S Corp Change in Ownership After a Shareholder’s Death

An S corporation provides owners with pass-through taxation, meaning the business itself is not taxed on its income. Instead, profits and losses are passed directly to the shareholders’ personal tax returns. This structure is governed by strict Internal Revenue Service (IRS) rules regarding who can be a shareholder and the total number of shareholders, which is capped at 100. The death of a shareholder introduces complexity for the company’s continuity, the surviving owners, and the deceased’s heirs.

Immediate Implications for S Corp Status

Upon a shareholder’s death, their ownership interest in the S corporation automatically transfers to their estate. This event does not immediately terminate the company’s S corporation status, as the IRS permits a decedent’s estate to be an eligible shareholder for a transitional period. This allowance prevents the company from defaulting to a C corporation status.

The estate is permitted to hold the S corporation stock for the duration of its administration. The Internal Revenue Code does not specify a maximum time limit for this period, but it is expected to be a “reasonable” length of time. An unduly prolonged administration could be challenged by the IRS, jeopardizing the S election.

If the deceased shareholder held stock within a grantor trust, that trust can also continue as an eligible shareholder for a limited time. Tax law provides a grace period of two years from the date of the shareholder’s death for such a trust to hold the shares.

Transfer of Shares and Shareholder Eligibility

The transfer of S corporation shares from the estate to a permanent owner is dictated by the deceased’s estate plan, such as a will or living trust. If no such plan exists, the distribution of shares is governed by state intestacy laws. This transfer poses a risk to the corporation’s S status, as the shares must land in the hands of a permissible shareholder. A single ineligible shareholder can terminate the S election for the entire company.

Qualifying Trusts for S Corp Stock

Eligible shareholders are generally restricted to U.S. citizens and resident aliens, but the most complex rules apply when shares are transferred into a trust. Only specific types of trusts can hold S corporation stock, with the two most common being the Qualified Subchapter S Trust (QSST) and the Electing Small Business Trust (ESBT). Each requires a formal election to be filed with the IRS.

A QSST can have only one income beneficiary at a time, who must be a U.S. citizen or resident. All income the trust receives from the S corporation must be distributed to that beneficiary annually. The beneficiary is personally taxed on that income and is responsible for making the QSST election.

An ESBT offers more flexibility, as it can have multiple beneficiaries and can accumulate income. With an ESBT, the trustee makes the election, and the trust itself pays tax on the S corporation income at the highest individual income tax rate. Transferring shares to a non-qualifying entity, such as a partnership, a corporation, or a non-resident alien, will terminate the S corporation status.

Key Tax Considerations and Reporting

The death of a shareholder triggers several tax events that affect the deceased, their estate, and the heirs. These considerations involve the tax basis of the inherited shares, the allocation of the corporation’s income or loss for the year of death, and final tax reporting duties.

Step-Up in Basis

An heir inheriting S corporation stock benefits from the “step-up in basis” under Internal Revenue Code Section 1014. The heir’s cost basis in the shares is adjusted to the fair market value of the stock on the date of the shareholder’s death. This can substantially reduce or even eliminate capital gains tax if the heir later sells the shares. For example, if stock purchased for $100,000 is worth $1 million at death, the heir’s basis becomes $1 million.

This step-up applies only to the basis of the corporate stock, not to the underlying assets owned by the S corporation. The corporation’s assets retain their original tax basis, which can create a “trapped asset” problem where selling a corporate asset generates a large taxable gain for all shareholders.

Allocation of Income and Loss

In the year a shareholder dies, the S corporation’s income or loss must be allocated between the deceased shareholder and their successor. The default method for this allocation is a pro-rata, per-share, per-day basis. This approach distributes the total income or loss for the entire year evenly over 365 days, assigning a portion to each shareholder based on their ownership percentage for each day.

Alternatively, the corporation can make an election under Section 1377 to use the “closing of the books” method. This election treats the corporation’s tax year as two separate periods: one ending on the date of the shareholder’s death and the second beginning the following day. This method allocates income and expenses based on when they were actually incurred. Making this election requires the consent of all shareholders.

Final Tax Returns

The chosen allocation method impacts the final tax returns. The S corporation income or loss allocated to the period before death is reported on the shareholder’s final individual income tax return, Form 1040. Income or loss allocated to the period after death is reported by the estate on its fiduciary income tax return (Form 1041) or by the heir who receives the stock. Any previously suspended losses the deceased shareholder could not deduct expire upon death.

The Role of a Buy-Sell Agreement

A buy-sell agreement is a legally binding contract among shareholders that provides a plan for handling a change in ownership. When triggered by a shareholder’s death, this agreement can solve many uncertainties by controlling the transfer of the deceased’s shares. The agreement can create a mandatory obligation for the corporation (a redemption agreement) or the surviving shareholders (a cross-purchase agreement) to purchase the decedent’s stock. This mechanism prevents the shares from passing to an ineligible shareholder, thereby safeguarding the S election.

The agreement also establishes a valuation method for the shares in advance, such as a fixed price, a formula based on earnings, or a process for obtaining a professional appraisal. This helps prevent disputes between the surviving owners and the estate over the value of the business interest.

A buy-sell agreement provides liquidity for the deceased shareholder’s estate. The estate often needs cash to pay estate taxes and other expenses, and the agreement guarantees a buyer for the closely held stock, which otherwise has no ready market. These agreements are often funded with life insurance policies on each shareholder, ensuring that the funds needed to complete the purchase are available upon a shareholder’s death.