Pub. 1 2019 Issue 6

25 nebraska society of cpas W W W . N E S C P A . O R G BASIS PLANNING FOLLOWING THE DEATH OF AN S CORPORATION SHAREHOLDER BY MITCH HIATT & ALEX WOLF, KOLEY JESSEN Decedent’s estates frequently include interests in closely held businesses taxed as partnerships or S corporations. As a general matter, any assets included in a decedent’s estate for federal estate tax purposes will be subject to a basis adjustment under §1014. The §1014 basis adjustment applies to the partnership interests and S corporation stock owned by a decedent (the basis in the partnership interests and/or S corporation stock is commonly referred to as the “outside basis”), but not to the assets owned by the partnership or S corporation (the entity’s basis in its assets is commonly referred to as the “inside basis”). Subchapter K of the Code provides entities taxed as partnerships with a statutory mechanismunder §754 and §743 to adjust the insidebasis inpartnershipassets inconnection with a partner’s death. More specifically, a §754 election allows a partnership to adjust the inside basis of partnership assets to the extent an estate’s outside basis (which is adjusted to equal fair market value under §1014) exceeds the estate’s proportionate share of the partnership’s inside basis. 1 In short, the goal of §754 is to achieve uniformity between the estate’s outside basis and the estate’s share of the inside basis following the death of a partner. 2 Unfortunately, for S corporations and their shareholders, Subchapter S does not contain a provision similar to §754 with respect to assets held by an S corporation. In certain situations, however, there may be an opportunity to obtain a tax-free basis adjustment for the assets held by an S corporation by going through the mechanics of a liquidation. Mechanicsof SCorpLiquidationsWith Appreciated Assets As a preliminary matter, there are two fundamental concepts underlying the planning st rategy discussed herein: the first is the effect of §1014 on the outside basis of S corporation stock following the death of a shareholder; the second is the income tax consequence of distributing appreciated property from an S corporation to its shareholders. §1014 Basis Adjustment for S Corp Stock As noted above, generally under §1014, the tax basis of a decedent’s property is adjusted to be equal to the fair market value of such property at the time of the decedent’s death. For S corporation stock specifically, the outside basis in the stock that was owned by a deceased shareholder will be adjusted to be equal to its fair market value at the time of the shareholder’s death. 3 However, §1014 will have no effect on the inside basis of the S corporation’s assets. Distribution of Appreciated S Corp Assets For S corporations not subject to the built-in gains tax under §1374, 4 a non-liquidating distribution of appreciated assets triggers gain in the same manner as if the assets had been sold. Any such gain would be passed through to the shareholders under the normal Subchapter S rules, 5 which causes each shareholder’s outside basis in his/her stock to increase to the extent of his/her proportionate share of such gain. 6 Similarly, when an S corporation liquidates, the S corporation generally recognizes gain or loss on the distribution of its assets, equal to the difference between the fair market value of each asset and the corresponding tax basis of such asset, and such gain is passed through to the shareholders under the normal Subchapter S rules. 7 In a liquidation transaction, the shareholders surrender their stock in exchange for the assets of the S corporation; each shareholder will recognize gain (or loss) to the extent the fair market value of the assets received from the S corporation is greater than (or less than) the shareholder’s outside basis in his/her S corporation stock. Thus, a liquidation of an S corporation has two effects on the shareholders’ individual tax returns: (1) a gain (or loss) passes through to the shareholders in connection with the distribution of the S corporation’s assets, thereby increasing (or decreasing) each shareholder’s outside basis in his/her S corporation stock; and (2) a separate gain (or loss) is recognized by each shareholder on the sale of S corporation stock to the extent the assets received in exchange for the stock have a value greater (or less) than the shareholder’s outside basis in the stock. Bywayof example, assume anS corporation entirely owned by a decedent’s estate owns assets (all of which are capital assets) with a fair market value of $2,500,000 and an inside basis of $2,000,000. When such assets are distributed to the shareholder’s estate, $500,000 of long-term capital gain must be recognized by the estate. Thus, following such distribution, the estate’s outside basis in the S corporation will increase by $500,000 from $2,500,000 (which corresponds to the fair market C O U N S E L O R ’ S C O R N E R