Basis step-up planning with S corporation stock

Section 1014 resets the basis of property received from a decedent to its fair market value on the date of death, or to the value six months later if the executor makes the alternate valuation election. Applied to S corporation shares, that reset lands on the stock itself, which practitioners call outside basis. Picture a founder who paid 12,000 dollars for her shares in 1994 and dies when an appraiser values the same block at 4,300,000 dollars. Her children take the stock with a 4,300,000 dollar basis. A sale three weeks later at the appraised figure produces no taxable gain, and the sale is still reported on Form 8949 and carried to Schedule D. The rule for property acquired from a decedent is laid out in Publication 551, and the mechanics of computing gain on a later disposition appear in Publication 544. One point of scope before we go further. The Reed Corporation is a certified public accounting and tax firm. We do not practice law and we do not draft wills or trust instruments. Your attorney owns those documents. We handle the tax treatment the documents produce, and we sit next to counsel so the drafting and the tax return agree with one another.

The limit that catches families off guard is that the step up in basis reaches the shares and stops there. An S corporation has no counterpart to the partnership election that adjusts the basis of assets held inside the entity, so equipment and self created goodwill on the company books keep whatever basis they carried the day before the shareholder died. Suppose the corporation owns a machine carrying 12,000 dollars of remaining basis that a buyer will pay 260,000 dollars for. Structured as an asset purchase, the corporation recognizes 248,000 dollars of gain, a large slice of it recaptured at ordinary rates under the depreciation rules summarized in Publication 946, and that gain rides out on the Schedule K-1 to the same heirs who just received stepped up stock. There is a partial cushion. Passthrough gain raises stock basis, so the liquidating distribution that follows produces less capital gain than it otherwise would. That cushion arrives only after the ordinary rate has been paid, which is a poor trade in most transactions. The corporate return is Form 1120-S and the asset level detail goes on Form 4797.

The mistake we see most often is a family that reads a short summary of the step up in basis, concludes the company can now sell everything without tax, and signs a letter of intent drafted as an asset purchase before anyone runs the number. On a mid sized operating company the spread between a stock deal and an asset deal has run past 400,000 dollars of federal tax in files we have worked, and the buyer will not volunteer that information because the asset structure is what gives him depreciable basis going forward. A related mistake is skipping the appraisal. Nobody reconstructs a defensible date of death value four years after the fact when a purchaser asks for basis support, and a number with no report behind it invites an examiner to supply his own. Watch who receives the shares as well, because only certain shareholders may hold S corporation stock without ending the election. A grantor trust holding those shares qualifies for a limited window after death before it has to convert to a qualified subchapter S trust or an electing small business trust, and that conversion deadline is easy to miss while an estate is still being settled.

Basis records for a closely held company are only as reliable as the accounting underneath them, which is why we keep client ledgers current through our bookkeeping work, and the personal reporting of any later sale runs through individual tax returns 1040 alongside the estate filings your attorney oversees. Families that pin down value in the first year usually find the sale conversation two years later takes weeks rather than months.

Yes, and the direction catches people by surprise. Section 1014 is an adjustment to fair market value rather than a guaranteed increase, so the same rule that raises basis on appreciated shares lowers it on shares that have fallen. Consider a shareholder whose stock basis had climbed to 900,000 dollars through years of taxable income left inside the business, who dies when the company appraises at 640,000 dollars. The heirs take 640,000 dollars of basis. The 260,000 dollar built in loss simply disappears. Had the same shareholder sold during life, that loss would have offset capital gains dollar for dollar and up to 3,000 dollars of ordinary income each year afterward, reported on Form 8949 and Schedule D under the rules described in Publication 550. Death turned a usable deduction into nothing at all.

S corporation stock basis is a moving number, which is what makes the downward risk real rather than theoretical. Basis rises with passthrough income and with additional capital the owner puts in. It falls with distributions and with losses that pass through to the return. A profitable company that retains its earnings pushes shareholder basis higher every single year, because the owner already paid tax on income he never took out. Ten years of 120,000 dollar Schedule K-1 income with no distributions adds 1,200,000 dollars of basis to a block that may have started at 12,000 dollars. If the business then loses its largest customer and the appraised value drops below that accumulated figure, the family is sitting on a large built in loss that section 1014 will quietly erase on the date of death. Publication 551 covers the underlying basis rules and the annual adjustments trace back to the Form 1120-S reporting.

Suspended losses deserve their own look. Losses a shareholder could not deduct because stock basis ran out do not travel to the estate or to the heirs. They expire when the shareholder does. Passive losses suspended under the rules covered in Publication 925 follow a different path. They are allowed on the decedent’s final Form 1040 only to the extent they exceed the basis increase the property receives at death, so a generous step up in basis actually absorbs the suspended loss instead of releasing it. A shareholder holding 300,000 dollars of suspended passive loss whose stock picks up a 250,000 dollar basis increase deducts 50,000 dollars on that final return and forfeits the remaining 250,000 dollars. Nobody discovers this in time unless someone is tracking basis and suspended amounts year by year.

The common mistake is a family that holds a declining asset purely to wait for a step up in basis that is never going to arrive in the direction they expect. A second mistake is assuming a lifetime gift fixes it. A gift carries the donor’s basis forward rather than resetting it, and when the property is worth less than that basis on the day of the gift, the recipient has to compute any future loss using the lower value, which strands the built in loss a second time. Selling the depressed shares to an unrelated buyer, or triggering the loss in a year that already holds offsetting gains, usually beats both alternatives by a wide margin.

We model these outcomes as part of tax strategy consulting and carry the results onto the personal return through individual tax returns 1040, always in coordination with the attorney who drafted the plan, because the choice of instrument is a legal decision and not ours to make. Owners who review basis annually rather than once at death keep the ability to act while the loss still has value.

In a community property state, section 1014(b)(6) treats the surviving spouse’s half of community property as though it too was acquired from the decedent. Both halves receive a new basis at the first death. In a common law state, only the decedent’s interest adjusts, which for jointly held shares generally means half. The difference is large enough to change a family’s entire plan. Take shares worth 3,000,000 dollars with an original cost of 12,000 dollars. Under community property treatment the survivor holds all 3,000,000 dollars of basis and can sell the next morning with no gain. Under common law joint ownership the decedent’s half steps to 1,500,000 dollars while the survivor’s half stays at 6,000 dollars, leaving roughly 1,494,000 dollars of built in gain. At a 20 percent federal capital gain rate plus the 3.8 percent net investment income tax reported on Form 8960 where it applies, that gap runs near 355,000 dollars. The basis rules sit in Publication 551 and the disposition mechanics in Publication 544.

Nine states run a community property system, among them Texas, California, Washington, and Nevada. Several other states allow married couples to place assets into an elective community property trust. Whether a particular block of S corporation stock carries community character is a legal question that turns on when it was acquired, what money bought it, and what the couple signed. That determination belongs to your attorney. Our part is the tax computation that follows from the answer, and the record keeping that proves it. Two states matter often in our practice for a second reason. Texas imposes no personal income tax and administers the franchise tax through the Texas Comptroller, while California taxes capital gain as ordinary income at rates administered by the Franchise Tax Board, so an identical federal step up in basis produces very different after tax cash depending on which side of that line the survivor lives on.

The mistake that costs the most is retitling. A couple in Texas or California opens a new brokerage account or restates a stock certificate as joint tenancy with right of survivorship because a bank employee suggested it, and in doing so converts community property into something that may no longer qualify for the double adjustment. Another version happens on relocation. A couple earns and buys shares while living in Nevada, moves to a common law state, and never documents the character of what they brought with them. Years later the survivor is trying to prove community character from memory. A written agreement prepared by counsel at the time, backed by our records showing the source of the funds, settles the question while it is still cheap to settle.

There is an S corporation specific wrinkle worth flagging. Shares titled in one spouse’s name alone can still be community property in substance, and the corporation’s stock ledger may not reflect that at all. When the shares pass to a trust for the survivor, the trust has to qualify as an eligible S shareholder or the election terminates, which would convert the company to a C corporation and change every number in this answer. Coordinating the stock ledger with the estate plan is unglamorous work that pays for itself.

We handle the underlying records through bookkeeping and build the projections in tax strategy consulting, then hand the analysis to your attorney so the documents and the tax result line up. Couples who settle the character question during the first spouse’s lifetime give the survivor a far simpler year when it finally matters.

Section 1014 applies to property acquired from a decedent, and in practice that means property pulled into the taxable estate. When a founder sells or gives S corporation shares to an irrevocable trust designed to sit outside the estate, the whole point of the design is that the shares are not included when he dies. The estate tax saving comes with a matched cost. Those shares keep the basis they had before the transfer. A gift carries the donor’s basis forward, and a sale to a grantor trust is disregarded for income tax purposes while the grantor is alive, so no basis is created there either. The family trades an income tax benefit for an estate tax benefit, and the trade only makes sense if the estate tax was ever going to apply. Publication 551 and Publication 544 cover how the resulting basis carries into any later sale.

Run the numbers on a real fact pattern. A founder moves shares with a 12,000 dollar basis into an irrevocable trust when they appraise at 900,000 dollars. By the date of death the same shares are worth 6,000,000 dollars. Keeping 5,100,000 dollars of growth out of a taxable estate at a 40 percent rate saves roughly 2,040,000 dollars. The family gives up a step up in basis on 5,988,000 dollars of gain, which at combined federal capital gain and net investment income tax rates near 23.8 percent costs about 1,425,000 dollars whenever the shares are sold. In that example the trust still wins. Now change one fact. Suppose the total estate would have landed comfortably under the federal exclusion, so no estate tax was ever due. The family gave up 1,425,000 dollars of income tax benefit and bought nothing with it. That is the single most common mistake we find in older plans, usually drafted when the exclusion was a small fraction of today’s amount and never revisited.

The reporting picture also shifts at death. Grantor trust status ends, and the trust becomes its own taxpayer filing Form 1041 rather than reporting through the founder’s personal return. For S corporation shares this starts a clock. A grantor trust that held the stock stays an eligible shareholder for a limited period after the grantor’s death, after which the trust has to become a qualified subchapter S trust or an electing small business trust or dispose of the shares. Blowing that deadline terminates the S election and turns the company into a C corporation, which is a much larger problem than the basis question we started with. The election history sits behind Form 2553 and the annual filing is Form 1120-S.

Many irrevocable grantor trusts contain a power allowing the grantor to substitute assets of equal value, and where that power exists the family can often swap cash or high basis securities into the trust and pull the low basis stock back into the estate, restoring the step up in basis without disturbing the trust. Whether your instrument grants that power, and whether using it is appropriate, is a question for the attorney who drafted it. We do not read trust documents as counsel and we do not advise on their terms. We build the tax model for each path and give both you and your lawyer the same set of numbers to work from through tax strategy consulting, with the personal side reported through individual tax returns 1040. Any plan built before the current exclusion levels deserves a fresh look this year rather than after the fact.

Start with a qualified appraisal of the shares as of the date of death. Closely held stock has no public price, so the value rests on a written report that considers earnings, comparable transactions, and any supportable discount for lack of control or lack of marketability. That report is the document a buyer’s counsel will ask for, and it is the document that answers an examiner years later. The executor also has a valuation timing choice. The alternate valuation date six months after death is available only when the election lowers both the gross estate and the estate tax due, so it is off the table for most estates that owe nothing. If the estate has to file a federal estate tax return on Form 706, the basis consistency rules require the executor to furnish beneficiaries a statement on Form 8971 with Schedule A, and the beneficiary’s basis cannot exceed the value reported there. Neither form appears in the linked material below because they sit outside the reference set we cite, so ask your attorney for the filing deadlines that apply to the estate.

Next comes an S corporation item that most executors have never heard of. Income in respect of a decedent reduces the stock basis adjustment. If the shareholder’s pro rata share of unreported accrued income is 180,000 dollars and the shares appraise at 2,400,000 dollars, the stepped up basis becomes 2,220,000 dollars rather than the full appraisal figure. Miss that adjustment and the first return after a sale reports too little gain, which is the kind of error that surfaces during examination with interest attached. Basis and accounting method questions run through Publication 551 and Publication 538.

Then handle the income split for the year of death. By default the corporation allocates its annual results across the year on a daily pro rata basis between the decedent’s final return and the successor shareholder. If all affected shareholders agree, the corporation can instead elect to close the books on the date of death and cut the year in two, which matters a great deal when a large gain or a large loss landed on one side of that date. A company that earned 60,000 dollars through March and 900,000 dollars after a September sale produces wildly different results under the two methods. The final personal return is Form 1040, the entity return is Form 1120-S, and prior year filing history can be pulled through IRS transcripts when records are thin.

Do not overlook the trust that will hold the shares going forward. A qualified subchapter S trust election and an electing small business trust election each carry their own filing deadline measured from the date the trust receives the stock, and the two produce different tax results. The qualified subchapter S trust pushes the corporation’s income out to a single income beneficiary who reports it at personal rates. The electing small business trust taxes the S corporation portion inside the trust, where the top bracket arrives at a very low income level. On 400,000 dollars of passthrough income that choice can swing 20,000 dollars or more of annual tax, and it interacts with how much cash the trustee actually distributes to the family. Your attorney decides which structure the trust document supports. We price out both paths before the election is signed, working from the entity comparison material the agency publishes on business structures.

The recurring mistake in year one is treating the estate as a paperwork exercise and postponing the valuation until someone needs it. The second is letting the trust election deadline pass while everyone focuses on probate. Both are avoidable with a calendar and a short checklist. If your family is working through a shareholder death and wants the tax steps sequenced before deadlines pass, you can request a consultation and we will map the year with your attorney rather than around him. We keep the corporate records straight through bookkeeping and file the returns through individual tax returns 1040. Executors who finish the valuation and the elections inside the first twelve months hand the next generation a clean file instead of an argument.