C and S Corporations in Estate Planning: An Introduction

Deciphering the tax complications of of the corporate tax structure

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Series Index

1. Introduction (this article)

2. Basics of Stock Basis

3. Tax Accounting

4. Constructive Dividends and Intro to Stock Redemptions

5. Section 303 Stock Redemptions After Death

6. Income-Shifting and Grantor Trusts

7. Eligible Shareholder Requirements

8. The Qualified Subchapter S Trust

9. Electing Small Business Trusts (ESBTs)

10. Substantially Disproportionate Redemptions

11. Related Corporations and IRC Section 304

12. Tangential Issues:

    1. PLR 202407005: Trust and Estate Administration

Intro

C and S corporations can be extremely confusing in isolation. However, they are often (and unfortunately) taught in isolation. If I had my way, they would be taught in tandem.

Luckily, through this newsletter, I have my way.

On a broader level, I routinely encounter wealth transfer professionals who both lack and desire a better understanding of the tax rules for C and S corporations. Knowing these rules can be very important for tax planning purposes. In addition, knowing how these rules interface with transfer taxes can add immense value. But, as I mentioned above, the rules can be quite complicated. It is rare to see a side-by-side comparison of the various tax principles that apply. So, this is the approach I plan to take with this article series.

Let’s start with the basics, shall we?

What do the terms “C corporation” and “S corporation” mean?

Simply put, these are income tax statuses of business entities. These tax statuses can be used by corporations, obviously, but may also be elected by other business entities as I will explain below.

The “C” and “S” tags refer to the subchapter of Subtitle A, Chapter 1 of the Internal Revenue Code where these tax rules are found.

The two other for-profit tax statuses include partnerships (rules found in Subchapter K), and disregarded entities (no entity-level federal income tax or tax accounting). There are other industry- or trade-specific tax statuses that can be elected, but these statuses often operate off a chassis of C corporation taxation.

Now, before I explain the tax rules, it is vital to understand that the form of entity created under state law does not always directly correlate to the tax status(es) available and/or elected. Long story short, a C or S corporation does not have to be a corporation. State-law LLCs (including single-member LLCs), and partnerships, can both elect to be taxed as a C corporation or S corporation. On the other hand, a state-law corporation cannot elect to be taxed as a partnership or disregarded entity.

However, if you start with a state-law corporation, it is by default taxed as a C corporation. The corporation may elect to be an S corporation, if it meets certain requirements we will later discuss. But, if you start with a state-law partnership or LLC, it must elect under the check-the-box rules of Treas. Reg. 301.7701-3 to be taxed as an association which, by default, causes the entity to be taxed as a C corporation. Alternatively, the entity can make an S corporation election (if eligible), which deems it to have first made an election to be taxed as an association (see Treas. Reg. 301.7701-3(c)(v)(C)).

In other words, while not necessarily considered or expressly stated as such, a domestic partnership or LLC can decide not to be taxed as a partnership or disregarded entity but, instead, to be taxed as a “C corporation election” by electing to be taxed as an association. Likewise, certain foreign entities can qualify for this election (see Treas. Reg. 301.7701-3(b)(2)). (Whenever you see the term “association”, this is a non-corporate entity that has elected to be taxed as a C corporation. It is not actually a corporation, and this term is used to avoid confusion.)

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