Generally, the property you inherit from a decedent receives a “step-up” (increase) in basis equal to the fair market value of the property at the time of death. The step-up is potentially valuable as it allows the beneficiary to avoid paying capital gains tax on any appreciation in the value of the asset prior to the decedent’s death upon the future sale of the inherited property. However, when it comes to inheriting shares of stock in an S corporation, beneficiaries can be hit with a significant tax bill if they are not careful about selling property owned by the corporation.
Benefits of a step-up basis
To illustrate the advantages of a step-up in basis, here’s an example:
Grandmother purchased real estate 25 years ago for $300,000. This is her tax “basis” in the property. If she were to sell it at its fair market value of $800,000, she would pay capital gains tax on the $500,000 of appreciated value.
If instead, Grandmother keeps the property until her death and it passes to her grandchild through her will, the basis automatically jumps to the fair market value as of her death (assume it is $800,000). If her grandchild later decides to sell the property for $900,000, he will pay capital gains tax only on $100,000 of appreciation (from $800,000 to $900,000). The original $500,000 in appreciation is never taxed.
A step-up in basis applies to real and personal property, both tangible (e.g., artwork) and intangible (e.g. stocks). However, it is not available for property that is not owned in the decedent’s name, such as property owned by a business. Therefore, if Grandmother transferred her property into a business before she died, her beneficiaries could face significant capital gains tax liability when the property is sold by the corporation.
Property owned by S Corporation
When a beneficiary inherits property that is owned in an S corporation, the step-up in basis is not applied to the property. For example, assume Grandmother transferred her real property to Grandma Corp., an S corporation of which she owns 100% shortly after she buys it. Grandma Corp. has its own basis in the property, which is separate from Grandmother’s basis in her shares of Grandma Corp. stock. At death, Grandmother owned the personal property (the stock in Grandma Corp) and not the real property, so her stock receives the step-up in basis up to its date of death value. For simplicity, assume the date of death fair market value of the stock is $800,000, which is equal to the value of the rental property, the only asset of the corporation.
However, the corporation’s own “inside” basis in the property of $300,000 remains unchanged. When the corporation sells the property for $800,000, it realizes taxable income of $500,000. Because it is an S corporation, the corporation’s taxable gain passes through to its shareholders who inherited Grandmother’s stock, who must pay the tax on this amount at their personal capital gains income tax rate.
The pass-through taxation feature of S corporations provides an opportunity to minimize gains by creating a capital loss that can be used to offset the capital gain realized on the sale of the real property. This is accomplished by liquidating the corporation in full. If the property is sold in the hands of the corporation, the corporation must be liquidated in the same tax year as the sale occurs.
From the S corporation’s standpoint, the distribution of assets in a complete liquidation is treated as a sale to its shareholders. Let’s assume the market is slow and Grandma Corp. has been unable to sell the rental property. Nonetheless, when it dissolves, the rental property will be treated as having been sold for its fair market value ($800,000). Therefore, Grandma Corp. realizes a capital gain of $500,000 which passes through to the beneficiary (who is the shareholder of the stock). Normally, the beneficiary would pay the tax on the $500,000 at the end of the tax year, and the basis in the stock would increase by $500,000.
From the beneficiary’s standpoint, the liquidation is treated as the beneficiary selling his stock back to the S corporation in exchange for all of the corporation’s assets which are distributed to the beneficiary in the liquidation. In our example, the beneficiary receives the rental property worth $800,000 in exchange for his stock in Grandma Corp.
Here, the timing of the adjustment to the beneficiary’s basis in the stock helps create the capital loss needed to offset the capital gain from the deemed sale of the rental property. Because the beneficiary is treated as selling his stock back to the corporation, his basis is adjusted immediately prior to the sale and therefore, prior to determining the gain/loss on the liquidating distributions. In the example we have been using, that means the beneficiary’s date of death basis in the stock is adjusted to $1,300,000 ($800,000 fair market value of the stock plus the $500,000 capital gain which passes through to the beneficiary). Since the beneficiary only receives the rental property worth $800,000, he has a capital loss of $500,000 on his stock which offsets the $500,000 of the corporation’s gain.
Going forward, the beneficiary’s basis in the rental property will be the fair market value at the time of distribution – that is, $800,000. So when he goes to sell it, the gain is minimized.
This method is unique to S corporations. If assets are owned by a different vehicle (single-member LLC or partnership with multiple owners), there are other types of planning that need to be done to minimize taxes if large gains are expected for a particular estate.
For executors and beneficiaries of estates with property held by S corporations, it is crucial to be aware of the potential tax impact of selling all or some of the property. If the corporation sells its property without liquidating in the same tax year, the beneficiary will lose the opportunity to offset gains with a loss on its stock and therefore, may be faced with a significant tax bill. Accordingly, before trying to sell property owned by an S corporation, executors and beneficiaries should consider the tax consequences of a sale and market conditions for the property, the beneficiaries’ goals with respect to the business and any issues which would need to be resolved prior to liquidation.
A qualified attorney can help determine the tax impact as well as coordinate the sale of property and liquidation of the business to ensure tax benefits are retained.
This post does not constitute legal advice or establish an attorney-client relationship.