Even though the S corporation’s assets do not receive a basis step-up upon a shareholder’s death, the deceased shareholder’s estate may be able to leverage the stepped-up basis of the deceased shareholder’s stock to reduce tax on the sale of the assets. To do so, the corporation must liquidate and distribute assets in the year of the deceased shareholder’s death. As discussed in Distributions from S Corporations, liquidating distribution is treated as a sale—a payment in exchange for the deceased shareholder’s stock.
At the corporate level, this deemed sale results in gain to the S corporation, which is passed through to the estate of the deceased shareholder. When added to the basis step-up to fair market value by virtue of the deceased shareholder’s death under Code § 1014, the deemed sale increases the basis of the deceased shareholder’s stock in excess of the fair market value. This gives the deceased shareholder’s estate an extra amount of basis.
Because the deceased shareholder’s basis exceeds the fair market value of the stock (due to the enhanced basis increase), the estate is treated as having a capital loss. This capital loss offsets the estate’s gain from the deemed sale (a wash for capital gain purposes). The estate’s basis in property received as part of the liquidation equals the property’s fair market value. This effectively gives the estate a full basis step-up in the S corporation’s underlying assets even though the deceased shareholder only owned stock (and not the underlying assets) at the time of death.
Whether this liquidation technique will be beneficial depends on the circumstances, including whether liquidation of the S corporation is a feasible alternative. This technique is often helpful in situations where the S corporation’s assets need to be sold to pay debts, estate taxes, or to fund distributions. If there are multiple shareholders, however, the tax consequences to the surviving shareholders must be analyzed separately since they will not have the benefit of a basis step-up in their S corporation stock.
 I.R.C. § 336.
 I.R.C. § 1366(a).
 I.R.C. § 1367(a)(1).
 I.R.C. § 334.