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Why Do I Cringe Every Time I See an S Corporation in My Client’s Estate Plan?

Jan 16, 2020

Presented by Carol A. Cantrell, Cantrell & Cantrell, PLLC

Ms. Cantrell discussed how to confront practitioners’ fears of dealing with S corporations in their clients’ estate plans.  Ms. Cantrell stated there are “5.1 million S corporation returns filed every year in the United States which is more than any other type of tax return.” These returns are growing at a faster rate than other returns, so we cannot avoid dealing with the “speed bumps” that they present.  Ms. Cantrell highlighted some key rules and areas to focus on as well as some recent developments.

Eligible shareholders in S corporations are:

  • S. citizens or resident individuals
  • Estates
  • Several, but not all, types of trusts, with the most common being wholly owned grantor trusts, electing small business trusts (“ESBTs”) and qualified subchapter S trusts (“QSSTs”)
  • IRC Sec. 501(c)(3) charitable entities and certain retirement plans such as Employee Stock Ownership Plans (“ESOP”).

QSSTs and ESBTs are trusts specifically created to be eligible S corporation shareholders.  Their qualifications and key provisions are as follows:

  • QSST
    • Only one beneficiary or multiple shares each with only one beneficiary
    • All accounting income must be distributed currently and the beneficiary is treated as shareholder of the S corporation for income tax purposes.
    • The beneficiary (and not the trustee) must file timely the QSST election.
    • Trust terminates at the earlier of current income beneficiary’s death or trust’s termination
    • Multiple crummey power holders are not possible (other than when you have multiple shares; each share may have one) and powers of appointment are not permitted during beneficiary’s lifetime.
  • ESBT
    • Multiple beneficiaries are allowed including individuals and estates
    • Non-resident individuals can be current beneficiary of trust (as of January 1, 2018)
    • Trustee makes timely the ESBT election
    • Income can accumulate in trusts, with no requirement to distribute
    • All taxable income is taxed at the trust level at the highest income tax rates net of deductions including IRC Sec. 199A and charitable deductions.

It is possible to toggle back and forth between QSSTs and ESBTs when there are multiple shares.  This change is allowed once every three years and both the trustees and beneficiaries must sign agreeing to change.

S corporation status will terminate based on voluntary revocation, ceasing to qualify (ineligible shareholder, over 100 shareholders, multiple classes of stock), or if there is excess net passive income and accumulated earnings and profits for the last three consecutive years.  Upon termination, there will be a need for short period returns for the S corporation and C corporation respective periods.   A new Selection can be made five years after the termination date.

Recent cases concerning valuations of S corporations have allowed for “tax affecting” the value for the taxes that will be paid by the individual shareholders.  Also, in Kress v. U.S., the courts did not agree with the government’s additional premium added to the value for the company’s pass-through status as an S corporation especially as it related to tax-free distributions.  These favorable rulings add to other commonly used favorable valuation techniques such as using voting and non-voting shares and minority discounts.

A couple of final items to point out:

  1. The new qualified business income “20%” deduction allows S corporations to potentially maximize the benefit by paying additional wages before year-end each year to owners to avoid limitations under IRC Sec. 199A.
  2. Unlike partnerships, S corporations are not entitled to the stepped-up-basis of their assets at death. Therefore, in the cases of inherited S corporations that sell the businesses through an asset sale, it is often advantageous to liquidate the corporation in the same tax year as the asset sale took place in order to take advantage of the capital loss on the S corporation shares which will have the stepped-up basis. If the liquidation of the S corporation is not accomplished in the same year as the asset sale, a large capital loss may be realized in a future year, with limited or no capital gains available to utilize the loss. In fact, the large capital loss may be carried forward for future years, and some or all of the loss may be never utilized.

The unique rules and problems associated with S corporations present challenges that will be overcome in most cases if confronted and addressed in a timely manner.

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