Pub. 1 2019 Issue 6

N O V E M B E R / D E C E M B E R 2 0 1 9 26 nebraska cpas corporation when a shareholder’s outside basis exceeds the shareholder’s proportionate share of the S corporation’s inside basis. While there are several considerations and challenges presented by this strategy, there are many instances where it could be very beneficial, including most notably following the death of a sole shareholder. t value of the S corporation’s assets) to $3,000,000. In liquidation of the S corporation, the estate surrenders its stock having an outside basis of $3,000,000 in exchange for assets having a value of $2,500,000, thus triggering a capital loss of $500,000. Thus, the $500,000 gain and the $500,000 loss realized in connection with the liquidation will offset, leaving the estate with an adjusted basis in the S corporation’s assets without triggering additional income tax. This example can be further illustrated as follows: 1. FMV Assets Distributed in Liquidation $2.5M 2. Inside Basis of Assets $2.0M 3. Shareholder Gain on K-1 $500K 4. Estate’s Outside Basis $2.5M 5. Shareholder Gain on K-1 $500K 6. Estate’s Outside Basis After Distribution $3.0M 7. FMV Assets Distributed in Liquidation $2.5M 8. Estate’s Outside Basis After Distribution ($3.0M) 9. Loss on Liquidation ($500K) 10. Long-term Capital Gain on K-1 $500K 11. Long-term Capital Loss on Liquidation ($500K) 12. Net long-term capital gain (loss) $ 0 Other Considerations and Challenges Depending on the nature of the S corporation assets distributed in liquidation, the income may be characterized as capital or ordinary. To the extent such income is characterized as ordinary, such income would not be offset by the capital loss recognized on liquidation. Instances where the income recognized in connection with the distribution of assets from an S corporation may be characterized as ordinary include those where: an asset is simply not a capital asset, such as inventory or accounts receivable; a taxpayer previously sold depreciable property and took an ordinary loss under §1231; §1239 is applicable to a distribution of depreciable property; and depreciation deductions taken on personal property must be recaptured under §1245. The tax cost resulting from the mismatch occurring as a result of these rules (i.e., the recognition of ordinary income on distribution and a capital loss on liquidation) may be partially offset by virtue of §199A, which does apply to ordinary income items but not capital gain. In addition to the above, state and local income tax consequences should be considered, particularly when the S corporation has taxable income in multiple jurisdictions. In those instances, the gain resulting from the distribution of certain assets may be subject to tax in multiple jurisdictions, whereas the loss resulting from the disposition of a shareholder’s stock would likely be recognized only in the domicile of the shareholder (as the disposition of stock would be taxed as a disposition of intangible personal property). Finally, in those instances when a deceased shareholder’s estate is not the sole shareholder, the estate should consider the tax consequences of a liquidation to the other shareholders and the fiduciary duties owed to the other shareholders, not all of whom may have outside bases exceeding their proportionate share of the S corporation’s inside basis. Conclusion While S corporations do not have a statutory mechanism similar to §754, it is possible to replicate the same effect by liquidating an S Alexander J. Wolf is a shareholder in Koley Jessen’s Estate, Suc- cession, and Tax Department and is the executive vice president of the firm. Wolf’s practice focuses extensively on estate planning and estate administration, business succession planning, and organizational/tax planning for closely held businesses and nonprofit entities. Mitchell D. Hiatt is a senior associate in Koley Jessen’s Estate, Succession, and Tax Department. Hiatt provides tailored tax, estate planning, and trust and estate administration counsel. He has extensive experience in designing and implementing so- phisticated wealth transfer planning strategies and also routinely advises clients on business succession planning matters. Example 1 Note that a § 754 election can have the opposite effect as well, causing a downward adjustment in basis. 2 Note that a § 754 election can also be made when there has been a transfer of a partnership interest by sale or exchange. 3 IRC §§ 331, 1001(a). 4 The built-in gains (BIG) tax is applicable to an S corporation that was previously taxed as a C corporation. 5 IRC § 1366(a). 6 IRC §§ 1367(a)(1), (b)(2)(B). 7 IRC §§ 1371(a)(1), 336.