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create unnecessary tax issues for every- fully deductible on the decedent’s final
Upon the death of one involved. income tax return.
an owner, special Tax matters of the deceased Example: J, a single taxpayer, died
rules will apply to owner, owner’s estate, and/or on Sept. 1, 2018. His suspended
trust
loss carryover from XYZ Ltd. Part-
suspended passive Unique situations arise upon the death nership was $10,000. At the time of
losses arising from of an owner in a partnership or S cor- death, J’s estate received a $2,500

a passthrough entity poration. Various carryovers, material step-up in the tax basis of XYZ. (J’s
participation rules, and basis adjustments
partnership interest was appraised
interest held at death. must be considered when preparing a at $20,000 and had an adjusted tax
deceased owner’s final return, the return basis of $17,500.) Therefore, on J’s
for the owner’s estate or trust, and tax final Form 1040, U.S. Individual
returns for the beneficiaries of the estate Income Tax Return, the remaining
Life insurance is a common tool to or trust. Below are some key tax issues to $7,500 of the suspended loss is
provide the necessary liquidity to fund consider on an individual level when a deductible ($10,000 – $2,500 Sec.
these transactions. Such policies are shareholder or partner dies. 1014 step-up).25
typically owned either by the corpora-
tion or by its shareholders. The preferred Suspended losses upon death of Suspended losses due to lack of
ownership will often depend on the an owner regular tax basis: Suspended losses
structure of the buy-sell agreement. Suspended passive losses: due to lack of regular tax basis will
Buy-sell agreements are typically Upon the death of an owner, special disappear upon the transfer from an
structured in one of two ways: as re- rules will apply to suspended passive individual at death to her estate, trust,
demptions or as cross-purchases. With losses arising from a passthrough entity and beneficiaries.
a redemption, the corporation will have interest held at death. The unused Suspended losses due to lack
first right (or obligation) to purchase losses are allowed as a deduction on the of at-risk basis: Unused at-risk losses
shares of the deceased shareholder. A decedent’s final personal income tax re- will also not carry forward to the de-
cross-purchase gives the other share- turn but only to the extent these losses cedent’s estate, trust, and beneficiaries.
holders the option (or obligation) to are in excess of the difference between Instead, these amounts are added to the
purchase the shares of the deceased. the basis of the interest in the transfer- basis of the interest in the hands of the
The consequences of a cross- ee’s hands over the adjusted basis of the recipient.26 However, because this is
purchase versus a redemption may not interest immediately before the death done prior to the basis adjustment
differ significantly. But the parties can of the taxpayer.22 This “difference” in under Sec. 1014, there is no net change
run into trouble if the ownership of the basis is more commonly known as the in basis.
life insurance policies is not in unison step-up or step-down of the basis of Pre-death planning: There are var-
with the provisions of the buy-sell agree- an asset upon death to its FMV.23 Es- ious techniques that can be used if you
ment. When the buy-sell agreement sentially, this means that to the extent have a terminally ill client. For example,
calls for the S corporation to redeem a of the basis step-up, suspended passive if a taxpayer is terminally ill, consider-
deceased shareholder’s shares, the corpo- losses will be permanently disallowed. ation should be given to selling an inter-
ration should typically own and be the Those unused passive losses will not est with suspended losses if the benefit
beneficiary of the life insurance policy. carry forward to the decedent’s estate, of triggering the carryovers exceeds
Alternatively, if the buy-sell agree- trust, or its beneficiaries.24 Losses in ex- any gain on disposition. Consideration
ment is structured as a cross-purchase, cess of the basis step-up will be allowed should also be given to the potential
the shareholders typically should own on the decedent’s final tax return. If ordinary income recapture embedded
and be the beneficiaries of the policies. there is no basis step-up (for example, in the gain on a sale of a partnership
Taxpayers that fail to coordinate the because the value of the interest has interest. If a partnership interest is held
policies with the buy-sell agreement can declined), the suspended losses will be at death, the pre-death built-in gain

22. Sec. 469(g)(2)(A). 25. PPC’s Federal Tax Compliance Library, 1040 Deskbook (see Chapter 16:
23. Sec. 1014. Passive Activities; Key Issue 16D: Disposition of Passive Activities).
24. Sec. 469(g)(2)(A). 26. Prop. Regs. Sec. 1.465-67.

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