Stock Redemption Buy Sell Agreement

In an entity purchase buy sell agreements, also known as a stock redemption for corporations, the business itself will enter into an agreement with each owner to purchase a deceased owner’s business interest. To accomplish this, the business purchases a life insurance policy on each owner’s life in an amount that equals the value of his or her respective ownership interest in the business. The entity then agrees to purchase (or redeem) all of the interest of a deceased owner and the owners agree to sell their interests to the entity.

Shareholder Consequences

No Basis Increase. An entity purchase buy-sell arrangement with a C corporation does not increase the basis of the remaining shareholders’ stock. However, life insurance proceeds received by an S corporation will increase the basis of its shareholders’ stock.2

Possible Ordinary Income Treatment. Ordinarily, amounts received in a stock redemption are treated as a dividend to the shareholder that is having his or her stock redeemed. If treated as a dividend, the entire redemption amount (not just the gain) is taxed as ordinary income. However, if certain requirements are met, the redemption can be taxed as a sale. Taxation as a sale is usually beneficial because only the gain (i.e., the redemption price reduced by basis) is subject to tax at capital gain rates. When a redemption occurs at death, there is generally no gain to report because the deceased shareholder’s estate received a basis step-up.

Risk of Corporate Creditors. Life insurance purchased by a corporation to fund a buy-sell arrangement will be subject to claims of the corporation’s creditors. Moreover, state law may prohibit a redemption if the corporation is insolvent or lacks adequate capital.

Corporate Consequences

Life Insurance Premiums are Non-Deductible. Life insurance is a common means of funding a buy-sell arrangement. Life insurance premiums paid by a corporation are not deductible.

Alternative Minimum Tax (AMT). Life insurance proceeds are ordinarily received income tax free. However, in some instances, life insurance proceeds received by a C corporation can cause an alternative minimum tax liability. The possible application of the AMT is often cited as a primary reason not to use a entity purchase buy-sell arrangement. In reality, the AMT will not be applicable in many instances or may be nominal in amount. Therefore, the possible application of the AMT should be considered on a case-by-case basis.

Increased Value of Corporation. Any assets held by an entity to fund a buy-sell arrangement increase the value of the entity. This increase in the entity’s value (including the amount of life insurance proceeds received upon an owner’s death) should be considered when determining the selling price under an entity purchase buy-sell arrangement.

Accumulated Earnings Tax. When earnings are accumulated to fund an entity purchase buy-sell arrangement (including the cash value of a life insurance policy), the corporation can become subject to the accumulated earnings tax. However, a reasonable accumulation of cash to fund a buy-sell arrangement may be considered an exception to the prohibition on excess accumulations.

How It Works

Establishing and Funding the Plan

Step 1

The Company establishes an entity purchase (stock redemption) agreement with Shareholder A & B. Each agree to sell their interest to the business at the death or other triggering event such as disability or retirement.

Step 2

The Company purchases a life insurance policy on each shareholder  equal to their share of the business. The company is the beneficiary of the policy.

The Company is the owner, beneficiary and premium payer for the insurance.

At Death

Step 3

Assuming Shareholder A dies, the insurer pays income tax-free proceeds to Company. Proceeds from an insurance policy are generally income tax free. The death benefits may be subject to state income taxes and corporate Alternative Minimum Tax (AMT).

Step 4

The Company pays the proceeds to Shareholder A’s estate in exchange for the estate’s interest in the business.


Result

The Company continues with the surviving owner in control of the business. The estate of the deceased has cash from the sale of the business interest.

Next Steps

Designing a business continuation plan is a crucial step to ensure your business remains intact at your retirement, death or other triggering event. Whether you leave your business by choice or by chance, you’ll leave your business on track and help provide for your family’s future. With an entity purchase (stock redemption) arrangement, you can help protect yourself, your business, co-owners and your family.

Talk to learn more contact an HNW Life Insurance Professional at (877) 579-9574 or submit an online request to schedule a time to discuss your particular situation.