S-Corp tax treatment continues to be a popular choice for many business corporations as they seek favorable tax treatment of business income. The S-Corp status helps a corporation lessen its tax consequences by having income taxed at the individual, shareholder level instead of at higher corporate rates. Corporations with S-Corp status avoid double taxation as well as the payment of tax on the sale or liquidation of business assets. Like a partnership, an S-Corp reports its profits and losses on an individual tax return, but unlike a partnership, an S-Corp is a distinct, standalone legal entity that can survive the death of its shareholders. Subject to qualification requirements, LLCs can elect S-Corp tax treatment as well. For completeness, LLCs can elect partnership or C-Corp tax treatment too.
In order to qualify as an S-Corp, a business must:
- Be a domestic corporation or LLC;
- Have only the following allowable shareholders: individuals, certain trusts, and estates. Partnerships, corporations, or nonresident alien shareholders cannot be shareholders;
- Have no more than 100 shareholders;
- Have one class of stock; and
- Not be an ineligible corporation, i.e., certain financial institutions, insurance companies, and domestic international sales corporations. See 26 U.S. Code § 1361(b)(1).
Since the S-Corp is a distinct entity separate from its shareholders, it does not dissolve upon a shareholder’s death; instead, it retains its obligations and liabilities. Shareholders of an S-Corp must plan early, however, to ensure that the S-Corp stays intact and is able to continue reaping the tax benefits of being an S-Corp even after the death of a principal shareholder.
When a shareholder dies, his or her shares in the S-Corp will be inherited according to the deceased shareholder’s will and/or living trust, or the state’s intestate laws. S-Corps cannot have irrevocable trusts or estates as shareholders; it ruins eligibility.
Loss of S-Corp eligibility is not absolute. A significant factor in determining whether the S-Corp will be able to keep its tax-preferred designation is to whom the shares are passed down. The heirs of the deceased shareholder must be qualified owners, i.e., an individual, estate, exempt organization, or a certain kind of trust, in order for the corporation to continue as an S-Corp. If the heir is not a qualified owner, the S-Corp will lose its status and convert it to a C corporation. S-Corp shareholders are narrowly defined by the IRS, so any individual or entity that fails to meet the definition cannot qualify as an S-Corp shareholder. For example, if a principal shareholder leaves his or her shares in the S-Corp to a non-voting trust or nonresident alien, the shares will pass on to an ineligible owner and the corporation could lose its S-Corp designation.
The good news is that there is a 2-year period leniency period for certain types of trusts. After an S-Corp owner dies, there is an immediate ownership change to descendants. To provide a transition period for resulting changes in S-Corp ownership, tax law offers a grace period of 2 years for certain trusts. See 26 U.S. Code § 645(b)(2). If a deceased shareholder of an S-Corp leaves his or her shares to a grantor or a testamentary trust, the trust may continue as a shareholder of the S-Corp for up to 2 years. A grantor trust is an eligible shareholder of an S-Corp for up to 2 years from the death of the grantor shareholder. Note that 100% of the corpus of the trust must be included in the deceased shareholder’s estate in order to qualify.
A testamentary trust may also be considered an eligible S-Corp shareholder for up to 2 years from the date the shares are transferred to a testamentary trust. Note that the 2-year rule applies only if a trust is set up by a grantor who is a U.S. resident or citizen immediately before the shareholder’s death. For both types of trusts, the shares of the S-Corp must be transferred to another eligible S-Corp shareholder at the end of the 2-year period or the S-Corp risks losing its favorable tax treatment.
An S-Corp may also lose its status at the death of a principal shareholder if such a shareholder leaves his or her shares to new owners where the total shareholder count of the S-Corp exceeds 100. If so, the new shareholders would fail to become qualified owners and thus cause the S-Corp to lose its status. If a principal shareholder passes down equity in the company to an unqualified owner or exceeds the maximum number of shareholders, the business could still continue as a C corporation but would lose its S-Corp tax advantages. Careful tax planning that involves successors can be a useful tool to avoid losing S-Corp status and ensuring that the S-Corp continues even in the event of the death of its principal shareholder.