Estate planning for S corporation shareholders.

Estate Planning for S Corporation Shareholders

The small business corporation (commonly referred to as the S corporation) is a form of business ownership that may provide substantial income tax benefits to its shareholders. If properly planned, the income tax benefits generated from this form of business ownership can be substantial.

First, the taxable income of the S corporation is taxed directly to its shareholders according to their pro rata share of ownership in the corporation. As a result, the corporate entity avoids payment of corporate income tax. Instead, the income is reported directly by the shareholders on their individual income tax returns, as are losses of the S corporation which are reported directly by the shareholders on their individual return. In this way, the double taxation normally accorded the income of a regular C corporation is avoided. If the individual shareholder is in a lower tax bracket than the corporation, an overall income tax saving is achieved.

Second, when a shareholder dies and the estate becomes the owner of the S corporation stock, the passive loss rules may apply. If the estate has substantial passive income, the losses from any passive activities of the S corporation may be used to offset the passive income, achieving a reduction or elimination of income tax liability for the estate.

Third, if a shareholder dies and the estate owns the S corporation stock, the estate will receive a stepped-up basis on the value of the stock. This step-up in basis may be sufficient enough, from a tax perspective, to permit a deduction of losses that the decedent could not have deducted if the step-up in basis had not occurred. This is especially true when the amount of the deductions exceeds the decedent's basis in the stock.

If these tax benefits are to remain viable for the shareholders of the S corporation, as well as for the beneficiaries of estates containing S corporation stock, proper lifetime planning is imperative. Without it, the corporation could inadvertently lose its S corporation status and the tax benefits associated with this form of ownership. This article focuses on planning strategies that may be used for a transfer of S corporation stock from a shareholder or a shareholder's estate.

Pitfalls to Avoid

A corporation does not become an S corporation without proper planning. An election must be made by the shareholders to treat their corporation as an S corporation for income tax purposes. To be considered for S corporation treatment, the business entity must meet a number of Internal Revenue Code eligibility requirements. Code Section 1361 requirements prohibit a business entity from becoming an S corporation if the corporation:

1. Has more than 35

shareholders; 2. Has a nonresident alien or a

nonhuman entity (such as a

partnership) as shareholder

(Certain kinds of trusts, as

explained later, are excluded

from this nonhuman entity

category.); and 3. Has more than one class of

stock.

If a corporation possesses any of these characteristics, it cannot elect S corporation treatment. Proper planning, therefore, becomes imperative to ensure that none of these situations occurs.

Well-meaning stockholders who wish to benefit their beneficiaries and younger family members through transfers of S corporation stock may be unaware that they are jeopardizing the corporation's eligibility to qualify as an S corporation. The following kinds of transactions most frequently result in disqualification for S corporation treatment:

1. Transfers to disqualified shareholders under Code Section 1361 (b) (1) (B). This would include both lifetime gifts and testamentary transfers of S stock to an ineligible corporation, a partnership, a nonresident alien or any kind of trust that is not exempted under the qualification rules. (Only Section 678 trusts, certain grantor trusts, certain testamentary trusts and trusts that meet the definition of a qualified sub-chapter S trust are permitted to hold S corporation stock.)

2. Transfers to spouses who subsequently obtain a divorce. Under the Code provisions relating to the grantor trust rules, a husband and wife are considered a single shareholder for purposes of S corporation eligibility. Thus, if transfer of stock is made to a husband and wife who hold the stock jointly as the 35th shareholder, a subsequent divorce and property settlement splitting the S stock equally would result in the two being considered separate shareholders. As a result, there would now be 36 shareholders instead of 35, and the corporation, in the absence of planning, would lose its S corporation status.

3. Transfers that result in more than 35 shareholders. Other types of transfers can result in the disqualification of a corporation for S corporation treatment. For example, if a shareholder makes a bequest of his S corporation stock in equal shares to his three children, this transfer results in two additional shareholders for eligibility purposes. Similarly, if each of these children dies, survived by two children each, three more shareholders have been added, bringing the total to five over what it was when the original shareholder died. Under these circumstances, it is very easy to see how the 35 limit can easily be exceeded, resulting in a disqualification for S corporation treatment.

4. Transfers of stock pending a lengthy estate administration. Under Reg. 1.64 (b)-(3) (a), if the estate of an S corporation shareholder is unduly long, the estate could be terminated for tax purposes and each beneficiary of the stock under the shareholder's estate plan would be considered an individual shareholder. Thus, it would be relatively easy for the number of shareholders to exceed the 35 limit, disqualifying the corporation.

Planning Strategies

To ensure proper retention of S corporation eligibility for a shareholder, the corporation and its intended beneficiaries, the following strategies should be considered:

1. Where feasible, all members of the S corporation should enter into shareholders' agreements that restrict or prohibit transfers of stock to disqualified shareholders, such as partnerships, nonresident aliens and trusts that do not fall within the exceptions of Code Section 1361. Also, the language of the agreement should ensure that each shareholder's interest in the stock must be a fee simple interest. Interests in the stock for a term of years or for a life estate would disqualify the stock for S corporation treatment under Prop. Reg. 1.1361-1A (f)(3). Finally, any agreements entered into should specify that there is, and can be only one class of stock for the corporation.

2. Where feasible, the stockholders should enter into a restrictive agreement that prohibits a transfer of shares where such a transfer would result in more than 35 shareholders. Normally, a cross purchase agreement entered into among the current shareholders (and funded appropriately with life insurance or accumulated earnings) could be used to accomplish this purpose. However, before pursuing such an agreement, local law should be consulted to ensure that such restrictive agreements are enforceable, especially in light of a surviving spouse's elective share statute or other statutory authority that gives the surviving spouse the right to select the S corporation stock from the decedent's estate. Such statutes could effectively override the provisions of such a restrictive agreement that might otherwise prevent the number of shareholders from exceeding 35. Another solution might be to have the spouse become a party to the agreement and, under its terms, expressly waive his or her rights to select the property under the elective share statute.

3. In a situation involving a lengthy estate administration, the administrator of the estate should attempt to qualify the estate for installment payments of federal estate tax under Code Section 6166. If the estate meets the eligibility requirements (basically, the value of the stock must exceed 35% of the decedent's adjusted gross estate), it may be possible to extend the payment of federal estate taxes out over a 14-year period, thus ensuring that the estate will remain open for tax purposes. In this way, the estate cannot be terminated, and the stock will be able to retain its eligibility as S corporation stock.

4. When a shareholder plans on transfers of S corporation stock for the benefit of family members, every attempt should be made to qualify the transfer of the stock under one of the trust arrangements recognized as valid transfer devices for S corporation stock.

Specifically, the shareholder should consider the use of a qualified subchapter S trust (QSST) or a Section 678 trust. Either trust permits the stock to be held in trust while still qualifying for S corporation treatment.

Code Section 1361 defines a QSST as one which:

1. Owns stock in one or more

electing S corporations; 2. Distributes, or is required to

distribute, all of its income to

one individual or resident of

the United States annually; 3. Has certain trust terms,

especially requiring that there be

one trust beneficiary at any

given time; 4. Does not distribute any

portion of the corpus to anyone

other than the current income

beneficiary during the income

beneficiary's lifetime; and 5. Ends the income interest of

the current beneficiary upon

his death or the termination of

the trust, whichever occurs first.

Of course, to be treated as a QSST, the trust beneficiary must make an election by signing and filing a statement at the IRS center where the S corporation files its income tax return. In addition, the executor of the

shareholder's estate needs to make the appropriate election on the decedent's federal estate tax return, which qualifies the property for marital deduction treatment.

With careful drafting, it is possible to qualify a QSST as a Q-TIP trust for the primary benefit of the shareholder's surviving spouse. Upon the death of the surviving spouse, S corporation eligibility could be retained by creating a separate QSST for each remainderman of the Q-TIP trust, assuming that these remaindermen are the children of the decedent and the surviving spouse, and also assuming that the creation of such separate QSSTs would not result in more than 35 shareholders in the corporation.

It might also be possible to qualify a marital (general power of appointment) trust as a Section 678 trust, thus preserving the S corporation status, as well. The Section 678 trust is any trust that treats the trust beneficiary as the owner of the entire trust corpus if the beneficiary has the sole power to vest either the income or the corpus in himself in the form of a general power of appointment. A marital trust that gives the surviving spouse a general power of appointment in either the income or the corpus, or both, could qualify for the marital deduction in the estate of the decedent and also could retain its status as S corporation stock, provided that the decedent's estate followed all procedures for qualifying the property for the marital deduction.

Because the Section 678 trust gives the beneficiary a general power of appointment over the trust corpus or income, such a trust would probably be inappropriate where the shareholder wished to make transfers of S corporation stock to a minor child. A transfer to a UGMA or UTMA account on behalf of the child would be more appropriate.

Conclusion

By following the strategies outlined in this article, it is possible to preserve the income tax benefits of the S corporation while transferring the stock to family members or other intended beneficiaries as a part of the shareholder's estate plan.

Paul J. Lochrary, JD, is an academic associate at the College for Financial Planning, Denver, Colorado, where he develops course materials for the Estate Planning Series of the Advanced Studies Program.