(3)(A)(iii).

vi. If the trust terminates during the income beneficiary’s

lifetime, all trust assets are distributed to that beneficiary. IRC § 1361(d)(3)(A)(iv).

b. Election.

i. The QSST election is made by the current income

beneficiary, not the trustee. IRC § 1361(d)(2)(B)(i).

ii. The QSST election must be filed within two and a half months of when the subject trust receives the S corporation stock (or otherwise becomes an ineligible shareholder) or after the corporation elects S status. IRC § 1361(d)(2)(D). Revenue Procedure 2013-30 provides the method for obtaining relief from an inadvertent late election.

iii. The beneficiary must make an election for each corporation

whose stock is held in the trust. IRC § 1361(d)(2)(B)(i).

iv. A beneficiary’s consent to the corporation’s S election is not a QSST election.

v. A form of election meeting the requirements of Treasury

Regulations section 1.1361-1(j)(6)(ii) is included as Appendix 1. The election must be filed with the IRS service center with where the corporation files its income tax return.



5. Electing Small Business Trust (ESBT)

a. An ESBT is much more flexible with its permissible terms than a QSST, but there are some tax issues with ESBTs that sometimes make them less desirable than QSSTs (discussed below).

b. Requirements.

i. Multiple beneficiaries are allowed. All beneficiaries must be individuals, estates, or certain types of charitable organizations. IRC § 1361(e)(1)(A)(i). No beneficiary may be a nonresident alien. Treas Regs § 1.1361-1(m)(1)(ii)(D).

1. A “beneficiary” of an ESBT for this purpose includes each person with a present, remainder, or reversionary interest in the trust. Treas Regs § 1.1361-1(m)(1)(ii)(A).

2. A permissible recipient under a power of appointment is considered a beneficiary only after that power of appointment is exercised in favor of such permissible recipient. Treas Regs § 1.1361-1(m)(1)(ii)(C).

3. Each “potential current beneficiary” of an ESBT

counts as a shareholder of the corporation. IRC § 1361(c)(2)(B)(v). A potential current beneficiary is a beneficiary that, during the time period at issue, may receive a trust distribution of income or principal. Treas Regs § 1.1361-1(m)(4)(i). If the trust has no potential current beneficiary for a period of time, then the trust is considered the shareholder for that period. IRC § 1361(c)(2)(B)(v).

ii. The trust did not purchase its interest in the corporation.

IRC § 1361(e)(1)(A)(ii). If any part of the trust’s basis in the stock is determined under IRC section 1012, then the trust acquired its interest by purchase. IRC § 1361(e)(1)(C). Thus, the ESBT must acquire its interest by gift or bequest. (Note that this requirement excludes ESBTs from part gift-part sale transactions discussed below.)



c. The trustee makes an ESBT election. IRC § 1361(e)(1)(A)(iii).

i. The Trustee files a statement with the IRS service center where the corporation files its income tax return to make the ESBT election. Treas Regs § 1.1361-1(m)(2)(i).

ii. Generally only one election is required, even if the ESBT

holds stock in multiple S corporations. However, if those corporations file returns in multiple IRS service centers, then an election must be filed in each applicable service center. Treas Regs § 1.1361-1(m)(2)(i).

iii. The ESBT election must be filed within the period required

for a QSST election, which is within two and a half months of when the subject trust receives the S corporation stock (or otherwise becomes an ineligible shareholder) or after the corporation elects S status. Treas Regs § § 1.1361-1(m)(2)(iii); 1.1361-1(j)(6)(iii). Revenue Procedure 2013-30 provides the method for obtaining relief from an inadvertent late election.

iv. A form of election meeting the requirements of Treasury

Regulations section 1.1361-1(m)(2) is included as Appendix 2.

d. The following trusts are not eligible to make ESBT elections. IRC

§ 1361(e)(1)(B).

i. A QSST. ii. A tax exempt trust.

iii. A charitable remainder annuity trust or a charitable remainder unitrust.

6. Voting Trusts. A voting trust is created primarily to exercise voting rights

of S corporation stock. All beneficial owners must be U.S. residents or citizens treated as owners of the stock under the grantor trust rules for each owner’s portion. Each beneficial owner of the voting trust is treated as a shareholder of the S corporation. IRC § 1361(c)(2)(B)(iv). An eligible voting trust is created by the shareholders under a written trust agreement that

a. Delegates to one or more trustees the right to vote;

b. Requires all distributions with respect to the S corporation stock

held by the trust to be paid to or on behalf of the beneficial owners of that stock;



c. Requires title and possession of that stock to be delivered to those beneficial owners upon termination of the trust; and

d. Terminates on or before a specific date. Treas Regs § 1.1361-

1(h)(1)(v).

iv. Certain charitable organizations. Qualified tax-exempt shareholders are defined in IRC § 1361(c)(6).

II. Estate Planning Techniques and Considerations with S Corporations a. Basic Estate Planning – Wills and Revocable Trusts

i. When drafting a will or revocable trust for a client who owns S corporation stock,

an attorney must be careful to ensure that all testamentary dispositions and continuing trusts will not inadvertently terminate the corporation’s S election. The will or revocable trust must require that the S stock be distributed or devised to an eligible shareholder. If this stock is to be distributed to a testamentary trust or continuing irrevocable trust, then that trust must be an eligible S corporation shareholder as outlined above.

ii. Revocable trust. As noted above, a revocable trust may hold S corporation stock for a period of two years after the death of the settlor. After that, stock must be distributed to an eligible S corporation shareholder or the trust must become a grantor trust, a QSST, or an ESBT.

iii. Wills. Using a will rather than a revocable trust as the primary estate planning

vehicle can have advantages for S corporation shareholders. As noted above, an estate is an eligible S corporation shareholder for a reasonable period necessary for estate administration. Revocable trusts must distribute or otherwise become qualified S corporation shareholders within two years. Often, a reasonable period to administer a complex, taxable estate exceeds two years. In addition, a testamentary trust is an eligible S corporation shareholder for two years following receipt of the S corporation stock without other qualification. Thus, that reasonable period of administration, which may exceed two years, has another two years beyond that (assuming use of the testamentary trust) before stock must be distributed to or retained by an otherwise eligible shareholder.

b. Common Estate Planning Techniques and How they Work With S Corporation Stock.

i. Irrevocable Trust Funded During Life (non-grantor trust). For an inter vivos

irrevocable trust that is not a grantor trust to be an eligible S corporation shareholder, it must qualify as a QSST or an ESBT and the appropriate election must be made.

ii. Irrevocable Trust Funded During Life (grantor trust). As noted above, grantor

trusts are eligible S corporation shareholders. Therefore, no further qualification or election is necessary for a grantor trust to hold S corporation stock. That



makes planning with irrevocable grantor trusts a popular technique with S corporation shareholder clients.

1. Crummey trusts. Many clients desire to make annual exclusion gifts to

family members but prefer to give to trusts for the benefit of those family members, rather than outright, due to the recipients’ age or financial capacity or for reasons of asset protection. Structuring such a trust as a grantor trust allows the donor to use this technique for S corporation stock without the limitations of a QSST or the often adverse tax aspects of an ESBT. Note: If the trust has hanging Crummey withdrawal powers, the beneficiary will be considered the grantor (and thus the S corporation shareholder) for the portion of trust principal subject to any unlapsed withdrawal right.

2. A popular estate planning technique with grantor irrevocable trusts is to

fund it via a part gift, part sale transaction. The settlor will give property to the trustee and then sell property (often substantially more than was contributed by gift) to the trustee. If structured properly and if using the appropriate assets, this technique can save substantial gift, estate, and generation-skipping transfer tax. Because of the pass through income taxation of an S corporation and because a grantor trust is a disregarded entity, using S corporation stock in such a part gift, part sale transaction works well.

3. Caution: For an estate planning technique involving the transfer of S

corporation stock to an irrevocable grantor trust to be successful, there must be some mechanism for the stock to be held by an eligible S corporation shareholder after the trust ceases to be a grantor trust (most commonly after the death of the grantor or after the grantor releases a power that caused the trust to be a grantor trust). Commonly, the trust will provide that the S corporation stock is distributed to individuals within two years of cessation of grantor trust status or that the trust become eligible for the beneficiary to make a QSST election within the time period. The trust will not be able to qualify as an ESBT if it purchased some or all of its S corporation stock.

4. Caution: A planner must be sure that the settlor has the ability to pay the

tax attributable to the S corporation stock in the grantor trust without access to trust assets and without a disproportionate distribution from the S corporation.

iii. Grantor Retained Annuity Trust (GRAT). If the grantor retains an annuity

interest with a reversion value worth more than five percent of the value of the trust estate, then the trust will be classified as a grantor trust. IRC § 673. To ensure that both the income and principal interests of the GRAT are classified as a grantor trust, planners should consider adding trust terms to ensure that it is a grantor trust for all purposes. If the GRAT is a grantor trust for all purposes, then the GRAT will be an eligible S corporation shareholder for as long as it remains a grantor trust.



iv. Charitable Remainder Trusts (CRT). CRTs are ineligible S corporation shareholders. Rev Rul 92-48, 1992-1 C.B. 301.

v. Common Types of Trusts That Might Want to Make QSST or ESBT Elections

1. General Power of Appointment Marital Deduction Trust (IRC

§ 2056(b)(5) trust). This trust will generally qualify to make a QSST election. See the requirements for a GPOA trust that qualifies for the marital deduction under IRC § 2056(b)(5).

2. Testamentary Qualified Terminable Interest Property Trust (IRC § 2056(b)(7) trust) (QTIP Trust). A QTIP trust will generally qualify to make a QSST election pursuant to the requirements of IRC § 2056(b)(7). Note: Two elections are required for a QTIP trust that holds S corporation stock: A QTIP election on the decedent’s estate tax return and a QSST election made by the surviving spouse/beneficiary.

3. Inter Vivos Qualified Terminable Interest Property Trust. Generally, an

inter vivos QTIP trust is a grantor trust under IRC § 677, so no QSST or ESBT election will be necessary for so long as it remains a grantor trust.

4. Qualified Domestic Trust (IRC § 2056A trust) (QDOT). A QDOT will

not be an eligible S corporation shareholder unless the surviving spouse becomes a US resident. As noted above, nonresident aliens are ineligible S corporation shareholders.

5. Section 2503(c) Trusts. A Section 2503(c) Trust for the benefit of a minor

will generally qualify for a QSST election if the trustee actually distributes all income.

6. Credit shelter trusts. A credit shelter trust will not qualify as a QSST if it

has multiple beneficiaries or if the trustee accumulates income. It might qualify as an ESBT if all other ESBT requirements listed above are satisfied.

c. Fiduciary Duties. In the context of closely-held businesses, and particularly family

businesses, individuals may find themselves with varying, and sometimes conflicting, duties. This is particularly true when S corporation shares are held in trust.

i. Minority Position. If the trustee holds a minority position in the company and thus lacks control, and if the majority shareholders take actions that constitute minority shareholder oppression, then the trustee may have a duty to take action to protect the beneficiaries’ and trust’s interest. See, i.e., trustee duties set forth in ORS 130.650-655. The action that the trustee’s fiduciary duty requires him or her to take may conflict with his or her personal interest or the interests of close family members.

ii. Majority Position. If the trustee holds a majority position and thus has control, he or she may have conflicting duties. Controlling shareholders can have fiduciary



duties to minority shareholders. See, i.e., Zidell v Zidell, Inc., 277 Or 413, 560 P2d 1086 (1977); Granewich v Harding, 329 Or 47, 985 P2d 788 (1999); Naito v Naito, 178 Or App 1, 35 P3d 1068 (2001). Trustees have fiduciary duties to beneficiaries. See, i.e., ORS 130.650-655. When those duties conflict, the trustee may be in an untenable position for which he or she may need to petition the court for instructions on how to resolve. See below for actions that may mitigate risk from conflicting duties.

iii. Conflicting Duties and Loyalties. Many times, particularly in family business

contexts, individuals wear more than one hat. Regardless of whether the trustee holds a majority or a minority position, he or she may personally be a shareholder. An individual may be a shareholder of a family S corporation both in his or her individual capacity and as trustee of a trust for the benefit of other family members. That individual may face circumstances where his or her fiduciary duty to the trust beneficiaries conflicts with his or her personal interest, with outside business interests of the trust beneficiaries, or with the interests of other family members. Sometimes, conflicts such as these are unavoidable in the closely-held business and family business context, but trustees and shareholders can mitigate the risks of such conflicts. Such mitigation techniques may include: strict adherence to corporate formalities; strict adherence to corporate best practices; obtaining legal advice; setting reasonable expectations; good communication; obtaining prior approval from beneficiaries for trustee actions; full disclosure of potential conflicts (both in general and relating to specific transactions or actions); and employing independent decision-makers. When drafting trust agreements under circumstances where these potential issues may be present, the drafting attorney may help to mitigate these issues by techniques such as building in a beneficiary’s veto or advisory rights to certain trustee actions or allowing for the appointment of an independent trustee for certain trustee actions that might have an inherent conflict.

d. Treatment of Intangible Assets of S Corporation During Estate Administration

i. In Estate of Adell v. Comm. T.C. Memo. 2014-155, the decedent’s estate included all of the equity of a C Corporation. In determining the value, the court allowed an operating expense adjustment of approximately 40%, in the valuation formula, to account for the son’s personal goodwill.

1. The original 706 included a value of $9.3MM for the business, which was followed by an unrelated amendment and then a second amendment to reflect a zero value of the business.

2. In 2010, the son formed NEWCO, resigned from the former company along with all but one employee, and secured the single customer of the former company.

3. In Court, the estate’s experts argued for a $4.3 value to reflect the valuation of the Company’s assets, while the IRS expert was pursuing a $26MM value, with Court concluding on the original $9.3MM.



ii. Valuation of interests in businesses include assets of the business. Reg. §20.2031-3.

1. Ownership of intangible assets in the form of rights to relationships cannot be attributed to the company when there was no employment agreement, covenant not to compete, or any other agreement that would give the company ownership. Martin Ice Cream Company v. Comm. 110 T.C. 189 (1998).

2. Intellectual property such as business name may be intentionally or unintentionally outside of the S Corporation, registered in the founder’s name or in another entity.

III. Income Tax Considerations for Trust and Estate Administration with S Corporations

a. Selecting a QSST vs. an ESBT

i. Flexibility in terms

1. ESBTs are more flexible with regard to permissible beneficiaries. Unlike

a QSST that must have a single current income beneficiary, an ESBT may have multiple beneficiaries, including estates, other trusts, and charities.

2. ESBTs are also more flexible with regard to income distributions. A QSST must distribute all income annually to the single current income beneficiary. An ESBT may be a sprinkle trust and may permit the accumulation of income.

3. To qualify a QSST, the beneficiary must make the election. To qualify an

ESBT, the trustee must make the election. If a beneficiary is unwilling to make the QSST election, then the trustee’s ESBT election may be the only option for the trust to qualify as an S corporation shareholder.

ii. Income taxation

1. For a QSST, the single current income beneficiary is treated as owning the

QSST’s S corporation stock for income tax purposes. Therefore, all gain or loss is reported on that beneficiary’s personal income tax return. Tax is calculated and paid at that beneficiary’s income tax rate.

2. For an ESBT, income taxation is governed by Internal Revenue Code

section 641 and the regulations thereunder. For income taxation, an ESBT may have up to three separate shares:

a. For any part of an ESBT that is also a grantor trust, the person

considered to be the owner of that part for income tax purposes will report the gain or loss from that share on his or her personal income tax return. Treas Regs § 1.641(c)-1(b)(1), (c).



b. For any part of an ESBT that is not a grantor trust but holds no S corporation stock, then that part of the trust is taxed under the income tax rules for trusts that are neither grantor trusts nor ESBTs. Treas Regs § 1.641(c)-1(g)(1).

c. Any part of an ESBT that holds S corporation stock and is not

considered a grantor trust is treated as a separate trust. Treas Regs § 1.641(c)-1(a) (b)(2). The income of such separate trust, other than capital gains, is taxed at the highest marginal rate for trusts. IRC § 641(c)(2)(A). See IRC §1(e), (h). The exemption for such separate trust under IRC § 55(d) for alternative minimum tax is zero. IRC § 641(c)(2)(B). Regardless of what distributions the ESBT makes, no income may be apportioned to any beneficiary and no distributions carry out distributable net income. IRC § 641(c)(2), (3).

3. Analysis.

a. Generally. Because all ESBT income is taxed to the trust at the highest rate and all QSST income is taxed to the beneficiary at his or her rate, then income tax considerations often indicate choosing QSST status over ESBT. However, if the beneficiary is in the highest tax bracket, then the question or whether to qualify a trust as a QSST or an ESBT can be income tax neutral.

b. With the 3.8% net investment tax, however, a QSST may be preferable, regardless of the beneficiary’s income tax bracket. If the beneficiary materially participates in the business, the net investment tax may not apply because the beneficiary is considered the owner of the S corporation stock for income tax purposes.

c. If the beneficiary is in the highest federal income tax bracket and

resides in a high-income tax state and the trust is sited in a low- or no-income tax state, then making an ESBT election might actually be better than a QSST election because income would be taxed to the trust without being taxed to the beneficiary in the high-income tax state.

b. Section 645 Election. Under IRC section 645, following the death of a decedent, the

successor trustee of the decedent’s revocable trust and the executor of the decedent’s estate may elect to treat the trust as part of the estate for income tax purposes. As noted above, a revocable trust must distribute S corporation stock or otherwise become an eligible S corporation shareholder within two years of the decedent’s date of death. An estate, however, may continue as an eligible S corporation shareholder for a reasonable period of administration, which may exceed two years. Therefore, a section 645 election may extend the period during which the revocable trust may be administered without the necessity of distribution of S corporation stock or a QSST or ESBT election.



c. Allocating income in the year of death.

i. When a shareholder terminates his or her interest in an S Corporation (dies), annual corporate income items are prorated between the decedent and the successor shareholder by allocating an equal daily amount to the period before and after death. IRC §1377(a)(1); Reg. §1.1377-1(a).

ii. Income allocated to the period before death is included on the decedent’s final income tax return. IRC §1377(a)(1); Reg. §1.1377-1(a).

iii. Income allocated to the period after death is included on the successor’s income

tax return. IRC §1377(a)(1); Reg. §1.1377-1(a).

iv. Alternatively, the S corporation shareholders may elect the closing of the books method, through an election to terminate the year. This election divides the corporation’s taxable year into two separate years, the first of which ends at the close of the day the shareholder died. IRC §1377(a)(2); Reg. §1.1377-1(b)(1). This election is available only if a shareholder terminates his entire interest in the S corporation, all of the “affected shareholders” agree, and the corporation properly attaches the election to its tax return for the year. Reg. §1.1377-1(b)(5). Affected shareholders include those shareholders whose interest is terminated and those to whom shares are transferred during the year. Reg. §1.1377-1(b)(2).

1. An election to terminate the year does not affect the due date of the

corporate return and may be filed up until the final due date of an amended return (typically 3-years after the original extended due date). Reg. §1.1377-1(b)(5).

2. A shareholder’s interest in an S corporation is terminated when the

shareholder’s entire stock ownership ceases, whether through a gift, spousal transfer, or death of a shareholder. Reg. §1.1377-1(b)(2).

v. Example: 100% shareholder passed away on June 30. The S corporation had $1

million in ordinary income during the 6-months from July 1 to December 31 and no other income or expenses during the year. Under a regular daily proration, decedent’s final income tax return and decedent’s beneficiary would each report $500,000 of ordinary income. With an election to terminate year, the entire $1 million would be reported by the beneficiary. Reg. §1.1361-1(j)(7).

vi. Consequences:

1. Beneficiary and decedent tax rates may be different, including NII 3.8% tax,

2. Allocation to the beneficiary may provide deferral if using a fiscal year estate,

3. For a taxable estate, allocation to the decedent may reduce the taxable

estate through increased income tax liability,



4. Different individuals may have income tax liability, depending on the terms of estate documents,

5. Allocation of income to the decedent may result in loss of basis as

determined by IRC § 1014.

d. Family Groups. S corporations report gain on the distribution of appreciated property to shareholders. Shareholders’ stock redemptions are also treated as exchanges. IRC §311(b) and IRC §302(b). Therefore, the tax costs of liquidating an existing S corporation followed by a contribution of the business to a more flexible entity such as a LLC may be prohibitive.

i. As a wealth transfer vehicle, as mentioned earlier, a major downside of a S

corporation is that there is no provision to adjust the basis of the assets inside the S corporation as there is with IRC §754 for partnerships with a deceased partner.

1. This may not be an issue where the founder’s plan is to transfer all or a majority through gifting.

2. Liquidation and reforming as an LLC after death of founder may, as discussed earlier, may have high income tax costs to other family S corporation owners.

ii. Family members are to receive reasonable compensation for their services and

contribution of capital. Reg. 1.1366-3. Additionally, differences in voting rights are permitted. Reg. 1.1361-1.

IV. S Corporation Dispositions

a. Asset Sales (Timing of asset sales with liquidation)

i. The stock of an S corporation acquires a basis equal to its market value under IRC

§1014, along with a long-term holding period under IRC §1223(11).

ii. There is no provision to adjust the basis of the assets inside the S corporation as there is with IRC §754 for partnerships with a deceased partner. Therefore, the income tax consequences of an S corporation selling property are unchanged by a death of a shareholder. The basis of a shareholder’s share of stock is increased by the shareholder’s portion of income items. Reg. §1.1367-1(b)(2).

1. Unless the corporation has other losses to offset gains on sales of assets, it

is generally desirable to plan to liquidate the corporation in the same tax year as the asset sale to utilize the liquidation loss in the same tax year as the gain.

2. Liquidation losses may not offset gains for assets held by the corporation outside of the shareholder’s resident state.



3. Certain S corporation gain items may be subject to higher income tax rates, such as ordinary income property and IRC §1250 unrecaptured gain.

iii. Example. Shareholder was a 100% owner in an S corporation, where the

corporation’s only asset was land valued at $100,000 with an original cost basis of $20,000. The S Corporation’s IRC §1014 value was also $100,000 (assuming no discounts). Land sale and liquidation in same year: S Corporation reports $80,000 capital gain, S Corporation stock basis is increased by gain to $180,000 Proceeds of $100,000 are distributed for a $80,000 loss on liquidation Gain and loss of $80,000 are offsetting.

iv. When there is a distribution of appreciated property from an S corporation to a shareholder, the distribution is treated as a deemed sale of the asset by the S corporation to an unrelated party at market value, where the income from the sale is passed to the S corporation shareholders. IRC §301(b); §1368(a).

1. If planned with liquidation as described above, the additional income tax may be limited to the items that are taxed at rates higher than capital gains rates.

2. Additional tax may also result from valuation discount on the entity, where the stock basis is lower value than the S corporation’s underlying assets.

3. There may be a planning opportunity for additional depreciation from stepped up basis for property that is to be retained.

v. S corporation stock basis determined under IRC §1014 is reduced by the portion

of the value of the stock which is attributable to items constituting IRD. IRC §1367(b)(4)(B). Additionally, IRC §691 shall be applied with respect to any item of income of the S Corporation in the same manner as if the decedent had held the item directly.

1. IRD items that may come up in an S corporation may include cash basis receivables and installment obligations. IRC §691(a)(2) and IRC §691(a)(4).

2. IRC §1367(b)(4)(B) provides that reduction from §1014 value shall be the portion of the value of the stock attributable to item of IRD. This is not the same as the value of the item constituting IRD inside the corporation.

3. A specific bequest of property including IRD would include S corporation

stock with IRD. IRC §691(a)(2).



b. Stock Purchases Treated as Asset Acquisitions – IRC § 338(h)(10)

i. When a purchaser acquires S corporation stock, there is generally no adjustment

to the inside basis in the S corporation’s assets, unless there is a joint election made under IRC§338(h)(10).

ii. The mechanics of an IRC §338(h)(10) election are:

1. An IRC 338(h)(10) election is made jointly by purchaser and selling S corporation shareholders, within the 15th day of the ninth month after the transactions occurs, where all S corporation shareholders must consent. Reg. 1.338(h)(10)(c)(3).

a. The purchaser must be a C corporation, although a partnership or individual(s) could fund an acquisition corporation to complete the transaction. Reg. 1.338-1(a).

b. A purchase of 80 to 100% of the S Corporation required. IRC §338(d)(3).

c. Negotiated as part of purchase transaction.

2. The selling S corporation is deemed to have sold assets to an unrelated party in an amount equal to the stock purchase price plus the liabilities discharged. Reg. §1.338-1(a).

3. The selling S corporation is deemed to liquidate and recognizes gain or loss on liquidation and the S corporation and shareholders recognize no gain or loss on the stock sale. Reg. §338(h)(10)-1(d)(5)(iii); Reg. §338(a).

4. The buyer is deemed to have purchased the assets, receiving an inside stepped up basis. IRC §338(b).

iii. The benefits of a IRC§338(h)(10) to the buyer are a stock transaction along with stepped up basis in assets. IRC §338(b).

iv. The seller may have additional tax if there are assets that are taxed at higher rates such as ordinary income property.

c. S Corporation Stock Sales. Without an IRC §338(h)(10) election, the basis of the assets

inside the S Corporation remain unchanged. Therefore, a regular S Corporation stock purchase is sometimes or frequently prohibitive from a cash flow standpoint to the buyer.





Appendix 1 – QSST Election Form

Name of Beneficiary Beneficiary Address

Beneficiary Phone Date IRS Service Center Address where Corporation files return RE: Qualified Subchapter S Trust Election Name of Trust Name of Corporation Dear Sir or Madam: This letter is an election to treat a trust as a Qualified Subchapter S Trust (QSST) under Internal Revenue Code section 1361(d)(2) effective on effective date. Current income beneficiary: Beneficiary’s name Beneficiary’s address Beneficiary’s social security number

Trust: Trust’s name (and trustee) Trust’s address Trust’s taxpayer identification number

Corporation: Corporation’s name Corporation’s address Corporation’s taxpayer identification number The date on which the name of corporation stock was transferred to the name of trust was date of transfer. Under the terms of the name of trust and applicable law in state of governing law, I am the sole income beneficiary during my lifetime. I am a United States resident or citizen. [Note: If spouses are beneficiaries, state that they will file joint income tax returns and that they are both US residents or citizens.] Trust corpus cannot be distributed to anyone other than me during my lifetime. My income interest will terminate upon my death. [Note: If the trust terminates upon other occurrence, specify that occurrence.] If the trust terminates during my lifetime, then all trust corpus will be distributed to me. The terms of the trust require it to distribute all income to me. [Note: If the trust terms do not require that, then state that the trustee will in fact distribute all income to the beneficiary.] The trustee may not distribute income or principal in satisfaction of the grantor’s legal obligation of support. Sincerely, Income Beneficiary’s Name and Signature





Appendix 2 – ESBT Election Form Name of Trustee Trustee Address

Trustee Phone Date IRS Service Center Address where Corporation files return RE: Electing Small Business Trust Election Name of Trust Name of Corporation(s) Dear Sir or Madam: This letter is an election to treat a trust as an Electing Small Business Trust (ESBT) under Internal Revenue Code section 1361(e)(3) effective on effective date. Potential current beneficiary: (list all that apply) Beneficiary’s name Beneficiary’s address Beneficiary’s social security number

Trust: Trust’s name (and trustee) Trust’s address Trust’s taxpayer identification number

Corporation: (list all that apply) Corporation’s name Corporation’s address Corporation’s taxpayer identification number The date on which the name of corporation stock was transferred to the name of trust was date of transfer. [List multiple if appropriate.] The trust meets all of the definitional requirements of Internal Revenue Code section 1361(e)(1). Specifically, all trust beneficiaries are individuals, estates or qualified charitable organizations. [Note: elaborate under IRC § 1361(e)(1)(A)(i)(III) if applicable.] The trust did not acquire its interest in an S corporation stock by purchase. The trust is not a Qualified Subchapter S Trust, a tax-exempt trust, a charitable remainder annuity trust, or a charitable remainder unitrust. All potential current beneficiaries of the trust meet the shareholder requirements of Internal Revenue Code section 1361(b)(1). Specifically, no potential current beneficiary is a nonresident alien. [If the ESBT has a beneficiary that is an estate or a trust, specify why that estate or trust is an eligible S corporation shareholder.] Sincerely, Name and signature of trustee



Documents

Estate Planning and Administration with S Corporations · 2018-03-02 · Chapter 2 Estate Planning and Administration with S Corporations1 AmeliA HeAtH US Trust, Bank of America Private