What Happens when the Principal Owner of a Sub S Corp Dies?

By Ari Mushell, J.D.

What Happens when the Principal Owner of a Sub S Corp Dies?

By Ari Mushell, J.D.

S corporations, so called because of their position under Subchapter S, Chapter 1, of the Internal Revenue Code, can face various challenges. One challenge occurs when the S corporation principal dies. What happens next? Because the S corporation is legally distinct from its owner, it does not die when the owner dies. Instead, it retains its obligations and liabilities. However, it is good business sense to prepare for such a scenario ahead of time.

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S Corporations

S corporations, sometimes referred to as "sub S corporations," are typically closely held entities that issue stock to a limited number of individuals. They can have up to 100 shareholders, although they often have only a handful. S corporations sometimes have one shareholder who manages the affairs of the business while the other shareholders act as silent investors.

S corporations enjoy a pass-through taxation scheme, wherein profits earned by the corporation pass through to the shareholders and are then taxed at the shareholder level. Profits are not taxed at the corporate level, avoiding double taxation. Shareholders also do not pay self-employment tax.

Qualified Owner vs. Nonqualified Owner

Upon the death of the S corporation's principal, the decedent's shares pass to the individual's estate—not to other shareholders. If the estate or heir is a qualified owner—meaning an individual, estate, exempt organization, or a certain kind of trust—it can carry on the business as before. If, however, the principal's heir is a nonqualified owner, the S corporation becomes a C corporation.

If the death of the principal causes the stock to transfer to several people so that the shareholder amount increases above the 100-shareholder threshold, then the owners do not qualify. This would result in the business losing its S corporation status.

Surviving Heirs

Upon the principle's death and unless provided in a will otherwise, the shares pass to heirs, who may or may not be interested in the business. The heirs may have little business acumen yet are shareholders alongside existing shareholders. Such a circumstance can be very difficult for all involved. To guard against this, it is best to have a succession plan.

Buy/Sell Agreement

One effective method to ensure a smooth transition is to have a buy/sell agreement and key person life insurance. In this scenario, the principle implements a succession plan that involves the purchase of life insurance to be paid to a key person in the company. The shareholders agree that, upon the passing of the principle, they will purchase the shares then held by the principle's heirs. The shareholders, through the key person, use the proceeds of the life insurance for this purpose and the heirs walk away with cash.

A buy/sell agreement is only possible when the company consists of more than one shareholder. If there is a principle who owns 100 percent of the shares, it is not possible to do a buy/sell agreement because there are no other shareholders who can agree to buy shares. In such a case, the business passes to a surviving heir who may need to sell the company.

If you own or are involved in an S corporation, it is best for all involved to create a succession plan that would unfold if the owner died. Such a plan can provide for a smooth transition to the successors. Not having a plan can invite a difficult situation.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.