Volume 12 Issue 1 -- January/February 2000
On the death of an "S" corporation shareholder, the shareholder's estate or heirs will get a step-up in basis in the stock to the fair market value (FMV) of the stock as of the date of death. While this occurrence can create some significant tax benefits, the situation can also create some significant problems.
These problems stem from the difference between the corporation's "inside" basis in its assets and the "outside" basis in the shareholder's stock. If, after the shareholder's death, there is a sale of "S" corporation's assets, unfortunate tax problems may arise unless the corporation liquidates in the same year. To avoid such problems, "timing is everything," as the Comedian, Jack Benny, used to say.
While it is clear that the basis in a deceased shareholder's stock gets
stepped-up to the date of death FMV, what happens to the "S"
corporation's basis in the corporate assets? The answer is "nothing."
Because the corporation does not die, there is no step-up in the corporation's
basis in its assets. Hence, there is a potentially substantial difference
between the corporation's basis (the "inside" basis) in its assets and
the shareholder's stock basis (the "outside" basis). A sale of all or
part of the corporation's assets can create a potential problem.
Let's look at an example
Assume that Mr. Snively owns all of the stock of Snively's Sniffers, Inc., an
"S" corporation created to develop an invention to sniff out illegal
drugs at airports. Mr. Snively contributes $25,000 in capital and thus has a
$25,000 basis in his "S" stock. After Snively's Sniffers becomes very
successful, Snively dies unexpectedly in December 1999, worrying about the
effects of Y2K problems on the corporation's sniffing software. At the time of
his death, the basis in his "S" stock increased to its FMV as of
December 1999, which is $1,000,000.
Snively's heirs are approached and offered $1,000,000 for the corporation's assets. At the time, the corporation's basis in its assets - the "inside" basis - is $25,000. If this offer is accepted during 2000, the Corporation will have taxable gain from the sale of the corporate assets of $975,000 ($1,000,000 - $25,000). This gain will pass through to Mr. Snively's heirs, who are now the "S" shareholders, and they will have to pay tax on that gain in 2000. What happened to the benefit of the step-up in basis on Snively's death?
As of the date of Snively's death, the heirs' basis became $1,000,000. After the asset sale, the basis was increased to $1,975,000 (the original date of death basis plus the $975,000 of gain passed through to the heirs). Regardless of whether all of the proceeds of the sale are distributed in 2000, the heirs will still have to pay tax on the $975,000 gain. Up to this point, the heirs cannot take advantage of the step-up in basis resulting from Snively's death.
The only way the heirs can be sure to benefit from the step-up in basis is to liquidate Sniffers in 2000. On the liquidation, they will recognize a loss on the liquidation that will offset the gain on the corporation's asset sale. Hence, the sale will become largely tax-free to the heirs.
This loss happens because the heirs' basis in their stock (after the asset
sale) has become approximately, $1,975,000, and on the liquidation they will be
receiving sale proceeds of approximately $1,000,000 (ignoring the effect of
state and local taxes, commissions, etc.) The difference between their basis -
$1,975,000 - and the $1,000,000 distribution will generate a loss of
$975,000, which will offset the capital gain on the corporation's asset sale.
Bad Timing and the Unfortunate Result
What if Snively's heirs wait until 2001 to liquidate Sniffers? Bad timing
gives them a most unfortunate result. The gain from the sale of Sniffers' assets
will still be recognized in 2000 - but, the capital loss on the liquidation
of the corporation will not be recognized by Snively's heirs until 2001. Unless
the heirs have large off-setting capital gains in 2001, the Sniffers capital
loss, of roughly $1,000,000, will be deductible at the rate of $3,000 per year,
indefinitely. Incidentally, the unclaimed capital losses of Snively's heirs do
not survive their own deaths if they have not been able to use all of such
losses before they die.
Other events can create differences between the inside and outside basis of "S" corporations but they are less common. One example would be distribution of "S" stock as part of a deferred compensation plan in which the recipient-employees recognize gain based on the value of the stock at that point. The taxable gain on the distribution can result in a basis in the stock that is relatively high in relation to the corporation's basis in its assets. Another example is distribution of appreciated "S" stock in satisfaction of an obligation, thus causing corporate gain.
The message? If you have a situation in which inside and outside basis of an "S" corporation are different, because of death or other events, it will usually be wise to liquidate the "S" corporation in the same taxable year as a sale of the corporation's assets.
Jack Benny was right - timing is everything.
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
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