Basis Planning for the Closely Held Business
Diane owns 100% of a manufacturing S corporation with a basis of $300,000 and a fair market value of $5,000,000. Her estate is $7,000,000, all of which passes to her two children equally under her will. Diane is 70 and in good health. Her accountant proposes she make a $1,000,000 lifetime gift of stock to each child now to 'remove appreciation from the estate,' noting the 2023 exclusion is $12,920,000. The accountant also suggests Diane sell the remaining stock to a grantor trust she creates for the children in exchange for a note. Diane's attorney raises concerns about the step-up in basis at death and the S corporation eligibility rules.
1. Compare the income tax consequences of the lifetime gift versus holding the stock until death, assuming Diane dies with the stock and the estate is below the exclusion.
Read the worked answer
A lifetime gift of appreciated stock carries over Diane's $300,000 basis (per share), so the children would inherit a low basis and face large capital gains on sale. Holding until death gives the stock a stepped-up basis to FMV ($5,000,000) under §1014, eliminating the built-in gain. Because Diane's $7,000,000 estate is below the $12,920,000 exclusion, there is no estate tax savings from the gift-the accountant's premise is wrong. The gift therefore produces a pure income tax detriment (loss of step-up) with no transfer tax benefit. Diane should generally not make the gift; the better planning is to retain the stock for the step-up, or use a grantor trust/defective grantor trust structure only if it preserves basis or achieves other goals.
2. Evaluate the proposed sale to a grantor trust. What are the S corporation eligibility and valuation issues?
Read the worked answer
A sale to a grantor trust for a note is a common freeze technique, but three issues arise. (1) S corporation eligibility: an S corporation may have only eligible shareholders; a grantor trust is generally a permitted S shareholder during the grantor's life, but on the grantor's death the trust may become ineligible and terminate S status unless it qualifies as a QSST or ESBT. Counsel must draft for one of these. (2) Adequate interest and valuation: the note must bear adequate interest (at least the applicable federal rate) and the stock must be appraised; an underfunded note or below-market rate creates a gift. (3) Estate inclusion risk: if the trust is a grantor trust as to Diane, the trust assets are included in her estate under §2036/§2038 only if she retains prohibited interests; a properly structured sale avoids inclusion, but the note itself remains in her estate. The freeze shifts future appreciation but does not eliminate the note's value.
3. If Diane dies owning the stock and the estate later sells the business for $6,000,000, what basis do the heirs take and what gain is recognized?
Read the worked answer
The heirs take a basis equal to the FMV at Diane's death ($5,000,000) under §1014. On a sale for $6,000,000, the recognized long-term gain is $1,000,000, taxed at capital gains rates. The $5,000,000 of pre-death appreciation escapes income tax entirely. Compare the gift scenario: if Diane had gifted the stock, the children's basis would be $300,000 (carryover), and a $6,000,000 sale would produce $5,700,000 of gain-a dramatic difference. This confirms the step-up is the dominant consideration and that the lifetime gift is inadvisable absent a transfer tax problem.