Article: Taxes/S Corporation/Ownership-r

CORPORATE STRUCTURE

Liliana Dimitrova, LL.B., LL.M.

Published on 08 SEP 2023 8:00 am ET.

Ownership Restrictions and Other Negative Influence on S Corporation Business and Stock Valuations.

S corporations are a type of business entity that can have some tax benefits, but also some limitations Like restrictions on who can own their stock and how many shareholders they can have.

5 Min Read

Many privately owned businesses will elect to be treated as S corporations under the provisions of Subchapter S of the US. Internal Revenue Code. The owner of S corporation and their professional advisors (including accounts, financial planners, estate planners, and legal counsel) are often interested in obtaining an estimate of the current market value of the subject business entry. - or of its component equity interests.

Business will directly or through their professional advisors will often engage specialized valuation analysis, to develop S corporation valuation analysis and to report the business security value estimates.

The valuation of an S corporation ownership interest is a typical business valuation assignment for most experienced analysis. Such valuations are regularly developed for transaction pricing, taxation planning and financing collateral, family law, and other types of litigation, and many other purposes. In particular, such valuations are often developed with regard to the planning, compliance, and controversy aspects related to gift tax, estate tax, generation skipping transfer tax, and other US. federal transfer tax matters.

In such equity interest valuation analysis, analysts typically recognize the economic benefits of the S corporation tax pass-through structure compared to that of the C corporation structure. Such analysts have developed a variety of procedures to quantify the value impact that the value increments associated with the S corporation structure. Many of these value measurement procedures involve the following three-step analysis process.

Value the actual S corporation as if it were a C corporation.
Separately measure some (or all) of the S corporation federal income tax benefits related to the company's S corporation income tax status.
Sum the two value components to conclude the total value of the S corporation entity or equity ownership interest.

However, even experienced analysts sometime neglect to account for the fact that there are negative4 influences as well as positive influences associated with a company's S corporations income tax statue. Some negative influences include (1) restrictions on the number of and type of company shareholders; (2) limitations on the ownership exit opportunities for the current shareholders; (3) numerous events that could cause the inadvertent termination of the entity's S corporation statues' (4) special tax situations that arise upon the death of the S corporation shareholders; (5) state income tax requirements for S corporations; (6) other issues that may negatively impact the value of the S corporation ownership interest.

In S corporation business and security valuations developed for a transaction, taxation, accounting, planning, litigation, and any other purposes, the analyst should be aware of while also maintaining a perspective a company's income tax status.

There are special tax considerations related to the transfer of the S corporation stock at the time of the stock owner's death. Moreover, owners of S corporation stock have to intentional with regard to risk and tax costs associated with an inadvertent termination of the company's S corporation status. In addition, analysts and S corporation owners and their various professional advisors should be aware that many states tax S corporations for state corporation income tax purposes.

Many states tax S corporations as if they were C corporations. Also, many other states apply a special corporate income tax rate on s corporation income.

This article is will not dive into the topic of specific analyst procedures related to the measurement of the S corporation tax status value premium or recommend specific analysts procedures related to the measurement of any special discounts for lack of marketability ('DLOM') or any other value decrement related to a company's S corporation tax status.

The article summarizes the risk factors associated with S corporation shareholders, the owner's personal advisors, and the company's legal counsel and other professional advisors as it pertains to the valuation of an s corporation ownership interest.

Summary of S corporation Economic Benefits

The economic benefits of electing S corporation federal income tax status are generally well known. An S corporation is sometimes referred to as a hybrid type of business organization, an entity that is a cross between a C corporation and a partnership. The S corporation tax status avoids the double taxation disadvantage associated with privately owned C corporation. In a S corporation all entity level income, losses deductions and certain credits passthrough to the company's shareholders. This why S corporation is referred to as a TPE.

For federal income tax purposes, all of the entity's income is taxed once at the shareholder's level, however some states will impose a corporate tax. Not having to pay a federal income tax at the business level is the principle economic benefit of the S corporation election. This particular economic benefit is the most valuable in the early years of a company's business life.

This because the start-up or the early-stage company may have limited liquidity. The cash that would otherwise go to pay C corporation income tax payments can be used to fund growth-related operating expenses, working capital investments, or capital expenditures.

S corporations are mostly exempt from most federal income taxes. For example, certain capital gains and passive income are subject to federal taxation at the S corporation level.

In addition, the S corporation tax status may reduce the total income tax liability of the privately owned company stockholders. By characterizing the distributions from the company as either salary payment or dividends distributions, the shareholder/employees may be able to reduce their self-employment taxes. The S corporation is allowed to deduct business expenses and reasonable salaries paid to employees this include also shareholder/employees as well.

The S corporation shareholders can be company employees. Such employee/shareholders can earn salaries that are deductible by the company. In addition, such employee/shareholders can also receive distributions of the company's profits on a tax-free basis as long as the distributions do not exceed the shareholder's stock basis. if the distribution does exceed the shareholders stock basis, the excess may be taxed as capital gains which is much lower tax rate than under ordinary income.

Outside of the taxation area, incorporations may provide credibility to a start-up, early stage, or other privately owned company compared to either sole proprietorship or partnership status.

That is potential customers suppliers, landlords, employees, bankers, and others may find a corporation entity to be more creditable compared to a similar sized partnership or proprietorship. S corporation provides certain legal liability protections to the company owners.

S corporation status and limited liability company (LLC) status provide the assets of the business owners with certain protection from business creditors. In addition, the S corporation and the LLC business owners generally cannot be held personally liable for in lawsuits filed against the private company.

Risk Associated with the S corporation Income Tax Status.

S corporations are permitted under Subchapter S of the Internal Revenue Code. An S corporation is defined in the Internal Revenue Code Section 1361. To achieve S corporation income tax status, the company has to file IRS Form 2553, Election by a Small Business Corporation. The Form 2553 should be signed by all of the company shareholders. The Form 2553 should be filed with the IRS within 75 days of the company's initial incorporation or within 75 days after the beginning of each tax year. The IRS may accept the filing of an S election after the 75 day period has passed but they are required to do so.

Valuation analysts, the company owners, and its advisors are generally familiar with the economic benefits associated with S corporation tax status. The most significant benefits have been summarized. Analysts have developed numerous methods and procedures to measure the value premium associated with the tax election.

These value premium measurement methods and procedures are generally given the valuation literature. When choosing S corporation tax status, owners should perform a risk to benefit analysis. Risk involved when making investments, transactions, financing, taxation and litigation decisions. The financial planners and estate planners should consider these same risks when making and implementing personal financial planning or estate planning recommendations to the owners.

Legal counsel should consider these risks in terms of law, bankruptcy, shareholders, disputes and other controversy decisions related to the private company. Tax counsel should consider these risk as they relate to issues of income tax, gift tax, state tax and other tax planning recommendations both at the company level as well as on the shareholder level.

In additions valuation analysts should consider such risk as they relate to the valuation of the S corporation entity and its securities.

The analysts should be aware of the risks and their associated value. influences when developing and reporting the S corporation valuation analysis. In addition, the company owners and their professional advisors should expect to see the analyst's consideration of the risk in both the development of and the reporting of the S corporation business or security valuation.

Some ways of incorporating these risk factors is through the following:

The development and final selection of the present value discount rate or the direct capitalization rate in the application of the business valuation income approach.
The assessment, adjustment, and the final selection of valuation pricing multiples (whether capital-marketed-derived or transaction-derived) in the application of the business valuation market approach.
The identification and measurement of goods-will (or of the recognition of some kind of tax deferred tax liability) in the application on the business valuation-asset based approach.
The recognition (a) of some increment in the assessment and measurement and the assessment of the entity-level value adjustment fort illiquidity or (b) of a security-level value adjustment for lack of marketability on the valuation synthesis and conclusion process.
Other adjustments (a) to the valuation variables applied or (b) to the value indications concluded.

The best practice is to consider both the risks (i.e. economic disadvantages) described above in any S corporation analysis.

Restrictions on the Number and the Type of S corporation Shareholder

Internal Revenue Code Section 1361 provides for limitations and restrictions with regard to S corporation shareholders. A company elects to become an S corporation under the provisions of Section 1362. The most common of the Section 1361 limitations and restrictions are:

The company has to be a domestic corporation or other entity.
The company may have more than 100 shareholders at any given time (an individual and their spouse are considered as one shareholder).
Each of the S corporation shareholders has to be an individual, estate, trust, tax-exempt organization, or another S corporation (a C corporation or a partnership cannot be an S corporation shareholder).
The company may not have a nonresident alien as a shareholder.
The corporation may only have one class of stock. All of the company stock should have the same rights with regard to profit distributions.
The company may not be an ineligible corporation, including a financial institution, an insurance company, or domestic international sales corporation. ("DISC")
The company has adopted either a December 31tax year-end (the most common) or a natural business year-end, an ownership tax year, or a 52-or 53- week tax year.
The company has the consent of each of the shareholders. (If two spouses have a community interest in the S corporation stock, both spouses need consent.

To be an S corporation, the company has to be a corporation or entity based in the United States. The company may have no more than 100 shareholders at any given time. Shareholders may buy and sell the S corporation stock during the year. So, in total, the company may not have more than 100 shareholders throughout the year.

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Members of a family may be treated as one shareholder. A husband and wife (the term used in Section 1361(c)(1)(A)(i) and their estates are treated as one shareholder. Also, all members of a family (and their estates) are treated as one shareholder.

Section 1361 (c)(1)(B)(i) states 'The term members of a family' means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendants".

The Internal Revenue Service Code prohibits most types of entities from being shareholders to an S corporation. Even individuals have to meet the qualifications to be shareholders of an S corporation. To be an S corporation shareholder. an individual has to meet the following two qualifications:

Be a US. citizen
Be a permanent resident of the United States.

Therefore, individuals who are not US. citizens or US. residents cannot be shareholders in an S corporation:

A C corporation
A partnership
A nonresident alien
A foreign trust
A multiple-member limited liability company
A limited liability partnership
An individual retirement account (IRA)

Section 1361(b)(1)(D) clearly indicates that an S corporation may not have more than one class of stock. However, Section 1361(c)(4) provides for differences in common stock. However, Section 1361(c)(4) provides for differences in common stock voting rights as follows: "For purposes of subsection (b)(1)(D), a corporation shall not be treated as having more than one class of stock solely because there are differences in voting rights among the shares of common stock.

An "ineligible corporation" cannot be an S corporation shareholder. The term "ineligible corporation" is defined in Section1361(b)(2) as follows:

For purposes of paragraph (1), the term "ineligible corporation" means any corporation which is

(A)a financial institution which uses the reserve method of accounting for bad debts descried inn Section 585

(B)an insurance company subject to tax under subchapter 2, or

There are several requirements related to the selection of the S corporation's tax year. To be an S corporation, the company has to change to or adopt one of the following tax years:

The calendar year ending December 31,
A period of 12 consecutive months that ends during a low period of business activities.
An ownership tax year.
A tax year selected pursuant to Section 444.
A 52- or 53-week tax year, as long as the company's fiscal year is maintained on the same basis.
Any other tax year for which the company demonstrates a valid business purpose.

Section 1362 describes the shareholder election requirements related to an S corporation. Section 1362(a)(2) states that all shareholders have to consent to the S election, as follows:

An election under this subsection shall be valid only if all who are shareholders in such corporation on the day in which such election is made consent to such election.

Given the above-listed restrictions, who can be a shareholder to an S corporation? We know that any US. citizen or US permeant citizen can be S corporation shareholders. However, many types of entities are prohibited from owning S corporation stock.

The types of entities that are permitted to be S corporation shareholders fall into three categories:

Single member businesses.
Estate of recently deceased S corporation shareholders.
Bankruptcy estates of S corporation shareholders who have recently filed for bankruptcy.

In many of the above-listed instances, the entity is only allowed to hold the S corporation stock on a temporary basis.

That is, the Internal Revenue Code allows such temporary ownership in order to prevent the collapse of the S corporation due to the bankruptcy or the death of the S corporation shareholder.

When measuring the impact of liquidity (or the lack thereof) on the value of the S corporation shares, the analyst should consider that the following types of individuals and entities may not own S corporation stock: (1) all foreign individuals (who are not permanent US. residents): (2) all partnerships: (3) all C corporations: (4) all multi-member limited liability companies: (5) all limited liability partnerships: (6) all business trust: (7) all foreign trusts: and (9) all IRAs

Analyst considerations Regarding S corporation Liquidity

Even ignoring the investment risk associated with an S corporation inadvertent disqualification and other risk factors, the analyst should appreciate that S corporation stock is generally less liquid than the identical C corporation stock. Let assume that the S corporation has the same entity size expected growth rate, profit margin, return on investment, and other financial and operational attributes as the hypothetical identical C corporation. The fact is there are simply fewer market participants available that would qualify to be willing buyers and to transact with the S corporation current owner[s]/willing sellers.

That is there is a smaller pool of willing buyers who could own (and therefore, who could by) the S corporation stock, compared to th otherwise C corporation stock.

The analyst should consider this relatively limited population of potential marketr particpants somewhere and somehow in the valuation analysis. That is the analyst may account for these considerations within each valuation appoach and each valuation method developed within the analysis. That is the analyst may account for these considerations within each valuation method developed within the analysis.

The analysis may incorporate these considerations as a component of a discount for the lack of marketability or some other type of valuation adjustment when recording the various value indication into the final value consideration. One other another, these considerations should be accounted for in valuations developed for accounting, taxation, litigation and estae planning. In addition, these considerations have practical implications for S corporation transaction pricing and structuring proposes. That is, the number and type of S corporation shareholders may directly impact the exit strategies available to the S corporation owners seeking an ownership transition.

Impact of Limitations on S corporation Owner Exit Strategies

Most owners of private companies eventually have to plan for an ownership transition. This statement applies to most family-owned companies (Closely Held Corporation CHC). Also, this statement generally applies to most private companies. The company's current management/owners will want to retire.

Many owners of successful private businesses may consider an initial public offering of the stock as a potential exit strategy. Other owners may consider the sale of the business or practice equality sponsor, a sale through a roll-up transaction involving serval companies, a sale to the company non-owner management team, or a sale to the general employees through an employee stock option ownership plain, or other structure.

Even those business owners who are planning to "keep the company in the family" are de facto considering an ownership transition transaction. Such an ownership transfer to the next generation could be accomplished by sale, gift, or bequest.

Implicitly or explicitly the analyst has to incorporate exit strategies in their business valuation analysis. All generally accepted business valuation approaches and methods incorporate some type of residual value, reversionary value, or terminal value, or some point, there will be a new owner to enjoy the benefit of that expected future income.

However, if the private company wants to retain its S corporation, status, several typical ownership transactions or exist strategies may not be available to it. For example, the S corporation cannot be a publicly traded company. Some private equity or other types of investors may not be interested in buying the S corporation less it converts to a C corporation. The reluctance to purchase may be the case with a large C corporation as well. The C corporation cannot be an S corporation shareholder. Other exit options may be available but may be limited in their implication or structure. Typically, the ESOP can own an S corporation. However, many ESOP acquisitions involve multiple classes of equity. The ESOP sponsor company employee may buy one class of stock through ESOP trust. The sponsor company management may buy a different class of stock. Certain founding family members may retain a different class of company stock at least for a period of time. However, such a more complex capital structure would violate. the one common stock class restriction for S corporation.

The analyst most accommodate these exit strategy restrictions in the S corporation business or security valuation. In addition, the current company owners, their legal and tax council, and their other professional advisers may have to consider these restrictions in their transaction, taxation, litigation, or planning deliberations.

The Inadvertent disqualification of S corporation Status

Most of the S corporation disqualification events relate to the limitations and restrictions summarized. if the S corporation fails to maintain its status as a small business corporation under Section 1361(b), that selection automatically terminates on the date that disqualifying event occurs. Section 1361(b)(1) and Section 1362(d)(2) can be considered to be joined together to develop a list of disqualifying events that could unexpectedly terminate the company's S corporation status.

The risk of the inadvertent disqualifying event includes the following:

The company has more than 100 stockholders at any time during the year. This event could happen to a company with fairly large number of shareholders, particularly when there are shareholder coming and going at various times during the year.
The company has an intangible shareholder. This event could happen when one of the current qualifying shareholders transfers the stock to a C corporation, partnership, ineligible trust. or a nonresident alien. This event could happen for instance, when a current qualifying shareholder experiences a divorce. The S corporation shares are allocated between the spouses. A former spouse moves to another country and remarries. The there may a nonresident shareholder the company is unaware of.
The company has more than one class of stock Initially the declassification is easy to prevent. However, after many years of business operations it is possible to forget this requirement. The disqualification event may be inadvertently triggered by when one group employees/ shareholder or one group of family/ shareholders receive some special profit share of or similar consideration.
The company becomes an "ineligible corporation "for example" the subject company becomes a financial institution. an insurance company or an DISC. This type of disqualifying conversion or acquisition should be relatively easy to spot and to prevent.
The company changes its place of incorporation to a foreign country losing its domestic corporate status. Such a change of incorporation should be easy to spot, unless the S corporation requirements are simply overlooked.

Section 1362c provides all of the specific events that can cause a corporation to fail to qualify as a small business corporation. Filling the corporation's income tax return based on an unacceptable tax year is not a Section 1362 disqualifying event and such a filling the IRS may forgive.

The S corporation should be careful not to trigger a disqualification if it dissolves and reincorporates for whatever reason. However, the IRS has issued private letter ruling allowing S corporation to keep its status when it was administratively disclosed by its state of incorporation.

In these stances the subject companies failed to file annual reports and pay annual license fees to the respective states. later reinstated the corporation and the company

In another instance a state administratively dissolved an S corporation. The state letter reinstated the S corporation and the they obtained a new Employer Identifcation Number ("EIN"). The IRS did make the corporation file a new Form 2553 Election by Small Business Corporation status.

These S corporation disqualifying events should be easy to prevent, but they can also occur. Some other examples:

Assume the successor beneficiary of a qualified subchapter S trust ("QSST") refuses to consent to the original QSST election. Such a refusal would mean that the QSST is no longer a qualifying S corporation shareholder, and the stock election is disqualified.
Assume the subject S corporation stock is pledged as collateral for a shareholder's personal loan. The S corporation stock collateral is foreclosed by financial institution creditor. The financial institution is an ineligible shareholder therefore the S election is disqualified.
Assume the subject S corporation has accumulated earnings and profits ("AE&P") and receives more than 25% of its gross receipts from passive income for three years in a row The passive income will disqualify the business S election status.
Assume a S corporation shareholder dies, and the shareholder's estate holds on to the shares for more than two years. The estate's prolonged stock ownership will disqualify the S election.

Analysts and other interested parties should be aware that the Tax Court has ruled that Section 1362(d) does not provide an exhaustive list of all of the S corporation disqualifying events. Example the Farmers Gin Tax Crout decision relates to an S corporation that inadvertently terminated its S corporation. In the Farmers Gin decision, the company did not adopt a permitted tax year after its business condition changed so that its previously permitted tax year was no longer allowable.

The point is, as stated, the use of an unpermitted tax year is not a disqualifying event that is specified in Section 1362. Events, obvious or otherwise, that can cause an inadvertent disqualification of the company's S election represent a risk both to the S corporation and to the company's shareholders.

As with any business risk, the analyst should consider the risk of inadvertent S election disqualification in the S corporation valuation.

If the company deliberately or unintentionally experiences an S election disqualifying event, the IRS can withdraw the company" S corporation status. In some cases, the IRS may require the campany to pay back income taxes, at the C corporation income tax rate, for three years prior to the S status revocation. In addition, such a company/practice would have to wait another five years to reapply for S corporation income tax status.

Consideration when an S corporation Shareholder Dies

The death of an S corporation shareholder can create tax complications for the TPE. One of the complications and a risk of the S corporation stock ownership is an inadvertent termination of the company's S corporation status. There may also be tax complications related to the decedent shareholder's estate. Many of the typical complications are summered below. Analysts and S corporation shareholders and their professional advisors should consider the impact of these potential tax complications on the value of the S corporation ownership interest.

Reporting the S corporation Income and Loss in the Year of Death.

In an S corporation, a shareholder's pro rate share of the company's income and loss is typically determined by allocating equal portions to each day of the year. Then, the company allocates the income and loss to each shareholder based on the number of shares outstanding on each day.

This allocation procedure is described in Section 1377(a)(1) of the Internal Revenue Code. In the year when the shareholder's S corporation ownership interest terminates, such as in the case of death, the S corporation can elect under 1377(a)(2) and Reg. 11377-1(b) to implement an interim closing of the company's books. That is, the TPE company can elect to treat the S corporation's tax year as two separate tax years for income allocation purposes. All effected company shareholders and the S corporation itself have to consent to the election.

Such a separate tax year election may or may not benefit the S corporation shareholders. Due to accounting and tax return preparation fees, interim closing of the company books may be as well costly. However, making the selection may be beneficial, particularly in situation where extraordinary items occur either before or after the date of the shareholder death.

For example, assuming that an S corporation generates a large gain pre-death. In this case, the ultimate beneficiaries of the shares may prefer that the descendent pay their full share of tax on the item in contrast to burdening the beneficiaries with a portion of the gain and other related taxes. If the descendant's estate is subject to estate tax, the payment of tax on the S corporation gain reported on the descendant's final income tax return will reduce the income tax liability. When such a situation occurs, the descendant's beneficiaries and the company practice itself will have to carefully analyze the pros and cons on this tax election.

Inadvertent termination of an S election After a Shareholder's death

The failure of the corporation and the successor shareholders to consider all of the implications of the corporation's S tax status after a shareholder's death is a typical cause of the inadvertent termination. In many cases, the successor shareholder, whether that shareholder be the estate, a testamentary trust or a beneficiary, may not recognizes that it needs to take certain steps to remain a qualified shareholder.

These steps are generally described in Section 1361(b)(1)(B) and Section 1361(c)(2)(A) and in Reg. 1361-1(h)(1). By the time the S corporation or the new company shareholder[s] recognizes, for example that a qualified Subchapter S trust or electing small business trust election has been overlooked, there may be an S termination event triggered. In many cases the S corporation itself may not be aware of what its shareholders are doing at the time of each shareholders' death. The S corporation generally has no visibility into the estate plans of its various shareholders. That is, the company or practice itself is unaware of who will get shares upon the shareholders death, and whether those parties are timely making the needed elections. In many cases, the S corporation may be unaware that one of its shareholders has died. This means that the company's S election can terminate before TPE is even aware of the event that triggered the S termination. Such termination events are generally described in Section 1362(d)(2) and Reg. 1.1362-4(b).

Consider an example, assume that a particular decedent owned the S corporation shares in a revocable trust during their life. Upon death, the revocable trust becomes irrevocable, with its own income tax filling requirement. During the first tax year, the executor/trustee makes a timely Section 645 election to treat the trust as part of the estate. This election allows the executor/trustee to file one income tax return. The tax return reports the combined activity of the estate and of the qualified revocable trust. This trust may or may not need to make an S election. The need to make an election depends on what happens with the S corporation shares and when it happens. If the S corporation shares are immediately transferred to another trust, an election may be needed within two and half months of the transfer.

Alternatively, if the S corporation shares are retained for the maximum duration of the Section 645 period, a S election may not be due for more than four years. The provision is more fully described in Reg. 1.1361-1(h)(1)(iv).

What is to be considered is that any time an S corporation shareholder dies, the parties should pay immediate attention to the decedent's plan with respect to (1) the transfer of the TPE shares and (2) any potential need for, and timing of, required election. It is noteworthy that Revenue Procedure 2013-30 may provide automatic relief for taxpayers to make a late S election in these types of situations. However, the window for relief under the revenue procedure closes three years and 75 days after the election intended effective date. The latest intended effective date for an irrevocable granter trust is two years after the death of a granter. This window may possibly provide additional time to make the S election.

However, the risk is that these types of required S election oversights may not be discovered until many years after the fact. Such a late-stage discovery can trigger the need to seek uncertain relief through the private letter ruling process.

S corporation Gain on the Sale of Assets and Step-up in the Basis of Decedent's Shares.

A partnership TPE can take advantage of a Section 754 election to help a successor partner equalize their inside and outside basis. However, an S corporation has no option. When an S corporation shareholder dies, the decedent's TPE shares basis is stepped up to fair market value. However, there is no adjustments to the inside basis of the S corporation's assets.

As a consequence, the benefit of the step-up may be deferred until the S corporation successor shareholder[s] disposes of their stock. The deferral can create a potential trap for the successor shareholder[s]. Let consider what would happen if, at later date, there is a sale of substantially all of the S corporation's assets. Let's assume that the S corporation shareholder doesn't liquidate their interest in the same year. In this example let's assume that an S corporation has an inside net basis of $10 million. The S corporation is owned by shareholders with an outside basis of $50 million due the step-up in basis upon a previous shareholder's death.

If the S corporation sells all of its assets, $40 million of gain will be triggered. This gain will pass through to the shareholder[s] and increase the S corporation stock basis.

If the shareholders fail to liquidate their ownership interest will not shield the $40 million of gain. Instead, the loss that will likely occur during liquidation would be deferred. Also, the loss would be deferred when the shareholder[s] have no offsetting gains. This deferral will trap the loss and defer the related tac benefits until the shareholder[s] can trigger other gains.

A successor S corporation shareholder[s] should be aware of such a situation. The shareholder[s] should plan to time recognition of any losses so they occur in the same tax year in which the gain from the S corporation asset sale is reported.

Buy-sell Agreements and Shareholders Life Insurance

A buy-side agreement is typically an agreement (1) between the S corporation and the shareholders or (2) between the S corporation and the corporation itself. The agreement specifies the terms of the events, such as the death of the shareholder, that will trigger the required transferor the corporation shares.

A buy-side agreement is an important ownership transition plaining device in the case of any privately owned company. Such an agreement is particularly important in the case of an S corporation. This because such an agreement can help provide assurance as how shares will transfer from the deceased shareholder. Such a buy-sell agreement can help prevent transfers that may otherwise trigger an inadvertent termination of the corporation S tax status. Life insurance on the shareholder is the typical means to provide the necessary liquidity to fund these buy-sell transitions. Such life insurance policies are typically owned either (1) by the S corporation itself or (2) by the corporation's shareholders. The appropriate ownership of the life insurance policies typically depends on the structure of the individual buy-sell agreement.

Buy-sell agreements are typically structured in one or two ways (1) as redemption agreements or (2) as a cross-purchase agreement. With a redemption agreement, the S corporation has the right or obligation to purchase TPE shares of the deceased shareholder. A cross-purchase agreement, gives the other company shareholders the option or obligation to purchase the TPE shares of the deceased shareholder.

The ultimate ownership consequences of a cross-purchases agreement versus a redemption agreement may not differ significantly. However, the agreement parties can encounter difficulties if the ownership of the life insurance policies are not in line with the buy-sell agreements.

When the buy-sell agreement calls for the S corporation to redeem the deceased shareholder's shares, the company should typically own and be the beneficiary of the life insurance policy. Alternatively, if the buy-sell agreement is structured as a cross-purchase, the shareholders typically should own and be the beneficiaries of the life insurance policies. Taxpayers who fail to coordinate the ownership of the insurance policies with the buy-sell agreement can create unnecessary tax problems both for themselves and for the corporation.

Suspended Passive Losses Upon Shareholder's Death

Upon the shareholder's death special rules will apply to suspended passive losses arising from the TPE interest owned at death. The unused losses are allowed as a deduction on the decedent's final personal income tax return. The unused losses are only allowed to the extent these losses are in excess of the difference between (1) the basis of the ownership interest in the transferee's hands in excess of (2) the adjusted basis of the ownership interest immediately before the death of the taxpayer.

These rules are also proved in Section 469(g)(2)(A). This difference in basis is typically referred to as the step-up, or step-down upon death of the basis an asset to fair market value. The rules are generally provided in Section1014. This provision means that effectively, to the extent of the basis step-up, the suspended passive losses will be permanently disallowed. Those unused passive losses do not carryforward to the decedent's estate, trust or beneficiaries. The rules are provided in Section 469(g(2)(A). Losses in excess of the basis step-up are allowed on the decedent's final income tax return. If there is no basis step-up for example because the value of the ownership interest has decreased, the suspended losses are fully deductible on the decedent's final income tax return.

Buy-sell Agreements and Shareholders Life Insurance

Suspended Losses Due to Lack of Regular Tax Basis Upon Death

Suspended losses dur to a lack of regular tax basis will disappear at death upon the transfer from the decedent to their estate trust, and beneficiaries.

Suspended Losses Due to Lack of At-risk Basis Upon Death

Unused at-risk losses will also not carry forward to the decedent's estate, trust and beneficiaries. Instead, these amounts are added to the tax basis of the ownership interest in the hand of the recipient. However, because this addition occurs prior to the basis adjustment under Section 1014, there is no net change in the tax basis.

Estate Planning Procedure

There are various planning procedures tht can be implemented with regard to older S corporation shareholders. For example, the older S corporation shareholder should consider selling the ownership interest with the suspended losses. Such a sale would be beneficial if the benefit of triggering the carryovers exceeds any gain on the ownership interest.

State Taxation of the S corporation

The analysts and S corporation shareholders should be aware of that many state apply some form of TPE income tax on S corporations. Such a state income tax should not be ignored in the valuation of the S corporation or of the S corporation ownership interest. Currently, over half of the 50 states impose some form of income tax on a TPE.

Effectively these states ignore the company's S corporation status for state income purposes. Many states impose a reduced corporation income tax rate such a 1 percent state income tax rate on the TPE. While such a reduced income tax rate is advantageous in comparison to the C corporation tax rate, the valuation analysis should recognize that the TPE is still subject to some income tax liability. In addition, the valuation analysis may consider the possibility that those states in which the subject S corporation operates may (1) impose a de novo income tax on the TPE or (2) increase a currently reduced TPE income tax rate to a higher income tax rate. In other words, the valuation analysis should recognize the risk that the S corporation may be subject to a greater state income tax liability in the future.

It is also noteworthy that many states require the company or practice to elect TPE status in that state. In addition, TPE may not be automatically achieved when the company files a federal S corporation election. Such states have their own election, periodic filling, and shareholder qualification requirements. Therefore, in some states, there is the risk that the S corporation could inadvertently terminate its state S tax status even if it does not terminate its federal S tax status. The takeaway is that analysts and S corporation shareholders and their professional advisors should not ignore state income tax considerations in any analysis of an S corporation or other form of TPE.