The Family Business As an S Corporation
Besides helping with family succession planning, S corporations can offer certain estate and income tax advantages for your client. This article takes a closer look.
May 15, 2008
Sponsored by BNA Software
by Nancy Faussett, CPA
It is becoming more and more common for a family business to be incorporated as an S corporation and for this to represent a significant portion of one’s income, as well as one’s estate. There are certain advantages to operating as an S corporation that you should be aware of when doing both estate tax and income tax planning.
This article will look at the reasons an S corporation is desirable and discuss how tax planning software can help.
Some S Corporation Advantages
While there are several reasons why you might incorporate a family business, one important consideration is that corporate shares are much more easily transferable than either a partnership interest or sole proprietorship assets. Also, a corporation can limit the owner’s liability.
There are also certain advantages of operating as an S corporation rather than a C corporation. Since an S corporation is a pass-through entity, its taxable income flows directly through to the S corporation shareholders, increasing their bases and eliminating the corporate level income tax. An S corporation thus avoids double taxation that often occurs when a C corporation issues dividends.
Furthermore, S corporation shareholders can receive distributions. This is important when financial difficulties occur as it may reduce the pressures of needing to sell the business.
Transfer of an S Corporation Interest
Operating a closely-held business as an S corporation can help with family succession planning. Furthermore, the transfer of an interest in an S corporation can also assist both estate tax and income tax planning. For example, to reduce the size of one’s estate for estate tax purposes, an S corporation shareholder might transfer his or her stock to another, usually younger, family member. This is a good estate tax planning technique since it will reduce the estate tax, as well as ensure that the business stays under the control of someone of your choice. Of course, the recipient must be someone qualified to be an S corporate shareholder so as not to inadvertently terminate the S corporate status.
One technique for transferring stock is to use a trust. The trust, however, must be eligible to be an S corporation shareholder and should not contain any provisions that would cause the stock (now a trust asset) to be included in the estate for tax purposes. The types of trusts that can be used for this purpose are:
Selecting the proper kind of trust is important as each has its own tax consequences. For example, if the trust is a QSST, there can only be one trust beneficiary (versus, an ESBT, which can have more than one beneficiary) and the trustee must distribute all of the trust income to its beneficiary. One problem with a QSST is that a surviving spouse, who is the beneficiary in a QSST marital trust, must report the trust’s share of the S corporation income on his or her tax return but may not necessarily have the funds to pay the tax owed. Another point is that gifts of S corporation stock to an irrevocable QSST or Section 675(4) grantor trust may qualify for the annual gift tax exclusion, whereas the exclusion is not available for gifts to a GRAT or GRUT because the gift of the remainder interest is not a present interest.
Besides being beneficial for estate tax planning, the transfer of S corporation stock can also be an excellent income tax planning tool as it shifts income to other family members. However, you do need to be careful. If the family member is your child, the “kiddie tax” can tax the child’s income at your top rate. Furthermore, if it can be shown that the transfer lacks “economic reality” (such as when the transferor retains control over the stock), the IRS can disregard the transfer. In fact, the IRS can reallocate the S corporation income if you continue to perform services or give capital to the corporation without receiving sufficient compensation in return.
Note: Shifting income cannot be accomplished if a GRUT or GRAT is used. This is because to qualify as an S corporation shareholder, it must be a grantor trust and, therefore, the income will be taxed to the grantor. Furthermore, an ESBT is also not an effective conduit for shifting income as, under Section 641(c)(2)(A), it will be treated as a separate trust, taxed at the maximum individual rate.
A buy-sell agreement is often wisely used as an estate planning tool as it can impose restrictions on the transferability of the corporation’s stock. Such an agreement can guarantee the continuing S corporation election by ensuring that the stock is not allowed to be transferred or sold to a nonqualifying trust or shareholder.
Transfer of Appreciated Property
Another benefit of operating a family business in the form of a corporation is that one can transfer appreciated property into the corporation in exchange for stock. If immediately after the transfer, the transferors are in control of the corporation, no gain will be recognized, per IRS Section 351. This tax-free treatment is given to S corporations as well as C corporations.
A word of caution, however, when using a Section 351 transfer to accomplish the goal of having multiple family members own stock. The shares issued must represent the relative fair market value of the property transferred into the corporation by each of these shareholders. If this is not the case, then a gift will deemed to have been made to the extent that a disproportionate number of shares is issued, resulting in the gift tax being assessed.
Using Tax Planning Software
An S corporation does not pay tax on its taxable income but passes the income through to its shareholders on IRS Schedule K-1. Individual income tax planning software can help you transfer the K-1 information to the individual tax return. Each line of data entered on the K-1 retains its character (such as capital versus ordinary) on Form 1040. Be aware that a shareholder is taxed on the S corporation’s earnings whether or not it is distributed.
And, should the kiddie tax be evoked, good individual income tax planning software can handle that as well.
Estate tax planning software can assist with both IRS Code Section 303 and Section 6166 planning. These code sections were created to assist the estate of a closely-held business owner meet its death-tax requirements when the decedent’s interest in the business is more than 35% of the adjusted gross estate. Section 303 treats the redemption of closely-held business stock (when used to pay certain estate expenses) as a sale or exchange (rather than dividend treatment). Section 6166 extends the time (up to 14 years) for paying the estate tax attributed to a closely-held business interest.
Just remember that when you think about taxes and wealth, accurate planning done right can give you the best possible outcome.
Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.