|July 31, 2009|
Previously published on July 24, 2009
The death of a shareholder owning S corporation stock poses unique challenges to those administering the decedent’s estate. Unfortunately, failure to address these issues properly in the administration of the estate can have materially adverse effects on the corporation and the other S corporation shareholders; and they might not even know it!
For estate planning purposes, shareholders often register their stock in the name of their living trust. A living trust is a substitute for a probate estate. Avoiding probate has its advantages; however, where S corpo¬ration stock is involved, the living trust must be carefully drafted and, as important, carefully administered after death. Titling S corporation stock into a living trust will create a number of challenges and deadlines for the individuals administering the decedent’s estate. If these deadlines are not met, the corporation’s S election may be inadvertently terminated and the company may not know it. The corporation is then faced with the need to approach the Internal Revenue Service for a reinstatement of the inadvertent termination of the S election. Consider the following set of facts based on an actual situation.
Mary passed away June 2005. Mary’s estate and trust assets were not large enough to require the completion of a federal estate tax return. Therefore, the attorneys who had crafted the estate plan were not involved with estate and trust administration. Mary’s husband, Carl, was named trustee. Carl worked with his accountant to file the income tax returns for the trust during the period of trust administration. The accountant was generally familiar with Mary and Carl’s income tax returns, but was not familiar with the deadlines for the re-registration of the S corporation stock. Certain real estate had to be sold and there was a dispute with one of Mary’s creditors. Therefore trust administration exceeded a critical two-year deadline. Several months after that deadline, the S corporation shares were transferred to an irrevocable trust which was formed to protect Carl from certain creditors and claims involving his business. In addition, Carl’s estate was potentially subject to federal estate tax; therefore it was vital that the S corporation’s shares in Mary’s trust not be confused with Carl’s assets. One of the Board members of the corporation had heard of Mary’s death and was generally aware that only certain types of trusts are allowed to hold S corporation stock. The Board member contacted an attorney at Miller Johnson to discuss the situation. After some discussion, it was apparent that, in fact, over the years there had been other deaths involved with the shareholder base. In recent years, the absolute number of corporation shareholders had increased and the share¬holder group was not nearly as close-knit and informed as they had been in the past. It was discovered that more than one that had owned S corporation stock was no longer qualified to do so. The corporation’s S corporation election had inadvertently been terminated on at least one prior occasion. The Board member shared these results with the other corporation directors, officers, and fellow shareholders, all of whom were justifiably concerned.
Business owners electing S corporation status are keenly aware of the importance of the S election. The Internal Revenue Service has been rather forgiving of inadvertent S corporation terminations. However, to obtain the Internal Revenue Service’s forgiveness often requires the time and expense of a private letter ruling or, in certain circumstances, the compliance with a complex revenue procedure. Clearly the better answer is to avoid these problems to begin with. Whenever there is a death in the shareholder base, someone needs to immediately follow up with the shareholder’s personal representative or trustee to ensure that proper steps are being taken to facilitate the continued ownership of the S corporation shares. One of the key documents to be immediately reviewed is any shareholder agreement which governs the transfer of S corporation shares.
All too often shareholder agreements command a great deal of attention at execution, but little thought afterwards. Opinions of counsel are not obtained where required. Mandatory shareholder consents may not be solicited. Where S corporation stock is involved, the results can be significant. Lack of consistent application of the terms and conditions of the shareholder agreement can provide the Internal Revenue Service with an ability to challenge the legitimacy of the shareholder agreement due to lack of consistent enforcement. Make sure the death of an S corporation shareholder does not also result in the death of the S corporation’s election.