When you learn that a decedent held an interest in an S corporation that owns real estate, it is not uncommon to hear an audible groan in the room, a collective lamenting of the loss of the opportunity for a basis adjustment to the underlying real estate that would be easily available if we just had a partnership which owned the real estate instead of an S corporation.
While the S corporation wrapper serves to block an “inside” basis adjustment for assets owned by the S corporation at an owner's death, not all assets raise the same difficulties as real estate. For example, if the S corporation owned stock of a publicly traded company, there would be no “inside” basis adjustment for the securities on the decedent's death, just as is the case with real estate. However, with the IRC §1014 “outside” basis adjustment to the S corporation stock, the S corporation could liquidate, and offsetting capital gain and loss would be available to the shareholder, with the result that the publicly traded stock would be held outside the S corporation and, on liquidation, would have a “cost” basis equal to fair market value. (All section references are to the Internal Revenue Code of 1986, as amended.)
The same, though, would not be true in a liquidation of an S corporation with directly owned real estate, where §1239 operates to snatch defeat from the jaws of basis adjustment victory. Because the real estate would be “of a character subject to the allowance for depreciation provided in [§167]” in the hands of the transferee (the trust or estate shareholder), if the trust/estate has more than a 50% interest in the S corporation, the S corporation's gain passed through to the shareholder will be recharacterized as ordinary income, and the shareholder's capital “loss” on liquidation will result in a mismatch and not offset the ordinary income.
This raises the question of which result occurs if the S corporation owns its real estate through a partnership? Today's case file review explores this question using an overly simplified example – the decedent's living trust (“Trust”) owns 100% of an S corporation (“Company”), which holds a 75% interest in an entity taxed as a partnership (“Partnership”) which owns real property with a fair market value greater than its basis (“Property”). The potential for an inside basis adjustment to the real estate owned through a partnership held by an S corporation becomes particularly useful where multiple real properties are held within the S corporation, and it might be impractical to sell all properties in the year of liquidation to properly time the offsetting gain and loss. Note that this article provides only a general overview of each of the mechanical concepts discussed, and is not intended as an exhaustive exploration of each applicable concept of S corporation liquidations, recharacterization of related party transfers under §1239, partnership transfer taxation, and partnership basis adjustments due to a §754 election.
Company Outside Basis Adjustment at Death
On the decedent's death, Trust's basis in Company stock will be adjusted (“stepped up”) to its fair market value as of the date of the decedent's death. §1014. This basis adjustment is automatic and is not by election. Suppose the 75% interest in Partnership is Company's only asset and is worth $750,000 (assume no valuation discounts or adjustments, for simplicity) and that Trust's Company stock is also worth $750,000. Thus, Trust's basis in Company stock is now $750,000.
Liquidation of Company
Company adopts a plan of liquidation and distributes all of its assets, consisting of the 75% interest in Partnership owning Property, to Company's sole shareholder, Trust. The liquidation of Company is treated, for income tax purposes, as a deemed exchange of Company's assets for Trust's stock in Company, and causes Company to recognize income on the unrealized appreciation when Partnership interest is distributed, which gain flows to Trust as Company's sole shareholder. §336(a). If Partnership interest has a zero basis, and assuming date of death values on liquidation of Company, the gain on its deemed sale is $750,000. Trust's basis in Company stock is further increased as a result of the tax on this income to $1.5 million, the sum of the $750,000 date of death value and the $750,000 gain passed through on Company's K-1 to Trust. §1367(a)(1). Because the distribution is a full liquidation of Company and Trust's basis in Company stock exceeds the fair market value of the interest in Partnership received by Trust, Trust would have a loss offsetting the income Company passed through to Trust. Treas. Reg. §1.331-1(b). In other words, when Company liquidates, Trust receives $750,000 in assets in exchange for its stock with a $1.5 million basis, recognizing a $750,000 loss. This $750,000 loss on liquidation offsets the $750,000 K-1 income from the deemed sale of Company's Partnership interest. Although the loss is between related parties (Trust and Company), there is an exception to the general related party loss disallowance for a loss arising from a complete liquidation of a corporation. §267(a)(1). Note that if, for example, Partnership's value has increased since decedent's date of death, the loss on full liquidation of Company would not fully offset the income.
“Income,” “gain,” and “loss” are used rather generically here. The actual tax character of the income and the resulting tax liability from a deemed sale of an interest in Partnership owning Property could involve “recapture” income from previous depreciation of Property, causing the resulting income to be characterized as ordinary income, or as capital gain but subject to tax at a higher rate (to the extent not offset by capital losses). §1231, §1245, §1250, §751(c). Importantly, these attributes derived from tax benefits previously obtained by the transferor will be relevant in a transfer of the Partnership interest, whether or not to a related party, to understand whether the income can be appropriately offset by a capital loss, as well as to ensure the same income is not taxed again on ultimate sale of Property by the Partnership.
As noted above, characterization of the income recognized on liquidation as capital is critical to our basis quest. Section 1239 operates to convert what would be capital gain income into ordinary income if, in the hands of the related party transferee, the property transferred is of a character subject to the allowance for depreciation under §167, which would also include an amortizable §197 intangible. For this purpose, related parties are (1) a person and an entity in which the person owns more than 50%, (2) a taxpayer and trust in which the taxpayer or taxpayer's spouse is a beneficiary, and (3) an executor and beneficiary of an estate (except with respect to gain recognized on satisfaction of a pecuniary bequest). Note, then, that there may be instances where a transfer of depreciable property occurs to someone “related,” in the general meaning of the term, but not a “related party” within the meaning of §1239 (for example, in our scenario, if Company were owned only 49% by Trust at the time of liquidation). However, when §1239 applies, what would be capital gain income to Company on transfer of the interest in Partnership to Trust is recharacterized as ordinary income and, as a result, the capital loss arising from the “excess” outside basis described above would not offset the ordinary income on liquidation of Company. Where this result occurs, the entire amount of income is recharacterized as ordinary to the transferor, rather than just the “recapture” portion attributed to prior tax benefits received by the transferor.
By its own terms, §1239 should not apply to the deemed exchange of Partnership interest by Company because the Partnership interest itself is not a depreciable asset, even if Property owned by Partnership is. At least one private letter ruling, decided under prior law, supports the position that a partnership interest is an intangible asset, “the useful life of which is not limited,” and not a depreciable asset that becomes subject to §1239. PLR 8052086. Likewise, a proposed version of modifications to §1239 that would have expressly brought partnerships into the purview of §1239 based on unrealized gain in the partnership's depreciable property, was not enacted. H.R. Rep. No. 110-431 (2007). Nonetheless, there are other instances where the underlying tax attributes of a partnership's assets are relevant to determine the character of the income on sale or exchange of a partnership interest, as if the partner sold its proportionate share of the partnership's assets. §751.
Note that §1239 focuses on the transferee's potential income tax relationship with the transferred asset to dictate the character of the transferor's income from the transfer, rather than focusing on the transferor's actual tax benefits and relationship to the transferred asset. In other words, even if the transferor had not taken any depreciation and would not otherwise have any income subject to recapture, the transfer of the asset which, in the hands of the related party transferee could be depreciated, causes what would otherwise be characterized as capital gain income to the transferor to be recharacterized as ordinary income. It is clear from existing guidance that, if the entity is not taxed as a partnership, or the tax partnership were to terminate on the transfer of the partnership interest (for example 100% of the partnership is owned by a sole partner or one partner acquires 100% of the partnership from the other partner(s)), the transferee would be treated as receiving the underlying assets of the partnership (the depreciable real estate), not a partnership interest. Rev. Rul. 72-172.
This debate should recall the tensions between “entity” vs. “aggregate” theory approaches to partnership taxation. While a full investigation into §1239 is beyond the scope of this brief article and requires its own full case file inquiry, the potential application of §1239 and risk of recharacterization of income remains a critical point in liquidation of Company.
Outside Basis Adjustment to Partnership
Assuming the transfer of Partnership interest to Trust by Company successfully remains outside the reach of §1239, Trust would have in the same tax year a capital gain (from the deemed exchange on liquidation) and an offsetting capital loss from the excess basis. Again, any income recharacterized due to recapture must be considered and may not benefit from offsetting capital loss. Following the liquidation, Trust will be the new partner of Partnership and succeed to Company's 75% interest in Partnership. Because Trust is deemed to have acquired its interest in Partnership in an “exchange” for Trust's stock in Company, Trust's income tax basis in the 75% interest in Partnership is equal to its cost, or the fair market value of Partnership interest on the date of the liquidation. §331, §334(a). Where Trust started with an at-death §1014 basis adjustment with respect to Company stock, Trust now holds, through the liquidation, Company's 75% interest in Partnership with a fair market value “outside basis.”
Section 754 Election and an (Almost) Reportable Transaction
When a §754 election has been made or is in effect on a transfer of a partnership interest, the “inside” basis of the transferee partner's proportionate share of the partnership's assets is adjusted to match the transferee partner's outside basis in the partnership. §743(b), §754. As noted previously, the liquidation of Company and distribution of Partnership interest from Company to Trust is considered an exchange of Partnership interest. §761(e)(3). In this case, assuming a proper §754 election is made or is in effect for Partnership, the deemed exchange would result in an adjustment to the inside basis of Trust's “share” of Partnership's assets, with the result that Trust would be in a position comparable to the position it would have been in had decedent died with Trust owning Partnership interest directly (not through Company) and a §754 election was made or was in effect with respect to Partnership on decedent's death.
Although these adjustments are mechanical in nature with a §754 election, the language of recently finalized Treasury Regulations involving partnership basis adjustments in related party transactions would have made these adjustments“reportable transactions” subject to disclosure if the basis increase would exceed by at least $10 million the amount of gain recognized, as a “substantially similar” transaction to the listed transactions of interest, even though the above described structure may not be the type of abusive transaction these regulations were designed to target. Treas. Regs. §1.6011-18(d)(2). However, in Notice 2025-23, released on April 17, 2025, the IRS and Treasury Department announced their intent to withdraw these regulations retroactively which would have made this a reportable transaction, and so it appears that this concern was short-lived.
The Critical Inquiry
Through the above-described Company liquidation and §754 election with respect to Partnership, Trust is able to find a similar basis for its interest in Partnership, and with respect to Partnership's underlying assets, as if Trust had owned Partnership interest directly at decedent's death and recover what might have otherwise been a lost basis adjustment opportunity. However, the history behind the enactment and revision of §1239 was to address a potential abuse between related taxpayers, wherein a transferor could incur a capital gain and, as a result, the related transferee would receive an asset with a fair market value (cost) basis, and be in a position to subsequently reduce ordinary income with depreciation from the new cost basis. H.R. Rep. No. 586, 82d Cong., 1st Sess., C.B. 1951-2. This is, in effect, the outcome of the basis adjustments that occur following Trust's §1014 basis adjustment in Company's stock on transfer of the 75% interest in Partnership by Company to Trust and the §754 election with respect to Partnership.
Thus, while we may be onto something, and the inside basis adjustment has been hiding all along in the S corporation's partnership investment, the case to find a post-death inside basis adjustment for assets in an S corporation at the decedent's death is not yet completely solved, and an examination of §1239 needs its own deeper case file inquiry before we can declare Case Closed!
Originally published by Bloomberg Tax
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
