Entity (Stock Redemption) Buy-Sell Arrangement

In an entity arrangement, the corporation owns life insurance on the stockholders and uses the proceeds to purchase (redeem) their stock at death. Entity or stock redemption, in many ways, offers the virtues of simplicity and ease of administration. If the agreement is funded by life insurance, the corporation is the owner, premium payor, and beneficiary of a policy on the life of each stockholder. The premiums are nondeductible by the corporation.

The cash value of a life insurance policy can be recorded as an asset on the corporation’s balance sheet, which is viewed as a plus by the insureds’ accountants, and other financial professionals. When a stockholder dies, the corporation receives the insurance proceeds income tax free and uses it to redeem the stock from the estate of the deceased. The surviving stockholders don’t own the decedent’s shares, and their ownership interest in the company will increase proportionately. But generally, the shares are either cancelled or become treasury stock.

If 300 shares are owned equally by three shareholders and the corporation redeems A’s 100 shares, B and C now own 50% of the company, similar to a cross-purchase, except B and C don’t own A’s redeemed shares.

One drawback to the stock redemption arrangement is that the surviving stockholders are not able to increase the basis of their shares following redemption because the corporation has purchased the stock of the deceased stockholder.¹ This could affect the capital gain amount if the surviving shareholders ever were to gift or sell their respective shares.

If the stock redemption arrangement is selected for a family-owned corporation, the possible application of the attribution rules of Internal Revenue Code (IRC) § 318 could result in the characterization of the redemption as a taxable dividend rather than as a tax-free sale or exchange. Certain planning techniques can circumvent these rules and should be considered if a stock redemption arrangement is used for a family-owned business.

¹ It is possible to achieve an increase in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).

Practice Tip: Step-Up in Basis to Surviving Owners

Important Note (If entity is taxed as a partnership): Whether the buy-sell arrangement is structured as an entity or a cross-purchase, the surviving partnership/LLC owners receive an increase in basis for the purchase of the decedent’s interest. With an entity arrangement this is achieved by allocating the insurance proceeds received by the LLC to the capital accounts of the surviving owners, which increases their basis in the LLC. With a cross-purchase arrangement, the surviving purchasing members get a direct increase in basis equal to the price they paid for the interest purchased with the insurance proceeds. Thus, unlike with an entity purchase in the corporate setting, there is a great deal of flexibility within the partnership setting as it is possible to have a reduced number of policies with the entity purchase and still achieve an increase in basis for the survivors.

Strategy — Entity (Stock Redemption) Plan

At Inception

Business is premium payor and owner of policies on both Owners A and B and is the beneficiary of policy proceeds in the event of the death or disability of either owner.

In the Event of the Death or Disability of Owner A

If Owner A dies or becomes totally disabled, policy proceeds will be paid to Owner A or A’s estate, in return for A’s interest in the business, which will transfer to the business.

The Beneﬁts and Tax Considerations of an Entity Purchase Arrangement

The Benefits

Beneﬁts to Your Business

Beneﬁts to Surviving Owners

An entity purchase buy-sell agreement allows a smooth transition to a new ownership arrangement in the event of the death or disability of one of the owners.
The agreement can reduce the potential delays, conflicts, and expenses of the heirs of the deceased or disabled owner who are making a claim on the business.
Cash values on certain life insurance policies may be available as reserve funds for your business.²

Peace of mind that the business can continue to operate in the event of the death or disability of an owner.
In the event of disability, the buy-sell agreement will provide the proper valuation formula or amount to be paid to the disabled owner. Utilizing disability insurance as a funding vehicle in such an agreement can be an ideal way to provide the funds necessary to meet the obligation.
In the event of death, the buy-sell agreement will provide the proper valuation formula or amount to be paid to the deceased’s estate. Utilizing life insurance³ as a funding vehicle in such an agreement can be an ideal way to provide the funds necessary to meet that obligation.

² Distributions under the policy (including cash dividends and partial/full surrenders) are not subject to taxation up to the amount paid into the policy (your cost basis). If the policy is a Modiﬁed Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10% tax penalty. Access to cash values through borrowing or partial surrenders can reduce the policy’s cash value and death beneﬁt, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.
³ Recent court cases have held that life insurance death proceeds payable to a corporation to fund a stock redemption buy-sell arrangement increased the value of the stock included in the decedent shareholder’s estate. Business owners utilizing this type of arrangement should consult with their tax and legal advisors to assess the impact of this decision on their buy-sell arrangement and future planning needs.

Tax Considerations

Business

Owner(s)

Policy premiums are paid for by the business and are not tax-deductible.
If a death or disability of an owner occurs, the policy proceeds are paid to the business and are generally income tax free.
If this is a C or S Corporation, the surviving owner will not be able to increase the basis in their shares.⁴ (The surviving owner could be subject to a larger capital gains tax if the business is ever sold.)

No personal tax liabilities if a proper valuation of the business is done at the time of death; however, with a disability buyout, a disabled owner’s interest is terminated, and they will be taxed on any gain.

⁴ It is possible to achieve an increase in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).