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Accounting - Estate and transition planning, the S Corporation

image James P. Cook, CPA Tax Manager, Ridout Barrett & Co., San Antonio, TX

AUSTIN - S Corporation ownership transition planning must be carefully followed in order to balance the needs of the owners and preserving the S Corporation’s status. A few examples here will show methods using trusts that elect to hold S Corporation stock, using voting and nonvoting stock and a cancelling note.





    If a trust is used, it should elect to be a qualified Subchapter S trust (QSST) or an electing small business trust (ESBT) to keep the S election in effect after the two year holding period for S Corporation stock expires in non-electing trusts.  These trusts do have drawbacks.  A QSST may only have one beneficiary and the S Corporation income must be reported by the beneficiary, even when there is no distribution. An ESBT may have more than one beneficiary, but the income from the S Corporation is taxed at the trust level at the highest individual rates (including capital gains).

    A very simple method of transfer that allows control to be retained while passing current and future value is the use of nonvoting stock.  Differing voting rights are not considered to violate the one class of stock rule for S Corporations as long as all outstanding shares of stock have identical rights to distributions and liquidation proceeds.  This can be accomplished by recapitalizing the S Corporation with a Type E reorganization.

    For example, a 50 year old owner of an S Corporation that expects the growth and value of the business to be substantial over the next 20 years would like to maintain control of the company until he reaches 70, but would like to transfer ownership to his two sons.  The owner would exchange all of his stock for 2,000 shares of voting common stock and 8,000 shares of nonvoting common stock.  All of this stock should be identical except for the voting rights.  The stock would then be gifted to his two sons:  4,000 shares of the nonvoting stock and 250 shares of voting stock each.  Now the two children would hold 85% of the corporation’s stock (as well as current and future value), but the father holds 75% of the corporation’s voting stock, keeping him in control.

   Owners in an estate tax situation may want to remove the company and its future appreciation without the use of gifting.  This can be achieved with the use of a self-cancelling installment note (SCIN). Although SCINs must be properly executed and structured under strict guidelines, they are extremely useful when the seller’s actual life expectancy is less than his or her actuarial life expectancy.  Once the note is canceled under the terms of the SCIN, only the remaining unrecognized installment sale income is included in the gross estate.  This method allows the seller to keep an income stream, while excluding the company from his gross estate. 

    For example, an owner with a life expectancy greater than 20 years sold his S Corporation stock to his son 15 years ago.  The owner accepts a cash down payment, a properly executed 20 year SCIN and reports his gain on sale using the installment method.  Both the sales agreement and the installment note automatically cancel all sums due upon the owner’s death.  The SCIN included all necessary terms upon execution, including a written medical opinion stating the owner is in good health and a risk premium to compensate for the cancellation feature.  With 5 years of payments remaining totaling $80,000 of unrecognized installment sale income, the owner’s death cancels the installment obligation under the terms of the SCIN.  Since the note receivable doesn’t transfer but cancels upon death, only the cancellation of the remaining obligation is included in the owner’s gross estate, $80,000.  Since the sale was for S Corporation stock, the son can deduct on his tax return the interest portion of the installment payments as either business or investment interest, depending on the S Corporation’s activities. 

    James Cook, CPA is a tax manager at Ridout Barrett & Co.’s San Antonio Office.  He joined the firm in May 2017.

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