The death of the owner of a closely held S corporation does not necessarily mean the death of the business. Since the corporation is a separate legal entity from the owner, with its own contractual obligations, the corporation lives on until formally dissolved by stockholders. However, in order for a corporation to survive the death of its principal owner and become an asset for heirs and surviving stockholders, the owner or owners must be proactive and engage in careful planning.
When the principal owner of an S corporation passes away, the shares of the corporation go to his heirs. In many cases, the deceased owner specifies who will inherit the business after his death. If he does not do so, the shares of the business enter probate, where the court will divide them according to the state's intestate probate laws. In most cases, the shares of the business will go to a surviving spouse. If there is no surviving spouse, the assets will pass to direct descendants. Failing that, the court will distribute assets to the closest living relative.
Unless the business owner has specifically provided for such in her will, the surviving shareholders do not receive the deceased owner's shares in the business. The surviving relatives generally become the new business owners and if there are other owners, the heir becomes a co-owner with them. This can be a problem when the new shareholder has little expertise or interest in running the business and brings nothing of value to the table to assist in managing the enterprise.
This is why many businesses implement buy-sell agreements, together with key person life insurance. A life insurance policy on the owner will pay a cash death benefit, tax free, to whomever the owner selects. The beneficiary can be the business itself or surviving partners. In the event of the death of the owner, the surviving partners agree to purchase the business shares from the owner's heirs. This way, the heirs receive cash rather than an ownership in a business they don't want, while the surviving owners and employees incur a minimal disruption of business activities. In the absence of surviving business partners, owners can enter buy-sell agreements with key employees. The key employee buys out the heirs with life insurance proceeds and continues to run the business as his own.
The deceased business owner's estate, through a representative, must file a final income tax return. First, the estate must file Form 1040 for the year in which she died, as well as complete returns for all years in which the deceased failed to file a return. The estate must include the decedent's share of income from the S corporation on the personal income tax return.