Editor: Marcy Lantz, CPA
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has caused tax advisers to review and question the proper entity selection for business clients. To properly advise business owners, CPAs must proactively consider the impact that the entity structure will have on a client's estate plan. An adviser cannot be shortsighted in how the choice of entity will affect future generations. This discussion considers some of the key differences that affect post-mortem planning when looking at entity selection.
An entity taxed as a partnership can elect, under Sec. 754, to have the decedent's share of the partnership assets adjusted to the fair market value (FMV) at the decedent's death. In contrast, when a decedent owns stock in a C corporation or an S corporation, the basis of the corporate assets remains the same; only the stock receives an adjustment of basis. In most instances, because of past depreciation or market appreciation, the basis adjustment of either is upward.
If it is expected that the business will be liquidated soon after the decedent's death, the income tax impact of the entity being taxed as a partnership versus an S corporation would be minimal except for the tax impact of possible depreciation recapture. A liquidation of a business soon after the owner's death would most likely occur in a scenario where the business is a personal service business, especially where the business's viability relies heavily on the current owner. Conversely, where the business is heavily capitalized with depreciable assets and is expected to survive the owner's death, the ability to increase the basis of the assets, thereby increasing the depreciation deduction, could be significant for the beneficiaries.
If the entity is structured as a C corporation, the prospect of double taxation remains a consideration for the beneficiaries. Often, the liquidation of a closely held C corporation is accomplished via an asset sale rather than a stock sale. The sale of the corporation's assets potentially causes income taxes to be paid at the corporate level (where there are no favorable capital gain rates), leaving less funds available to distribute to the beneficiaries.
The personal income tax effect to the beneficiaries of the deceased owner's share should be minimal since the proceeds paid to the shareholders will most likely qualify as liquidating distributions pursuant to a plan of liquidation under Sec. 346(a) rather than a qualified dividend. The stepped-up basis of the C corporation stock would offset the liquidation proceeds, minimizing the tax impact to the individual. The corporation should remember to file a Form 966, Corporate Dissolution or Liquidation, with the IRS within 30 days after a resolution or plan is adopted to liquidate the corporation.
When the TCJA was passed, a common question was how to treat a Sec. 743(b) basis adjustment to a decedent's share of assets when computing the Sec. 199A deduction. Final regulations for Sec. 199A, which were issued Jan. 18, 2019, clarified that a Sec. 743(b) basis adjustment "should be treated as qualified property to the extent the Sec. 743(b) basis adjustment reflects an increase in the fair market value of the underlying qualified property" (preamble, T.D. 9847). Stated differently, only that portion of the step-up in basis that exceeds the original basis of the property is treated as qualified property.
Example: Partner 1 dies owning a 50% interest in ABC Partnership. ABC Partnership has no liabilities and one asset, which it purchased several years ago for $600,000. Between the date of purchase of the asset and the date of Partner 1's death, the asset had been depreciated $100,000, leaving a $500,000 tax basis. The FMV of Partner 1's 50% interest is determined to be $350,000. As shown in the table, "Calculation of Basis Adjustments in the Example," (below) the step-up in basis is calculated to be $100,000, of which $50,000 is treated as qualified property (under the rule described in the previous paragraph), while the remaining $50,000 is nonqualified property.
Additionally, this basis adjustment should be treated as a separate item of qualified property with the acquisition date being the partner's date of death. This also means that the portion of the basis step-up treated as qualified property will restart the 10-year measurement period for qualified property under Sec. 199A. For high-income taxpayers, the ability to restart the 10-year measurement period could be very valuable.
Trusts as beneficiaries
When considering an entity change for a business client to an S corporation, a careful reading should be done of all the existing estate planning documents, especially trusts with testamentary powers and the last will and testament, to verify that (1) any trust that may potentially own S corporation stock after the owner's death is appropriately drafted to hold such stock; (2) the change in ownership will not cause the number of shareholders to exceed 100; and (3) the income tax effects of the trust owning the stock are understood and considered.
Under Sec. 1361(b), only certain types of shareholders are eligible to own S corporation stock. If a trust is to own S corporation stock, the provisions of the trust must qualify, and the appropriate elections must be timely filed. For a testamentary trust to own S corporation stock, it must be a qualified Subchapter S trust (QSST) or an electing small business trust (ESBT). Generally, the main differences between a QSST and an ESBT are (1) the number of income beneficiaries allowable; (2) who is taxed on the S corporation's income; and (3) who is required to consent to the election. These differences should be considered as the estate documents are reviewed. A QSST must have only one income beneficiary, while an ESBT may have multiple beneficiaries. The individual income beneficiary of a QSST will be taxed on the S corporation income, while the trust will pay the income taxes when it is an ESBT.
Obviously, in this instance, any differences in tax rates between the individual beneficiaries and the trust should be considered. To qualify as a QSST, the current income beneficiary must make the election. An ESBT election must be made by the trustee.
A tax adviser looking to properly advise business owners as to entity selection needs to look beyond the immediate impact of that decision. Today's decisions also affect the future owners of the business as drafted through the business owner's estate plan. Additionally, it is important to make sure that all estate planning documents are updated to accommodate any changes the adviser and client agree are beneficial.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or email@example.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica Inc.