I. INTRODUCTION... 1 II. ALLOCATION OF INCOME IN THE YEAR OF DEATH... 1 A. S Corporations... 1 B. Partnerships... 2 III. SHAREHOLDER ELIGIBILITY...

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1 I. INTRODUCTION... 1 II. ALLOCATION OF INCOME IN THE YEAR OF DEATH... 1 A. S Corporations... 1 B. Partnerships... 2 III. SHAREHOLDER ELIGIBILITY... 3 A. Estate as an Eligible Shareholder... 3 B. Trusts as Qualified S Corporation Shareholders Grantor Trust Voting Trust Testamentary Trust Qualified Subchapter S Trust (QSST) Electing Small Business Trust (ESBT) IRA as an S Shareholder... 9 C. 100 Shareholder Limit D. Charitable Organizations as S Shareholders IV. INCOME IN RESPECT OF A DECEDENT...11 A. S Corporations B. Partnerships Statutory IRD Judicially Created IRD C. Reporting Requirements for IRD V. BASIS ADJUSTMENTS AT DEATH VI. TAXATION OF DISTRIBUTIONS A. S Corporations Corporations Without Earnings and Profits Corporations With Earnings and Profits B. Partnerships General Rules Distributions after October 22, 2004 Requiring Basis Adjustments Distributions Within Seven Years of Contribution Distributions of Marketable Securities - 731(c) VII. FUNDING WITH STOCK OR PARTNERSHIP INTERESTS A. Funding Events That Close the Books B. Gain or Loss on Funding with S Stock or a Partnership Interest C. IRD Recognition on Funding with S Stock or a Partnership Interest D. Carrying Out DNI When Funding with S Stock or a Partnership Interest The Separate Share Rule Pecuniary Bequests and DNI Carryout Income from Pass-Through Entities Special Rule for IRD Included in DNI VIII. HOLDING S CORPORATION OR PARTNERSHIP INTERESTS IN TRUST... 31

2 A. Determining Trust Income from an S Corporation or Partnership QTIP Trusts That Own a Partnership or S Corporation Deemed Dividends of a QSST and Trust Income The 20-Percent Rule NCCUSL Considers Changes to UPIA B. Carrying Out Capital Gains of an S Corporation or Partnership C. Who Pays Income Taxes on S Corporation or Partnership K-1 Income? QSSTs ESBTs All Other Trusts NCCUSL Amends UPIA D. Administrative Expenses and the 2-Percent Floor The Supreme Court s Holding in Knight Proposed Regulation Notice Administrative Expenses From Passthrough Entities Legislative Change Expected E. Passive Losses of S Corporations and Partnerships F. Charitable Contributions of S Corporations and Partnerships IX. SALE OF S CORPORATION ASSETS AFTER DEATH A. Ten-Year Built-in Gains Tax B. Timing the Sale of S Corporation Assets With Liquidation C. Delaying the QSST or ESBT Election D. Excess Passive Income of S Corporations with C Corporation E&P X. OTHER PLANNING OPPORTUNITIES WITH S STOCK A. Shareholder Agreements and the One Class of Stock Rule B. Redemption Agreements C. Alternate Valuation XI. CONCLUSION EXHIBIT A Sample QSST Election EXHIBIT B Sample ESBT Election EXHIBIT C Sample Election and Consent to Use the Interim Closing of the Books

3 I. INTRODUCTION There are many critical differences between partnerships and S corporations that fiduciaries and their advisors need to know when administering estates and trusts with these entities. Some of the differences arise because S corporations typically operate businesses, whereas partnerships generally manage passive investment portfolios. Other differences relate to who can be an owner, the types of elections that are available, basis adjustments that occur on death of an owner, how income in respect of a decedent is determined, who reports the entity s taxable income, and the tax effect of distributions, funding, redemptions, sales, and liquidations involving these entities. This outline covers most of these issues in the hope that it will be helpful to those who are familiar with the tax attributes of one but not both entities. II. ALLOCATION OF INCOME IN THE YEAR OF DEATH A. S Corporations When an S corporation shareholder dies, the corporate income is prorated between the decedent and the successor shareholder on a daily basis before and after death. Income allocated to the period before death is included on the decedent s final income tax return. 1 Income allocated to the period after death is included on the successor s income tax return. Alternatively, the S corporation may elect the interim closing of the books method. This divides the corporation s taxable year into two separate years, the first of which ends at the close of the day the shareholder died. 2 This election is only available if the corporation and all the affected shareholders agree and the corporation attaches the election to its tax return for the year it is effective. 3 Affected shareholders are those whose interest is terminated and those to whom shares are transferred during the year. 4 It can make a big difference which method the S corporation chooses if income is not earned evenly throughout the year and the beneficiaries of the estate are different from those who inherit the S corporation stock. Mary died on June 30 and left her 40% interest in S Corp. to her son, Jack. Her daughter is the residuary beneficiary of Mary s estate. The S Corp incurred a $1 million capital gain on August 1 and has no other income or expense that year. Under a daily proration, Mary s final income tax return and Jack each report a $200,000 capital gain. [40% X 6/12 X $1,000,000]. But under an interim closing, Mary s final return reports nothing and Jack reports $400,000 [40% X $1,000,000]. 5 1 IRC 1377(a)(1); Reg (a). 2 IRC 1377(a)(2); Reg (b)(1). 3 Reg (b)(5). 4 Reg (b)(2). 5 Reg (j)(7). 1

4 Mary s Final Return Jack s Return Total Daily Proration $ 200, ,000 $ 400,000 Interim Closing ,000 $ 400,000 Jack may not agree to an interim closing of the books because it causes him to report more income than the daily proration method. Because Jack is an affected shareholder, he can force the corporation to use the daily proration method. B. Partnerships Partnerships also use two basic methods to allocate income and deductions when a partner terminates his interest during the year. 6 But with a partnership, the default method is the interim closing of the books. An interim closing separates the partnership into two or more segments during the year. Items occurring in each segment are allocated to those who were partners during that segment. Alternatively, the partners may agree to the proration method, which allocates to each partner a fraction of partnership income for the entire year, regardless of when the partnership incurred the items. Any reasonable proration method may be used. 7 Contrast this flexibility with the S corporation rules, which require a per share-per day allocation. Because of the potentially significant difference between the two methods, the executor should work with the partnership to determine which one produces the better result for his clients. Regardless of whether the proration or interim closing method is used, cash basis partnerships must use the accrual basis to allocate interest, taxes, payments for services or the use of property (other than guaranteed payments subject to Section 83), and any other items specified in the regulations. 8 The partnership must assign a portion of these items to each day in the period to which it is attributable. The daily portion is then assigned to the partners in proportion to their partnership interest at the close of each day. This prevents partners from deliberately misstating income among the partners by timing the payment of large cash basis expenses. The most common cash basis items likely to affect family limited partnerships under this rule are real estate taxes and payments for services. Don is a 50 percent partner in DS Partnership. He died on September 30. DS incurred a capital gain of $1,000,000 on June 1, just before Don died, and has no other income or expenses during the year. Under an interim closing of the books, Don reports $500,000 [50% of $1,000,000] of capital gain on his final 1040 resulting in a tax liability of $75,000. His estate may deduct this income tax liability as a debt on his federal estate tax return Form The estate reports no income or loss. 6 Reg (c)(2)(ii); Richardson v. Comm r., 693 F.2d 1189 (5 th Cir. 1982). 7 Reg (c)(2)(ii). 8 IRC 706(d)(2); Prop. Reg (a) (2005); See Cantrell, Partnership Interests for Services Regs. Offer Estate Planners a Bona Fide Solution, The Tax Adviser, October 2005, at 636 (taxation of partnership interests granted for services rendered). 9 Reg (f). 2

5 The proration method is illustrated in the following example: Using the same facts as the preceding example, Don, a 50 percent partner in DS Partnership, died on September 30. DS incurred a capital gain of $1,000,000 on June 1, just before Don died, and has no other income or expenses during the year. Under a proration method based, Don reports $375,000 [9/12 50% X $1,000,000] of capital gain on his final 1040 and the resulting tax liability is deductible as a debt on his federal estate tax return. 10 The estate reports $125,000 of capital gain [3/12 X 50% X $1,000,000]. Depending on the particular income and estate tax rates and other relevant facts, one method may be clearly superior to the other. Executors should work with the partnership to selecting the best method for both the outgoing and incoming partners, if possible. If the partners can t agree, the partnership must use the interim closing of the books method. 11 III. SHAREHOLDER ELIGIBILITY There are no restrictions on who is eligible to own a partnership interest. Therefore, an estate or trust is always eligible to own a partnership interest. This is not true, however, with respect to an S corporation. An S corporation can only have certain types of owners in order to maintain its S status. 12 These include U.S. citizens, resident individuals, estates, certain trusts, and certain tax exempt organizations. If the estate transfers S stock to an ineligible owner, the corporation s S status will terminate. In some cases, this produces no harm other than the nuisance of converting the entity from an S corporation to a C corporation. But in many cases, it can work a grave harm to the S corporation and its other shareholders. A corporation whose S status is terminated is not eligible to make another S election until the 5 th taxable year following the first taxable year in which the termination occurred. Therefore, the fiduciary who inherits an interest in an S corporation should take steps to preserve the S status of the corporation. A. Estate as an Eligible Shareholder An estate is an eligible shareholder of S stock under IRC 1361(b)(1)(B). Therefore, the death of an S shareholder generally will not result in termination of the corporation s S status where the estate becomes the new shareholder. There is no statutory length of time an estate can be left open. An estate may remain open for federal income tax purposes for the period required by the administrator or executor to perform the ordinary duties of administration, whether that period is longer or shorter than specified under local law for the settlement of estates. 13 During that time the estate will report the items of income and deduction reflected on Schedule K-1 issued to it by 10 Reg (f). 11 Reg (c)(2)(ii) 12 IRC 1361(b)(1). 13 Reg (b)-3(a). 3