Inherited S-Corporation: Step-Up & Shareholder Issues

Your inherited S-corp stock receives a step-up in basis, but the underlying business assets do not. Understanding this mismatch and navigating shareholder requirements are essential for tax planning.

Shareholder eligibility is strict. Only certain types of owners can hold S corp stock: individuals, certain trusts, and estates. If the stock passes to an ineligible trust or entity, the S election terminates and the company becomes a C corporation -- triggering double taxation. An estate can hold S corp stock during the administration period, but subsequent transfers must go to eligible shareholders.

Stock basis steps up, but inside basis does not. Under IRC 1014, your stock basis resets to fair market value at death. However, unlike partnerships, there is no mechanism like Section 754 to adjust the basis of the corporation's underlying assets. This creates a permanent gap: you have a high stock basis but the company's assets retain their old depreciated basis.

Built-in gains risk. If the S corp was formerly a C corp, the built-in gains tax under IRC 1374 may apply to asset sales within five years of conversion. This is a corporate-level tax that reduces what flows through to you.

The pitfall: The S election can be inadvertently terminated by an improper transfer to an ineligible shareholder. Once lost, the election cannot be re-made for five years without IRS consent.