When an S corporation shareholder dies, the heir’s stock gets a step-up in basis to fair market value at the date of death, the same treatment any inherited capital asset receives under IRC Section 1014.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent The assets sitting inside the corporation do not. That split is the whole story, and most of the planning trouble with inherited S corp stock traces back to it.
What Steps Up and What Doesn’t
Two basis figures live in every S corporation, and they move independently.
The first is stock basis: what the shareholder personally has invested in the shares. It starts at purchase price, goes up with income reported on the K-1, and comes down with losses, distributions, and nondeductible expenses.2Internal Revenue Service. S Corporation Stock and Debt Basis Stock basis controls how much of a distribution the shareholder can take tax-free and how much gain or loss they recognize on a sale.
The second is corporate asset basis: what the company itself carries on its books for each piece of property it owns. A building bought for $800,000 sits on the corporate ledger at $800,000, reduced by depreciation over time. The corporation uses that figure for its own depreciation deductions and for gain or loss when it sells the property. It belongs to the entity and has nothing to do with who owns the stock.
At death, only the first figure resets. The heir’s stock basis becomes the fair market value on the date of death, or the value six months later if the executor elects the alternate valuation date under Section 2032.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent All of the appreciation the decedent built up during their lifetime disappears from the tax base. If the estate files Form 706, the value reported there sets a ceiling on the basis the heir can claim.3Internal Revenue Service. FAQ on Inherited Property and Taxable Income Because closely held S corporation shares don’t have a market quote, a formal appraisal is usually required, and the IRS follows the framework in Revenue Ruling 59-60.4Internal Revenue Service. S Corporation Valuation Job Aid for IRS Valuation Professionals
The death of a shareholder is not a taxable event for the corporation itself, so the buildings, equipment, inventory, and receivables inside the company keep the same depreciated values they had the day before. Tax professionals call the result an inside-outside basis difference: the heir’s outside stock basis is high and fresh, while inside asset basis stays low and old. That gap has real annual consequences. Because the corporation’s depreciation deductions run off old numbers, it reports higher taxable income on Form 1120-S than it would with revalued assets.5Internal Revenue Service. Form 1120-S – U.S. Income Tax Return for an S Corporation That inflated income flows through to the heir on Schedule E and raises their personal tax bill year after year.6Internal Revenue Service. About Schedule E (Form 1040)
Partnerships handle this better. Under a Section 754 election, a partnership can adjust the inside basis of its assets to match a new partner’s stepped-up outside basis, wiping out the gap for that partner.7eCFR. 26 CFR 1.743-1 – Optional Adjustment to Basis of Partnership Property The tax code gives S corporations no equivalent. If the entity form is still an open question, this is a reason to think twice about the S corporation.
The IRD Reduction That Shrinks the Step-Up
The step-up is not as clean as it first looks. Section 1367(b)(4) requires the heir to reduce their stepped-up stock basis by the portion of value attributable to income in respect of a decedent, or IRD.8Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders, Etc. IRD covers income the decedent had earned but not yet been taxed on. For an S corporation, that usually means the heir’s share of unrealized accounts receivable, accrued but unpaid compensation, and similar items.
The statute treats the heir as if the decedent had held those items directly. The heir includes them in gross income when received, and the ordinary or capital character carries over from the decedent.9Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents Say the stock is worth $1 million, and $200,000 of that reflects uncollected receivables. The heir’s stepped-up basis drops to $800,000, and the $200,000 in receivables shows up as ordinary income when the company collects them. Sell the stock right away for $1 million and the heir reports a $200,000 gain, not the zero they expected. This adjustment is often missed, and missing it consistently understates the tax cost of inheriting S corporation stock.
Community Property States Get a Bigger Step-Up
Married shareholders in community property states have an extra advantage. Section 1014(b)(6) steps up both halves of community property when one spouse dies, not just the decedent’s half.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent If the S corporation stock was acquired during the marriage and held as community property, the surviving spouse’s own half also gets a new basis. In a common-law state, only the decedent’s share steps up and the surviving spouse keeps their original basis. In states like California, Texas, or Washington, that single distinction can save hundreds of thousands of dollars in future capital gains tax.
Keeping the S Election Alive When Stock Goes Into a Trust
An S corporation can only have eligible shareholders. Individuals, estates, and certain qualifying trusts count. Corporations, partnerships, and nonresident aliens do not.10Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined Stock often lands in a trust created under the decedent’s will or revocable living trust, and the code gives that trust a two-year grace period to qualify as an eligible shareholder.11eCFR. 26 CFR 1.1361-1 – S Corporation Defined After that window, the S election terminates automatically unless the trust qualifies on its own terms.
To continue past the grace period, the trust has to qualify as either a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT), with the corresponding election filed within two months and 16 days after the stock transfers in.10Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined A QSST fits a trust with a single income beneficiary who receives all income currently. An ESBT allows multiple beneficiaries and discretionary distributions, but the S corporation income in the ESBT portion is taxed at the highest individual rate rather than passing through at the beneficiary’s own rate.
Missing this deadline is expensive. A termination throws the company back into C corporation status from the date of termination, and the entity cannot re-elect S status for five taxable years without IRS consent.12Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination The IRS can grant relief for inadvertent terminations through a private letter ruling, but the fees are substantial. Getting the trust election right at the start costs far less than repairing a blown S election later.
Options for Getting the Assets Stepped Up Too
Because the inside asset basis doesn’t step up on its own, heirs and advisors sometimes engineer a transaction that revalues the assets. None are cheap, and the right choice depends on the buyer and the balance sheet.
Section 338(h)(10) Election
When an heir sells S corporation stock to a corporate buyer, the parties can jointly elect under Section 338(h)(10) to treat the stock sale as if the corporation had sold all its assets and liquidated.13Office of the Law Revision Counsel. 26 U.S. Code 338 – Certain Stock Purchases Treated as Asset Acquisitions The buyer picks up a fully stepped-up asset basis and depreciates and amortizes the purchase price going forward. The seller recognizes gain on the deemed asset sale, but the heir’s stepped-up stock basis absorbs most of it. The election requires a corporate purchaser, so individual buyers and partnership-structured private equity funds are out.
Section 336(e) Election
Section 336(e) uses a similar mechanic without the corporate-buyer requirement. If shareholders sell or distribute at least 80% of the stock in a qualifying disposition, the selling group can unilaterally elect asset-sale treatment. That opens the same result to individual buyers and pass-through acquirers.
Corporate Liquidation
A full liquidation is the most direct way to reset asset basis and often the most costly. The corporation recognizes gain on each asset as if sold at fair market value, and that gain flows through to the shareholder. The heir’s stepped-up stock basis offsets the stock side, but character can mismatch badly: ordinary income from inventory and receivables meets a capital loss on the stock, and capital losses only offset capital gains plus $3,000 of ordinary income per year. Liquidation works best when the corporate assets are mostly capital in character or the overall gain is small next to the step-up.
Selling vs. Holding the Inherited Stock
An heir who sells shortly after inheriting the stock owes little or no capital gains tax on the stock itself, because the sale price is close to the stepped-up basis. Inherited property is automatically long-term regardless of how quickly the heir sells, so any gain qualifies for long-term capital gains rates.14Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property The sale goes on Form 8949 with “INHERITED” in the date-acquired column and carries to Schedule D.15Internal Revenue Service. 2025 Instructions for Form 8949 Remember the IRD haircut: value attributable to receivables and other unrecognized income items reduces the basis and produces ordinary gain.
An heir who holds the stock benefits from the step-up in a different way. Distributions from an S corporation are tax-free up to the shareholder’s stock basis.2Internal Revenue Service. S Corporation Stock and Debt Basis With a $500,000 stepped-up basis, the heir can take up to $500,000 in distributions before any amount is taxed as a capital gain. The tradeoff is the annual drag from low corporate depreciation, which slowly eats into the practical value of the step-up. Anyone planning to hold the business long-term should build that ongoing tax cost into the decision about whether keeping the shares beats selling them at a stepped-up price.