C corporation stock does get a step-up in basis at death, but the corporation’s underlying assets do not. Under Section 1014, the stock passes to the estate or heirs at its fair market value on the date of death, wiping out pre-death appreciation for capital gains purposes.1Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent The corporation itself, though, keeps its original cost basis in real estate, equipment, and everything else it owns. That single-sided step-up is the whole story, and it is what turns what looks like a clean tax reset into an expensive puzzle for heirs.
What the Stock Step-Up Actually Gives You
If a shareholder paid $100,000 for stock now worth $2 million on the date of death, the heir’s new basis is $2 million. Sell the shares for $2 million shortly after death and there is little or no capital gain. That is the promise of Section 1014, and for stock held directly by the decedent, it works exactly as advertised.
The executor can use the date-of-death value or, when it would reduce the overall estate tax, the value six months later under the alternate valuation date election.2Office of the Law Revision Counsel. 26 USC 2032 – Alternate Valuation The alternate date is only available when it lowers the estate tax owed, which in practice means values have to have fallen since death.
Whichever date is chosen, a formal valuation of the closely held stock is essential. The IRS can impose a 20% accuracy-related penalty on any tax underpayment caused by a substantial estate valuation misstatement.3Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The stock value fixed on the estate tax return also sets the ceiling for the heir’s basis going forward, so this number matters long after the estate is closed.
Why the Corporation’s Assets Don’t Get Stepped Up
A C corporation is its own taxpayer, separate from its shareholders. Its basis in the assets it owns is what the corporation paid for them, and the death of a shareholder, even a 100% owner, doesn’t change that. The stepped-up basis lives at the shareholder level. The old basis lives inside the corporation. Nothing in the code bridges the two.
Partnerships work differently. When a partner dies, the partnership can make a Section 754 election, which triggers a Section 743(b) adjustment aligning the inside basis of partnership assets with the new outside basis of the deceased partner’s interest. The adjustment is specific to the successor partner and doesn’t touch anyone else’s share. C corporations have no equivalent mechanism.
S corporations sit in between. They also lack the 754 adjustment, so inside asset basis stays frozen at death. But because S corporation income flows through to shareholders, there is no corporate-level tax when appreciated assets are sold. Heirs who ultimately liquidate through an S corporation face one layer of tax; heirs liquidating through a C corporation face two.
The Trapped Gain Problem
The gap between the heir’s high stock basis and the corporation’s low asset basis is invisible on paper. It surfaces the moment the corporation sells assets and tries to move cash to the shareholders.
Take an heir who inherits stock worth $5 million, with a stepped-up basis of $5 million. The corporation’s assets have a historical cost basis of $1 million. The corporation sells everything for $5 million and recognizes $4 million in gain. Federal corporate income tax at 21% is $840,000, leaving $4.16 million available for distribution.
The heir then receives a $4.16 million liquidating distribution against a $5 million stock basis, producing a capital loss of $840,000. That loss can offset other capital gains, but if the heir has no other gains, only $3,000 of excess capital losses can be deducted against ordinary income each year. The step-up was supposed to eliminate tax on $4 million of appreciation. The corporation paid $840,000 anyway, and the heir has no easy way to recover it.
State corporate income taxes make it worse. Many states add their own corporate tax on top of the 21% federal rate, pushing the combined burden to 25% or higher depending on location. Every dollar of state tax further widens the gap between sale proceeds and what actually reaches the heirs.
The 3.8% Net Investment Income Tax
Heirs with significant income face a 3.8% net investment income tax on capital gains, dividends, and other investment income above $200,000 for single filers or $250,000 for joint filers. These thresholds are not adjusted for inflation.4Internal Revenue Service. Questions and Answers on the Net Investment Income Tax The NIIT doesn’t apply at the corporate level, but it can add another shareholder-level layer on portions of a large liquidation or on investment income earned during the wind-down.
Community Property Doubles the Step-Up
Married shareholders in community property states get a meaningful edge. Under Section 1014(b)(6), when one spouse dies, both halves of community property receive a step-up to fair market value, not just the decedent’s half.1Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent If C corporation stock is held as community property, the survivor’s half is reset too. In common-law states, only the decedent’s share gets the new basis.
This applies in California, Texas, Washington, Arizona, and the other community property jurisdictions. It doesn’t fix the trapped corporate gain, but it maximizes the surviving spouse’s stock basis for any future sale or liquidation.
Form 8971 and Basis Consistency
When an estate is large enough to require a federal estate tax return (Form 706), the executor must also file Form 8971 and furnish a Schedule A to each beneficiary reporting the value of property received. The beneficiary’s basis cannot exceed the value reported on Schedule A. This is the basis consistency rule under Section 1014(f).5Internal Revenue Service. Instructions for Form 8971 and Schedule A
Form 8971 is due within 30 days after the Form 706 is filed, or 30 days after its due date including extensions, whichever comes first.5Internal Revenue Service. Instructions for Form 8971 and Schedule A Supplemental filings for additional property are due by January 31 of the following year.
Estates below the federal estate tax filing threshold ($15 million per individual for 2026) generally are not required to file Form 8971. Even then, the heir should document fair market value with a professional appraisal near the date of death. The IRS can challenge a claimed basis years later, and the appraisal is what protects it.
Ways To Reduce the Damage
No single move erases the trapped-gain problem. Several strategies can shrink it materially, and the right one depends on whether the shareholder is still alive and can plan ahead, whether the business will be sold or kept, and who the likely buyer is.
Elect S Corporation Status Before Death
Converting to an S corporation is the most widely used strategy. The election is made by filing Form 2553, generally no later than two months and 15 days into the tax year it takes effect.6Internal Revenue Service. Instructions for Form 2553 Once effective, income flows through to shareholders and future asset sales escape corporate-level income tax.
The catch is the built-in gains tax under Section 1374. Appreciation that existed in corporate assets on the date of the S election is subject to a corporate-level tax at 21% if those assets are sold within a five-year recognition period.7Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains Hold the appreciated assets for the full five years and the built-in gains tax falls away. Sell inside the window and the shareholder is right back where a straight C corporation liquidation would have left them.
Timing decides the outcome. A conversion five or more years ahead of an expected death or sale clears the built-in gains window entirely. Eligibility also matters: no more than 100 shareholders, one class of stock, and no partnership or C corporation shareholders.
Sell the Stock, Not the Assets
If cashing out is the goal, selling the stock directly is usually the most tax-efficient path. The heir’s stepped-up basis matches the sale price, so gain is minimal, and the corporation never sells anything, so no corporate-level tax fires.
The buyer inherits the corporation’s low asset basis and will face the trapped-gain problem down the road. Buyers know this and typically negotiate a discount to reflect the embedded tax liability. Even at a discount, the heir usually nets more than a corporate asset sale followed by liquidation would produce.
Buyers sometimes push for a Section 338(h)(10) election, which treats a stock purchase as an asset acquisition for tax purposes. That election is only available when the target is part of a consolidated group, an affiliated subsidiary, or an S corporation. A standalone closely held C corporation doesn’t qualify, which is why the stock-versus-asset structure gets so heavily negotiated in these deals.
Section 303 Redemptions for Estate Expenses
When C corporation stock makes up more than 35% of the adjusted gross estate, Section 303 lets the corporation redeem enough stock to cover estate taxes, funeral expenses, and administration costs, and the redemption is treated as a sale or exchange rather than a dividend.8Office of the Law Revision Counsel. 26 USC 303 – Distributions in Redemption of Stock To Pay Death Taxes, Etc. Because the heir has a stepped-up basis in the redeemed shares, little or no gain results. Section 303 doesn’t touch the broader trapped-gain issue, but it pulls cash out of the corporation to pay estate expenses without triggering dividend treatment.
Section 1031 Exchanges and Life Insurance
When the corporation holds appreciated real estate, a Section 1031 like-kind exchange can swap it for replacement real property without recognizing gain.9Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment The replacement property carries over the old basis, so the tax is deferred rather than erased. Section 1031 applies only to real property held for business use or investment, not to equipment or inventory.
Life insurance is a liquidity tool rather than a tax fix. An irrevocable life insurance trust can hold a policy on the shareholder’s life outside the taxable estate. The tax-free death benefit gives the family cash to cover the corporate-level tax on a later asset sale, or simply to replace what double taxation takes.