Identifying Tax Opportunities on Stock Received from an Estate

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Potomac, MD

Editor’s note: This case study has been adapted from PPC Tax Planning GuideS Corporations, 16th edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2002 ((800) 323-8724; www.ppcnet.com).

Facts: Wilson was a 25% shareholder in a calendar-year S corporation. He died in an auto accident on Aug. 23, 2002. At the beginning of 2002, Wilsons stock had a $10,000 adjusted basis; at his date of death (DOD), it had an estimated $100,000 fair market value (FMV). Based on the value of other assets Wilson owned, his estate will have to file a return and pay estate tax. Wilsons heirs seek advice from their tax adviser as to how Wilsons death affects his S stock, noting that an opportunity may exist to sell the stock in the near future. The corporation has no income in respect of a decedent. Issue: What tax consequences and opportunities arise from an S shareholders death?

Analysis

The adviser first tells Wilsons heirs that his stock was an asset includible in his gross estate; the estate tax value is determined by the stocks FMV, either (1) at the time of death, under Sec. 2031 or (2) using the Sec. 2032 alternate valuation date (which could be up to six months later) if allowed and elected. The adviser provides balance sheet and prior income information on the S corporation to assist in computing the FMV of Wilsons stock, including a possible discount of the FMV for Wilsons minority position and the stocks lack of marketability.

Income or Loss Allocation

A shareholders death terminates his or her interest in an S corporation, requiring an allocation of income, deductions, losses and credits for the portion of the year the decedent held the stock. There are two methods for allocating S-year income to the period of stock ownershipthe general per-share, per-day allocation method and the specific-accounting allocation method. The resulting allocable share of the corporations income, deductions, losses and credits to the DOD is reported on the corporations Schedule K-1 and included in the decedents final Form 1040.
Depending on the decedents personal tax situation, the chosen allocation method could save income tax on his or her final-year return. If the corporation elects to use the specific-accounting method, affected shareholders must consent to the election. Affected shareholders are those whose interests terminated and those who acquired shares during the tax year. If the shares were transferred to the corporation, all shareholders who owned stock during the year will be affected. The estate executor or administrator consents to the election on the deceased shareholders behalf, according to Regs. Sec. 1.1377-1(b)(5)(ii). If the stock goes into the estate (rather than directly to another beneficiary), the executor or administrator must also consent on the estates behalf.

To determine which allocation method to use, the decedents overall tax situation and that of the new owners of his or her stock (e.g., estate, heirs or trust beneficiaries) must be analyzed. For example, under Rev. Rul. 74-175, if the decedent had a net operating loss, it would be deductible only on his or her final return, not the estates. If the specific-accounting method results in additional income passed through to the decedent, this method is preferable. On the other hand, if that method results in less income, the general per-share, per-day allocation method would be better.

Basis Step-Up

Under Sec. 1014(a), the basis of property acquired from a decedent is its FMV at the DOD (or the alternate valuation date, if elected). Accordingly, Wilsons heirs will receive his stock with a $100,000 basis. The tax adviser notes that this can lead to two important planning opportunities:

1. A stock sale by the estate or heirs will generally result in only nominal gain or loss, due to the fresh basis received. Further, the holding period of property received from a decedent is automatically deemed to be long-term under Sec. 1223(11), even if sold shortly after death. Accordingly, an opportunity exists for Wilsons estate or heirs to dispose of his stock at its full FMV, with little or no gain recognition.

2. The basis step-up will provide a higher basis for loss allocation. The estate and heirs will have a $100,000 tax basis in Wilsons shares.
To the extent losses are incurred by the S corporation, this basis step-up permits the shareholders to deduct larger passthrough losses. Although S stock basis can be significantly stepped up on a shareholders death, the basis of assets inside the corporation are unaffected, in contrast to the potential result in a partnership.

For example, following the death of a partner, a unique opportunity exists under Sec. 743 to elect a basis step-up within the partnership, to reflect any higher FMV of partnership assets, based on the appraised value of the deceased partners interest. Had Wilson been a partner in a partnership rather than an S shareholder, the partnership could have elected to increase the basis of its assets by the $90,000 excess of FMV over basis. This increased basis could then have generated income tax benefits for the successor to the partnership interest, in the form of higher depreciation and amortization deductions and higher basis in assets sold. There is no comparable step-up in the inside basis of S assets.

If the excess of the FMV over the basis of Wilsons stock before his death was attributable to appreciation of land, even though the stock basis was stepped up to $100,000 after his death, a distribution or sale of the appreciated property would result in gain passing through to the shareholders. Thus, the basis step-up does not allow deferral or avoidance of gain associated with the disposition of individual S assets.
 

Other Tax Consequences

The adviser notes that several negative consequences stem from Wilsons death. Any previously taxed income attributable to his shares will be lost, as will any unused loss carryovers that he may have had due to insufficient S stock basis. However, the substantial advantage of a basis step-up to FMV usually outweighs the other tax consequences of stock passing through an estate.

Finally, the adviser cautions the family as to the S eligibility rules. Wilsons estate is an eligible S shareholder, and will remain so for as long as it is in existence. If Wilsons will directs the S stock to a testamentary trust, the trust will qualify as an eligible shareholder for only a two-year period, beginning when the stock is transferred to the trust. If the corporation is to remain an S corporation, the stock will have to be distributed to a qualifying shareholder by the end of the two-year period, unless the trust can qualify to elect treatment as a qualified subchapter S trust or electing small business trust.

Conclusion

The stepped-up stock basis caused by the shareholders death presents several tax planning opportunities. A stock sale can occur with little or no gain recognition; the new, higher basis creates a greater opportunity for the use of S passthrough losses and tax-free distributions.