1931 ALI-ABA Course of Study Planning Techniques for Large Estates April 28 - May 2, 2008 New York, New York Comparing S Corporations and Partnerships in Estate Planning By Carol Cantrell Briggs & Veselka Co. Bellaire, Texas
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1933 I. INTRODUCTION... 1 II. ALLOCATION OF INCOME IN THE YEAR OF DEATH... 1 A. S Corporations... 1 B. Partnerships... 1 III. ELIGIBILITY OF ESTATE OR TRUST AS S SHAREHOLDER... 3 A. Estate as an Eligible Shareholder... 3 B. Trusts as Qualified S Corporation Shareholders... 4 1. Grantor Trust... 4 2. Testamentary Trust... 4 3. Qualified Subchapter S Trust (QSST)... 4 4. Electing Small Business Trust (ESBT)... 6 5. Regular or Roth IRA... 8 C. Ineligible Shareholders... 8 D. Charitable Organizations as S Shareholders... 8 IV. INCOME IN RESPECT OF A DECEDENT... 9 A. S Corporations... 9 B. Partnerships... 9 1. Statutory IRD... 10 2. Judicially Created IRD... 11 C. Reporting Requirements for IRD... 12 V. PARTNERSHIP SECTION 754 ELECTION... 12 A. Mechanics: The Hypothetical Sale... 13 B. Effect on Community Property... 14 C. When Not to Make the Election... 15 D. When the Election is Mandatory... 16 1. The $250,000 Threshold... 16 2. The Mechanics... 17 3. Partnership Discounts and the $250,000 Threshold... 18 E. Responsibility for Recordkeeping... 19 F. Impact of 754 on Other Partners... 19 G. How and When to Make the Election... 21 1. Curing Late Elections... 21 2. Revoking the Election... 22 3. Revocation by Termination... 23 a. Bequests Greater than a 50 Percent Partnership Interest... 23 b. Dividing the Partnership Before Death... 24 VI. DISTRIBUTIONS OF CASH OR PROPERTY... 25 A. S Corporations... 25 1. Corporations Without Earnings and Profits... 25 2. Corporations With Earnings and Profits... 25 B. Partnerships... 26 1. General Rules... 26 2. Distributions after October 22, 2004 Requiring Basis Adjustments... 27
1934 3. Distributions Within Seven Years of Contribution... 29 4. Distributions of Marketable Securities - 731(c)... 34 VII. FUNDING BEQUESTS WITH S STOCK OR PARTNERSHIP INTERESTS... 37 A. Funding Events That Close the Books... 37 B. Gain or Loss on Funding with S Stock or a Partnership Interest... 38 C. IRD Recognition on Funding with S Stock or a Partnership Interest... 39 D. Carrying Out DNI When Funding with S Stock or a Partnership Interest... 39 1. The Separate Share Rule... 40 2. Pecuniary Bequests and DNI Carryout... 40 3. Income from Pass-Through Entities... 41 4. Special Rule for IRD Included in DNI... 41 VIII. HOLDING S CORPORATION OR PARTNERSHIP INTERESTS IN TRUST... 42 A. Determining Trust Income from an S Corporation or Partnership... 42 1. QTIP Trusts That Own a Partnership or S Corporation... 42 2. Deemed Dividends of a QSST and Trust Income... 43 3. The 20-Percent Rule... 44 4. NCCUSL Considers Changes to UPIA 401... 45 B. Excess Passive Investment Income of S Corporations... 45 C. Carrying Out Capital Gains of an S Corporation or Partnership... 46 1. Allocating Taxes Attributable to QSSTs... 49 2. Allocating Taxes Attributable to ESBTs... 49 3. Passthrough Entity Makes No Distributions... 50 4. Entity Designates a Payment for Taxes... 51 5. Entity Distributes Less Than its Taxable Income... 52 6. Other Interpretations... 53 7. Possible NCCSL Amendments to UPIA 505... 54 E. Administrative Expenses and the 2-Percent Floor... 55 1. The Supreme Court s Holding in Knight... 56 2. Proposed Regulation 1.67-4... 56 3. Notice 2008-32... 57 4. Administrative Expenses From Passthrough Entities... 58 F. Passive Losses of S Corporations and Partnerships... 58 G. Charitable Contributions of S Corporations and Partnerships... 59 IX. SALE OF S CORPORATION ASSETS AFTER DEATH... 60 A. Ten Year Built-in Gains Tax... 60 B. Mismatch of Gain and Loss in QSST with S Stock... 60 C. Delaying the QSST or ESBT Election... 61 X. CONCLUSION... 61
1935 I. INTRODUCTION In 2006 there were 3.6 million S corporation and 2.7 million partnership returns filed. 1 When those shareholders and partners die, the executor or trustee must be familiar with the unique rules that apply to S corporations and partnerships as well as all of the fiduciary income tax rules. The Internal Revenue Code states that the taxable income of a partnership or an S corporation is computed in exactly the same way as an individual, unless otherwise provided. 2 However, these exceptions are numerous and there are also a number of critical differences between partnerships and S corporations. Some of the differences arise because S corporations usually involve family businesses, while partnerships tend to consist of securities and other investments. Other critical differences relate to ownership eligibility, basis adjustments on date of death, income in respect of a decedent, who reports the entity s taxable income, and the tax impact of distributions, funding, redemptions and liquidations involving these entities. This is a tall order for estate tax planners who usually focus only on the transfer tax issues. This outline covers most of the income tax rules that estate planners need to know. It also compares S corporations and partnerships where there is a difference, which may be especially helpful for those who are familiar with one but not both types of entities. II. ALLOCATION OF INCOME IN THE YEAR OF DEATH A. S Corporations In a year that a shareholder dies, the income of the S corporation is prorated on a daily basis between the portion of the year prior to the decedent s death and the portion thereafter. The part allocable to the period prior to death is included in the decedent s final return. 3 However, if the executor and the corporation agree, the income or loss for the taxable year of the S corporation can be allocated based on an interim closing of the corporation s books on the decedent s date of death. 4 However, certain cash method items must be prorated on an accrual method under the interim closing as discussed below. An interim closing is beneficial if the income prior to the decedent s death is greater than the income after his death. This increases the decedent s taxable income which could qualify for joint return rates and the tax liability can be included as a debt of the estate to reduce federal estate taxes. On the other hand it may be beneficial to push income to the post death period using the proration method, which results in a larger basis increase after death. This concept is illustrated in the example on the next page, only using a partnership. B. Partnerships Like S corporations, partnerships use two basic methods to allocate items when a partner terminates his interest during the year. 5 One method is the interim closing of the books, which 1 Tax Stats available at www.irs.gov. 2 IRC 703(a), 1363(b). 3 IRC 1377(a)(1); Reg. 1.1377-1(a). 4 IRC 1377(a)(2). 5 Reg. 1.706-1(c)(2)(ii); Richardson v. Comm r., 693 F.2d 1189 (5 th Cir. 1982). 1