Does my Company Lose its S-Corp Election if a Shareholder Dies?

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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.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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