Analyst Consideration of Negative Influences on S Corporation Business Values

(Part II of II)

There are special tax considerations related to the transfer of S corporation stock at the time of the owner’s death. Therefore, owners of S corporation stock must be intentional with regard to the risks (and the tax costs) associated with an inadvertent termination of the subject entity’s S corporation status. S corporation owners—and analysts—should be aware that many states tax S corporations for state corporation income tax purposes. Many states tax S corporations as if they were C corporations. In addition, many other states apply a special corporate income tax rate to S corporations. The second part of this two-part article (read Part I here) summarizes these considerations related to S corporation ownership.

Introduction

Valuation analysts (“analysts”) are routinely asked to develop a valuation of an ownership interest in an S corporation for taxation, financial accounting, personal financial planning, transaction pricing and structuring, financing collateral, family law and other litigation matters, and many other purposes. Analysts may also be asked to value an ownership interest in a limited liability company, partnership, or other tax pass-through entity (TPE). In these valuation assignments, it is important for the analyst to understand that there are material taxation (and, therefore, economic) differences between an S corporation and an otherwise identical C corporation. It is also important for the analyst to understand that there are material taxation (and, therefore, economic) differences between the S corporation and other types of TPE.

There are obvious federal income taxation benefits associated with electing S corporation status for an industrial or commercial business entity. These benefits typically result in a value increment or increase for the S corporation—compared to the value of an otherwise identical C corporation. Part one of this article summarized these well-known benefits of S corporation income tax status.

There are also somewhat less obvious negative aspects related to electing S corporation status for an industrial or commercial business entity. These negative aspects include restrictions on the number and type of S corporation shareholders. Such restrictions may negatively impact the liquidity of S corporation individual ownership interests. And such restrictions may negatively impact the ownership transition and exit planning strategies available to a family-owned S corporation. These ownership and transferability restrictions were described in part one of this article.

There are special tax considerations related to the transfer of S corporation stock at the time of the owner’s death. Therefore, owners of S corporation stock must be intentional regarding the risks (and the tax costs) associated with an inadvertent termination of the subject entity’s S corporation status. S corporation owners—and analysts—should be aware that many states tax S corporations for state corporation income tax purposes. Many states tax S corporations as if they were C corporations. In addition, many other states apply a special corporate income tax rate to S corporations. This second part of this article summarizes these considerations related to S corporation ownership.

The Inadvertent Disqualification of the S Corporation Status

Most of the S corporation disqualification events relate to the limitations and restrictions summarized above. If the subject S corporation fails to maintain its status as a “small business corporation” under Section 1361(b), the S election automatically terminates on the date that the disqualifying event occurs.

Section 1361(b)(1) and Section 1362(d)(2) can be considered together to develop a list of disqualifying events that could unexpectedly terminate the company’s S corporation status. As explained further below, this risk of a disqualifying event can impact both the company/practice itself and the company/practice shareholders.

The most common of the S corporation disqualifying events include the following:

1. The company or practice has more than 100 shareholders at any time during the year. This event could happen to a company with a fairly large number of shareholders, particularly when shareholders are “coming and going” at various times during the year.
2. The company or practice has an ineligible shareholder. This event could happen when one of the current qualifying shareholders transfers the stock to a C corporation, partnership, ineligible trust, or nonresident alien. This event could happen, for instance, when a current qualifying shareholder experiences a divorce. The S corporation shares are allocated between the former spouses. A former spouse moves to Canada (or any other country) and remarries. Now, there may be a nonresident alien shareholder that the S corporation is totally unaware of.
3. The company or practice has more than one class of stock. Initially, this disqualification is easy to prevent. However, after many years of business operations, it is possible to forget this (and other) requirements. The disqualification event may be inadvertently triggered when one group of employee/shareholders—or one group of family/shareholders—receive some special profit sharing or similar consideration.
4. The company or practice becomes an “ineligible corporation.” For example, the subject company becomes a financial institution, an insurance company, or a DISC. This type of disqualifying conversion (or acquisition) should be relatively easy to spot—and to prevent.
5. The company or practice changes it place of incorporation to a foreign country (and no longer qualifies as a domestic corporation). Such a change of incorporation should be easy to spot—unless this S corporation requirement is simply overlooked.

Section 1362 provides all the specific events that can cause a corporation to fail to qualify as a small business corporation. Filing the corporation’s tax return based on an improper tax year is not a Section 1362 disqualifying event and such a filing may be forgiven by the Service (if corrected).

The S corporation should be careful not to trigger a disqualification if it dissolves and reincorporates, for whatever reason. However, the Service has issued private letter rulings allowing a corporation to keep its S corporation status when it was administratively dissolved by its state of incorporation. In these instances, the subject companies failed to file annual reports and pay annual license fees to the respective states. In another private letter ruling, a state administratively dissolved an S corporation. The state later reinstated the corporation, and the company obtained a new employer identification number (EIN). The Service ruled that the administrative dissolution did not disqualify the S corporation status. However, because of the new EIN, the Service did make the corporation file a new Form 2553, Election by a Small Business Corporation.

The above-listed S corporation disqualifying events, while typical, are easy to identify—and to prevent. Some other S corporation disqualifying events are rare, but they are also easy to miss. Some examples include the following events:

1. Say the successor beneficiary of a qualified subchapter S trust (QSST) refuses to consent to the original QSST election. Such a refusal would mean that the QSST is no longer a qualifying S corporation shareholder—and the S election is disqualified.
2. Say the subject S corporation stock is pledged as collateral for a shareholder’s personal loan. The shareholder defaults on the loan. The S corporation stock collateral is foreclosed by the financial institution creditor. That financial institution is an ineligible shareholder—and the S election is disqualified.
3. Say the subject S corporation has accumulated earnings and profits (AE&P) and receives more than 25 percent of its gross receipts from passive income for three years in a row. That passive income will disqualify the S election.
4. Say an S corporation shareholder dies, and the shareholder’s estate holds on to the shares for more than two years. The estate’s prolonged stock ownership will disqualify the S election.

Analysts (and others) should be aware that the U.S. Tax Court has ruled that Section 1362(d) does not provide an exhaustive list of all of the S corporation disqualifying events. For example, the Farmers Gin U.S. Tax Court decision[1] relates to an S corporation that inadvertently terminated its S election. In the Farmers Gin decision, the company did not adopt a permitted tax year after business conditions changed so that its previously permitted tax year was no longer allowable. The point is, as mentioned above, the use of an unpermitted tax year is not a disqualifying event that is specified in Section 1362.

Events, obvious or otherwise, that can cause an inadvertent disqualification of a company’s S election represents a risk associated with S corporation ownership. In fact, such an inadvertent S status disqualification represents a risk both to the S corporation and to the company/practice shareholders. As with any other business risk, the analyst should consider this risk of inadvertent S election disqualification in the S corporation business valuation.

If the company or practice deliberately or unintentionally experiences an S election disqualifying event, the Service can withdraw the company’s S corporation status. In some cases, the Service may require the company or practice to pay back taxes, at the C corporation income tax rate, for the three years prior to the S status revocation. In addition, such a company/practice would have to wait another five years to reapply for S corporation income tax status.

Considerations When an S Corporation Shareholder Dies

The death of an S corporation shareholder can create tax complications for the TPE. One of the complications—and one of the risks of S corporation stock ownership—is an inadvertent termination of the company’s S corporation status. There may also be tax complications related to the decedent shareholder’s estate. Many of the more typical complications are summarized below. Analysts—and S corporation shareholders—should consider the impact of these potential tax complications on the value of the subject S corporation ownership interest.

Reporting S Corporation Income and Loss in the Year of Death

In an S corporation, a shareholder’s pro rata share of the company’s income and loss is typically determined by allocating equal portions to each day of the year. Then, the company allocate income and loss to each shareholder based on the number of shares outstanding on each day. This allocation procedure is described in Section 1377(a)(1). In the year when the shareholder’s S corporation ownership interest terminates, such as upon the shareholder’s death, the S corporation can elect (under Section 1377(a)(2) and Regulations Section 1.1377-1(b)) to implement an interim closing of the company’s books. That is, the TPE company can elect to treat the S corporation’s tax year as two separate tax years for income allocation purposes. All affected company/practice shareholders and the S corporation itself have to consent to this election.

Such a separate tax year election may or may not benefit the S corporation shareholders. Due to accounting and tax return preparation fees, the interim closing of the company/practice books may be costly to complete. But making the election may be beneficial, particularly in situations where extraordinary items occur either before or after the shareholder’s death.

For example, let’s assume the subject S corporation generates a large gain predeath. In that case, the ultimate beneficiaries of the shares may prefer that the decedent to pay his or her full share of tax on that item in contrast to burdening the beneficiaries with a portion of the gain (and the related tax).

If the decedent’s estate is subject to estate tax, then the payment of tax on the S corporation gain reported on the decedent’s final income tax return will reduce the estate tax liability. When such a situation occurs, the decedent’s beneficiaries—and the company/practice itself—will have to carefully analyze the pros and cons of this tax election.

The Inadvertent Termination of an S Election

The failure of the corporation and the successor shareholders to consider all of the implications to the corporation’s S tax status after a shareholder’s death is a typical cause of the inadvertent termination. In many cases, the successor shareholder, whether that shareholder be the estate, a testamentary trust, or a beneficiary, may not recognize that it needs to take certain steps to remain a qualified shareholder. These steps are generally described in Section 1361(b)(1)(B) and Section 1361(c)(2)(A) and in Regulations Section 1361-1(h)(1). By the time the S corporation or the new shareholder recognizes, for example, that a qualified Subchapter S trust or electing small business trust election has been overlooked, there may be an S termination event triggered.

In many cases, the S corporation itself may not be aware of what its shareholders are doing at the time of the shareholder death. The S corporation generally has no visibility into the estate plans of its various shareholders. That is, the company or practice itself is unaware of who will get shares upon the shareholders’ death, and whether those parties are timely making the needed elections.

In many cases, the S corporation may be unaware that one of its shareholders has died. This means that the company’s S election can terminate before the TPE is even aware of the event that triggered the S termination. Such termination events are generally described in Section 1362(d)(2) and Regulations Section 1.1362-4(b).

Let’s consider an illustrative scenario. Let’s assume that a particular decedent owned the S corporation shares in a revocable trust during his or her life. Upon death, the revocable trust becomes an irrevocable trust, with its own income tax filing requirement. During the first tax year, let’s assume that the executor/trustee makes a timely Section 645 election to treat the trust as part of the estate. This election allows the executor/trustee to file one income tax return. That tax return reports the combined activity of the estate and of the qualified revocable trust.

This trust may or may not need to make an S election.

The need to make an election depends on what happens with those S corporation shares—and when it happens. If the S corporation shares are immediately transferred to another trust, then an election may be due within 2-1/2 months of that transfer.[2]

Alternatively, if the S corporation shares are retained for the maximum duration of the Section 645 period, then an S election may not be due for more than four years. This provision is described in Regulations Section 1.1361-1(h)(1)(iv).

The takeaway is that any time an S corporation shareholder dies, the parties should pay immediate attention to the decedent’s plan with respect to (1) the transfer of the TPE shares and (2) any potential need for, and timing of, required elections.

It is noteworthy that Revenue Procedure 2013-30 may provide automatic relief for taxpayers to make a late S election in these types of scenarios. But the window for relief under this revenue procedure closes three years and 75 days after the election’s intended effective date. The latest intended effective date for an irrevocable grantor trust is two years after the death of a grantor. That window may possibly provide additional time to make the S election.

However, the risk is that these types of required S election oversights may not be discovered until many years later. Such a late-stage discovery can trigger the need to seek uncertain relief via the private letter ruling application process.

S Corporation Gain on the Sale of Assets and Step-Up in the Basis of Decedent’s Shares

A partnership TPE can take advantage of a Section 754 election to help a successor partner equalize his or her inside and outside basis. However, an S corporation has no similar option.

When an S corporation shareholder dies, the decedent’s TPE shares basis is stepped up to fair market value.[3] However, there is no adjustment to the inside basis of the S corporation’s assets.

Therefore, the benefit of the step-up may be deferred until the successor S corporation shareholder disposes of his or her stock. This deferral can create a potential trap for the successor shareholders. Let’s consider what would happen if, later, there is a sale of substantially all the S corporation’s assets. Let’s assume that the S corporation shareholder does not liquidate his or her interest in that same year.

In our illustrative example, let’s assume that an S corporation has an inside net basis of $10 million. That S corporation is owned by shareholders with an outside basis of $50 million (perhaps due to a step-up in basis upon a previous shareholder’s death). If the S corporation sells all its assets, then $40 million of gain will be triggered. This gain will pass through to the shareholders and increase the S corporation stock basis.

If the shareholders fail to liquidate their ownership interests in that same tax year, the step-up basis will not shield the $40 million of gain. Instead, the loss that will likely occur upon liquidation would be deferred. And the loss may be deferred to a year when the shareholders have no offsetting gains. This deferral will trap the loss and defer the related tax benefit until the shareholders can trigger other gains (assuming that is even possible).

A successor S corporation shareholder should be aware of this type of trap. The shareholder should plan to time the recognition of any losses, so they occur in the same tax year in which the gain from the S corporation asset sale is reported.

Buy-Sell Agreements and Shareholder Life Insurance

A buy-sell agreement is typically an agreement (1) between the S corporation shareholders or (2) between the S corporation shareholders and the corporation itself. The agreement specifies the terms of the events, such as the death of the shareholder that will trigger the required transfer of the corporation share.

A buy-sell agreement is important in the case of any privately owned company or professional practice. Such an agreement is particularly important in the case of an S corporation because it can help provide assurance as to how shares will transfer from a deceased shareholder.

Such a buy-sell agreement can help prevent transfers that may otherwise trigger an inadvertent termination of the corporation’s S tax status.

Life insurance on the shareholder is the typical means to provide the necessary liquidity to fund these buy/sell transactions. Such life insurance policies are typically owned either (1) by the S corporation itself or (2) by its shareholders. The appropriate ownership of the life insurance policies often depends on the structure of the buy-sell agreement.

Buy-sell agreements are typically structured in one of two ways: (1) as a redemption agreement or (2) as a cross-purchase agreement.

With a redemption agreement, the S corporation has the right (or the obligation) to purchase TPE shares of the deceased shareholder. A cross-purchase agreement gives the other company shareholders the option (or the obligation) to purchase the TPE shares of the deceased shareholder.

The ultimate ownership consequences of a cross-purchase agreement versus a redemption agreement may not differ significantly. But the agreement parties can encounter difficulties if the ownership of the life insurance policies is not in line with the provisions of the buy-sell agreement. When the buy-sell agreement calls for the S corporation to redeem the deceased shareholder’s shares, then the company should typically own and be the beneficiary of the life insurance policy. Alternatively, if the buy-sell agreement is structured as a cross-purchase, then the shareholders typically should own and be the beneficiaries of the life insurance policies. Taxpayers who fail to coordinate the ownership of the insurance policies with the terms of the buy-sell agreement can create unnecessary tax problems both for themselves and for the corporation.

Suspended Passive Losses upon Shareholder Death

Upon the shareholder’s death, special rules will apply to suspended passive losses arising from the TPE interest owned at death. The unused losses are allowed as a deduction on the decedent’s final personal income tax return. These unused losses are only allowed to the extent these losses are more than the difference between (1) the basis of the ownership interest in the transferee’s hands in excess of (2) the adjusted basis of the ownership interest immediately before the death of the taxpayer. These rules are also provided in Section 469(g)(2)(A). This “difference” in basis is typically referred to as the step-up or step-down upon death of the basis of an asset to its fair market value. The rules are provided in Section 1014.

This provision means that effectively to the extent of the basis step-up, suspended passive losses will be permanently disallowed. Those unused passive losses do not carry forward to the decedent’s estate, trust, or its beneficiaries. The rules are provided in Section 469(g)(2)(A). Losses in excess of the basis step-up are allowed on the decedent’s final tax return. If there is no basis step-up (for example, because the value of the ownership interest has decreased), then the suspended losses are fully deductible on the decedent’s final income tax return.

Suspended Losses Due to Lack of Regular Tax Basis upon Death

Suspended losses due to a lack of regular tax basis will disappear at death upon the transfer from the decedent to his or her estate, trust, and beneficiaries.

Suspended Losses Due to Lack of At-Risk Basis upon Death

Unused at-risk losses will also not carry forward to the decedent’s estate, trust, and beneficiaries. Instead, these amounts are added to the tax basis of the ownership interest in the hands of the recipient. However, because this addition occurs prior to the basis adjustment under Section 1014, there is no net change in the tax basis.

Estate Planning Procedures

There are various planning procedures that can be implemented regarding older S corporation shareholders. For example, the older S corporation shareholder should consider selling the ownership interest with the suspended losses. Such a sale would be beneficial if the benefit of triggering the carryovers exceeds any gain on the ownership interest.

State Taxation of S the Corporation

Analysts—and S corporation shareholders—should be aware that many states apply some form of TPE income tax on S corporations. Such a state income tax should not be ignored in the valuation of the S corporation or of the S corporation ownership interest. Currently, over half of the 50 states impose some form of income tax on a TPE.

Some states impose the regular C corporation income tax rate on the TPE. Effectively, these states ignore the company’s S corporation status for state income tax purposes. Many states impose a reduced corporation income tax rate (for example, a flat 1 percent state income tax rate) on the TPE. While such a reduced income tax rate is advantageous in comparison to the C corporation tax rate, any valuation analysis should recognize that the TPE is still subject to some income tax liability.

In addition, the valuation analysis may consider the possibility that states in which the subject S corporation operates may (1) impose a de novo income tax on the TPE or (2) increase a currently reduced TPE income tax rate to a higher income tax rate. In other words, the valuation analysis should recognize the risk that the S corporation may be subject to a greater state income tax liability in the future.

It is also noteworthy that many states require the company or practice to elect TPE status in that state. In other words, state TPE status may not be automatically achieved when the company files a federal S corporation election. Such states have their own election, periodic filing, and shareholder qualification requirements. Therefore, in some states, there is the risk that the S corporation could inadvertently terminate its state S tax status—even if it does not terminate its federal S tax status.

The takeaway is that analysts—and shareholders and other professional advisers—should not ignore state income tax considerations in any analysis of an S corporation or other form of TPE.

Summary and Conclusion

Valuation analysts (“analysts”) are routinely asked to develop a valuation of an ownership interest in an S corporation for gift tax, estate tax, income tax, financial accounting, personal financial planning, transaction pricing and structuring, financing collateral, family law and other litigation matters, and many other purposes. Analysts may also be asked to value an ownership interest in a limited liability company, partnership, or other tax pass-through entity (TPE).

In these valuation assignments, it is important for the analyst to understand that there are material taxation (and, therefore, economic) differences between an S corporation and an otherwise identical C corporation. It is also important for the analyst to understand that there are material taxation (and, therefore, economic) differences between the S corporation and other types of TPE.

There are obvious federal income taxation benefits associated with electing S corporation status for an industrial or commercial business entity. These benefits typically result in a value increment or increase for the S corporation—compared to the value of an otherwise identical C corporation. This two-part discussion summarized these well-known benefits of S corporation income tax status.

Over the years, analysts have developed various methods and procedures for quantifying the value increment associated with the subject private company or professional practice S corporation tax status. Generally, most of these valuation methods and procedures apply a three-step process. That process is summarized as follows:

1. Apply generally accepted approaches and methods to value the subject entity as if it were a regular C corporation
2. Identify and quantify the income tax (and other) economic benefits associated with the subject entity’s TPE status
3. Sum value component one (as if the subject entity were a C corporation value) and value component two (sometimes called the S corporation value premium) to conclude the total value of the subject entity

There are also somewhat less obvious negative aspects related to electing S corporation status for an industrial or commercial business entity. These negative aspects include restrictions on the number and type of S corporation shareholders. Such restrictions may negatively impact the liquidity of S corporation individual ownership interests. And such restrictions may negatively impact the ownership transition and exit planning strategies available to a family-owned S corporation.

The takeaway of this two-part discussion is that analysts—and private company/professional practice shareholders, financial and estate planners, legal counsel, and any other professional advisers—should be aware of the risks and restrictions associated with an S corporation ownership interest. Analysts should incorporate these negative considerations (either quantitatively or qualitatively) in the S corporation valuation developed for various purposes.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

[1] Farmers Gin, Inc. v. Commissioner, T.C. Memo 1995-25.

[2] See Sections 1361(c)(3) and Regulations Sections 1361-1(j)(6) and 1.1361-1(m)(2).

[3] See Internal Revenue Code Section 1014(a)(1).

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.