Tax & Business Insights

Tax Basis at Death: 

S Corporation Inside and Outside Basis

Volume 20 Issue 4 --  July/August 2008

Back in the 1940s, the Army football team had a “Mr. Inside,” Doc Blanchard, and a “Mr. Outside,” Glenn Davis. Somewhat similarly, in tax “inside” and “outside” matter when it comes to basis.

In tax law the inside basis is the cost basis of an entity (such as a corporation, partnership, or LLC) in its assets. The outside basis is the owners’ basis in their interests in the entity. Often, the inside and outside basis can be quite different.

Suppose Mr. Ball contributed $1,000 for all of the stock in N‑Run, Inc. when he formed it in the 1930s.  Now, in 2008, N–Run owns and operates a for-profit museum displaying thousands of pieces of sports memorabilia. Mr. Ball dies in 2008 at which time the assets of N-Run are worth $1 million.  N-Run’s cost basis in its assets, the inside basis, is $60,000.  The basis of the N‑Run stock in the Estate of Mr. Ball, the outside basis, is $1 million because there is a step-up in the basis of Mr. Ball’s stock in N-Run to the fair market value (FMV) of the stock on the date of death.

Mr. Ball died without a Will or Trust, and his heirs cannot agree on anything, such as whether they should sell the entire corporation, sell its assets, or liquidate the corporation. In considering the alternatives, the difference between the inside and the outside basis can be important.

If Mr. Ball’s Estate sells all of the stock in the corporation to a buyer for its FMV, there will be no gain for tax purposes because the outside basis of $1 million is equal to the sales price. On the other hand, if the corporation sells its assets or liquidates, taxable gain on the corporate level will be determined by the inside basis.

For example, if N-Run sells all of its assets for $1 million, it will have gain based on the difference between the sale price ($1 million) and the inside basis ($60,000), or $940,000. If N-Run is a C corporation, it will pay a corporate level tax on that gain, before anything is distributed to the shareholders. The tax will likely be in the range of about $320,000.

If N-Run is an S corporation, the corporation will recognize the $940,000 in gain that will pass through to the shareholder — Mr. Ball’s Estate — on a K‑1. The Estate will pay tax on the $940,000 in gain (at the current individual capital gains tax rate of 15%) and receive a basis increase in its stock. The outside basis will be increased to $1,940,000.

Suppose N-Run decides to liquidate and distribute the $1 million sales proceeds to the Estate and eventually to the heirs. The tax consequences here depend upon whether N-Run is a C corporation or an S corporation.

If N-Run is a C corporation, the liquidating distribution of $1 million, reduced by the $320,000 of corporate level taxes, will trigger recognition of gain or loss to the shareholder (the Estate) to the extent of the difference between the amount of the after-tax distribution ($680,000) and the outside basis ($1 million), meaning that there will be a loss of $320,000 at the shareholder level. Unless the Estate has sufficient capital gains to offset that loss, the loss would have to be carried forward, perhaps for a very long time.

If N-Run is an S corporation, because of the basis increase resulting from the corporate level gain and the step up in basis because of Mr. Ball’s death, the Estate’s outside basis is $1,940,000, while the amount of the liquidating distribution would be $1 million, because there are no corporate level taxes. In that case, the loss on the liquidation of the corporation would be $940,000, which, could also be subject to being carried forward and used at the rate of $3,000 a year.

In situations such as this, it may be possible to reduce the tax consequences by liquidating N-Run in the same tax year that the asset sale occurs. Then the Estate will recognize the capital loss on the liquidation in the same year that the corporation passes through the gain (often mostly capital gain) on the asset sale.

For example, if the Estate recognizes the $940,000 of K-1 capital gain income on the sale of the assets in the same year that the corporation liquidates, it will be able to offset all of the $940,000 with the $940,000 capital loss on the corporate liquidation, with no net tax due as a result of the asset sale. If the liquidation does not occur in the same year as the sale, the Estate will pay $141,000 in tax on the gain from the sale of the assets in one year and generate a $940,000 capital loss in a subsequent year.

Inside and outside tax basis issues arise in other contexts, such as partnerships, but those situations are well beyond the scope of this newsletter.

Tax professionals, like football players in the 1940's, must keep their eyes on both the “inside” and “outside.” If you have problems in this area, contact The Tax & Business Professionals.

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