Estate and Succession Planning With S Corporations

The Planning Landscape – Post ATRA

Estate, business and succession planning changed dramatically with the enactment of the American Taxpayer Relief Act (ATRA) in early 2013.  Now, with a federal estate tax exemption set at $5.43 million for death in 2015 and a “coupled” gift tax exemption of the same amount, very few estates will be subject to the federal estate tax.  That doesn’t mean that state death taxes can be ignored.  In the states that impose taxes at death, the exemption levels are typically much lower than the federal exemption level.  Also, farmland values have increased significantly in recent years, virtually matching (in percentage terms) the percentage increase in the federal estate tax exemption.  So, for larger agricultural estates, the increase in the exemption is basically worth about the same as it was several years ago.   

Considerations When An S Corporation Is Involved

The goal of most individuals and families is to minimize the impact of the federal estate tax at death.  But, with the exemption at $5.43 million for 2015 deaths and “portability” of the amount of any unused exclusion at the death of the first spouse for use by the surviving spouse, the estate tax is not an issue except for very few estates.  That means that, for most families, it is an acceptable strategy to cause assets to be included in the decedent’s estate at death to get a basis “step-up.”  Thus, succession plans that have been in existence for a while should be re-examined. 

Buy-out agreement.  For family businesses involving an S corporation, some sort of shareholder buy-out agreement is a practical necessity.  Over time, however, if that agreement is not revisited and modified, the value stated may no longer reflect reality.  In fact, it may have been established when the estate tax was projected to be more of a potential burden than it is now.  The ATRA changes in the federal estate tax may be one reason, by themselves, to take another look at that agreement. 

Consider Not Making Gifts of Business Interests.  Historically, transition planning has, at least in part, involved the parents’ generation gifting business interests to the next generation of the family interested in operating the business.  However, there might be a better option to consider.  It may be a more beneficial strategy to have the next generation of operators start their own businesses and ultimately blend the parents’ business into that of the next generation.  Not only does this approach eliminate potential legal liabilities that might be associated with the parents’ business, it also avoids gift tax complications. 

A couple of recent cases provide guidance on this approach:

• In Bross Trucking, Inc. v. Comr., T.C. Memo. 2014-107, a father owned and operated a trucking company as a C corporation.  He was the sole shareholder.  The company got embroiled in some safety issues and ceased operations.  Consequently, the father’s three sons started their own trucking business.  The sons used some of the equipment that had been leased to their father’s business.  The son’s had used the same business model and the business had the same suppliers and customers.  Importantly, the father was not involved in the son’s business.  However, the IRS claimed that the father’s corporation should be taxed on a distribution of intangible assets (i.e., goodwill) under I.R.C. §311. That goodwill, the IRS also maintained, had been gifted to the sons.  The Tax Court disagreed, holding that the goodwill was personal to the father and did not belong to the corporation.  Key to this holding was that the father did not have an employment agreement with the corporation and there was no non-compete agreement.  Thus, there was nothing that tied the father’s conduct to the corporation.  The lack of an employment contract or a non-compete agreement avoided the transfer of goodwill that might have been attributable to customer relationships or other corporate rights.  That had the effect of reducing the corporate value and also reduced its value on liquidation (an important point for C corporations). 

• In Estate of Adell v. Comr., T.C. Memo 2014-155, a similar strategy was involved with a favorable result.  In this case, the Tax Court allowed a reduction in value for estate tax purposes by the amount of the executive’s personal goodwill.  The point is that the value of a business is dependent on the contacts and reputation of a key executive.  Thus, a business owner can sell their goodwill separate from the other business assets.  In the case, the decedent owned all of the stock of a satellite uplink company at the time of his death.  It’s only customer was a non-profit company operated by the decedent’s son.  The estate and the IRS battled over valuation with the primary contention being operating expenses that included a charge for the son’s personal goodwill – the success of the decedent’s business depended on his son’s personal relationships with the non-profit’s board and the son did not have a non-compete agreement with the father’s business.  Thus, the argument was, that a potential buyer only if the son was retained.   The Tax Court determined that the son’s goodwill was personally owned independent of the father’s company, and the father’s company’s success was tied to the relationship with the son’s business.  In addition, the Tax Court found it important that the son’s goodwill had not been transferred to his father’s business either via a non-compete agreement or any other type of contract.  The ultimate outcome was that the decedent’s estate was valued at about one-tenth of what the IRS initially argued for.    

These cases indicate that customer (and vendor) relationships can be an asset that belongs to the persons that run the businesses rather than belonging to the businesses.  Thus, those relationships (personal goodwill) can be sold (and valued) separately from corporate assets.   That’s a key point in a post-ATRA planning world.  Now, when the general plan will be to include assets in the estate to get a basis increase rather than gifting those assets away pre-death to the next generation, an entirely separate entity for the next generation of operators can also provide valuation benefits.  Planning via wills and trusts at the death of the parent can then merge the parent’s business with the next generation’s business.

Another case on the issue, involving an S corporation, resulted in an IRS win.  However, the case is instructive in showing the missteps to avoid:

• Cavallaro v. Comr., T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son.  The parents' S corporation developed and manufactured a machine that the son had invented.  The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine.  The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received.  The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value.  The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987.  The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987.  Instead, the lawyers executed the transfer documents in 1995.  The IRS asserted that no technology transfer had occurred and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid.  The Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million. 

Note – This case represents a succession plan gone wrong.  The taxpayers in the case were attempting to transfer the value in their company (which had been very successful) to their children via another family business in a way that minimized tax liability.  As noted above, what was structured was a merger that was based on a fictitious earlier value transfer between the entities.   The IRS claimed that the taxpayers had accepted an unduly low interest in the merged company and their sons had received an unduly high interest.  The Tax Court agreed.

Other S Corporation Planning Issues.  Several other issues must be carefully monitored when an S corporation is utilized in the planning/succession process.

• Reasonable compensation.  An S corporation shareholder-employee cannot avoid payroll taxes by not being paid a salary.  This is a “hot button” audit issue with the IRS and, fortunately, recent caselaw does provide helpful guidance on how to structure salary arrangements for S corporation shareholder-employees and the methodology that the IRS (and the courts) uses in determining reasonable compensation. 

• Health care costs.  The health care law enacted in 2010 made significant changes to medical reimbursement plans starting in 2013.  Basically, the reimbursement of individual health care premiums to employees is an improper employer payment plan.  In early 2015, the IRS granted transitional relief to small employers.  These employers won’t have to file Form 8928 (to self-report violations and compute the penalty tax) and won’t be liable for the penalty tax for having an illegal plan through June 30, 2015.  The IRS relief, however, does not apply to small employers who offered stand-alone health reimbursement arrangements or other medical reimbursement plans to their employees.  In addition, the IRS provided no guidance on the question of whether the reimbursement of S corporation two-percent shareholder-employees’ individual premiums are subject to the health care law’s restrictions.  The only guidance offered was that reimbursing such employees won’t trigger the penalty tax through 2015.  This all means that two-percent shareholders of S corporations can rely on IRS guidance last issued in 2008, until further guidance is provided.

• Sales of interests.  The 2010 health care law also potentially impacts the sale of interests in entities, including S corporations.  Gain on sale might be subject to an additional tax of 3.8 percent if the gain is deemed to be “passive” – not related to a trade or business.  This means that the stockholder selling their interest must be engaged in the business of the S corporation.  There is a somewhat complex procedure that is used to determine the portion of the gain on sale that is passive and the portion that is deemed to be attributable to a trade or business.  In many small, family-run S corporations much of the gain may not be subject to the health care law’s “passive” tax.  That will be the case if all of the assets of the entity are used in the entity’s business operations and the selling owner materially participates in the business.  There are income thresholds that also apply, so if income is beneath that level, then the “passive” tax doesn’t apply in any event.

If interests are redeemed, the IRS issued a private letter ruling in 2014 (Priv. Ltr. Rul. 201405005 (Oct. 22, 2013)) that can be helpful in succession planning contexts.  The facts of the ruling involved a proposed transfer of ownership of an S corporation from two co-equal owners to key employees.  The IRS determined that the profit on the redemption of the co-owners' shares in return for notes would be treated as capital gain in the co-owners' hands and would be spread-out over the term of the notes.  The IRS also said that there would be no gain to the S corporation, and that the S corporation was entitled to a deduction for interest paid on the notes.  Also, the IRS said that the notes did not constitute a disqualifying second class of S corporate stock. To get these results requires careful drafting. 

• S corporation stock held by trusts.  Trusts may also be a useful planning tool along with an S corporation as part of an estate/succession plan.  However, only certain types of trusts can own S corporation stock without jeopardizing the S status of the corporation.  Thus, proper structuring of trusts in conjunction with S corporations is critical.  The basic options are a qualified subchapter S trust (QSST), an electing small business trust (ESBT), a grantor trust and a voting trust.  Each of these types of trusts require precise drafting and careful maintenance to ensure that it can hold S corporation stock without causing the S corporation to lose its S status. 

• Issues associated with the death of a shareholder. 

Income tax issues.  Upon an S corporation shareholder’s death, the S corporation’s income is typically prorated between the decedent and the successor shareholder.  The proration occurs on a daily basis both before and after death.  Income that is allocated to the pre-death period is reported on the decedent’s final income tax return, and income that is allocated to the post-death period is reported on the successor’s income tax return.  But, an S corporation can make an election to divide the S corporation’s tax year into two separate years.  The first of those years would end at the close of the day of the shareholder’s death. 

Transfer of stock to testamentary trusts.  Again, the issue here is to make sure the passage of the stock to a trust doesn’t jeopardize the S corporation’s status.  While the decedent’s estate holds the stock, there should be no problem in maintaining S status unless the administration of the estate unreasonably is extended.  Once a testamentary trust is funded, it must take steps to be able to hold the S corporation stock for two years.  After that, the trust must qualify as one of the types of trusts eligible to hold S corporation stock.  The types of trust that might be involved include credit shelter trusts (a.k.a. “bypass trusts”), grantor retained annuity trusts (GRATS), dynasty trusts (often structured as grantor trusts), self-settled trusts (a.k.a. domestic asset protection trusts), intentionally defective trusts and insurance trusts.  If the testamentary trust is an irrevocable trust, the trust language will be the key to determining whether the trust can be appropriately modified to hold S corporation stock. 

Drawbacks of S Corporations

While S corporations can be beneficial in the planning process, they do have their drawbacks.While the following is not intended to be a comprehensive list of the limitations of utilizing S corporations, each of these points needs to be carefully considered.

• Limitations on stock ownership.  As indicated above, only certain types of trusts can hold S corporation stock.  Also, corporations (except for Qualified S Corporation Subsidiary Corporations (Q-Subs)), LLCs and partnerships cannot be S corporation shareholders.  In addition, there is an overall limitation on the number of S corporation shareholders (but it’s high enough that it won’t hardly ever cause problems for family-operated S corporations).  But, the limits on trust and entity ownership of S corporation stock could prove to be a limiting factor for estate, business and succession planning purposes.

• Special allocations for tax purposes.  An S corporation must allocate all tax items pro rata.  Special allocations are not permitted.  But, special allocations are permitted in an LLC or any other entity that has partnership tax treatment.  So, for example, an entity taxed as a partnership can allocate (with some limitations) capital gain or loss as well as ordinary income or loss to those members that can best utilize the particular tax items. The special allocation rule doesn’t just apply to income and loss, it applies to all tax items.  That would include, for example, depreciation items.  An S corporation can’t do special allocations.  This often can be a distinct disadvantage.    

• Death-time basis planning.  A partnership (or LLC taxed as a partnership) is allowed to make an I.R.C. §754 election to increase the basis of its assets when a partner’s interest is sold or when a partner dies.  That means that the entity can increase its adjusted tax basis in the entity’s assets so that it matches the basis that a buyer or heir takes.  That would normally be, for example, the step-up (date of death) basis for inherited property.  An S corporation cannot make an I.R.C. §754 election.  Consequently, this can be another tax disadvantage of an S corporation.

• Business loans.  Care must be taken here.  A loan to an S corporation can jeopardize the S election.  Also, state laws must be followed and the IRS likes to characterize loan repayments as distributions that are taxable.  Also, distributions must also generally be pro rata.  There is more flexibility regarding loans to and from the entity for a partnership/LLC.  A corresponding concern with S corporation loans involves accounting issues involving the matching of interest and other income.  The bottom line is that, in general, it’s more cumbersome to make loans to and from an S corporation compared to an LLC/partnership.

• Farm programs.  Whenever there is a limitation of liability, the entity involved is limited to a single payment limit.  That would be the case with a farming S corporation.  So, generally, a general partnership is the entity that best maximizes farm program payment limits – there is a limit for each partner.  Each member can hold their interest as an LLC to achieve the liability limitation that an S corporation would otherwise provide, but there wouldn’t be an entity-level limitation.

• Asset distribution.  An S corporation has the potential to recognize gain when corporate assets are distributed.  Generally, LLCs don’t have that issue.

• Formalities.  The state law rules surrounding formation are more elaborate with respect to S corporations as compared to LLCs. 

• Dissolution.  There generally is less tax cost associated with dissolving an LLC as compared to an S corporation. 

Conclusion

S corporations can be a useful estate/succession planning tool in the post-ATRA era.  With the general plan now being one of inclusion of assets in the decedent’s estate, creating a separate entity for the successor generation can provide valuation benefits for the decedent.  However, care must be taken in utilizing the S corporation.  In addition, other entity types (particularly the LLC) can provide greater tax benefits on numerous issues.  There are drawbacks to using an S corporation.  Also, it’s important to remember that with any type of entity planning as part of an estate/succession plan, there is no such thing as “one size fits all.”  As with any type of planning, consultation with experienced professionals is a must.