Here It Comes
According to many, the long-awaited intergenerational transfer of assets from the Baby Boomer generation, and from what remains of the Silent Generation, to younger members of their families[i] – estimated by some to exceed $100 trillion in total, worldwide, over the next two decades – is well under way.
Most of this shift in wealth will occur within families whose members already count themselves among the wealthiest on the planet.[ii] Indeed, according to one source, “[t]he wealthiest 10 percent of households will be giving and receiving a majority of the riches.” Within that group, the top 1 percent holds about as much wealth as the bottom 90 percent, and it “will dictate the broadest share of the money flow.”[iii]
In many cases, this wealth originated from a lucrative, closely-held business – often family-controlled – that turned into a cash cow for its owners, or from which the owners exited via a profitable sale. The resulting liquidity was subsequently invested not only in the public markets, which have generated handsome returns over the last few decades,[iv] but also in private transactions, which have outperformed the public markets.[v]
It’s What You Keep
The income, employment, and estate tax laws have played a significant role in the growth and subsequent intra-family transfer of individual wealth.
Income Taxes
Favorable tax rates for long-term capital gains (and later for dividends) have facilitated this performance: the Tax Reform Act of 1986 capped the rate at 28%; the Taxpayer Relief Act of 1997 lowered the rate to 20%; the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rate further, to 15%, and also made it applicable to qualified dividends;[vi] with the American Taxpayer Relief Act of 2012, the rate returned to 20%; and the Patient Protection and Affordable Care Act introduced the 3.8% surtax on net investment income including capital gains and dividends, effective 2013.
Perhaps more significant than a favorable tax rate is the fact that capital gains are subject to income tax only when they are realized; i.e, upon the taxable sale or other disposition of an appreciated asset. Until such an event occurs, no income tax is imposed upon the appreciation in an asset’s fair market value.[vii]
When an appreciated asset is held by an individual at the time of their death, the basis of the asset for the decedent’s estate and beneficiaries is adjusted (usually “stepped up”) to the fair market value of the asset at the date of the decedent’s death.[viii] As a result, the appreciation accruing during the decedent’s life on assets that are still held by the decedent at death completely avoids federal income tax.
Employment Taxes
The first $184,500 of compensation income payable to an individual employee for their services is subject to Social Security tax of 6.2%, and the entire amount of compensation is subject to Medicare tax of 1.45% or, in the case of higher earners, 2.35%.[ix] These taxes are withheld by an employer from the individual employee’s wages. Employers pay an equal amount of employment tax with respect to an employee’s wages, except for the additional 0.90% Medicare tax.
Estate, Gift & GST Taxes
In a sense, the federal estate tax has enjoyed the same favorable disposition Congress has shown toward long term capital gains. Some of you may recall that after 1996, the top estate tax rate was 60%: the regular top rate of 55% plus an additional 5% that was added to estates of more than $10 million (to eliminate the benefit of the progressive rate table), and the exclusion was $600,000 (in 1997; with set increases through 2001). After 2001, the additional 5% tax was eliminated, the rate was reduced to 50%, and the exclusion was increased to $1 million (from $675,000 in 2001). What followed was a steady increase in the exclusion to $3.5 million, and a steady reduction in the rate to 45%, in 2009. Starting 2010 (with its “optional estate tax”), the exclusion increased from $5 million to $5.49 million in 2017, while the rate went from 35% to 40% (where it has been since 2013). After the TCJA, the exclusion was basically doubled to $11.18 million, and is now at $15 million.
Higher Taxes
Against this backdrop, many states are considering the imposition of higher income tax rates on those individuals whom they define as wealthy, while others are proposing the enactment of wealth taxes. The strong support among voters for socialist candidates in recent congressional and state-level primaries in New York and elsewhere in the country, and their success over incumbents, may signify an impending change in the “rules of engagement” over tax policy.[xi]
Looking Ahead
Even without considering what appears to be the recent surge toward the “farther” left, it’s reasonable to expect that the next time the Democrats control Congress and the White House[xii] we will likely see increases in the income and estate tax rates, perhaps the elimination of, or additional limitations on the use of, certain planning vehicles, and maybe even the elimination of, or significant increase in, the Social Security tax earnings cap.
With the enactment of new or higher taxes just over the horizon, many owners are considering what they hope will be a rewarding after-tax exit on the sale of their business. They are also thinking about the transfer of some of their wealth to their families on a tax efficient basis. Time is not necessarily on their side, regardless of what the Stones say.[xiii]
While such planning is certainly prudent, it would also behoove them to examine their present tax situation; a mini-audit, if you will. Based upon what I have seen lately, there are a lot of folks out there who should be engaging in such an exercise – while they still have time to make any necessary corrections – before they start to solicit or entertain offers for the purchase of, or to make gifts of equity in, their business.
Here’s a “for instance.”
A Not So Hypothetical
Owner is in his mid-60s. He owns nearly all the issued and outstanding shares of stock of the corporation (“Corp”) out of which he has long operated his business. Corp elected to be treated as an S corporation for tax purposes from the date it was organized, approximately 30 years ago. Although Owner manages the business on a daily basis, Corp rarely pays him compensation for his services.[xiv]
Aside from the transfer of Corp stock to the Trusts, Owner has made no other gifts or engaged in any serious estate planning, notwithstanding that the fair market value of Corp’s business is almost $100 million.
Owner visits an attorney (“Mr. Grim”), from the firm of Death & Taxes, to start addressing the disposition of his future estate.
Grim reviews the trust agreements. The Trusts are administered by an independent trustee who is authorized (without the approval or consent of any other person) to distribute or accumulate income, or to pay out principal, to or for the benefit of the sole income beneficiary of each Trust, and no one else during the life of the beneficiary. The trustee is not authorized to add a beneficiary to the trust.[xv] The trustee is authorized, under a general lending power, to make loans to any person, including the Owner, without regard to interest or security.[xvi]
After satisfying himself that Owner cannot be treated as the . . . , well, . . . , owner, for purposes of the income tax,[xvii] of any portion of the Corp stock held by the Trusts, and knowing that Corp has always reported to the IRS as an S corporation and that Owner has always reported his pro rata share of Corp’s tax items on his own individual income tax return, Grim consults his tax partner (“Mr. Reaper”) regarding the Trusts’ eligibility to hold shares of S corporation stock.
Surprises Are Bad
Reaper examines the fiduciary income tax returns most recently filed for the Trusts.[xviii] The first page of each return identifies the Trust as a complex trust; neither the “ESBT” box[xix] nor the “Grantor type trust” box[xx] has been checked.[xxi] The return also indicates that an income distribution deduction was claimed for an amount equal to the total distributions shown as having been made by the Trust, which was less than the distributable net income of the Trust.[xxii] No Sch. K-1 was provided.[xxiii] The Trust return did not reflect any tax owing.
Reaper asked the tax preparer how the Trusts qualified as shareholders of an S corporation. The tax preparer replied that the Trusts distributed all their income every year;[xxiv] thus, he added, they were QSSTs.[xxv]
Reaper then asked for copies of the S corporation returns filed by Corp,[xxvi] and of the individual income tax returns filed by each income beneficiary,[xxvii] to see what distributions were made to the Trusts, and to compare the items from Corp’s returns with what was reported by the Trusts and the income beneficiaries.
Reaper thought his final request would be the most innocuous – a copy of the election filed by (or on behalf of) each beneficiary to treat their respective Trust as a grantor trust, and the beneficiary as the deemed owner of that portion of the Trust consisting of Corp stock.[xxviii]
Unfortunately, he was greeted by a deafening silence.[xxix]
Restoring the Election – Timing May Be Everything
Can Owner restore Corp’s status as an S corporation after it has terminated?[xxx] Can the income beneficiary of each Trust still make a QSST election, albeit late? Maybe. It depends.
The frequency with which QSST and other elections related to the status of an S corporation, are missed is evidenced by the IRS’s efforts over the years to provide simplified procedures pursuant to which taxpayers may obtain relief from the termination of their corporation’s “S” election that would otherwise result from an untimely election with respect to a shareholder-trust.
Under the latest iteration of these procedures, the request for relief from a late election must be made within 3 years and 75 days after the date on which the election is intended to be effective.[xxxi]
Notwithstanding this generous procedure, the IRS continues to receive many requests for relief under its general authority to grant extensions for regulatory elections that do not come within the purview of the procedure[xxxii] – as appears to be the case for Trust and Corp – and, so, it continues to issue taxpayer-favorable letter rulings in situations where the requesting taxpayer can establish that they acted reasonably and in good faith.[xxxiii]
Unfortunately, it will probably take at least six months for the IRS to process the taxpayers’ PLR request for permission to make a late QSST election with retroactive effect and, thereby, restore Corp’s status as an S corporation.
Potential Sale
What if a prospective buyer for Corp – one that is ready to pay cash at closing – comes along while the PLR request is pending? Worse yet, what if the interested suitor discovers the missing QSST election and the resulting loss of Corp’s “S” status during its initial due diligence?
Will Corp’s loss of “S” status affect the buyer’s interest in a transaction? Might the buyer be unwilling to wait for the IRS’s ruling? Will they just walk away?
Or will the buyer just ask Corp to undertake an F reorg with a newly formed S corporation parent,[xxxiv] and with state law Corp “converting” into a wholly owned state law LLC that is disregarded for tax purposes?
Double Taxation
While this reorganization will probably shield the buyer from the consequences of the lost election,[xxxv] its primary benefit to Dad, the Trusts, and Corp (i.e., its “successor”) will be the buyer’s willingness to proceed with a transaction.[xxxvi] Aside from that, the seller parties will still face the prospect of an additional tax burden for which the buyer, in all likelihood, will be unwilling to make them whole.
If the IRS determines that Corp was not an S corporation at the time of the transaction with the buyer, or if Corp does not qualify for any relief from the late QSST election, it will be treated as a C corporation for tax purposes, and the economic result for the seller parties will be much diminished from what they hoped for.
The gain arising from Corp’s sale of assets will be subject to federal corporate income tax at a rate of 21%,[xxxvii] but its shareholders will not be taxable in respect of the sale until Corp actually or constructively makes a distribution to its shareholders.
When Corp subsequently distributes the net, after-tax proceeds to its shareholders, they will subject to federal income tax at the rate of 23.8%.[xxxviii] If the distribution is made in liquidation of Corp, or in redemption of a single distributee’s shares of Corp stock, the amount subject to tax in the hands of the shareholders (or of the single distributee) will be reduced by their adjusted basis for their shares. If the distribution is, instead, treated as a dividend, then the entire amount of the distribution will be taxed at 23.8%.
New S-Election
It Pays to be Prepared
The foregoing scenario illustrates how one simple act (or failure to act) may adversely affect the net economic consequences of a transaction, or even jeopardize the deal altogether. More’s the pity because the problem could have been addressed easily and timely if it had been identified sooner.
The negative tax and, therefore, economic effects of such a misstep may be magnified if the error remains unknown until after the anticipated tax increases, described earlier, are enacted.
Now is the time for a “self-audit.” It may also be the time to take advantage of existing rules.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
Sign up to receive my blog at www.TaxSlaw.com.
[i] And to family-controlled charities – i.e., private foundations, in the U.S.
[ii] Thanks, in no small part, to the use of dynasty trusts.
[iii] https://www.nytimes.com/2023/05/14/business/economy/wealth-generations.html.
[iv] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html.
[v] https://www.investmentcouncil.org/new-report-private-equity-delivers-stronger-long-term-returns-than-any-other-asset-class/.
While the already well-to-do beneficiaries of this Great Wealth Transfer await their turn at the helm of one of the family businesses or investment portfolios, most other Americans are facing financial challenges presented by the high cost of living. https://news.gallup.com/poll/708905/affordability-dominates-americans-financial-worries.aspx.
[vi] All other dividends are taxed at the higher rate for ordinary income – currently, a top rate of 37%.
[vii] Let’s not forget the opportunities for deferring or avoiding altogether, the recognition of gain; for example, charitable contribution of appreciated property-in kind, tax-free reorganizations of corporations, like-kind exchanges, qualified opportunity funds, and qualified small business stock.
[viii] IRC Sec.1014.
[ix] I.e., an additional Medicare tax of 0.90%. Wages over $200,000 ($250,000 for taxpayers who file jointly).
[x] The Tax Court’s application of the “functional analysis” test is currently being contested in the federal Circuit Courts, most recently in the 2nd Circuit. Soroban Capital Partners v. Commissioner, Nos. 25-2027, 25-2250, argued 6/25/2026.
[xi] Bernie and Liz are certainly re-energized by the prospect. Their respective panties have been in a twist ever since Musk became a trillionaire. The federal budget deficit for the current fiscal year is projected to reach $2 trillion. The total outstanding federal debt is just over $39 trillion.
[xii] Not as remote a possibility as many would like.
[xiii] Time Is on My Side, sung by The Rolling Stones (1964).
[xiv] Guess he doesn’t care much for employment taxes.
S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which is subject to employment taxes.
[xv] IRC Sec. 674(c).
[xvi] IRC Sec. 675(2). The ability to make interest-free loans to the Owner-grantor is another issue impacting upon the inclusion of the trust in the Owner’s gross estate for purposes of the estate tax.
[xvii] Under the grantor trust rules. IRC Sec. 671 et seq.
[xviii] IRS Form 1041, U.S. Income Tax Return for Estates and Trusts.
[xix] Electing small business trust. IRC Sec. 1361(e); Reg. Sec. 1.1361-1(m).
[xx] According to the instructions to the Form, this includes qualified subchapter S trusts, or QSSTs. IRC Sec. 1361(d); Reg. Sec. 1.1361-1(j).
[xxi] Line A of Form 1041.
[xxii] Form 1041, Sch. B, Lines 11 and 7, respectively.
[xxiii] Please, when your attorney asks you for a copy of a tax return, make sure to include all the schedules and all the statements and other attachments. Thank you.
[xxiv] Reg. Sec. 1.1361-1(j)(1)(i). Even where a trust agreement does not require that all income be distributed at least annually, if all such income is in fact distributed, the trust will satisfy the distribution of income requirement.
[xxv] IRC Sec. 1361(d). According to Reg. Sec. 1.1361-1(j), all of the income (within the meaning of Reg. Sec. 1.643(b)-1) of the trust is distributed (or is required to be distributed) currently to one individual who is a citizen or resident of the United States. This refers to fiduciary accounting income rather than taxable income, gross income, or distributable net income. It includes distributions to the trust from the S corporation for the taxable year in question, but does not include the trust’s pro rata share of the S corporation’s items of income, loss, deduction, or credit determined under IRC Sec. 1366.
[xxvi] On IRS Form 1120-S, U.S. Income Tax Return for an S Corporation; including the Schedules K-1.
[xxvii] IRS Form 1040, U.S. Individual Income Tax Return; specifically, Schedule E, Supplemental Income and Loss, Part II, Income or Loss From Partnerships and S Corporations.
[xxviii] IRC Sec. 1361(d)(1)(A) and (B); IRC Sec. 678; Reg. Sec. 1.1361-1(j)(6)(i) [the election provided in section 1361(d)(2) (the QSST election) to treat a QSST (as defined) as a trust described in IRC Sec. 1361(c)(2)(A)(i), and thus a permitted shareholder]; Reg. Sec. 1.1361-1(j)(7)(i).
[xxix] Can you say “Fudge!”? Please pardon the poetic license.
[xxx] IRC Sec. 1362(d).
[xxxi] Rev. Proc. 2013-30.
[xxxii] An entity that does not meet the requirements for relief under this procedure may seek relief by requesting a letter ruling. The procedural requirements for requesting a letter ruling are described in Rev. Proc. 2026-1.
[xxxiii] Reg. Sec. 301.9100-3.
[xxxiv] Rev. Rul. 2008-18.
[xxxv] It will also ensure a cost basis for the Corp assets indirectly acquired by buyer.
[xxxvi] If it is contemplated that some of Corp assets will be rolled over into a buyer entity in exchange for equity therein, the LLC version of the business can facilitate the exchange.
[xxxvii] IRC Sec. 11.
[xxxviii] The 20% long-term capital gain rate under IRC Sec. 1(h), and the 3.8% surtax on net investment income under IRC Sec. 1411.
[xxxix] As a result of the failure to make a timely QSST election for the Trust. IRC Sec. 1362(g).
[xl] IRC Sec. 1374.
[xli] IRC Sec. 1366(a) and Sec. 1366(f)(2).