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TAX CLINIC

they do during their life affect the taxes certain elections is much shorter. In
of the decedent, a surviving spouse, the Beneficiary general, only certain trusts can own S
estate, the beneficiaries, and, potentially, corporation stock, and some of these
their trusts. designations should trusts require that special elections be
Below are 10 important income tax be reviewed to be made timely.
questions to consider when creating an Foreign trusts, nonresident aliens, in-
estate plan: sure they reflect the dividual retirement accounts, charitable
intended income remainder trusts, and other nonqualified
1. How will passthrough business trusts are not eligible to hold S corpora-
income be taxed after transfer? tax consequences, tion stock. To qualify for the favorable
especially if the
If the client owns a passthrough busi- tax election, S corporations also limit the
ness, one question to focus on is how account is left to a total number of shareholders.
that income will be taxed after transfer. Planning point: Make sure there is
Passthrough business income is typically trust. a plan for S corporation ownership. The
categorized as active, passive, or portfolio. rules on trusts owning S corporations
Ideally, taxpayers want income to be can be complex. It is important to work
classified as active because it is generally with an estate planning adviser who is
treated more favorably under the Code, taxed at a higher rate, and losses may not familiar with S corporations.
compared with passive income. If a tax- be deductible, depending on whether
payer actively participates in a business, the fiduciary participates in the income- 3. Should a partnership interest
the income may qualify for a lower tax producing activity. Use caution when be transferred during life or at
rate or allow for a loss deduction. It may relying on case law in planning, because death?
be important to preserve this treatment the IRS has not indicated that it agrees Another estate planning issue that arises
after lifetime transfers or at death. with the outcome of the cases. involves transferring a partnership inter-
Determining whether certain business est. Assets given away during life gener-
income is active or passive in relation to 2. Is favorable S corporation ally retain the transferor’s basis, while
a trust or estate is not as straightforward status safe after transfer? assets transferred after death receive
as it is for individuals. Participation prior If the client for whom estate planning is either a step-up or a step-down in basis.
to transferring the business interest is no being done is a shareholder of an S cor- If a partnership interest is given away
longer relevant, and there is no authorita- poration, it is important to ensure that during life and it appreciates in value,
tive IRS guidance for how activities of a the S corporation’s favorable tax election the growth is outside the transferor’s
trust or estate are tested for participation is not compromised after the transfer taxable estate, but the beneficiaries may
purposes. Instead, participation rules and and that it does not lose its passthrough have capital gain and ordinary income to
guidance for an estate or trust rely heavily tax treatment. Loss of the election report due to a lower basis.
on two prominent court cases, Mattie K. would cause tax to be paid at the entity If the partnership interest has a nega-
Carter Trust, 256 F. Supp. 2d 536 (N.D. level as a C corporation rather than tive capital account when gifted, there
Tex. 2003), and Frank Aragona Trust, 142 as a passthrough entity taxed on the can be adverse tax consequences. If the
T.C. 165 (2014). shareholder’s income tax returns. This is asset is held until death and receives
Based on case law, the participation of generally undesirable, as C corporations a step-up in basis, capital gain and
a trust or estate is determined by whether have potential double taxation. Relief ordinary income related to the activity
key individuals acting as a fiduciary (or may be available to save the passthrough during life are eliminated. There is also
agents of the fiduciary) are participating tax treatment (see Rev. Proc. 2022-19); an opportunity for beneficiaries to ben-
in the income-producing activity. The however, it is better to protect the S cor- efit from additional deductions, such as
IRS has indicated it will propose regula- poration election with proper planning. depreciation, if the partnership makes a
tions around this area. If regulations Generally, estates and trusts can hold certain election.
are issued, they could provide different S corporation stock for a limited period Planning point: Weigh whether it
guidance on how activities are tested for after death, so timing is important, as is more beneficial to transfer a partner-
income tax purposes. is ensuring the ultimate beneficiary is ship interest during life or at death.
Planning point: Consider the par- an eligible S corporation shareholder. Ensure there are no unintended adverse
ticipation rules when choosing a trustee When S corporation stock is trans- income tax consequences related to
or executor. Business income could be ferred during life, the period to make the transfer to ultimate beneficiaries.

12 April 2023 The Tax Adviser