Cost Basis For S-Corp Gain For Individual Shareholders?

Question

In Year 1 there is one owner of 500 shares in S-Corp with value of $50,000.
In Year 2 the 1st owner gives 100 shares each to 4 children resulting in 5 owners of S-corp with a value of $100,000
In Year 3 1st owner dies and 100 shares are given 25 each to children, Value of S-Corp is $200,000 at this time.
In Year 4 S-corp sells all assets for $1,000,000 for a gain within the S-Corp of $950,000. What is the basis for capital gains to the 4 children? One-fourth of the S-Corp gain ($237,500) or is it based on the value of their 125 shares which are now worth $30,000. Is their gain $237,500 - $30,000 (Share Cost) or $207,500?
Advantage is avoiding capital gains tax on the $237,500 vs only $207,500.

Answer 1

The basis for the first 100 shares is $10k for each recipient. The recipients of the gift get the pass-through basis; the total value doesn't matter.

(If gift tax was paid on the gift, it is adjusted upward for the Gift Tax attributable to the gain in value. Since you didn't mention gift tax, I'll assume that none was due or paid.)

When the owner dies, the beneficiaries get the stepped-up basis on the date of death. The 100 shares represent 20% of the value of the corp, or $40k total. Each heir gets 1/4 of that or $10k each in stepped-up basis for those shares.

Each heir now has 125 shares with a combined basis of $20k each. When the corp is sold, each shareholder gets $250k and has a gain of $230k.

I'm not sure where you got your numbers from, but I believe that mine are correct.

Here's where it gets a bit tricky. If, on the date of sale, they didn't hold those 25 shares that they received on the death of the other owner for MORE than one year, that portion of the gain will be short-term capital gain and will be taxed at the marginal rate. Only shares that were held for more than one year (the first gifted shares for sure, and the bequested shares if they were owned for OVER one year) are treated as long-term capital gains. Sorting THAT out would be a bit messy if they held those last shares for one year or less.

Answer 2

Their starting total basis is the death value of 200,000. The inside gain of 950,000 adds to their outside basis to make it 1,150,000. Any distributions reduce basis - assuming none then basis for each is 287,500. If they sold the S corp stock at any time after death the sale gain or loss would be long term - all inherited property is long term under the IRS code.