There is a lot of talk in general about how tax laws work in the US when you inherit. Currently, there is a threshold ($12.04 million). Anything over that and the estate will pay estate tax. Heirs receive step-up basis, which means the basis of what they receive is based on the fair market value at the decedent’s date of death. That all leads to a question I recently received as part of Wednesday Coaching.
What happens when you inherit property in an S Corporation?
This may seem like a strangely specific question, but it’s timely and important one right now. There are two big reasons:
- We are seeing a large transfer of wealth as older generations are passing on their estates to their heirs, and
- The S Corporation has been, by far, the most popular structure for holding everything from businesses to coin collections.
In this particular case, the decedent passed and left a large piece of land to 4 heirs. They owned it in 4 equal pieces. The property was held inside an S Corporation.
That’s an important point.
The property was held inside an S Corporation. So, the heirs didn’t actually inherit the land. They inherited stock in the S Corporation.
Now, a few years later and one of the heirs wants to sell his interest in the property. Because it’s in an S Corporation, he’s going to sell his shares in the S Corporation.
This then leads to the bigger questions. What is his basis? What tax consequences does he have? And does anything happen to the other heirs?
Unfortunately, there was an even bigger issue that the family didn’t realize. To understand that, we need to go over a bit of the basics of entities and tax law.
S Corporations and Step-Up Basis
If you’ve followed me through my blogs or are part of the Wednesday Coaching, you probably know that I often say that 95% of the time you should hold real estate within an LLC that is disregarded for income tax purposes. And the owner in that case would be one or more individuals.
If you have a single member LLC, your property income will be taxed on a Schedule C or E. (Probably E because it’s passive) If you have a multi member LLC, your property income will be taxed as a partnership,
A C Corporation would almost never be used. An S Corporation doesn’t have the inherit issues of double taxation and no capital gains rate that a C Corporation does, but it’s still not ideal for a handful of reasons.
Inheritance is an issue for S Corporations with inherited properties.
The heirs do receive a step-up in basis for the shares. The value of the shares will be determined based on the current FMV of the S Corporation. So it might appear that the step-up basis is set.
But there is one little problem. The stock shares go up in value, but the underlying assets do not. That means you can’t increase the basis and take more depreciation. That also means that at some future date if the S Corporation sells the appreciated assets, the S Corp (and the shareholders) have to pay tax on the gain.
One strategy that could work is to dissolve and liquidate the S Corporation in the year for the date of death of the decedent. Take a distribution of the property so that there is gain, but then it is offset by the loss from the liquidated shares. Theoretically, the gain and loss will offset. Make sure you run this strategy by your CPA first though. You need the offset so that you don’t inadvertently create an even worse tax situation for yourself.
If you can successfully dissolve and liquidate the S Corporation, put the property inside a multi-member LLC so that it is taxed like a partnership. A partnership assets CAN be stepped up in basis at the time of death.
Otherwise, if you ignore this strategy, you’re just creating a bigger problem for future years.
Estate planning can be very complicated. Make sure your attorney and CPA both understand the consequences of decisions and actions such as this.
In this case, the S Corporation becomes a ticking tax bomb if you’re not careful.