Sometimes it’s difficult to decide which type of buy sell agreement to recommend when dealing with business succession planning for C Corporations. Should it be a stock redemption plan funded with employer owned insurance or a cross purchase plan funded by cross owned insurance?
Using a cross purchase plan, the surviving shareholder gets a 100% cost basis increase when purchasing the shares from the estate of the deceased shareholder. On the other hand, the surviving shareholder gets a 0% cost basis increase when using a stock redemption agreement.
Many retail, wholesale, and manufacturing C Corps retain significant earnings and profits (E&P) on their balance sheets for business purposes. These E&P can normally be reduced only by a taxable dividend to the shareholders. However, these accumulated E&P can be distributed tax-free as part of a proportional stock redemption under IRC Section 312(n)(7). This transaction would be a desirable tax accounting strategy if it could be accomplished.
Given a choice between both positive results, is there a way we can get BOTH a 100% cost basis increase for the surviving shareholder AND a tax-free reduction of E&P under IRC Section 312(n)(7)? The answer is YES, and the strategy to accomplish both is a “Wait and See” Optional Buy Sell Agreement ( Click to learn about Buy-Sell Planning for QPSC, S Corp, and LLC Professional Practice Owners) coupled with cross ownership of the life insurance policies. In a “wait and see” plan Option #1 is cross purchase, Option #2 is stock redemption, and mandatory Option 3# is back to cross purchase.
Let’s take a look at a simple case study to illustrate the effectiveness of this “wait and see” plan…
Facts of case: Assume a C Corp is owned 50-50 by Albert and Barbara and has a fair market value for buy sell purposes of $4,000,000 ($2,000,000 each for Albert and Barbara). The C Corp has a book value of $3,000,000 which consists of $2,800,000 of retained E&P and $200,000 of original cost basis contributed equally by Albert and Barbara when they formed the company many years ago.
The shareholders and the corporation enter into a “Wait and See” Optional Buy Sell Agreement. They purchase $2,000,000 of life insurance each with Albert as the owner and beneficiary on Barbara’s life and Barbara as the owner and beneficiary on Albert’s life (cross-ownership). The company provides taxable bonus compensation to the shareholder-employees to pay the annual premium.
At Barbara’s death, the transaction sequence could proceed as follows for a 50-50 shareholder case:
- Albert collects the $2,000,000 income tax-free life insurance death proceeds on Barbara’s life (cross ownership).
- C Corp and Albert waive Option #1 (cross purchase) and select Option #2 (stock redemption). The corporation redeems Barbara’s stock in exchange for a short-term NOTE PAYABLE to Barbara’s estate using the short term Applicable Federal Rate (AFR) as the interest rate.
- This tax-free redemption reduces the corporation’s balance sheet E&P by 50% ($1,400,000) for tax accounting purposes under IRC Section 312(n)(7).
- A uses the tax-free life insurance proceeds to make a CAPITAL CONTRIBUTION (“paid-in” capital on the balance sheet) to the corporation of $2,000,000. This capital contribution increases Albert’s cost basis in the shares by 100% of the contribution. Albert’s cost basis is now $100,000 (original basis) plus $2,000,000 (paid-in capital) = $2,100,000.
- The corporation uses the $2,000,000 capital contribution to pay off the note and minimal interest to Barbara’s estate.
- Barbara’s estate transfers this cash payoff through the estate to the surviving spouse and family of Barbara to maintain their lifestyle.
- Albert is now the 100% owner of the C Corp with a cost basis of $2,100,000 for purposes of any future lifetime sale of the business to a third party. The potential capital gain on this future sale is reduced significantly because Albert’s cost basis was increased to $2,100,000 rather than only $100,000 if a stock redemption using employer-owned life insurance had been utilized.
BEFORE STOCK REDEMPTION
(Albert 50% Shareholder, Barbara 50% Shareholder)
SURVIVING STOCKHOLDER (ALBERT) COST BASIS
Contact BSMG Advanced Sales for a discussion of this ‘Wait and See” concept for your C Corp clients. We can provide a buy sell agreement template and sample buy sell agreement that the client’s attorney can use as a guide to draft the actual document.
Russell E. Towers JD, CLU, ChFC
Vice President-Business & Estate Planning
Brokers’ Service Marketing Group