What the S? Estate and Succession Planning With S Corporations

IRS data from 2013 revealed that S corporations are the most prevalent type of corporation in the United States.¹
More than 70 percent of corporate income tax returns that year were filed by S corporations.
Nontax reasons supporting their use include ease of formation, shareholder liability protection comparable to C corporations, and relative ease of compliance.

From a tax perspective, a primary advantage is that only the portion of S corporation income paid as salary to shareholders is subject to self-employment and payroll taxes, including FICA and Medicare, as compared with potentially all income of an LLC or partnership. S corporations also qualify for passthrough entity elections that allow the entity to pay income tax and provide a credit to shareholders.

From an estate planning and wealth transfer perspective, however, organizing as an S corporation may trade short-term gains for longer-term complexity. This article explores the unique challenges S corporations present for estate and succession planning.

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Capital, Management, and Succession Issues

S corporations have stringent ownership restrictions, both in number and in type.
They may have no more than 100 shareholders, and ownership is limited to individuals, certain trusts, estates, and exempt organizations.²
Further, individual shareholders must be U.S. citizens or residents, meaning nonresident noncitizens cannot be shareholders.³

These limitations significantly constrain long-term growth and capital formation.
Most sources of private capital, such as venture capital and private equity funds, are organized as partnerships, which are not permitted S corporation shareholders. As a result, S corporations face inherent limits on access to capital.
Additionally, stock in S corporations does not qualify as qualified small business stock, eliminating a major incentive for early-stage investors.

Employee incentives present another challenge. S corporations are permitted only a single class of stock
(although voting and nonvoting distinctions are allowed),⁴ and equity compensation granted to employees is generally taxed as ordinary income in the year of grant.
Because S corporations cannot be publicly traded and face shareholder number limits, any equity grant typically requires a contemporaneous valuation.

These requirements make equity compensation administratively burdensome and relatively uncommon in S corporations.
By contrast, partnerships and LLCs taxed as partnerships can issue profits interests that typically generate minimal or no income tax upon grant and provide greater flexibility in allocating economics and control.⁵
This disparity can discourage key talent from joining or remaining with an S corporation.

The incentive issue often extends to family members, particularly younger generations, who may be more motivated to participate in a family business if they can share in its upside.

S corporations also prohibit disproportionate distributions because multiple classes of stock are not allowed.
This restriction eliminates the ability to create tiered or threshold distributions tied to performance or priority returns.
Partnerships, by contrast, can structure disproportionate distributions through allocation models, subject primarily to the substantial economic effect rules.⁶

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Trust Ownership Issues

Qualification Issues

Succession challenges intensify upon the death of an S corporation shareholder. If the decedent held shares through a revocable trust, that trust becomes a non-grantor trust at death.
Similarly, irrevocable grantor trusts convert to non-grantor trusts when the grantor dies.

IRC sections 1361(c)(2) and 1361(d) identify seven types of trusts that may be S corporation shareholders,
none of which may be foreign trusts:⁷

• Trusts treated as owned entirely by a U.S. citizen or resident for income tax purposes, including revocable trusts and grantor trusts under IRC sections 671–678
• Trusts that were grantor trusts immediately before death, for a two-year period following death
• Trusts receiving S corporation stock under a will, for a two-year post-transfer period
• Trusts created primarily to exercise voting power over S corporation stock
• Electing small business trusts (ESBTs)
• Certain IRA or Roth IRA trusts holding bank or depository institution stock
• Qualified subchapter S trusts (QSSTs)

Following the expiration of the two-year grace periods, trusts must qualify as either QSSTs or ESBTs to preserve S corporation status.

QSSTs are the more restrictive option. To qualify, a QSST must meet all of the following requirements:⁸

• Only one income beneficiary, who must be a U.S. citizen or resident
• All trust income must be distributed currently to that beneficiary
• Any corpus distributed during the beneficiary’s lifetime may be distributed only to that beneficiary
• The income interest must terminate at the beneficiary’s death or upon trust termination

The income beneficiary is treated as the owner of the trust’s S corporation stock for income tax purposes,⁹
and the initial beneficiary must affirmatively elect QSST treatment.¹⁰
Successor beneficiaries are automatically subject to the election unless they opt out.¹¹

ESBTs, by contrast, allow multiple beneficiaries, including individuals, estates, and exempt organizations.¹²
Former QSSTs and charitable remainder trusts may not elect ESBT status.¹³
The ESBT election is made by the trustee and is generally irrevocable.¹⁴
Importantly, ESBTs may accumulate income rather than distribute it currently.

Ongoing administration can create traps. For example, an ESBT may not acquire S corporation stock by purchase,¹⁵ which can limit flexibility for future generations.

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Reporting and Tax Liability Issues

Tax reporting for QSSTs is relatively straightforward, as they generally qualify as simple trusts, except in years when corpus is distributed.¹⁶
ESBTs, however, introduce significant complexity, particularly at the state level.

California taxes non-grantor trusts using a cascading framework:

• All California-source income is fully taxable in California¹⁷
• Non-California income is apportioned based on the residence of fiduciaries
• Remaining income is apportioned based on the residence of non-contingent beneficiaries^{18 19}
• Previously untaxed accumulated income may be subject to throwback tax upon distribution to a California resident beneficiary^20 21

For ESBTs holding S corporation stock, federal law requires the trust itself to pay tax on S corporation income, rather than beneficiaries.²²
California generally follows these rules, which can create inequities when distributions are made to California resident beneficiaries because the trust bears the tax burden, reducing other beneficiaries’ shares.

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Basis Step-Up Issues

Upon the death of an S corporation shareholder, basis step-up applies only to the shareholder’s stock, not to the underlying corporate assets.²³
If heirs wish to sell the business, they must find a buyer willing to purchase S corporation stock, which significantly narrows the pool of potential purchasers.

If liquidation is required to sell the assets, other shareholders may incur taxable gain without offsetting basis step-up, making liquidation impractical where ownership is shared.²⁴

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Conclusion

S corporations are often poorly suited for estate and succession planning.
Because the challenges are unavoidable, advisers should proactively discuss restructuring options with clients, including partnership-style planning alternatives layered under the S corporation structure.

Numbered Citations

1. IRS, “SOI Tax Stats — S Corporation Statistics” (last updated Dec. 5, 2023)
2. IRC section 1361(b)(1).
3. IRC section 1361(b)(1)(C).
4. IRC sections 1361(b)(1)(D), 1361(c)(4).
5. Rev. Rul. 93-27; see also RSM, “Frequently Asked Questions About Profits Interests” (Apr. 2, 2024).
6. Treas. reg. section 1.704-1(b) (substantial economic effect rules).
7. IRC sections 1361(c)(2) and 1361(d).
8. IRC section 1361(d)(3); Treas. reg. section 1.1361-1(j)(1).
9. IRC section 1361(d)(1)(B).
10. IRC section 1361(d)(2)(A).
11. IRC section 1361(d)(2)(B)(ii).
12. IRC section 1361(e)(1)(A)(i).
13. IRC section 1361(e)(1)(B).
14. IRC section 1361(e)(3).
15. IRC section 1361(e)(1)(A)(ii).
16. IRC section 651; Treas. reg. section 1.651(a)-1.
17. Steuer v. Franchise Tax Board, 51 Cal. App. 5th 417 (2020).
18. California FTB, TAM 2006-0002 (Feb. 17, 2006).
19. Id.
20. Cal. Rev. & Tax. Code section 17745(b).
21. Cal. Rev. & Tax. Code section 17745(e).
22. Cal. Rev. & Tax. Code sections 17331 and 17331.5.
23. Herbert R. Fineburg and Charles A. McCauley III, “Avoiding an Adverse Tax Impact on Death of an S Corporation Shareholder,” 40 ABA Tax Times 2 (2021).
24. Id.