Transferring S-Corp Ownership: Tax Considerations for Family Succession

We're honored to have you with us as we explore the world of business succession planning. In our last article, you learned how gift tax limitations affect these programs. We hope you gained actionable strategies for designing a tax-efficient program with the guidance of a qualified business attorney.

With this in mind, this article explores the intricate details of transferring S-Corporation stock to heirs as part of business succession planning. Continue reading to learn more.

Understanding S-Corp Ownership

An S Corp or an S Corporation is a business structure that is a pass-through entity for tax purposes. This means the business does not pay taxes on its profits since profits and losses are passed through to the shareholders, who report them on their tax returns to be taxed at their individual income tax rates.

This structure offers several tax benefits that make these entities attractive to entrepreneurs. For one, it avoids double taxation, where income is taxed at both the corporate and personal levels. Finally, S-Corp members can split their income between salary and dividends—the latter is exempt from employment taxes.

Tax Implications of S-Corp Ownership Transfer

The tax implications for S-Corp stock transferred to heirs depend on whether the assets are gifted during your lifetime or bequeathed after death. Below is the taxation structure for gifted S-corp shares:

Capital Gains Tax Considerations

Upon sale, the difference between these assets' price and carryover basis (for gifted assets) is subject to capital gains tax. Here’s an example:

Suppose you bought S-corp shares at $100,000. Over time, they appreciated to $400,000. You later gift these shares to your children, who decide to sell them. The difference between the sale and the original price, $300,000, is subject to capital gains tax. For shares held for one year or less, the difference will be subject to short-term capital gains, typically at ordinary income rates. Shares held for more than one year are subject to long-term capital gain, which is generally more favorable than income tax rates.

As such, it is important to consult a business lawyer to manage the timing of a sale to qualify for long-term capital gains, reducing tax liabilities.

Step-up in Basis Potential

On the other hand, if the shares pass to your heirs after death, taxation works differently. Specifically, the step-up in basis adjustment applies, which is the readjustment of an asset's value for tax purposes upon inheritance.

Therefore, the value of these stocks is stepped up to the fair market value at the time of the previous shareholder's death. Should the new owner decide to sell these shares later, the adjustment will affect their capital gains liabilities.

For example, if the previous shareholder purchased the S-Corp shares for $100,000, which increased to $400,000 by their death, the inheritor's basis is readjusted to the fair market value of the shares at the time of the owner's death, i.e., $400,000. If the inheritor sells these assets at this price, they won't incur capital gains tax because the sales price equals the stepped-up basis.

However, should the inheritor bequeath the shares to their heirs, the step-up in basis will not apply. The adjustment only applies upon the death of the holder of the original shares.

Special Considerations for Business Succession Planning

When transferring your S-Corp stock to family members, be aware of the strict eligibility requirements for S-Corp ownership. The IRS stipulates that individual owners must be US citizens or permanent residents. Transferring shares to ineligible parties can jeopardize the business's eligibility for special S-Corp tax considerations.

When gifting shares to family members, it's crucial to remember that S-Corporations are limited to a maximum of 100 shareholders. This is particularly important for large families or when multiple generations are involved. Additionally, be aware of gift tax limitations that affect the total and annual value of assets you can gift.

Conclusion

This concludes the fifth publication in our comprehensive business succession planning series. By now, you should have a clear understanding of the tax issues involved in transferring S-Corp shares to family members. We invite you to join us for another insightful piece focusing on tax considerations when transferring partnership interests to family members.

Are you wondering about any of the issues mentioned above? Please email us at info@wilkinsonlawllc.com or call (732) 410-7595 for assistance.

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