Volume 18 Issue 1 -- January/February 2006
In the distress that usually accompanies the death of a business owner, there is often confusion about the roles and capacities of the survivors. It is easy for the business associates or the family survivors of a deceased owner to become confused about who does what to whom and for what reason.
The distinction between the estate of a decedent, the business, and the prior owner (now deceased) is often overlooked. For example, if a sole proprietor passes on, then the estate of the deceased individual would become the owner of the business.
With a corporation or LLC, it is different. Entities, such as corporations, do not die the way individuals do. The owners of a corporation are the individuals who own the stock. When one of the owners dies, the stock passes to the estate of the deceased owner.
For example, let’s take the all too common situation of one shareholder owning all of the corporate stock. Suppose that shareholder, Dudley DoRight (“Dud”), owns all of the stock of a garage called “Fix ’Em, Inc.” (“Fix’Em”). When Dud dies, his estate (or perhaps a Trust) becomes the entity that owns all of the stock of Fix’Em previously owned by Dud. The business now has a new owner — the estate of Dud.
Suppose Dud died in mid-2005 and Fix’Em was an “S” corporation. All income for the first part of the year until the date of death would be Dud’s and would be picked up on the final return (Form 1040) for Dud or Dud and his wife, if Dud is married and files jointly. All income after the date of death would be income of Dud’s estate, usually reported on a Fiduciary tax return, Form 1041.
It is very easy to confuse the distinction between the three entities — Dud, Dud’s estate, and Dud’s corporate business Fix‘Em, but it is extremely important to keep them straight.
What if Dud had a trusted manager named Cyrus (“Cy”) who had been running the business for the past five years while Dud’s health was failing. If Dud did not give the stock to Cy, then the owner of the stock becomes Dud’s estate until the estate is closed and the stock is distributed, either through intestacy or pursuant to a Will or Trust. While Cy may be the only survivor with a good working knowledge of how to run Fix’Em, he is not the owner. He does not have the authority to sell the business or even to sign documents on behalf of the corporation unless he was an officer of the corporation prior to Dud’s death.
If the stock of Fix’Em is to be sold, only the representatives of the estate of Dud have the authority to approve the sale of the estate’s stock. While Cy may be essential to the success of the corporation’s business, unless Cy is the representative of Dud’s estate, he does not have the authority to make these decisions.
The distinction between the entities can also be confusing to many would-be buyers. A would-be buyer might approach Cy, and Cy might believe that he has the authority to sell the business when in fact he does not. Also, if there is an ongoing probate of Dud’s estate, the authority of a commissioner or probate court may be needed for approval of the sale of the stock of Fix’Em to a new buyer.
Let’s assume the would-be purchaser of Fix’Em is Mr. Newby who does not want to buy the stock of Fix ‘Em but prefers to buy the assets. As you know from other newsletters, it would be somewhat unusual for a prospective buyer to buy the stock. It is much better, generally, for buyers, such as Newby, to buy the assets of the business.
In that case, the assets are owned by the business entity — the corporation or LLC — which must be the party to sell the assets. The owner of the corporation’s stock — here the estate of Dud — usually must also approve the sale.
To whom is the gain from the sale of the stock or assets taxable? If it is a sale of assets, the gain will first be reported on the entity’s tax return. If the entity is a pass-through entity, like an S corporation or LLC, the gain will flow through to the income tax return of the owner, such as the estate of the deceased owner. If it is a sale of stock, the answer typically depends on when the sale took place. If the sale occurs while the estate is in probate, then the gain would be gain attributable to the estate of the decedent. If the probate is completed and stock has been distributed to the heirs, then the gain would be attributable to the heirs who received Dud’s stock.
If there are other owners of Fix‘Em, there could be a buy-sell agreement. Such an agreement may require Dud’s estate to sell Dud’s stock back to the entity (the corporation or LLC) or to other surviving members (shareholders or LLC members). In that case, the estate of Dud would receive the proceeds (cash, usually, or promissory note) from the buy-sell agreement purchaser.
If you have questions about the relationship of the business and the estate of a deceased former owner, call The Tax and Business Professionals.
By Tax and Business Professionals, Inc.
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