The hidden tax risks in business succession plans and how to avoid them

Most business owners believe they have succession planning under control. There is a trust. There is an entity structure. There may even be a buy-sell agreement in place. On paper, everything looks orderly.

But succession planning often breaks down at the intersection of estate planning and income tax. The risk is not academic—it surfaces later, after a death or during a leadership transition, when the business is already under pressure. By then, the options are limited. Three concepts drive most of these surprises: step-up in basis, entity structure, and income in respect of a decedent (IRD).

Step-Up in Basis: Powerful, but Not Automatic

Some owners know the phrase “step-up in basis.” Many don’t. And that gap can mean a six- or seven-figure difference in taxes.

A step-up in basis can reset an asset’s tax basis to its fair market value at death. When it applies, it can eliminate capital gain on a future sale, increase depreciation, and significantly reduce income taxes for heirs. For owners of appreciated businesses or real estate, it can be one of the most valuable outcomes in the tax system.

But the step-up is neither automatic nor universal. It generally applies only to assets actually included in the taxable estate, and business ownership is rarely that simple. Prior transfers, retained interests, and layered ownership structures can complicate or limit the adjustment. Even when a step-up applies on paper, it may not solve the real-world problem if the business is illiquid or if a post-death transaction forces recognition of income shortly thereafter.

In succession planning, the step-up is a powerful tool, but only if the structure allows it to work.

Not All Entities Are the Same

One of the most common, and costly, assumptions business owners make is that once a step-up is achieved, the tax result will be the same regardless of entity structure. In reality, entity choice often determines whether a step-up delivers real value or only the appearance of it.

Two businesses with identical value can produce dramatically different tax outcomes at death solely because one is an LLC taxed as a partnership and the other is an S corporation.

In an LLC or partnership, the ownership interest may receive a step-up at death, but the underlying assets inside the entity do not automatically adjust. Unless the entity takes affirmative steps, heirs may own a “stepped-up” interest while continuing to receive tax allocations based on historic asset values. The result is missed depreciation, confusing K-1s, and taxable income that does not reflect economic reality.

In an S corporation, the mismatch can be even more frustrating. While the stock may receive a step-up, the corporation’s assets do not. There is no built-in mechanism to align asset basis with ownership basis. As a result, heirs can inherit an interest that appears tax-efficient and still face substantial taxable gain when the business sells appreciated assets.

For business owners, the takeaway is straightforward: entity selection is not just a formation decision, it is a succession decision.

IRD: The Bucket That Never Gets a Step-Up

Even well-designed succession plans often overlook income in respect of a decedent, or IRD. This is income the owner earned, or was entitled to, before death but had not yet received.

IRD does not receive a step-up in basis. When it is eventually collected, it is fully taxable to the recipient, even though the owner has passed away. Death does not reset the tax clock.

For business owners, IRD often hides in places they do not expect: deferred payments, accrued income, installment obligations, or contractual buyout arrangements. Families are frequently surprised to learn that assets they assumed would be “tax-free” after death are instead taxable—sometimes years later, long after the succession transition feels complete.

IRD is particularly dangerous because it surfaces quietly. The documents may look clean. The ownership transfer may go smoothly. And then a tax bill arrives, untethered from any new cash.

The Real Choice Owners Face

Succession planning forces business owners to make trade-offs, whether they realize it or not. You can prioritize estate tax minimization, income tax efficiency, liquidity, or control—but rarely all four.

Understanding how step-up in basis actually works, why entity structure matters, and where IRD lives allows owners to make those trade-offs intentionally rather than by accident.

The strongest succession plans are not document driven. They are built by coordinating estate planning, income tax consequences, and business operations well before a triggering event forces decisions under pressure. For owners who want their businesses to survive and thrive beyond them, that coordination is not extra planning. It is the plan.

Minna C. Yang is a director in Fennemore’s Tax practice group in the firm’s Sacramento office. A CPA-attorney with more than 30 years of experience, Minna advises business owners, real estate investors, and multi-generational enterprises on tax-efficient strategies for complex transactions and long-term planning. She can be reached at myang@fennemorelaw.com.